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Real Estate Inflation: Everything Investors Need To Know

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Real Estate Inflation: Everything Investors Need To Know

If you follow the financial news, you might be more confused about the future of our economy than someone who watches nothing. Watch three analysts, and they’ll tell you three different things. One will tell you that we’re entering a period of steep inflation, and another will say it’s deflation. The third, meanwhile, will forecast stagflation.

From 2010 through 2020, inflation in the United States averaged 1.8%. That’s slightly lower than the historical average, and it has provided a period of reliable – if sometimes boring – growth. But then came the Covid-19 pandemic. In two years, we saw a combination of supply chain shortages, business closures, and massive injections of stimulus money.

Now that things have – mostly – returned to normal, there’s a lot of debate about what’s going on. It’s undeniable that prices have gone up over the past year, but the outlook is less clear. Are these short-term aftershocks that will soon fade away? Or are we entering a period of sustained price instability?

Nobody has a crystal ball, but one thing is certain: you need to be prepared. This means understanding how real estate inflation works, how it can affect your investments, and how you can hedge against it.


What Is Inflation?

Inflation is the rate of price increase for goods and services within the economy. It’s typically measured annually, although some metrics provide quarterly or even monthly increases. To put it another way, it measures how much value a dollar loses over time.

Here’s a simple example. Let’s say you bought a $500 dishwasher in 2010. At a 1.8% inflation rate, the same dishwasher would cost you $509 in 2011. That might not sound like a huge increase. But keep in mind that the effect is cumulative, much like interest. In 2020, that same dishwasher would cost $597.65. That’s a significant increase!

Now imagine an annual inflation rate of 5%. That’s what Greece experienced during its financial crisis, and it’s easy to see how it could put a dent in your wallet.

Note that inflation is not the same as appreciation. When your real estate investments experience inflation, you’re not really getting any benefit. The dollar value may be higher, but the real-world value has remained the same.

Appreciation, on the other hand, is driven by demand. The more demand there is, the more a given investment will be worth. If all is going well, your rate of appreciation will exceed the rate of inflation. In other words, your home value will increase in real terms. If your rate of appreciation is slower than inflation, your property will depreciate in value.

How Does Inflation Affect Real Estate?

Inflation doesn’t have to be a bad thing. If you’re a savvy investor, it can be beneficial. During times of high inflation, it can be more challenging for people to qualify for a mortgage. People who are saving up for a down payment may find themselves suddenly priced out of the market. And with higher interest rates, mortgages can become prohibitively expensive for some would-be buyers.

As a result, more people stay in the rental market, and rental prices increase. If you’re a landlord, you can cash in on that increase. Invest in some rental properties, and you can earn a significant profit during inflationary periods.

That said, there are also some pitfalls. Banks raise their interest rates during high inflation to offset their losses. They also tighten their lending terms, making it harder to buy a property to begin with. In other words, prospective landlords suffer from the same roadblocks as prospective homebuyers. So the time to benefit from high inflation is beforehand when loans are still affordable.

In addition, not all rentals benefit from high inflation. While home rentals stand to gain, vacation rentals tend to suffer. Travel is one of the first things people cut from their budget when money gets tight.

Real Estate Investments For An Inflationary Economy

So, where should you be investing your money during an inflationary economy? Here are some of the real estate investments that perform the best:

  • Apartments and single-family homes – these will go up in value.
  • Mortgage note investing – banks will be offloading notes at discount rates.
  • Real estate investment trusts (REITs) – make sure they don’t invest in vacation rentals.

Remember that investing in real estate can be more expensive in inflationary times. It’s critical to have the cash on hand to take advantage of opportunities as they arise. Otherwise, you could get priced out of the market.

MACRO REALITIES FOR REAL ESTATE

Traditional wisdom suggests inflation can be a friend to real estate. Simply stated, rents re-price and existing assets appreciate in value as construction costs rise. But on the heels of one of the most rapid increases in inflation in 40 years, the theory of real estate as an inflation hedge is being put to the test. In response to inflationary pressure, interest rates have moved steeply off the post-pandemic lows in many markets, which is less friendly to real estate. Surging inflation has led central banks towards more aggressive tightening, particularly in the U.S. and Europe, which could potentially trigger a recession or at least an economic slowdown. Asian markets may benefit from a more dovish interest rate environment, but the region will contend with other macroeconomic risks. After more than a decade of abundantly available capital, declining interest rates, and improving cash flows for almost all property types around the world, fear of a changing macro environment is palpable. Global listed real estate share prices have declined nearly 20% this year1 and transaction activity in many private markets has taken a pause.
 

