Institutional real estate investors face no shortage of uncertainty in the current market. As such, a real estate investment portfolio should be customized to address each investor’s risk profile and liquidity needs. While it’s unclear exactly how the new US administration will proceed, the prospective policy changes have the potential to create volatility, dislocations and possibly inflation.
Commercial real estate is, broadly speaking, fully valued and substantial yield compression and rising valuations in major markets over the last few years suggest we are in the later stages of this real estate cycle, but investors seeking to hedge inflation may want to consider adding to their real estate holdings nonetheless. But, in doing so, investors should bear in mind that some real estate investments are more likely than others to protect in a downturn and some may provide more inflation hedging ‘insurance’ than others.
When it comes to identifying real estate investment opportunities and inflation hedges today, in general, investors should consider core real estate investments with low leverage, stable cashflows and inflation-linked lease structures. However, it may be difficult to find reasonably priced real estate investments fitting these criteria as the quantum of capital searching for yield has driven up core valuations. While some investors with a time horizon long enough to make them less sensitive to market cycles may still consider core real estate attractive today, many may find this ‘insurance’ too pricey.
So what’s an investor to do? Certain alternative property types, including senior living and medical office, are not yet fully valued and also offer some inflation hedging benefits, making them compelling options. These property types are less GDP and interest rate sensitive and benefit from positive long-term demographic trends. Investments in the medical office space, in particular, have the potential to offer some inflation hedging benefits given their triple net lease structures, which can protect against eroding purchasing power and contractual rent increases linked to CPI.
Higher-risk opportunistic investments in more traditional (and more cyclical) property types, including office, retail, multifamily and industrial, on the other hand, are generally fully valued today, particularly in primary markets, and are less likely to keep pace with inflation. Typically, these investments distribute little to no cash yield to investors as cashflows are often reinvested into the asset. They are also more sensitive to changes in interest rates than lower risk strategies given higher leverage levels and, as a result, are more likely to see declines in value due to their higher correlation to GDP. Should low economic growth persist and interest rates rise, property values in more traditional sectors could decline, or at best, not appreciate meaningfully.
In a more general sense, investors may also want to focus on managers with the flexibility to adapt to changing market and economic factors, like rising interest rates and inflation.
Opportunistic real estate managers with flexible, diversified ‘all-weather’ mandates have the ability to buy throughout the capital stack and, across the real estate spectrum, there could be attractive investment options, assuming they have proven their ability to flex at different points in cycles.
Ultimately, though, there are no safe bets when it comes to managing inflation risk, and no such thing as a perfect ‘inflation hedge’. Though some alternative property types present opportunities to hedge against inflation, they also come with risks. Investors need to be careful when selecting managers and operating partners to invest and work with. They will benefit from avoiding anything presented as a snake oil for rising inflation.
The bottom line: Amid today’s uncertainty, remember that different real estate investments play different roles within portfolios. Investors should start by pausing and taking stock of what they own, then figuring out what they want to achieve with their real estate investments – be it equity-like growth or a potential hedge against inflationary risks – and acting accordingly.