Amid rising inflation last year, investors turned to real estate as a hedge against potential losses in other asset classes.
But according to new research, the ability of real estate — particularly publicly traded real estate investment trusts — to hedge against inflation depends on a number of factors.
In fact, during periods of market turmoil such as the global financial crisis, publicly traded real estate companies did not provide a hedge against inflation and, in some cases, detracted from a diversified portfolio’s ability to hedge. This is according to a paper released this month by the Swiss Finance Institute.
“With those inflationary pressures, it becomes more important to take a fresh look at real estate’s inflation hedging capability by using state-of-the-art estimation techniques,” the researchers wrote. “Against this background, this paper aims to broaden our understanding of the inflation-hedging characteristics of real estate relative to other asset classes.”
The release of the paper comes at a time of upheaval for office properties as workers continue to want to work from home. At the same time, some non-traded real estate investment trusts are struggling, prompting firms like Blackstone and KKR to limited redemptions from their vehicles over the past two months. Still, investors continue to put money into real estate, along with infrastructure and commodities, as a way to protect their portfolios against inflation.
Real estate can protect against inflation because rental or lease payments can increase annually to reflect price increases and land and building values can rise alongside inflation.
Past research on listed real estate as an inflation hedge has used mean variance as a metric for measuring risk.
“However, using variance as the risk measure may not be what corresponds best to investors’ objectives, as variance treats both upside and downside risk as the same,” the paper said. “Because investors usually consider the upside risk to be favorable, the use of variance appears to be unsuitable.”
Instead, the researchers chose to use the expected shortfall, which focuses on measuring the risk of being far below the expected return.
The researchers culled data on publicly traded real estate companies between 1990 and 2021 using the European Public Real Estate Association and Refinitiv Datastream. They constructed portfolios for four regions — the United States, the United Kingdom, Australia, and Japan — that not only included real estate, but also other asset classes to achieve diversification.
The researchers found that in the United States, the United Kingdom, and Japan, listed real estate companies can positively hedge against expected inflation. “This can be explained by the fact that many commercial leases may be inflation-adjusted,” they wrote. “As a result, the cash flows of commercial properties are expected to increase with inflation.”
This holds true both in periods of expected and unexpected inflation, although real estate is a more effective hedge during periods of expected inflation
Where things go awry, though, is in periods of economic or financial turmoil. During crisis periods, such as the global financial crisis, the dot-com bubble, or the COVID-19 pandemic, the hedging ability of real estate vanishes, the researchers found.
They did not explain why this occurs; however, they noted that this is a short-term phenomenon.
In other words, for long-term investors like allocators, listed real estate in a portfolio can be an effective inflation hedge — as long as they hold the investment beyond a crisis.
