2021 was a great year for real estate returns, with the NCREIF ODCE index recording a return of 22.2 percent. Meanwhile, inflation surged last year in the US, with the Consumer Price Index up 7.1 percent. Does this prove the long-held belief that real estate is a great inflation hedge? With this being the first brush with higher inflation in a generation, it is worth digging deeper into the dynamics.
The key takeaway on the relationship between real estate returns and inflation from 2021 is real estate can be an inflation hedge at times, but not always. The strong returns last year were driven by select property types, while other sectors severely lagged. The shared characteristic of the property types with inflation-beating returns – industrial, apartments, life sciences, single-family rental homes – is market conditions were favorable for landlords as vacancy rates were low and demand was strong. However, retail and office markets had weaker market conditions, with returns and income growth that lagged inflation.
Strong fundamentals enable rent growth, which is critical to income growth, but healthy income also depends on expenses and lease resets. On the expense side, higher inflation put upward pressure on a variety of operating costs, but operating costs are more impactful for some property types than others. For instance, industrial often requires low landlord operating expenses while apartments have relatively high landlord operating expenses. This points to operating expenses not necessarily being important to inflation hedging in 2021.
Another dynamic is lease resets and term. Another driver of real estate value growth last year was yield compression. Yield compression can stem from low interest rates, or a reduced spread between real estate yields and interest rates. Interest rates stayed low in 2021, which contributed to yield compression. However, spread compression can occur in an inflationary environment if investors place more value on real estate income relative to bonds because real estate income can increase over time. As both low interest rates and spread compression were at play in 2020, it is hard to conclude how much investors’ higher valuation of real estate income was a factor.
Then there is the “hard” asset case for real estate as an inflation hedge. Inflation in 2021 was certainly strong in building inputs, both for materials such as lumber and steel and construction labor. Higher costs could have acted as a deterrent, if investors believed that higher costs would erode profit margins and make new development economically unattractive. However, that was not our experience in 2021. Instead, in many cases, the impact of higher costs on profit margins was offset by increased rents and lower cap rates contributing to value growth.
In conclusion, allocating to real estate as an inflation hedging asset is a start. But inflation hedging depends on the ability to grow rents and, in turn, income. Ultimately in both high and low-inflation environments, attention needs to be paid to sector fundamentals, market selection, and asset quality to enable real estate to be the inflation hedge desired.