Why Real Estate Is an Inflation Hedge

03.30.2022: Consumers, investors and business owners are bracing for an inflationary future. Bond investors have ratcheted up their 5- and 10-year inflation expectations as current inflation rates break 40-year records.  In light of this, we believe investors should consider an allocation to real assets as part of their portfolio mix. Real assets, including real estate, represent a hedge against inflation’s purchasing-power erosion.  But because properties carry unique attributes, such as location and usage, some types of real estate are better inflation hedges than others.

Graph 1, Market Update, 3.30.22

Residential real estate responds well to inflation, a fact that has not been lost on homeowners recently. Residential real estate prices in 20 US cities jumped 19.1 per cent over the 12 months ending in January, according to S&P CoreLogic Case-Shiller – the fourth-largest annual gain in 35 years, according to Bloomberg. Sun Belt cities, like Phoenix and Miami, were the biggest beneficiaries.

Most investment real estate generates rental income, is financed by a mortgage and appreciates or depreciates in value based on cap rates and market conditions, including replacement cost. Rental income can keep pace with inflation, or better, if leases turn over frequently enough and vacancy rates are low enough to command higher rents. Residential investment real estate has performed well in inflationary periods because leases renew annually. Residential real estate expanded in value relative to the size of the economy in the 1970s, while stock prices fell, according to a recent report in The Wall Street Journal. Commercial properties, like office, retail and industrial, could potentially suffer value erosion in an inflationary environment because commercial leases are often 10 years or more in duration. Over the last decade, apartment REITs have outperformed office REITs by more than 40 percentage points, with 18 percentage points of that outperformance occurring since the pandemic lockdowns.

Graph 2, Market Update, 03.30.2022

Inflation also makes new construction more expensive, helping boost real estate’s replacement cost and providing an appreciation tailwind. Lumber prices are a good proxy for construction costs. History has shown that housing prices and lumber prices have paved very similar paths over the last 20 years. Moreover, today’s supply-chain constraints have pushed prices for a variety of goods higher, adding additional costs to residential construction. Major appliances, like refrigerators, dishwashers and washing machines, have become nearly 25 per cent more expensive over the last 12 months. Such factors make the new construction of competing rental properties more expensive.

Graph 3, Market Update, 03.30.2022

The vacancy rate is another critical input to rent growth, offering a quick market supply and demand synopsis. Tight markets with low vacancy rates help landlords command pricing power when leases renew, while the opposite is true in markets where there’s an abundance of competing, empty properties. Between 2008 and today, rental vacancies have plummeted, helping drive the median asking rent from $700/month to over $1,200/month. We expect rental vacancy rates to remain low through 2024 at least.

Graph 4, Market Update, 03.30.2022

Financing is an important ingredient in real estate because physical collateral is relatively easy to borrow against. The same forces that push rents higher also make financing more expensive. In an inflationary environment, fixed-rate financing would help drive favorable financial leverage as rents rise and financing costs stay fixed. Nonetheless, prevailing financing rates are important in determining ongoing property values. Commercial property values could suffer if interest rates were to rise faster than inflation. History suggests, however, that 10-year rates tend to trail inflation to the upside, since the Federal Reserve’s inflation-fighting rates are typically overnight maturities. Real rates (interest rates adjusted for inflation) have been an important driver of real estate values. History has shown low or negative real rates propel property values higher.

Graph 5, Market Update, 03.30.2022

We expect inflation will be higher over the next 10 years than it was over the last 10 years.  Having a portfolio allocation to real assets, including real estate, could make sense as a hedge against lingering purchasing-power erosion.

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About Cresset

Cresset is an independent, award-winning multi-family office and private investment firm with more than $45 billion in assets under management (as of 04/01/2024). Cresset serves the unique needs of entrepreneurs, CEO founders, wealth creators, executives, and partners, as well as high-net-worth and multi-generational families. Our goal is to deliver a new paradigm for wealth management, giving you time to pursue what matters to you most.

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