Navigating inflation: how to build a resilient real estate portfolio

It has been two years since the post-COVID inflation spike hit its peak. After getting close to or hitting double digits in most countries, CPI is now back in line with central bank targets at around two percent in the US, UK, and EU.

This short but highly consequential bout of inflation may be over, but a quick look at the term premium on US government bonds suggests real estate investors would be wise to retain their focus on inflation. The term premium is the difference between short and long-term interest rates. It measures long-term inflation risk, increasing when there is growing uncertainty about inflation and economic growth.

The term premium on US ten-year treasuries is approaching a ten-year high. Such market pricing aligns with a general consensus among economists that we are in a period of heightened inflation volatility. Economists point to rising geopolitical tensions, less fiscal restraint, and higher government debt as causal factors. Some also identify the growing risk of extreme weather events, further increasing the likelihood of negative supply-side shocks.

Real Estate’s Inflation-Hedging Credentials

In an era of heightened inflation volatility, real estate investment managers can take heart. Historical data suggests that property has been a reliable store of value, providing positive real returns over long periods. A recent INREV research paper noted that "long-term investors seeking to exploit real estate's ability to provide a long-term store of value have not been disappointed. Over a range of periods, delivered returns have more than offset changes in the price level."

Real estate's scope to generate income growth is critical in this regard. Based on UK data, a 2011 Investment Property Forum report emphasized that “the positive real returns over the longer term were achieved primarily through receipt and reinvestment of the income return rather than capital value growth.”

However, while allocators are likely to look favorably on real estate as a source of protection against inflation in the long run, property does not act as a hedge against inflation over short periods. A recent update of the IPF report highlights, “this is owing to the effect of capital growth on total returns, which almost certainly reflects the interest rate response to rising inflation and its impact on property pricing."

So, while the income generated by real estate may keep up with the general price level, higher inflation tends to mean higher interest rates and, therefore, lower capital values.

In addition, real estate’s inflation protection is far from uniform, varying widely across sectors, lease terms, and market conditions. Structurally changing occupier markets may mean that the relationship between inflation and real estate income will differ in the years ahead.

Furthermore, as CBRE research shows, the cause of inflation matters. If inflation is driven by strong economic growth, it benefits commercial real estate returns due to rising rents and lower vacancy. However, if cost-push inflation occurs against the backdrop of weak growth, property owners find it harder to push through rent increases, and interest rates may be higher. So, stagflation resulting from supply shocks can hurt property investment returns.

Also, academic studies have shown that while real estate has strong inflation hedging attributes relative to expected inflation, there is a weaker relationship with unexpected inflation. So, as the INREV report notes, "any increase in inflation volatility should be expected to be associated with an erosion of the asset classes' hedging attributes."

Given the drivers of heightened inflation volatility that currently concern economists, real estate portfolios may provide less inflation protection over the medium term than hoped.

How best to pursue greater inflation protection in a commercial real estate portfolio today?

Building a Portfolio for Robust Inflation Protection

Intelligent market and stock selection is key to increasing the chances of holding assets that can capture inflation.

Portfolio managers should seek exposure to markets with a favorable supply-demand balance to retain a degree of pricing power through the cycle. This is likely to align with other determinants of a market selection process, but seeking inflation protection heightens the importance of getting it right.

Portfolio managers should favor sectors where assets typically have short lease durations where more frequent rent adjustments can help preserve real income levels as inflation fluctuates. A recent study for the Institute of Private Capital showed that private equity real estate tends to provide greater protection against inflation than public equity real estate and half of the difference can be explained by the different sectoral composition of the two universes. Private equity real estate’s inflation protection credentials are boosted by exposure to operationally intensive sectors with shorter duration cash-flows and greater pricing flexibility, such as hotels.

Even in sectors typically characterized by longer leases, asset selection can be tailored to find assets with flexible rent setting. This is particularly true given that many parts of the real estate universe are becoming more operationally intensive. For example, in the office sector, co-working units offer significant pricing flexibility, while multi-let industrial units can offer shorter-duration income than much of the logistics sector.

Those seeking enhanced inflation protection should reduce exposure to long leases. Even when leases are linked to inflation, the long duration makes the capital value of such assets particularly sensitive to changes in interest rates.

Such steps to increase inflation resilience reduce a portfolio's (nominal) income security. This is also true when considering how asset-level strategies can be modified to increase inflation resilience. For example, an inflation-conscious investment manager may be less likely to pre-let a development, preferring to have a chance to capture price growth with a lease signed later. Furthermore, active management and repositioning strategies may appeal more to those seeking inflation protection. Compared to signing a traditional lease on an asset, a well-executed repositioning may provide an opportunity for income growth, even in uncertain environments.

A Balancing Act

Pursuing more robust inflation protection should be carefully considered, as it can significantly alter a portfolio's composition. Increased exposure to inflation-aligned, higher-risk assets can reduce income security, potentially misaligning with client needs. If clients are specifically looking for inflation protection from their real estate allocation, focusing heavily on the type of assets that allow rental adjustments to preserve real rental levels is appropriate.

However, many clients require a more balanced approach, and more modest portfolio adjustments are appropriate. In such cases, doubling down on the sectors expected to perform strongly that happen to offer good inflation protection is a sensible step. For many portfolio managers today, that may mean taking overweight positions on supply-constrained residential markets and structurally supported student housing markets, for example.

Beyond that, a key lesson from the recent literature on real estate and inflation is that short-duration cash flows have an important role in a portfolio. Most portfolio managers should target diversity in the length of leases they are exposed to.

A version of this article originally appeared in The Property Chronicle. To read other articles I have written for The Property Chronicle, please click here.