We believe a new investment regime for real estate has begun. The rising-tide-for-all environment seems to have ended, likely to be followed by a period of more uncertainty and dispersion. Real estate returns over the next decade will likely become more dispersed, which should also offer more alpha opportunities globally. Three debates are forming the new “IRRs of real estate”: how will higher inflation impact different sectors of real estate, what happens as interest rates rise, and how will real estate perform in a recession? 

Historical analyses of sector performance in different inflationary environments, interest rate regimes, or recessionary periods of the past may be of limited use in predicting the future. Technology, demographic change and sustainability are secular shifts that are altering the fate of real estate. Many pandemic-induced changes in the work environment have proven to be enduring, although preferences are diverging in different parts of the world. Lastly, the path of interest rates in each developed economy is unique. The end result: variance in real estate performance is likely to become even more pronounced in the years to come. 

In our view, real estate is positioned to play an even more important role in client portfolios in the midst of the evolving macro conditions, given the ability of many types of property to weather a softer economy and provide a hedge against inflation. Even with broad tailwinds, we believe investors still have the ability to be on the right side of the secular trends in technology, demographics and sustainability as international dynamics will differ vastly. In short, the choppier waters ahead call for a more nuanced strategy that, if executed properly, can potentially result in more alpha-based returns. 

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The New “IRR” Realities: Inflation, Rates, Recession

 

Inflation

Real estate has historically provided a strong inflation hedge. Key to this is the ability for landlords to re-price rents upward. Higher construction and materials costs theoretically increase the replacement cost of existing assets while also restricting new supply, which tends to keep rents high. Additionally, real estate is generally financed with debt, which means owners can use inflated dollars in the future to pay off today’s liabilities.
 

While history can be a helpful guide, inflation comes in many forms. Some inflationary pressures, such as the food and energy price shocks stemming from the war in Ukraine and lockdowns in China may prove shorter-lived. But from a certain vantage point, it can seem that inflation is surging due to multiple long-term drivers—including extended expansionary monetary policy during the pandemic and possibly the early stages of deglobalization—which may not be resolved so quickly. Many economists thus far have taken a more sanguine view, focusing on the deceleration in sequential measures of core personal consumption expenditure (PCE) inflation, but acknowledge that pockets of inflation will likely persist. To better assess the potential effects of inflation, real estate investors should focus on three specific components: rents, labor rates and materials. 

The first consideration is the impact on income from changes in commercial rents and shelter rates. Unlike a bond with a fixed coupon, many forms of real estate can experience a relatively quick re-pricing of rents to lift cash flows alongside inflation. The shorter the lease duration, the more quickly rents can be repriced. Multifamily leases average under a year, and prices have been climbing steadily since inflation took hold. Initially driven by a rebound from pandemic-level rent cuts, the sustained increase in housing costs now reflects a significant supply/demand imbalance. Surging home prices and higher mortgage rates have combined to make home ownership more difficult, creating a particularly attractive backdrop for multifamily rental investing. Asking rents have decelerated from the peak in mid-year 2021, but remain significantly higher than pre-COVID-19.

Other short-duration areas include self-storage, where leases can reprice on a monthly basis, and hotels, which benefit from rents that literally reprice every night. Industrial assets have longer leases but are experiencing strong demand; the largest public company in the space believes there is a 50% upward mark to market in its global portfolio.2


The second inflation area of focus is labor rates, which impact both the cost to develop new assets and ongoing operational expenses. In the U.S., the current gap between available jobs and workers is the widest in postwar history and is likely to keep upward pressure on wages. In any industry, higher wages typically translate to margin compression, and indeed we are observing forward earnings estimates being reduced for many equity sectors. In real estate, however, several asset types operate with relatively light labor requirements, and owners are increasingly attempting to automate or use technology for labor-intensive roles. For example, many landlords are permanently transitioning to features that were introduced during the pandemic, such as “contactless” check-in at hotels and self-guided apartment tours. As markets remain tight, real estate is relatively better positioned to maintain margins as labor and other variable operating costs remain low. There may even be a real estate opportunity to service less-built markets that are benefiting from increasing wages.

The third key inflation component is the cost of construction materials, with many categories surging to records in 2021 amid supply chain issues and increased demand. Higher costs can be offset with higher rents in some cases, while other projects simply fail to make sense on paper. Historically, higher development costs have served to support real estate values, as replacement costs increase and additional supply is averted. But real estate investors need to monitor key materials markets closely, as shifts may require new assumptions for development. If globalization trends do indeed reverse, it could lead to structurally higher material costs for the foreseeable future. While a headwind to new construction efforts, this could present promising opportunities in industrial development as more manufacturing is brought back on-shore.

