Can an investment in real estate keep up with inflation?

The arti­cle rep­re­sents sub­jec­tive opin­ions of Hines Inter­ests Lim­it­ed Part­ner­ship (“Hines”)1, the spon­sor of invest­ment vehi­cles offered by Hines Pri­vate Wealth Solu­tions LLC (“Hines Pri­vate Wealth Solu­tions”). Oth­er mar­ket par­tic­i­pants may rea­son­ably have dif­fer­ing opinions. 

Since March 2022, the U.S. Fed­er­al Reserve (“the Fed”) (and oth­er cen­tral banks) have been fight­ing ele­vat­ed infla­tion sparked (at least in part) by pent-up, post-COVID demand com­bined with tem­po­rary sup­ply chain sna­fus. Data from around the world sug­gest mon­e­tary pol­i­cy­mak­ers are slow­ly gain­ing the upper hand, with some coun­tries more suc­cess­ful and oth­ers still with work to do. The gen­er­al­ly accept­ed road map for bat­tling infla­tion is for high­er inter­est rates to sup­press over­all demand, even­tu­al­ly bring­ing it into bal­ance with sup­ply so prices fall. But what hap­pens if pol­i­cy­mak­ers fol­low a dif­fer­ent map this time, and the Fed accepts a high­er lev­el of infla­tion and high­er inter­est rates for an extend­ed peri­od? As this would rep­re­sent a his­toric shift in the invest­ing envi­ron­ment, how might this impact real estate investments?

Could the consensus be wrong? 

There are sev­er­al rea­sons why the Fed and oth­er cen­tral banks might acqui­esce to a high­er infla­tion rate at this time – here are three:

  • By Declar­ing Victory – Many cen­tral banks could make the case that based on the recent data and oth­er trends, the infla­tion fight has been won and it will slow­ly abate. How­ev­er, if it doesn’t, cen­tral banks might allow the high­er equi­lib­ri­um rate (see rea­sons below).
  • To Avoid the Appear­ance of Polit­i­cal Bias – The Fed is sup­posed to be apo­lit­i­cal, but they need to avoid even a whiff of favoritism. Only once in the last 40 years1,2 has the Fed raised rates with­in two months of an upcom­ing elec­tion, so they like­ly want to be off the front page well in advance of next November. 
  • To Reduce the Val­ue of Out­stand­ing Debt – Infla­tion erodes the val­ue of out­stand­ing debt over time. As an exam­ple, if unex­pect­ed infla­tion was 5%, the real val­ue of non-indexed debt would drop by approx­i­mate­ly 19%3 because future repay­ments paid with nom­i­nal dol­lars will have lost pur­chas­ing power.

Inflation’s impact on real estate 

Source: NCREIF, CoStar, Hines Research, Q2 2023

As we not­ed, the Fed­er­al Reserve (and oth­er cen­tral banks) may not try/​may not be able to meet their infla­tion tar­gets but adjust them upward. Such a deci­sion would poten­tial­ly impact all invest­ments, includ­ing fixed income. Assum­ing for a moment that bond yields final­ly set­tle high­er (once investors are sat­is­fied that rate hikes are over), the future pur­chas­ing pow­er of a bond (or loan) prin­ci­ple is degrad­ed as not­ed in the graph­ic above. For exam­ple, the $100 par val­ue of a 10-year bond is worth only $82 at matu­ri­ty with 2% annu­al infla­tion. At 4%, the bond prin­ci­pal holds just $68 in real pur­chas­ing pow­er at maturity.

His­tor­i­cal­ly real estate rents have increased over time. Con­sid­er that rent growth for all U.S. com­mer­cial real estate has aver­aged 1.8% annu­al­ly since 1989. The math works the same as for the bond exam­ple. With $100 of rentable real estate, 2% infla­tion and 1.8% rent growth, the asset is worth over $98 in ten years (see below). Sim­ply put, real estate rent growth has his­tor­i­cal­ly helped off­set the impact of infla­tion.4 Of course past per­for­mance can­not guar­an­tee future results.

Source: NCREIF, CoStar, Hines Research, Q2 2023, The 1.8% rent growth is the annu­al aver­age for all U.S. prop­er­ties since 1989. Infla­tion assump­tions are from Hines Research based on the stat­ed tar­get of the U.S. Fed­er­al Reserve. 

His­tor­i­cal­ly, the val­ue of a prop­er­ty, if cap­i­tal­iza­tion rates stay flat, will (with all else equal) gen­er­al­ly appre­ci­ate at the rate of rent growth. The analy­sis above assumes his­tor­i­cal aver­age rent growth, but could real estate respond to increased long-term infla­tion in a pos­i­tive way, gen­er­at­ing an accel­er­a­tion in rent growth? His­to­ry has shown that rent growth accel­er­ates in response to a com­bi­na­tion of high­er, more per­sis­tent infla­tion and low­er sup­ply. Assum­ing rent growth fol­lows infla­tion high­er, this tilts the scale fur­ther toward real estate. With rent growth at (for exam­ple) 4% and infla­tion at 3.5%, in ten years the asset would be worth almost $105 in real terms. Of course, there is no guar­an­tee that his­to­ry will be repeated.

Real estate rent growth is key 

It may be time to look beyond the tra­di­tion­al rates up, cap rates up, val­ues down” analy­sis of inflation’s impact on real estate. While infla­tion erodes pur­chas­ing pow­er, real estate his­tor­i­cal­ly has brought a poten­tial anti­dote to the table. Cash flow growth at the prop­er­ty and port­fo­lio lev­el has negat­ed the neg­a­tive impact of infla­tion on cap rates and val­u­a­tions and enhanced the val­ue of these assets over time. A fixed-rate bond port­fo­lio can­not increase inter­est payments.