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How managers are navigating the inflation hedge maze

An increase in exit cap rates and cost of debt – as well as operating costs rising faster than rental rates – were among potential inflation-driven challenges cited by managers.

Real estate is typically considered an investment hedge for inflation, shielded from volatility through illiquidity. However, a market that is facing significant upheaval and in need of rotation could see more headwinds than usual.

Inflation has been above 5 percent for the last eight months and was estimated to hit 7.2 percent in January, its highest point since 1982. Long-term inflation is likely to impair performance of real estate investments over time, Nitin Chexal, chief executive of Palladius Capital Management, tells PERE.

“Exit cap rates will increase, the cost of debt will increase and operating costs may increase faster than rental rates, which can be particularly acute if these costs cannot be passed on to tenants,” Chexal says.

This means that investment decisions are likely to take longer and come with more considerations. Execution plans and capital structure considerations will need to be top of mind, Chexal notes, likely benefiting managers that are set up to be nimble.

Staying at the leading edge

This shift creates a greater desire for income. Real estate investors need to grow their net income to keep up with decreasing capitalization values, says Matt Hershey, partner at advisory firm Hodes Weill. For example, if net income on a property holds as equal and cap rates expand from 5 percent to 6 percent, the value of real estate decreases by 17 percent, Hershey adds.

For many core investors, the effect is unlikely to be felt unless the increased inflation lasts more than a year. However, the Federal Reserve’s planned interest rate hikes are expected to combat a continued rise in inflation. For core investors, “it is not worth trying to make strategic changes or even respond tactically as the positive impact will be very marginal,” Hershey says.

However, value-added investors have more immediate concerns because the more cap rates expand, the more profits from future sales will be negatively impacted, Hershey says. Transaction volumes are therefore likely to increase with assets being turned around faster or disposed of more quickly.

“That will lead these value-add investors and developers to try to achieve their net income growth earlier in their business plan and sell faster before capitalization rates expand further,” Hershey says.

For many managers, inflation protection will be built into their portfolio already if they have chosen the right asset classes. Real estate is broadly correlated to inflation but certain sectors, like retail and office, are less so. Many firms, ranging from mega-managers like Blackstone to more specialized shops like the UK-focused Moorfield Group, believe their focus on inflation-resistant, operationally-intensive property types like logistics, life sciences, rental housing and self-storage will help protect their portfolios from some of the negative effects of price increases.

Those property types all benefit from more frequent tenant turnover, thus presenting opportunities to raise rents more frequently and combat any consistent rise in inflation. However, development has been the preferred method for accessing many of these property types recently, as the cap rates for acquisitions of existing assets have compressed to levels that are nearly non-viable for investment. Yet, development raises additional questions for managers.

“Managers will be challenged by the question of whether it’s better to de-risk by pre-leasing the project earlier or waiting to lease with the hope that rents will continue to rise,” Hershey said. “For managers with operating assets, they will remain focused on staying at the leading edge of market-asking rents while controlling operating costs.”