In many developed countries, inflation has accelerated over the last few months and remains at its highest rate in more than a decade. Residential real estate returns have a long track record of beating inflation. This may explain why, despite valuations on a yield basis appearing expensive, institutional investors continue to allocate capital to residential rental assets.
High inflation is being driven by several factors, such as supply constraints, higher spending, rising energy prices and shipping delays. If inflation leads to higher wages, asset owners would be able to increase rents as the affordability ratio remains consistent. In these times of inflationary pressure, residential rental assets have many favorable characteristics that make this class of investment appealing.
First, shorter duration leases may provide one of the best inflation hedges. Within commercial real estate, residential assets are better positioned to benefit from an increase in inflation than many other asset types. Lease and rental payments are often reviewed at least annually, which provides the investor with the ability to adjust rents as prices increase.
Secondly, this asset class has a granular diverse tenant base. Typically, institutional investors have exposure to thousands of units within their portfolio. As a result, such investors are likely to deal with a high turnover of units, thereby providing the opportunity to reset rents and capture price increases.
Thirdly, this is an essential asset. At the most basic level, residential rental assets are necessity-based, as people require homes. The alternative to renting is property purchase and during periods of inflation, individuals are more likely to remain in the rental market due to rising house prices and potential increases to mortgage costs.
During the pandemic, institutional investors have been drawn to residential rental assets because of, among other things, the resilience of tenant demand. That has been the case throughout cycles, including the global financial crisis. Institutions could generally justify paying very tight cap rates given the quality of the cashflow, lack of volatility and high occupancy. Inflation may be providing those same institutional investors with another reason to continue investing in these assets: the belief that higher rents will materialize.