How do rising rates and inflation affect real estate?
As we emerge from the pandemic-induced recession, central banks and governments have implemented massive monetary and fiscal stimulus policies to support reopening. As a result, inflation risks are starting to feel more real. Real estate investors are asking how the potential for rising inflation and rates might impact their returns.
We believe rates and inflation are more likely to accelerate than decelerate over the course of 2021 and beyond. But, historically, higher interest rates have not necessarily resulted in lower property values and total returns.
The relative stability of real estate during the COVID-19 pandemic was the result of stable income generation during times of price volatility. This inflation and rate outlook highlights the importance of diversification and a highly active and localized approach to real estate investing.
Real estate may provide an inflation hedge
Real estate may provide a particularly attractive option for investors seeking to hedge against inflation, as both rents and property values are highly correlated with rising consumer prices. Most long-term leases have built-in rent escalators that are tied to inflation, which protects the income generation of in-place leases. New leases allow investors to capitalize on rising market rents.
The sharp increase in lumber and other building costs will constrain new supply to some degree, which will further support real estate values. While rising long-term interest rates may impact real estate values, the net impact largely depends on the speed at which long-term rates increase and the driver of those increases. If increases are due to increased economic growth expectations, the overall impact of rising rates and a reflationary environment should be positive for real estate.
We believe rates and inflation are more likely to accelerate than decelerate over the course of 2021 and beyond.
After analyzing the effects of the pandemic on these trends, Nuveen’s real estate experts see four key outcomes:
- At this point, our outlook indicates that rates and inflation are more likely to accelerate than to decelerate over the course of 2021 and beyond.
- Real estate may provide a particularly attractive option for investors seeking to hedge against inflation, as both rents and property values are highly correlated with rising consumer prices.
- Most long-term leases have built-in rent escalators that are tied to inflation, which protects the income-generation of in-place leases.
- The current outlook highlights the importance of diversification and a highly active and localized approach to real estate investing.
This inflation and rate outlook highlights the importance of diversification and a highly active and localized approach to real estate investing.
Results may vary
The impact of inflation differs by country and property type
Residential real estate leases are mainly short term, allowing for quick adjustment to new price levels. U.S. housing has historically been a low-risk segment, and its lower expected sensitivity to inflation risk is no exception.
While the industrial sector has intermediate- to long-term leases, many properties have below-market rents due to strong rent growth across the sector, even in a low inflationary environment. The sector is well-positioned to benefit from inflation driven by economic growth due to the expanding need for warehouse space.
Office properties also typically have intermediate- to long-term leases, placing the sector at greater risk. The medical office and life science segments face similar inflation risks with longer leases, but have a stronger fundamental operating environment than traditional office, making them more defensive.
The retail sectors carry greater inflation risk. The leases are intermediate-term and they rely on retailer operations, which have been challenging recently. The grocery-anchored segment offers a unique reprieve. Greater inflation would improve the grocery-anchor’s finances while the small-shop rents can adjust relatively quickly.
Japan is the only Asia Pacific residential market with a deep and liquid pool of multifamily assets. The traditional lease structure means rising inflation has little bearing on rental growth prospects.
In the office market, a rise in inflation benefits landlords, as the typically shorter lease term of three years allows for reversion to market. The exception is the Australian market, where step-up rents are inflation-linked and leases are generally intermediate- to long-term.
Retailers of non-discretionary goods such as groceries should benefit from rising inflation or inflationary expectations brought about by a recovery in wages and domestic demand, which in turn allows for greater rental affordability. But the discretionary and luxury segments are still likely to be fundamentally challenged, mainly from e-commerce penetration in markets such as China, South Korea and Hong Kong.
Industrial rents should benefit disproportionately from rising inflation, as margins improve for e-commerce and third-party logistics operators. This is especially true in markets with an undersupply of modern distribution or last mile facilities such as Seoul and regional capital cities in Japan.
For the industrial sector, a burst of higher inflation should benefit landlords in the short term. This shift would refresh income returns that have been gradually eroded since 2010 due to lower cap rates and only moderate market rental growth. However, rental growth for logistics historically has not kept up with inflation over longer periods.
In the office sector, rents are wholly or partly uprated by Consumer Price Index inflation, and higher inflation would benefit the operating income of landlords.
Retail markets should benefit from rising inflation as global pent-up demand outstrips supply in some consumer sectors (namely hospitality and apparel), resulting in higher prices and healthier occupier balance sheets.
Real estate may provide a particularly attractive option for investors seeking to hedge against inflation.
The housing sector proves to be one of the more defensive asset classes, largely linked to its income granularity and its essential nature, and should benefit from rising (and steady) inflation from a stronger economy.
In this issue
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A word on risk
Real estate investments are subject to various risks, including fluctuations in property values, higher expenses or lower income than expected, and potential environmental problems and liability. Please consider all risks carefully prior to investing in any particular strategy. A portfolio’s concentration in the real estate sector makes it subject to greater risk and volatility than other portfolios that are more diversified and its value may be substantially affected by economic events in the real estate industry. International investing involves risks, including risks related to foreign currency, limited liquidity particularly where the underlying asset comprises real estate, less government regulation in some jurisdictions, and the possibility of substantial volatility due to adverse political, economic or other developments.
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