Commercial real estate as an inflation hedge

05-16-2022
Commercial real estate as an inflation hedge

Plus lower correlation to equity and fixed-income returns

 

For many individuals, they either have no exposure to real estate or their exposure is through their home. It’s hard to argue that one’s home is an investment, as its primary purpose is shelter. Real estate, as an investment separate from one’s home, and especially commercial real estate (multi-family, industrial, office, retail, life sciences, and warehousing), may help to diversify investment portfolios. What makes it attractive is the potential for less volatility than the stock market and higher yields than traditional fixed income. Moreover, commercial real estate has historically acted as a hedge against inflation.

Individuals can invest like institutions

Institutional investors, like pensions and endowments, have long used commercial real estate to diversify their portfolios, and currently have about 9% of their total assets invested in real estate.1

Looking back historically, the institutional allocation to real estate reached in upwards of 15%-20% in the early 1980s as investors embraced real estate during the elevated inflation of the 1970s.2 Individual investors today have more options to participate in commercial real estate and create more robust allocations that historically were reserved for institutional investors.

As brick-and-mortar retail shrinks, industrial real estate grows

The pandemic’s effect on how we work and shop has had positive and negative impacts on commercial properties. Some commercial real estate property sectors, such as malls and office buildings, have suffered acutely during the pandemic as shoppers fled malls, restaurants and office buildings for the relative safety of working at home and online shopping. Other areas like multi-family and e-commerce-related real estate have thrived. Overall, commercial property prices rose about 20% over their prior year levels between January 2021 and January 2022.3

The trend of working from home seems to continue even as the pandemic abates. As the labor market tightens amid still-depressed participation rates, employers need to induce workers with greater workplace flexibility to attract employees. Many workers like working from home, and for others, work from home is not merely a convenience that emerged from the pandemic, but a necessity due to insufficient childcare coverage as well as the high costs, in both time and money, of commuting. Accordingly, there is uncertainty about the appropriate amounts of office space in many cities.

The opposite is occurring with industrial real estate, where vacancy rates have decreased considerably, potentially increasing the scope for higher prices and strong future construction growth. That may be less true, however, for many retail buildings, which have vacancy rates that are still above pre-pandemic levels and where changes in work and shopping habits may not revert to pre-pandemic norms.

Another area of strength is real estate related to transportation, warehousing, and distribution, which experienced strong declines in vacancy rates in both the United States and Europe. Demand for logistics-related real estate has benefitted from strong growth in e-commerce since the outbreak of the Covid-19 pandemic. U.S. e-commerce sales accounted for 13% of total retail sales in the fourth quarter (Q4) of 2021, below their peak in the second quarter of 2020 but ahead of their pre-pandemic level of 11% in Q4 2019.4

Demand for industrial real estate also looks to remain strong as tenants focus on improving e-commerce distribution channels, growing inventories to avoid supply-chain disruptions, and in reshoring overseas production. Exhibit 1 highlights this shift in investment into the industrial sectors based on these trends.

Finally, increased government spending on infrastructure is likely to provide opportunities in real estate centered around transportation and renewable energy. In addition, retrofitting existing structures to improve energy, water, and material efficiency is likely to be a key theme in coming years, supporting existing and new sectors of the construction industry. 

Inflation protection is built in

Another bright sector is multi-family housing, which has seen a surge in rental demand driven by strong job growth and household formation. Multi-family properties are one of the better hedges against inflation since landlords can adjust rents more quickly (typically on an annual basis) during an economic expansion period. Case in point: multi-family rents grew by 13.4% in 2021, much faster than the Consumer Price Index of 7.0%.5

Investment implications

Private commercial real estate has the potential to provide return and income streams with a lower correlation to returns from equity, fixed income, and home ownership as well as having sensitivity to inflation.

Stephen Dover, CFA, is Franklin Templeton’s Chief Market Strategist and Head of the Franklin Templeton Investment Institute. Originally published in Stephen Dover's LinkedIn Newsletter Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.

Notes

1. Source: Pension Real Estate Association 2022 Investment Intentions Survey. As of December 31, 2021.
2. Source: “Property and Pension Funds:  the case for an increased allocation to UK commercial real estate in pension fund portfolios” Cluttons Investment Management, March 2019.
3. Source: Real Capital Analytics.
4. Source: US Census Bureau.
5. Source: CBRE as of Q4-2021.

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