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
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.
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.