Inflation, from an economic standpoint, can be defined as a prolonged increase in prices of goods and services. If inflation rises faster than your income or value of your assets, in effect, you are losing ground on your purchasing power or real (inflation adjusted) net worth. It’s no wonder that savvy investors are concerned with inflation and turn to real estate as an important piece of their investment portfolio.
Historically, commercial real estate has outpaced inflation and served as an effective inflation hedge in both high- and low-interest rate environments. In fact, since the National Council of Real Estate Investment Fiduciaries (NCREIF) began tracking private commercial real estate returns in 1978, the NCREIF Property Index (NPI)* has exceeded inflation in 32 of 38 years. The only two periods within this time frame where inflation exceeded total real estate returns were during the recession of the early 1990s and the global financial crisis of the late 2000s. (Note that the NPI tracks the core institutional-grade commercial real estate market and that the return or outcome of a specific property or investment may not match the index).
*NCREIF Property Index tracks “core” institutional-grade real estate only. NCREIF Property Index includes both income and appreciation. Investments in specific properties or projects may not match the index. In this example, inflation is measured by the Consumer Price Index (CPI).
Although property values can decrease on a year-over-year basis (as most recently witnessed during the global financial crisis) commercial real estate has historically demonstrated capital appreciation in excess of inflation over the longer term, resulting in strong real returns (after adjusting for inflation) to investors. In aggregate from 1978 through 2015, the NPI is more than six times the rate of inflation!
*Inflation as measured by the Consumer Price Index (CPI). Rates are indexed beginning at a value of 1.0 in 1978. NCREIF Property Index tracks “core” institutional-grade real estate only. NCREIF Property Index includes both income and appreciation. Investments in specific properties or projects may not match the index.
What is it about real estate that provides this resilience to inflation? For starters, real estate is said to have intrinsic value. As a property may be used to help create other goods or services, there is a level of worth within the asset itself and should command some amount of demand, and thus value, under all economic conditions. Holding all else equal, as interest rates rise, commercial property values may decrease as initial yields (cap rates) required by investors increase. However, if inflation is driven by a growing economy, then a property’s net operating income (NOI) may increase accordingly. The greater the increase in NOI of a property, the more likely that the underlying value will also increase, even if interest rates increase.
Rental rates are another contributing factor. Commercial real estate leases provide the opportunity for increases in rental rates, with shorter-term leases adjusting at the end of the lease and longer-term leases often containing contractual rent escalations over the term of the lease. Because of the fixed nature of lease terms and rates, these adjustments may not move in lockstep with inflation, but does provide a degree of ongoing adjustment. Additionally, retail rents may be partially tied to nominal sales figures, effectively moving with the broader economy.
Another lease component, expense reimbursements, further adds to real estate’s ability to pace inflation. Leases frequently pass at least some degree of the property’s operating expense burden onto its tenants. Take for instance a triple-net (“NNN”) lease, which places the tenant responsible for 100 percent of property-related expenses. As utility and maintenance expenses rise with inflation, the landlord may remain (at least partially) insulated from their effects on the property’s cash flow.
Commercial real estate’s unique combination of traits as a hard asset, which produces current cash flow, and its ability to (partially) adjust to market conditions throughout a cycle, has resulted in it being one of the preferred inflation hedge investments available. To view a variety of institutional-quality commercial real estate investment opportunities, please visit the Realized Marketplace.