Real Estate Investing at an Inflation Inflection Point
Why could inflation be on its way?
Improving pandemic conditions, private sector liquidity, pent-up consumer demand, and fiscal stimulus could potentially combine to spur 2021 growth. In the short run, these coordinated factors combined with tight labor markets and supply chain imbalances could mean the highest levels of inflation in years.1 These dynamics may continue to drive up long-term interest rates.
Figure 1: Inflation on the Rise in 2021
Source: Morningstar, annual inflation represented by US BLS CPI All Urban NSA, as of 12/31/2020. Goldman Sachs Global Investment Research, estimate for 2021 CPI growth, as of 3/20/21.
What does inflation mean for real estate?
Real estate can offer dynamic cash flows. Unlike traditional bonds that generate fixed cash flows, the income streams from real estate can rise over time. Prioritizing assets with shorter lease durations in sectors with strong underlying growth fundamentals can result in faster translation of higher market rents into underlying operating cash flows. Hotels effectively have one-night leases. Other sectors, including apartments and warehouses, also tend to have shorter-duration leases. Certain assets with longer duration leases, such as net lease properties, often include contractual rent escalators to mitigate inflationary risks.
Sector selection matters. Bond-like assets that have long-term leases with limited rent resets are more susceptible as rates rise. Sectors facing tenant demand headwinds, such as U.S. regional malls and urban office buildings, may not be able to command near-term rent increases that can keep up with inflation.
Cap rates have room for interest rates to rise. Today, real estate trades at a historically high premium to 10-year Treasuries, with the major sectors cap rate spread significantly wider than the historical average2. Given this starting point, rising interest rates may not necessarily result in a commensurate increase in cap rates or decline in real estate values.
Limited supply generally supports valuations. Supply, even within in-demand sectors like industrial,3 remains in check. In an inflationary environment, increases in the cost of land, construction, and labor are likely to make new supply less financially feasible.
Private real estate income is a potential hedge to inflation
Figure 2: Real Estate Income and Inflation Since 1995 (Indexed, 1995=100)
As of December 31, 2019. Green Street Advisors, Bureau of Labor Statistics. Represents Blackstone Real Estate’s view of the current market environment as of the date appearing in this material only. There can be no assurance that the trends described herein will continue or not reverse. Past performance does not guarantee future results. Net operating income (NOI) growth represents the average NOI growth by year across the apartment, industrial, mall, office and strip retail sectors. The Consumer Price Index (CPI) measures changes in the prices paid by urban consumers for a representative basket of goods and services. NOI may not be correlated to or continue to keep pace with inflation.
U.S. private real estate values generally have increased during periods of rising interest rates
Figure 3: Private Real Estate in Rising Interest Rate Environments
Note: Morningstar, NCREIF. The time periods above (1993-1994, 1998-1999, 2003-2007, 2012-2013, 2016-2018) constitute select episodes over the 25-year period from 1993 to 2018 when treasury yields increased by more than 135bps. U.S. Private Real Estate Return is represented by the NCREIF Property Index (NPI) annualized return; annualized returns refer to the specified time period plus one additional year. The NPI quotes returns that do not reflect the use of leverage or the impact of management and advisory fees. Returns net of management and advisory fees would be materially lower. The NPI is a quarterly time series composite total rate of return measure of investment performance of a very large pool of unleveraged individual private real estate properties acquired in the private market for investment purposes only. The annualized return for the NPI for the time periods shown (1993-2018) is 9.2%. The rise in 10-yr UST is represented by the peak and trough 10-yr UST during each time frame presented. Past performance is not necessarily indicative of future results.
Access Real Estate Investing at an Inflation Inflection Point
- Bloomberg consensus forecasts, as of 3/22/21.
- Major sectors real estate cap rate was 5.4% as of March 31, 2021. 10-Yr UST was 1.7% as of March 31, 2021. The “long-term average” reflects the period between March 1986 to March 2021. “Major Sectors” is sourced from Green Street Advisors and reflects the equal weighted average of the asset weighted averages for the five major property sectors (apartments, industrial, mall, office, and strip center).
- CBRE-EA, as of 3/31/21.
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