Question Topic. Real Estate and Inflation. I was very impressed with your insight and pragmatic business approach to the current real estate cycle... I am preparing for a strategic planning session and wanted to get some insight / information on how real estate performs during periods of high inflation.  As a company, we have no experience in running a real estate portfolio during a period with meaningful inflation . . . while we don?t believe there is imminent risk of inflation . . . we do have concerns that beyond 3 years as the economy pulls out of this current dislocation, there may be some unique inflationary pressures.  In contemplating that scenario . . . we are trying to gain insight into how inflation might impact our company from both an operations and investment perspective.  I thought you might have conducted this type of research or at the very least have some real world experience that  could provide some insight.

DrD's Answer

Overview

First of all, thanks for the feedback; we covered a lot of ground in a brief time. You ask a great question and one that others should be thinking about as well. However, as the current commercial market continues to melt down --and I think we're at the beginning of that stage--most companies with real estate exposures are focusing on survival and other defensive strategies. Thus, you are fortunate to be forward looking as suggested by your question.

Let's start with a definition of inflation. Inflation is the risk of a loss in purchasing power due to a weakening of the dollar against some historical base. It is associated with rising prices for comparable goods with no corollary change in quality or quantity. Inflation risk is the risk that, after adjusting for erosion in purchasing power, a return might not be adequate to compensate for the risk associated with the investment. Investments that can hedge inflation are investments that provide some protection against loss of purchasing power associated with rising prices due to their tendency to generate higher net income during periods of price increases and/or command a higher residual value if offered to the market.

Real Estate as Inflation Hedge

In response to the first element of your question, real estate is an inflation-hedging asset. This is due to several attributes of real estate including its "real nature" which depends on materials and labor as factors of production. As the costs of these components rise, the of existing assets can increase due to laws of supply and demand; new competition will have a higher cost basis. As such, the value of comparable projects will rise. Another "inflation" hedging element of commercial real estate operates on the income side of the equation, with rents rising with inflation and in the case of retail, percentage rents tied to sales levels providing a kicker.

Portfolio Perspective

The issue you are dealing with is properly approached from a portfolio perspective, based on the mix of assets you hold and your goals and objectives. In developing your "strategic plan," you should start with an assessment of your existing portfolio, breaking it down by property type, location, tenant mix, and lease duration. I'd suggest reading my article "A Holistic Approach to Portfolio Management" to get a some ideas on portfolio construction. Try to classify your assets on their "relative inflation" hedging potential. Once you have them grouped, you can establish an inflation hedge rating say on a 1-10 scale. Now, based on what you are trying to do, you can adjust that by looking at buy/sell decisions to fine-tune the mix. Keep in mind you are doing this analysis and making these changes during a very difficult stage of the market in terms of asset sales. On the other hand, you will have some great opportunities to add retail which is the best inflation-hedging property type, especially if you have experience and can sift and winnow among all the weak assets that will be flooding the market over the next 12-18 months or so. Finally, your portfolio values will likely dip further so, if you are a mark-to-market owner, you should be ready for some challenging times but should look at stabilized value of your assets three years out. Good luck.

Category: Real Estate Markets

Question #: 104

Updated: Sept 24, 2009

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