CRE’s a Hedge Against Inflation, But So What?

Inflation is about as dangerous as an after-dinner mint these days, which casts some doubt on commercial real estate's traditional role as a hedge against inflation.

Inflation is about as dangerous as an after-dinner mint these days, which casts some doubt on commercial real estate’s traditional role as a hedge against inflation. The most recent numbers from the Bureau of Labor Statistics are the latest in a long line of flaccid readings. According to the BLS, its Consumer Price Index for All Urban Consumers increased 0.2 percent in February, and not only because of gasoline’s dead-cat bounce in prices. The small increase was actually broad-based, with increases in shelter, energy and food all contributing. However, the all items index was unchanged over the past 12 months, after showing a 0.1 percent decline for the 12 months ending January. The annual readings generally involved the large drop in the price of gas balancing the small increases in the prices of most everything else.

Considering that this is an age of easy money, the conventional wisdom has it that there should be more inflation—something like in the 1970s, another time of easy money. But the economy has been defying this wisdom for a fair number of years now, and only the most die-hard inflation hawks are worried about monetary policy bringing back the inflation of the Nixon, Ford and Carter years. Martha Peyton, head of global real estate strategy and research, wrote about some of the reasons for today’s meager inflation: “According to our analysis, several factors have combined to keep inflation at bay, including the growth in global trade, a relatively stable U.S. dollar and the expansion of the financial markets worldwide.”

In decades past, one reason to hold commercial real estate is to “hedge against inflation.” There are generally sound historical justifications for that practice: during periods of inflation, such as in the 1970s (around 12 percent at the end of the decade), or even the more modest inflation of the 1990s, real property generally does offer returns that stay ahead of whatever the inflation rate happens to be. The main reason is the structure of leases. Short-term leases can be negotiated to account for the rate of inflation, and even long-term leases often have increases built in, sometimes tied directly to the inflation rate. Landlords can’t always get these increases—much depends on the state of local markets—but on the whole, they do.

In the current climate, however, inflation isn’t that hard to stay ahead of. Thus in our time, owners focus on returns that stay ahead of that other important rate: interest rates. A property that can’t offer a return ahead of today’s pitifully small interest rates isn’t much of an investment. Conversely, a consistent return well ahead of interest rates will be most attractive to investors, who are loathe to park their money in, say, Treasuries or other low-yielding instruments. That contributes to the current condition of a lot of capital chasing the best commercial properties—and helping keep the sector healthy.