Inflation-Fighting Properties

by Matthew Kaplan, Head of Almanac, Neuberger Berman

Real estate has tended to get a prominent page in inflation playbooks—but do some parts of the market get a particularly strong tailwind from rising prices?

Today’s CIO Weekly Perspectives comes from guest contributor Matthew Kaplan.

With consumer price indices soaring faster than they have for 40 years, many investors are dusting off their inflation playbooks.

Real estate has tended to get a prominent page in those playbooks. Why is that? And are there some parts of the market that are particularly resilient or that experience inflation as a particularly strong tailwind?

Supply Constraints

When construction costs rise, along with commodity prices, wages and other inputs, there usually are two direct outcomes for real estate: The cost of developing new buildings increases, and the price to replace existing buildings increases. A lack of new supply serves to increase demand for existing buildings, typically leading to higher rents. Rising replacement costs support real estate values as both the land and structure generally increase in value. Put simply, most inflationary environments see limited new supply combined with growing demand.

Further, those developers who decide to build despite rising costs usually try to maintain yields by raising the rents on their new properties. That gives owners of existing properties across the same sector more room to raise their own rents, especially if that sector tends to have shorter leases and more frequent renewals.

Increasing costs of debt in an inflationary environment can also affect real estate values as most investors use borrowing for a large portion of their purchases. However, this may not be net-negative for returns for two reasons: First, real estate loans usually have “floors” that typically are above the base rate at the time the loan is made; therefore, the first portion of the base rate increase has no impact on borrowing costs. Second, in inflationary environments, rents tend to increase faster than borrowing costs as rising nominal economic growth supports demand; the same forces driving higher borrowing costs themselves support higher real estate values.

Key Economic Dynamics

Could any of this suggest particular corners of the real estate market to consider when inflation is running hot?

Investors might be tempted to favor shorter leases, just as they would favor shorter duration in bond coupons and equity earnings projections. A self-storage facility usually employs shorter-term, month-to-month leases; a hotel room’s lease is a matter of days. These might appear more likely to track inflation than the five-year lease on an industrial facility, let alone a 10- or 20-year lease on an office or large retail space. However, many long leases have contractual inflation-linked escalators precisely to protect lessors from this risk.

In our view, what is far more important than lease duration is pricing power. Pricing power is driven by the fundamentals of supply and demand. A run-down hotel in a bad market may not protect an investor from inflation despite the ability to reprice its room rates nightly. Contrast that with a new hotel in a highly desirable market that could see strong demand as both corporate and leisure travel recover from the pandemic, thereby potentially generating cash flows in the years ahead that may grow at a rate above inflation.

Several sectors have pricing power, connected to the current inflationary and post-COVID trends. Well-located industrial and retail real estate are seeing strong demand from tenants, likely driven by healthy consumer spending due to increasing wages and excess savings accrued during the pandemic. Residential real estate is benefiting from rising rents, largely driven by increasing wages and the rising costs of home ownership.

Fundamentals Rule

In sum, we believe higher inflation is positive for well-positioned real estate companies.

Demand remains strong in certain asset classes, enabling many companies to capture higher rents, while supply is being limited due to increased construction costs. When investors consider where to allocate within the asset class, we think it is important to push away the complexity and focus on the basic supply/demand dynamics that have been in play for generations: We believe real estate sectors that have a combination of short-term leases and pricing power are particularly well positioned to drive potential returns in an inflationary environment.

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