Why Real Estate is the Proper Hedge for the Current Inflationary Outlook

There is a growing community of economists and prominent investors who think the world could emerge from the pandemic into an era of higher inflation. During the past month, underlying prices in Europe rose at their fastest pace in five years. In the United States, after the next $1.9trn stimulus plan passes, nearly 28% of all U.S. dollars in existence will have been created in the last 12 months. The story is similar in Canada where it is estimated that businesses and households are sitting on upwards of $170 billion in excess cash. Unlike the period following the 2008 financial crisis where lenders tightened credit restrictions, this time around, lenders have flooded the global economy with liquidity. Central banks have no intention of pumping the breaks anytime soon as the United States Federal Reserve says it wants to overshoot its 2% inflation target.

The liquidity issued through historically large fiscal and monetary stimulus will act as an accelerant toward some longer-term inflationary dynamics. Specifically, Western and Asian societies are rapidly ageing which may create worker shortages and increased labour costs. Since the 1990s, globalization has ushered in disinflation through establishing a more efficient market for goods and labour. In recent years, this order has been challenged by populist forces in Western countries aiming to relocalize supply chains.

While the data is a little murky, researchers from the Bank of England have concluded that inflation typically rises in the year after a pandemic begins. In the aftermath of the 1918 pandemic, Western countries experienced double digit inflation for the following two years. As Western economies prepare for reopening, additional firms will have filed for bankruptcy and many survivors will be required to scale back certain activities. The case for inflation suggests that people’s willingness to spend will likely rebound faster than the productive capacity of surviving firms, resulting in higher prices for goods and services.  

Although the potential catalysts for an inflationary environment are clear, high inflation is far from guaranteed. Prior to COVID-19, extraordinarily low levels of unemployment did not spike prices upward and now millions more are unemployed. Nonetheless, the most sophisticated investors understand the devastating tail-risk that inflation presents. This risk was famously characterized in Warren Buffett’s 1977 essay “How Inflation Swindles The Equity Investor”.  While it is obvious how the devaluation of a future dollar vs today’s dollar reduces the value of a fixed coupon bond, Buffett made the interesting observation that aggregated stocks tend to perform similar to bonds in the sense that they provide a relatively constant return on book equity. He noted that this return cannot keep up with inflation, causing real equity returns (the inflation rate subtracted from the nominal rate of return) to plummet in inflationary environments. During the high inflation years of 1966-1982, the S&P 500 earned a real return of 0% as the annual return of 6.8% equalled the rate of inflation.

 If high inflation emerges in the coming years, investors need to consider whether their asset allocation is positioned to provide real returns. While gold, commodities, and perhaps Bitcoin are most likely to outperform in such an environment, we believe that real estate can provide the necessary degree of inflation protection given the current outlook. The reasons for this are two-fold; lease structures and capital appreciation. Real estate leases that are either indexed to CPI and/or short-term in nature can track inflation and offer a hedging benefit for investors. In terms of capital appreciation, the increase in labour and material costs in an inflationary environment will drive replacement costs upward. An analysis of U.S. real estate data shows that the quarterly correlation between private real estate total returns and inflation is 0.41 on an annual basis. Similarly, public real estate total returns (REITs) have exhibited a 0.43 correlation to inflation. These values demonstrate that real estate returns tend to reasonably increase with inflation. In contrast, broad equities (-0.090) and bonds (-0.18) do not offer protection against inflation as returns tend to decrease in an inflationary environment.

 With that being said, leasing durations can vary significantly by asset class which requires examining which property types provide the best hedge against inflation. In the U.S., apartment total returns have the highest correlation (0.51) followed by office total returns at 0.45. Retail and industrial total returns have the lowest positive correlation reflecting the longer-term nature of these leases. While we were not able to obtain reliable data on the niche self-storage asset class, we believe it is particularly well-suited to outperform in an inflationary environment. The month-to-month tenancies and lack of pricing regulation provide a near perfect opportunity to track inflation. Additionally, steel prices are likely to increase due to inflation and geopolitical issues, thereby driving replacement costs and capital appreciation.

 While real estate should not be expected to outperform gold, commodities, or Bitcoin in an inflationary environment, it offers a far less speculative and income generating opportunity with adequate inflation protection. As mentioned previously, even though the prospects of high inflation have increased, it is careless to believe that a 30-year trend of disinflation will certainly reverse itself. It is for this reason that savvy investors should not over-hedge against inflation to the complete detriment of current returns, yet still ensure that their portfolios are capable of generating some level of real returns in an inflationary environment.

Sources:

1. https://www.economist.com/leaders/2021/02/10/how-rising-inflation-could-disrupt-the-worlds-economic-policies

2. https://financialpost.com/news/economy/canadian-households-and-businesses-sitting-on-170-billion-excess-cash-hoard-cibc

3. https://www.economist.com/briefing/2020/12/12/a-surge-in-inflation-looks-unlikely

4. https://www.usinflationcalculator.com/inflation/historical-inflation-rates/

5. https://awealthofcommonsense.com/2014/06/1966-1982-stock-market-really-bad/

6. https://www.principalglobal.com/documentdownload/134350