Some people consider direct real estate investments to be an inflation hedge. But direct real estate investing and REIT (real estate investment trust) investing are two very different worlds. Are REITs also considered an inflation hedge? That’s what we’ll explore in this article.
Real estate has historically done well during inflationary periods. If the costs of construction and materials all increase as inflation increases, this causes the final product to increase as well. It isn’t just new construction that can increase with inflation. The real estate market as a whole historically increases, rents included.
However, once the Federal Reserve is well into a rate hiking campaign, real estate valuations can come down. In 2006, interest rates hit 5.25%. The median price of homes peaked in Q2 of 2006. They went up again in Q1 of 2007 before collapsing.
With the FED currently hiking interest rates again, we are seeing home prices flattening out in the second half of 2022 and even declining in some areas. The 30-year fixed rate mortgage is hovering just under 7%, helping to decrease demand.
But if we talk specifically about REITs, are they good investments during inflationary periods?
There are many different types of REITs to choose from, and all can perform differently during inflationary periods.
Different types of REITs:
Investors buying a 10-year bond are locked into a rate for ten years. If inflation goes up, these investors’ bonds aren’t going to do anything. So these bonds offer no inflation protection. If the FED is also hiking rates during this time, then new 10-year bonds will be more valuable since they’ll pay a higher rate.
For the above reasons, REITs with shorter-term leases (i.e., 1-2 years) offer more flexibility. It also allows those specific REITs to reset and attempt to keep up with the pace of inflation.
Mortgage REITs are fixed-rate, which means investors can be locked into a long-term rate. Most equity REITs do not have this issue.
REIT investors have an expectation that a REIT’s dividends will keep up with inflation. Historically, this has worked well. However, we can’t forget, at least for publicly-traded REITs, that they are still traded like stocks. As interest rates rise, they can depress the price of these REITs. So while dividends may climb with interest rates, the price of publicly-traded REITs may decline.
Historically, REITs are one of the better-performing sectors during inflationary periods. We can see this in the following image. You’ll notice REITs are in the upper right area, showing they are outperformers during periods of high inflation. In contrast, check where mortgage REITs are in the bottom left.
There’s no guarantee that if you buy a REIT for inflation protection that it will perform well. But buying certain REITs has historically worked to hedge high inflation.