Is CRE really a hedge against inflation?
August 4, 2023Commercial real estate is typically hailed as a strong hedge against inflation, but is that true today? Given the dynamics of our current inflationary environment, does that characterization still hold true or are rising cap rates eroding asset performance? We examined industry research and delved into the relationship between CRE assets and inflation. The results are reassuring, particularly for investors in the industrial sector, which continues to show its resilience and ability to generate strong NOI that translates to lower cap rates.
Erik Foster
Principal
Head of Industrial Capital Markets
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+1 312.273.9486
Is CRE really a hedge against inflation?
Commercial real estate has typically been characterized as a strong hedge against inflation, but are rising cap rates eroding that performance?
A McKinsey & Company report focused on that question and the broader relationship between commercial real estate and inflation. The short answer is that CRE has performed well during inflationary times, helping investors maintain value and outperform other asset classes such as stocks and bonds. The main reason for this is the tendency for cap rates to compress during inflationary times as interest rates tend to rise.
Is the story different today, however, given the current inflationary environment during the fastest monetary tightening on record? Investors are also sitting on a lot of capital, given the higher interest rate environment, pervasive uncertainty in the market and the bid-ask spread that has stalled much of the transaction flow. Without a larger flow of capital, asset prices will be stagnant (or drop) and cap rates will remain down. If cap rates expand, CRE will be less likely to outpace inflation, the report notes.
A look at historical performance
The company reviewed seven periods of higher inflation, including 1980-82, 1990-91, 2000-01, 2004-06, 2011-12, 2016-18 and 2021-22. The report speculated that cap rate compression during these times was due to people putting more money into the industry -- because they are expecting CRE to be a hedge against inflation. In each of those periods, rent growth did not keep pace with inflation and cap rate compression contributed to overperformance. The report found that annualized rent growth was 3% while inflation was 5%.
During the seven inflationary periods studied in this report, annualized returns were nearly 12% and generally provided a return that was higher than inflation, their own historical average, and other asset classes. CRE outperformed inflation in six of the seven periods studies, its own historical average in five of them, stocks in four of the seven periods, and bonds in six of them. This data makes the case for CRE historically being a good hedge against inflation.
A look at various CRE asset classes shows that in each period reviewed one asset class (multifamily, office, retail or industrial) outpaced inflation. And, in most periods, investors did not have to select the top performing sector to realize positive inflation adjusted returns.
The office sector produced strong returns during the 1980s, for example, and also during the dot.com boom in the early 2000s. Retail outperformed during the early 2000s as big box retailers took center stage before e-commerce pushed back against big box growth. And, as the millennial generation moved into the housing market in force during the 2010s, multifamily produced strong returns. Industrial has been a strong performer since the 2010s and, of course, during the pandemic surge in online shopping that fueled a massive expansion in distribution and warehouse space.
Today’s market is unique, however. Looking at all asset classes, the report noted that after investment losses during the pandemic, CRE returns have rebounded, but so has inflation. Persistent high inflation and rising interest rates, along with higher capital costs and constrained debt could lead to cap rate expansion.
Not all asset classes are alike, however. A few recent listings in the Inland Empire illustrate the strength of the industrial sector and the potential to generate significant rent growth that translates to higher NOI. Alere Property is selling a 3 msf portfolio worth nearly $1.1 billion and Manulife Investment Management is marketing a 1.4 msf business park. Both offerings include near-term lease expirations with current rental rates that are at least 35% below market. By boosting rents, new owners can realize stabilized cap rates of 5%, according to Real Estate Alert.
While the McKinsey report showed that CRE is a strong hedge against inflation, it also illustrated the importance of cap rates in that equation. Variables such as rising costs for building materials or labor should be monitored due to their ability to impact operating expenses and NOI. By paying attention to macroeconomic conditions and planning ahead for the impact of inflation, investors will be in a better position to prosper during these types of economic conditions.
Sources: GlobeSt., McKinsey & Company
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