Real estate as an inflation hedge

How does inflation affect real estate?

Real estate may provide an attractive inflation hedge, as rents and property values are highly correlated with rising consumer prices. Today’s inflation is partly due to an economy running at full speed, increasing the demand for real estate and driving rents upward. We believe investors should play the long game to benefit from real estate’s inflation hedge characteristics.

Growth in rent has moved in line with inflation

Real estate has generally served as a hedge against inflation over the long term. A key to its effectiveness lies in landlords’ ability to raise rents in markets with low vacancy rates, thus outpacing rising inflation and potentially increasing income to investors.

Landlords benefit from pricing power

In the 50 largest cities across the U.S. and Europe, many sectors showed below-average vacancy rates, giving landlords the power to raise rents. However, above-average vacancies in U.S. offices and European retail may mean rent hikes might not be possible at this time.

Strong demand meets limited supply

Inflation has increased almost in unison across developed markets to levels not seen for approximately 30 years. While we believe inflation will decline markedly as central banks take action to cool global economies, it is important to remember that, historically, higher inflation rates have not systematically affected real estate investment performance.

Real estate remained relatively steady during the COVID-19 pandemic, mainly due to the asset class’s stable income generation even during times of high economic volatility. Past data from the U.S. and European economies suggest that real estate may protect investors from inflation risks.

Inflation hedging works better in periods of demand-driven inflation compared to cost-driven inflation. The current environment features both types. The strong economic rebound has led to aggregate demand driving up wages and prices of goods and services including real estate, which benefits from higher rents. However, higher energy costs and supply bottlenecks have left less money for firms and households to spend on real estate.

Inflation hedges in practice

Inflation can directly drive net operating income growth (real estate income) when long-term leases have built-in rent escalators tied to inflation, which protects the income-generation of in-place leases. New leases allow investors to capitalize on rising market rents.

Today’s sharp increase in commodities and building costs will constrain new supply to some degree, further supporting real estate values. In fact, construction cost inflation has outrun other measures of inflation in recent years. High construction costs imply increased replacement costs for buildings, making existing real estate investments more valuable.

The current run of inflation is partly attributed to an economy running at full speed, which also increases the demand for real estate across the economy, driving rents upward. This can be witnessed across property types, in particular apartment rents and industrial/logistics rental growth.

Target the healthiest cities and sectors

Inflation rates vary widely around the world, and property markets function differently. While this period of inflation should be largely benign for real estate, perhaps even offering a cushion from rising prices, investors are best advised to gain exposure to a variety of property markets and sectors with particular focus on markets and sectors with strong current fundamentals and demand tailwinds.

•    Office: In Europe and Australia, longer-term leases are wholly or partly uprated by national inflation, benefiting operating income. In Asia, shorter leases allow for a quick reversion to market. U.S. offices typically have intermediate- to long-term leases that are generally not index-linked. U.S. medical office and life science segments have similar longer leases, but their stronger fundamental operating environment makes them more defensive.
•    Industrial: Europe directly benefits from index-linked lease terms. The U.S. lacks contractual inflation protection, but many properties have below-market rents due to strong rent growth. Globally, the sector is well-positioned to benefit from economic growth due to the expanding need for warehouse space. Structurally, industrial rents should gain disproportionately from rising inflation, as margins improve for e-commerce and third-party logistics operators. 
•    Retail: Demand outstrips supply in some consumer sectors (hospitality and apparel), resulting in higher prices and healthier occupier balance sheets. In the U.S., intermediate-term leases often capture a percentage of strong sales. Discretionary and luxury segments should remain challenged, mainly in markets such as China, Italy and the U.S. In the grocery-anchored segment, inflation fuels a recovery in wages and consumer spending, which allows for greater rental affordability.
•    Residential: U.S. housing has historically been a low-risk segment, with mainly short-term leases allowing for quick price adjustment. The more heavily regulated European housing sector offers limited options for landlords to raise rents, particularly in important markets like Sweden, Germany or the Netherlands. Japan is the only Asia Pacific market with a deep and liquid pool of multifamily assets, and rising inflation has little bearing on rental growth prospects.