Are You Worried About Inflation?
December 19, 2017 | Brad Case | Nareit
I’ve noticed an uptick in the number of people who seem to be concerned about an increase in the inflation rate, and the number of people who have inquired whether real estate—and REITs in particular—provide “a hedge against inflation.” Of course, there is substantial disagreement as to whether we are at imminent risk of increased inflation, but the concern is that tightness in employment markets may drive up wage growth, which could then drive up the price level. So I thought it would be a good time to review the historical evidence on the relationship between high inflation and REIT returns.
I typically don’t use the word “hedge” when talking about inflation, because essentially no investors (not even the largest and most sophisticated) literally set up a hedge to protect against inflation. Loose talk about “hedging” seems to have enticed many supposedly sophisticated investors into asking the wrong questions, doing the wrong empirical analyses, and investing in the wrong assets.
If what you’re going to do is set up a hedge, you need to compute a hedge ratio, which is based on the correlation between the risk you’re trying to hedge against (inflation) and the returns that will help you offset it. Inflation is reported monthly, so common practice is to compute the correlation between monthly inflation and monthly returns. Only one common asset has an especially high contemporaneous correlation with monthly inflation, and that’s energy-related commodities. (No surprise there: the main input that determines the monthly inflation rate is that month’s change in energy prices.)
