Inflation and Commercial Real Estate Returns
July 6, 2021 | James Sprow | Blue Vault
Before we delve into the relationship between inflation and returns on commercial real estate investment, let’s see if the inflation numbers we’ve seen lately are signs of a long-term trend that can be expected to continue, or a temporary or “transitory” blip due to bottlenecks in the supply chain as we recover from the pandemic.
U.S. consumer prices accelerated 5% in the year to May, for the biggest year-on-year increase in 13 years. But we need to be cautious when making those comparisons, recognizing that any year-to-year comparisons are likely to be unusual, given that 2020 was an anomalous year, to say the least, due to the pandemic. According to Ben Hunt of Epsilon Theory, “Every measurement you see about inflation in 2021 is impossibly corrupted by the year-over-year comparison to a pandemic-depressed economy, so it’s probably best if you just avert your eyes entirely.”
Matt King, Citi’s market strategist, said on July 1 that he’s not convinced that what we’re seeing is anything more than bottlenecks. “What you need is a sustained wage price cycle and I’m not convinced there’s a change here,” he told a Citi media summit.
Even in the Eurozone, leaders like ECB President Christine Lagarde have said “current price pressures are ‘mostly transitory.’”
For a very in-depth analysis of “transitory inflation” we recommend an article by Jim Welsh of Macro Tides entitled “Transitory Inflation? Not so Quick” at Transitory Inflation? Not so Quick – Macro Tides – Commentaries – Advisor Perspectives. That article states: “Core inflation is likely to continue to increase as service and shelter inflation trend higher. Finally, a number of factors are coming together to lift wage inflation in coming quarters as the reopening of the economy progresses and companies pay more to attract workers. As these four factors unfold headline inflation is unlikely to recede as much as expected and core inflation will hold significantly above the Fed’s 2.0% Core PCE target for the balance of 2021.”
One fact that cannot be denied is the historically unprecedented creation of massive amounts of money by the Federal government to support consumer demand during the pandemic. It is difficult to ignore the potential impacts of that monetary stimulus on the rates of inflation going forward. We are reminded of Milton Friedman’s observation: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Clearly, the trillions of dollars of stimulus have not been accompanied by proportional increases in economic output. While U.S. saving rates have increased at rates heretofore unseen, as the pandemic ends that pent up purchasing power will be released and demand will at least temporarily exceed supply, driving up prices.
To summarize, there are analysts who believe that recent inflationary trends are largely transitory, and other analysts who see higher persistent rates of inflation on the horizon. So many factors affect both actual rates of inflation and expectations of future inflation, both of which are important. We lean toward the view that higher rates of inflation are inevitable, simply because of the huge increases in the money supply that cannot be absorbed by an economy as it approaches full employment.
Commercial Real Estate Returns and Inflation
NAREIT provides convincing evidence from past periods that REIT returns consistently outperform inflation. For example, “Over the twenty-year period (2001 thru 2020), average annual growth for dividends per share 9.4% (or 8.4% compounded) compared to only 2.1% (2.0% compounded) for consumer prices.”
The following chart shows returns on listed REITs compared to S&P 500 returns during three different periods. Low inflation includes years when inflation was 2.5% or lower. REIT income returns and price returns taken together did not outperform the S&P 500. However, in periods of moderate inflation (2.4% to 6.9%) listed REITs outperformed the S&P in income returns sufficiently to overcome the index in total returns. In periods of high inflation (6.9% or higher) listed REITs outperformed the S&P 500 due to the increases in dividends the REITs provided when price performance was low for both investment types.
The data shows that REITs provide increasing distributions during every inflationary environment, sufficient to outperform the S&P 500 in periods of moderate to high inflation. These historical results show that, if those trends persist, REITs should provide a reasonable hedge if the U.S. economy experiences higher inflation due to the massive fiscal stimulus during the pandemic. And, if those analysts that don’t see higher inflation on the horizon turn out to be prescient, the income returns on listed REITs will still provide reasonable income returns and less volatility in price returns than the S&P 500. For a visual representation that shows the low volatility of continuously offered nontraded REIT returns compared to the S&P 500, see the chart below.
The long-term average total return for the S&P 500 was 0.70% monthly compared to the average return to the continuously offered nontraded REITs over the 17 months in the above sample was 0.56%, just 14 bps lower, with nowhere close to the volatility experienced in the equity market.
Sources: NAREIT, Individual Nontraded REIT websites, Epsilon Theory, Citi, Macro Tides, Financial Times
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