Value Insight Realty

Real estate can provide investors with an effective hedge against persistent inflation. Given its low correlation with traditional asset classes such as stocks and bonds, real estate fulfills a meaningful purpose in a diversified portfolio. By providing inflation-protected income, real assets support slow and steady long-term capital appreciation.

by Gaina Samarah, CFA, CAIA, MFin

The inflation conundrum and its economic implications have been dominating the press as of late, with many economists and investors contemplating the trajectory of price pressures. Is this inflation uptick transitory or more persistent? Is technology induced deflation on the horizon? No one knows for sure.

We propose that real estate can provide investors with an effective hedge against persistent inflation. Given its low correlation with traditional asset classes such as stocks and bonds, real estate fulfills a meaningful purpose in a diversified portfolio. By providing inflation-protected income, real assets support slow and steady long-term capital appreciation.

Macro Backdrop

Investment in private real estate has grown significantly in recent years. Between 2011 and 2021, global real estate investments rose from US$ 100 billion to approximately US$ 250 billion⁽¹⁾. The current macroeconomic backdrop is expected to support continued expansion of the asset class.

One of the driving factors of capital inflows to alternative assets has been the protracted low yield environment, which fuelled investor willingness to seek alternatives. Further exacerbating the hunt for yield is the volume of negative yielding debt globally, currently standing at $10.7 trillion, down from a peak of $18 trillion in December 2020⁽²⁾. With nominal rates at historic lows, these assets essentially guarantee negative real returns. In other words, invested capital is lost due to the erosion of the value of money.

Inflation or Deflation, both?

We believe that it is too simplistic to paint broad market considerations with a single brush. Both inflationary and deflationary pressures are building up in the economy, with winners and losers on each side.

Let’s begin with the inflationary pressures that matter to the average family. In Canada, the average household dedicates almost two-thirds of spending to shelter, transportation and food, which accounted for approximately 30%, 18.5%, and 15%, respectively, in 2019⁽³⁾.

Rising inflation has been driven by increases in essential goods: energy, food, and consumer staples. Numerous factors, including supply chain disruptions and pent-up demand, have pushed up costs of raw materials. Rising oil prices, which tend to have a disproportionate effect on low-income households⁽⁴⁾, have resulted from supply restrictions and ESG policies.

Many businesses have already begun public dialogue around cost-push inflation, suggesting that rising input costs and supply bottlenecks will be passed on to end consumers. For example, Unilever Plc has warned that costs for raw materials in shampoo, detergents and ice cream are rising in the high-teens, a percentage pace not seen in more than a decade, prompting plans to increase consumer prices⁽⁵⁾. If prices for basic goods and shelter increase over time and erode the purchasing power of the consumer, that is the basic definition of inflation.

Led by investment in innovation, deflationary pressures in services such as technology are also present in the economy. However, the majority of the efficiencies gained from automation and innovation are likely to accrue to corporate entities and benefit a more affluent portion of the population that isn’t as sensitive to price increases in everyday essentials. Both the Bank of Canada and the Fed hold the view that inflation is likely to be more transitory in nature. Market implied inflation as measured by the US 10-year breakeven inflation rate, is about 2.7%⁽⁶⁾, a level last seen prior to the Great Financial Crisis of 2008. Benjamin Tal of CIBC suggests that what matters more is to what extent inflation will be sticky, and how fast central banks will need to raise interest rates. He points out that inflation is a lagging indicator, and historically policy response has been late when inflation overshoots, leading to sharp interest rate increases ⁽⁷⁾.

The low-rate environment, potential implications of higher inflation and fairly muted central bank response may drive continued negative real returns, especially in the fixed income universe, pushing capital into alternatives. The chase for yield is likely to persist and accelerate, with assets like real estate standing to benefit from capital inflows.

Real Estate Investing

Institutional investors’ love for tangible assets has been growing since David F. Swensen, the former chief investment officer of the Yale University endowment fund, popularized the Endowment Model nearly 30 years ago. The investment strategy postured a focus on broad diversification, an equity orientation, and a relatively heavy exposure to alternative and private investments, such as direct real estate holdings⁽⁸⁾.

In recent decades, real estate price appreciation has provided an additional source of return to income, as new capital shifted from stocks and bonds for diversification. Allocations to direct investments in physical assets will likely continue to increase as investors seek to gain exposure to inflation sensitive assets as a hedge against uncertainty in the future inflation rate⁽⁹⁾.

Real estate assets have historically provided inflation hedge as property values generally increase with the cost of rent, as lease payments are often adjusted for inflation⁽¹⁰⁾. Replacement cost, the cost to rebuild an existing building is also often viewed as an indicator of current value. As prices of land, labor, and materials keep rising with inflation, so does replacement cost, pushing market values higher⁽¹¹⁾.

Commercial real estate activity in Canada continues to rebound and the GTA continues to be one of Canada’s most sought-after real estate investment markets. The top assets preferred by investors remain industrial and land assets followed by food anchored retail strip assets that drive traffic and have growth potential⁽¹²⁾.

With the backdrop of the current prolonged low-interest rate environment, real estate continues to offer attractive investment income, diversification benefits to a portfolio, and a hedge against inflation.