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Real Estate: The Potential for Inflation Protection

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“Can investing in commercial real estate provide protection against inflation, and what impact do interest rates have on that dynamic?”

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As the events of 2020 have unfolded, governments and central banks around the world have been deploying measures to support economies impacted by the global health crisis. These policies can include increasing funding for small business loans and unemployment programs for example. This type of support helps economies stabilize during times of recession, but can sometimes lead to overheating of economies as they recover, which could eventually lead to inflation.

Why is this important for individual investors? Over time, inflation can eat away the real value of your portfolio in certain types of assets, such as fixed income or bonds. Other types of investments, such as real estate, have features that may protect its value against inflation.

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What is inflation and why does it occur?


Economic inflation refers to the increase in prices, or changes in the amount of money required to purchase a good or service in the market. The Consumer Price Index (CPI) is one of the most common measures of inflation. Published by the U.S. Bureau of Labor Statistics, CPI measures the change in price for a standardized basket of goods over time. Over the last 30 years, CPI has averaged 2.3% per year, with annual growth ranging from 6.1% to 0.1% per year.

In general, inflation is driven by two major components: (1) Increases in the cost to produce goods and services, where the seller must charge more to offset increasing costs; and (2) increases in demand for those goods and services, which allows the seller to charge more.

To prevent prices from rising too much or too quickly, the United States Federal Reserve Bank and other global central banks monitor and implement monetary policy to target a sustainable and modest inflation rate. Measures taken in monetary policy include controlling the supply of money in the economy. Expansionary (or dovish) policies pump more money into the market with lower interest rates to stimulate economic growth. On the other hand, contractionary (or hawkish) measures remove money from the market and increase interest rates to restrict liquidity which put downward pressure on inflation.

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Breaking down inflation and investing:


Maybe you’ve heard the concept of the time value of money, where “a dollar today is better than a dollar tomorrow.” Note that in this expression, the term “tomorrow” does not literally mean tomorrow, but represents any point in the future--let’s say one year from today for illustration purposes. Why is a dollar today better than a dollar a year from now? This time value of money concept recognizes the fact that inflation will make a dollar less valuable in the future than it is today as prices increase.

Think about it this way: using the actual historical CPI for general grocery items, a trip to the grocery which may have cost you $100 in 2010 would cost you $121.30 in 2020. From this you can see that each dollar buys you less than the year before, and since nearly all expenditures for goods and services are subject to inflation, you would require at least the same increase in your income/earnings just to stay even with inflation.

How does inflation impact different types of investments?


Now we can begin to explain the impact of inflation in reducing the real income or value on fixed income investments or bonds compared to investments that protect against inflation, such as variable rate investments, commodities and real estate.

As the name suggests, a fixed income investment such as a U.S. Treasury savings bond provides for a consistent, fixed cash flow yield throughout the term of the investment, rather than at a variable rate. Below we will examine how fixed income products are harmed by inflation from both and income and value perspective:

Imagine you buy a 10-year $1,000 bond with a coupon rate of 5% per year ($50 coupon). Let’s imagine the actual inflation rate in each year of owning the bond was 3%. In year 1, the amount you made on paper is 5%, but in reality, you only gained 2% in purchasing power, as 3% was lost due to inflation. In this example, the 5% is your “nominal” (before inflation) yield, and 2% is your “real” (inflation adjusted) yield.

The above illustrates how fixed income products can be harmed by inflation.

Investment Strategies and Inflationary Considerations:


Next, we will discuss how other types of investments, such as individual real estate assets or a Real Estate Investment Trust (REIT) portfolio, can act as an inflation “hedge.” Below we explain the fundamental reasons real estate investing may protect against inflation:

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  1. Real estate has a replacement cost – a current building has a replacement cost, or value, which would likely be more expensive for someone to build today.
  2. Rental rates in contractual leases account for future inflation in the market with annual rent escalation, as well as an increase in expenses, which is often passed on to the tenants.
  3. Market rental rates and property values may increase with inflation, instead of being eroded by inflation.
  4. Market rates and values may outpace inflationary growth if the real estate investment is successfully positioned or improved.

You may be familiar with the assumption that “real estate prices always increase.” While this is not an absolute truth (unfavorable market conditions can certainly cause real estate prices to decline), the general premise that, over time, real estate prices have tended to increase, has historically been true. This phenomenon can be explained by many different factors, such as increases in demand (renters, buyers), general value-creation (improvements to the property which impact desirability), and -- you guessed it, inflation. It should be noted, however, there is no way to guarantee real estate prices will increase over any amount of time, or that an investment in any REIT will absolutely yield positive returns for the investor.

Similar in concept to other goods and services in the CPI, part of this upwards trajectory in real estate prices over the last several decades is due to price inflation. Why does price or value inflation occur in real estate? Remember that the most common approach to valuing commercial real estate is based on its current and projected net income, which means that a real estate investment, by its very nature of including annual rent escalations in the lease terms, can keep pace with inflation and preserve the real value of the investment’s income and overall value.

According to the National Council of Real Estate Investment Fiduciaries (NCREIF), the NCREIF Property Index (NPI), which includes both income and value growth, has exceeded inflation in 32 of 38 years of tracking private commercial real estate returns.

Main Takeaway:


With the intrinsic value of real estate combined with annually adjusted lease terms and shared operating expenses that may increase a property’s net operating income over time, commercial real estate can help minimize the negative impacts of inflation as part of a diversified portfolio strategy.

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Sources:
1. http://mediacenter.toppanmerrill.com/interface/viewer.asp?LocationID=9677775&ClientID=63&Purpose=HUMAN_VIEW&Caller=RETRIEVE_FILE
2. https://www.realized1031.com/blog/real-estate-as-an-inflation-hedge
3. https://fundrise.com/education/blog-posts/real-estate-is-a-hard-asset

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The NPI is a quarterly, composite total return for private commercial real estate properties located in the United States. The NPI includes operating office, retail, industrial, apartment, or hotel properties accounted for on a market value basis and includes the impact of leverage employed on the properties in the index. The NPI Levered Index is illustrative of historical average annualized commercial real estate returns on a gross property level leveraged basis, and these historical returns may not be indicative of future results. Leverage adds additional risks because leverage providers generally get paid first and may have a full or partial recourse claim against a portfolio. Such real estate return data should not be used to estimate returns of Jamestown Invest investments. While Jamestown Invest 1, LLC may acquire properties that meet some of the NPI criteria, it may acquire properties that do not meet such criteria. Further, Jamestown Invest property returns may have a better or worse average annualized return performance compared to the index as each real estate investment is unique in nature, which is inherently problematic for benchmarking to the composite returns of a highly diversified index.