Despite generally favorable positioning, higher inflation is not a universal “buy” signal for real estate. The biggest and most obvious risk is in long-term leases with low fixed-rate increases or, even worse, no rental rate increases. These features were acceptable when inflation was mild and Treasury yields were depressed, but they pose a threat in the current environment. Rents in office markets may keep pace with inflation, but that often comes with commensurately high capital expenditures and tenant improvement dollars, which means less of a net inflation hedge to owners. We have seen remarkably strong hotel rates in leisure and resort properties, but today there are more governors on pricing power than ever before as travelers benefit from real-time pricing data and rebooking options, as well as alternative options like Airbnb that didn’t previously exist. Hotels also carry some of the higher labor cost components among real estate asset classes, which again blunts the bottom line to owners.

Certain long-term leased assets or labor-intensive leisure properties may still perform well despite the challenging backdrop. Newly developed office buildings with top-of-the-line sustainability features are still highly sought after in markets where work-from-home is less attractive. A recovering hotel asset in a market serving consumers looking to spend their higher wages, with proactive management installing labor-saving robotics where possible, could benefit from changing market dynamics. And if structured without any exposure to rising expenses, a triple net leased asset (i.e., where the tenant pays all expenses including tax and maintenance) to the right credit could be an opportunity. In addition to differentiation between asset types, financing costs around the globe are diverging, which is further impacting returns from similar assets. The overriding theme is dispersion, with a heightened importance for the specific characteristics and operating performance of each asset.

With many economists expecting the peak of inflation to be near, the subsequent deceleration is anticipated to be led by core goods (e.g., used cars, electronic equipment) while housing costs are expected to remain elevated. This could be considered a “Goldilocks” scenario for real estate—headline inflation that moderates enough to slow interest rate increases but suggests pricing power for real estate assets.

Interest Rates

The breakout in inflation has been met with a steep rise in interest rates in the U.S. as the Federal Reserve (Fed) attempts to rein in prices. The yield on 10-year Treasuries has more than doubled during 2022 to approximately 3% today; U.K. and German 10-year bonds have also moved dramatically higher, albeit at lower nominal levels. This “risk-free” rate is a key component in the discount rate that is theoretically used to price all assets, including real estate. Real estate valuations are often quoted in cap rates, or the yield at the time of property purchase, which can be compared to yields on bonds. As a result, many investors assume that cap rates must increase with interest rates (therefore decreasing real estate values), but the data tell a different story.

In the U.S. some periods of Fed tightening over the last 20 years experienced cap rate expansion while others saw compression. Clearly the growth outlook plays a major role, but capitalization rates are influenced by foreign capital flows as well. Furthermore, real estate performance at the subsector level has diverged more than ever today, with different asset types having fundamentally different growth prospects. Even as interest rates increase, for example, residential and industrial real estate could see valuations expand due to structural tailwinds. The asset’s lease duration is another key factor, as the ability to increase cash flows can mitigate the potential negative impact of rising rates on cap rates. Real estate owners can also leverage other tools, such as technology and investment capital, that can have a meaningful impact on the cash flow outcomes of a property.

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The most direct impact of rising rates will be to increase borrowing costs, which have already increased across the board in recent months. All else equal, this will have a negative impact on gross returns—a stark reversal from the strong performance tailwind from low rates since the financial crisis. But as discussed above, we see no basis for moving cap rates at a fixed spread to Treasuries, and we believe increased performance dispersion is likely among asset types, sectors and geographies as the risk-free rate moves higher. We also note that large pools of capital raised for private real estate (“dry powder”) have supported real estate valuations over the last several years—a dynamic that may continue if investors reallocate some capital out of fixed income and cash in the coming years.

Recession

The final macro reality to contend with today is the increase in recession risks. While the near-term likelihood of a recession in the U.S. remains low given robust labor conditions, market-implied risks have been on the rise. As a result, investors need to incorporate recessionary conditions into the downside scenario when underwriting new investments. Mapping to historical recessions is an easy enough exercise; digging more thoughtfully into how the triggers of this hypothetical recession would play out in real estate is more challenging. For example, multifamily and hospitality are often assumed to be outperformers in an inflationary environment—but that does not hold true in a recession where job losses and spending restrictions become important factors. Conversely, long-term leased assets to good credits (which would fare worse in an inflationary environment) are likely to perform best in a recession.

