Recently I had an interesting exchange of e-mails with my colleague, Rene Circ, over the extent to which commercial real estate functions as an inflation hedge. Circ is Grubb’s national director of industrial research, and we focus on many of the same topics, except he does so from an industrial perspective.
Real estate has a reputation as a hedge against inflation. If you compare annual returns from the National Council of Real Estate Investment Fiduciaries property index with the annual CPI, it clearly shows the surge in property values during the late 1970s and early 1980s, more than keeping pace with the surge in inflation during the Carter administration and the early Reagan years, which was the last widespread outbreak of inflation in the U.S. Commercial real estate is an inflation hedge in two respects. First, the leases usually contain escalation clauses tied to the consumer price index or a specific amount based on a percentage or absolute dollar increase. Secondly, rising inflation usually brings rising construction costs, which is reflected in the replacement cost of existing properties, thus driving up the appraised value.
My colleague reminded me that on the capital side, the opposite is true. If inflation escalates in the future (which many expect), cap rates are likely to escalate as well, eating into property values. Using round numbers to make it simple, let’s assume that an investor pays $100 for a property with a net operating income of $5 in year one, making the property worth $100 ($5 divided by 5 percent). Let’s assume that inflation and interest rates rise by 300 basis points over the first three years of the holding period, pushing the cap rate up by 300 basis points to 8 percent in year three. Let’s further assume that net operating income (primarily rent) rises at 7 percent per year beginning in year one. The value of the property falls from $100 to $76.57 in year three, but because rental rates continue to rise, the value returns to $100 by year seven and keeps rising from there.
In the long run, as inflation reverts to its mean and cap rates follow, real estate does offer protection not offered by most investment alternatives. In the short run, however, capital value destruction outpaces rent growth – a fact that investors should keep in mind as they think about their holding period.