Real estate need not worry about inflation yet

While rising prices are a top concern for global investors, the asset class is well insulated from inflation’s negative effects.

Inflation is beginning to hit the recovering world. The US, UK and Canada all reported sharp increases to their consumer price indexes this month. That is not entirely surprising as the countries emerge from a period of steep economic disruption.

Less predictable, though, is how long this climb will last and how far it will reach. The Federal Reserve Board of Governors, which governs the US central banking system, believes it will be “transitory,” offset by growth and eliminated by a restoration of supply chains. Public equities investors are less sanguine, as evidenced by stock sell-offs this past week.

For private real estate, the duration is of little consequence. The asset class is at its best when inflation is high and if there is a widespread reshuffling of portfolios, it is a likely recipient of redeployed capital.

But that does not mean the period ahead is free of risk. Real estate is often viewed as a hedge against inflation, and for good reason. Land prices rise with inflation, benefitting existing owners. And while higher costs might elicit sticker shock from buyers, corresponding rent growth helps cap rates pencil out favorably. Of course, long duration office and logistics leases can see their values depreciate amid inflation. But the former tends to tie annual rent increases to CPI and the latter has enough appreciation tailwind to bolster returns. Overall, as PERE reported this week, real estate outperforms stocks and bonds by wide margins when inflation is high, regardless of how quickly the broader economy grows.

Inflation does present some immediate head winds for the asset class. Chief among these is the rising cost of building materials. Lumber prices have quadrupled since the pandemic began. The health crisis has also created a shortage of labor, running those costs up, too. These expenses hinder ground-up construction and redevelopment projects, particularly those capitalized pre-pandemic. But this type of inflation is not entirely problematic. Higher replacement costs drive up property values and help prevent overbuilding – arguably the biggest threat to real estate, regardless of macroeconomic conditions. And, assuming supply chains and labor markets normalize as immunity proliferates, these costs are likely to come down sooner rather than later.

Ultimately, there are two reasons for real estate investors to be concerned about persistent high inflation. The first is rising interest rates. If inflation remains above the targets set by central banks, they will respond by increasing their benchmark rates. During the Federal Reserve’s April meeting, four of seven board members said they anticipate an increase in the overnight bank funding rate – currently targeting 0 to 0.25 percent – next year, which none expected in December. Interest rates are still well below long-term averages. But more costly financing will hurt investment.

The second concern is the potential systemic threat posed by the unprecedented fiscal and monetary responses to covid-19. If a large-scale crisis were to ensue, though, real estate would be just one of many potential casualties. For now, there is no indication rising costs are anything more than routine inflation.

Much remains to be seen about the post-pandemic world, and real estate will have many obstacles to overcome, but, given these points, inflation is unlikely to be one.