One area we expect could perform relatively well are assets in supply-constrained markets with demand that is not economically sensitive—in other words, assets with inelastic demand that likely will have some pricing power. One such market could be life sciences real estate. In aggregate, the entire life sciences real estate market in the U.S. is still only around 100mm square feet, and while there are 10,000 known diseases, only 500 are currently being medically treated, according to the largest public company in the space. Research and development investment into disease treatment has historically been fairly insulated from the economic cycle. Residential housing has also historically proven fairly defensive, with relatively short and shallow economic downturns. Time will tell what particular challenges the next recession will hold, but it is likely several forms of real estate will prove resilient.

Future Implications

Real estate as an asset class has many attractive features in a higher inflationary environment, but the corollary of increasing rates and the looming threat of a recession represent counterbalancing concerns. These macro factors define the new “IRR” factors in real estate, and we don’t expect history to be a perfect guide. These three macro factors will have implications for one another—with higher inflation and rates triggering recession signals, and conversely increasing recession signals potentially stemming rate hikes. But slowing growth does not equate to economic contraction, and many global economies remain incredibly resilient underneath all the macro risks. More than any other time in the last decade, we believe investors need a nuanced real estate strategy to position themselves for more alpha opportunities as dispersion increases. While inflation can be a friend to real estate, the best friend to a real estate portfolio is balance—for bolstering the ability to outperform regardless of the macroeconomic environment.

Strategic implications for real estate investors

Our analysis shows that the relationship between real estate and inflation is much more nuanced than conventional wisdom would suggest. Real estate’s inflation-protecting capabilities are best suited to long-term owners who are prepared to ride the fluctuations of multi-year economic and real estate cycles. For such investors, a significant degree of inflation protection for incomes and strong long-term capital preservation can be added to other investment characteristics which typically attract investors to the sector.

While not offering a “silver bullet” to protect from short-term inflation, there are clearly areas of the market that offer the best opportunity to generate positive real returns over the next few years, even in a heightened inflationary environment:

  • Shorter-term leases (or those with frequent rent reviews) can catch-up more quickly to inflation than longer term ones if market fundamentals are supportive.
  • Apartments, student accommodation and self-storage are underpinned by favourable demographics-often with frequent opportunities to mark-to-market if local supply is in check.
  • Long-term leases for office and industrial properties with annual indexation also provide short-term income protection, particularly if inflation is expected to increase and can be factored into negotiations.
  • Triple-net leases, offering expense pass-through to tenants, give investors some protection against rising input costs such as maintenance.
  • Returns from core real estate assets are mainly driven by income (which is more closely linked to inflation) than capital growth (which is vulnerable in a rising interest rate environment).
  • Moreover, rising construction and labour costs (typical in an inflationary environment) render development activity less financially feasible. As a result, prime centrally located office assets, for example, with state-of-the-art technology and sustainability credentials become scarce and more sought after by investors as well as tenants.

As the economic environment continues to evolve, investors should focus on the type of inflationary risk that emerges.

Summary

Real estate inflation can be bad news for would-be homebuyers or the ill-prepared. But if you know what to expect, you can put yourself in a position to succeed. And if you already own rental properties, you’ll be even better positioned to benefit.

What happens to real estate during inflation?

Inflation can lead to higher asset prices

Generally speaking, when inflation increases then housing and other real estate asset prices follow suit. That said, because we also see mortgage rates rise, this tends to put downward pressure on demand for real estate because debt becomes more expensive.

Is real estate good against inflation?

Real estate has long been considered one of the best hedges against inflation because you can pay less for your home over time compared to what you may pay in rising rent. This can help your wallet as you pay more for everyday items.

Do house prices go down with inflation?

Housing prices tend to rise with inflation. Absent economic and supply-and-demand pressures, the price of goods remains the same. If the only change introduced to the economy is the addition of money, the price of goods will rise.

Does real estate crash after inflation?

Rising inflation will impact home buyers and homeowners alike, but don’t expect a crash. Here’s how inflation is affecting housing in 2022.

Should I sell my house during high inflation?

If your home’s value has significantly increased

It’s a great time to walk away from the table and reinvest your money back in. Getting back into the purchase market would be just ideal because you can take advantage of buying cash or buying with a large down payment, which puts you in a different situation.”

Who is most hurt by inflation?

Inflation hurts poor people and those on fixed incomes the most. Inflation helps borrowers and investors in stocks, real estate, and commodities.

What assets do well in inflation?

Commodities like gold, oil, and even soybeans should increase in price along with the finished products that are made with them. Inflation-indexed bonds and Treasury Inflation-Protected Securities (TIPS), tend to increase their returns with inflationary pressures.

Why is real estate good during inflation?

Investors use real estate as a hedge against inflation by capitalizing on cheap mortgage interest rates, passing through rising costs to tenants with higher rent prices, and benefiting from rising home values over the long term.

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