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Higher inflation can be a friend to real estate investors

When investing in real estate, higher inflation is more likely to be a friend than a foe, helping protect investment from supply side issues and driving up the residual value of improvements, says Justin Blaess, portfolio manager at Quay Global Investors.

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“We take the view that investors shouldn’t fear inflation, particularly when it comes to real estate,” he says.

“Indeed, we believe real estate – and thereby listed real estate – is a good inflation hedge. Land is tangible, and well-located land has an intrinsic value; it can be used as a place to build shelter or as a place to do business or access services.

“Because of supply constraints, well-located land will generally appreciate over time. In addition, the cost of replacing any improvements built on the land will also increase through inflation. This is significant, because if there is excess demand for a type of real estate, the market will have to accept rising costs and thereby the rents required to economically justify construction – regardless of the inflation environment.

“Investors in real estate – both direct and listed – can therefore benefit from a higher inflation environment, particularly compared to global equities investments.”

Mr Blaess says it’s worth understanding how listed real estate has performed in previous periods where inflation has been elevated.

“Some questions for investors to consider include: at what levels of inflation does real estate perform best? Can there be too much inflation? Not enough inflation? What if the current US bond yields are correct (currently 1.2 per cent per annum) and we are headed for sustained low inflation?”

To answer these questions, Quay analysed US REIT and S&P500 real and nominal returns by constructing indices for when headline CPI was both less than and greater than 3 per cent and in increasing increments of 1 per cent. From these indices the average monthly nominal and real returns could be calculated for the purpose of comparison.

“Our analysis shows that listed real estate is an excellent hedge for inflation and has historically delivered strong positive nominal and real returns in higher inflationary environments. It also offers a better relative return when compared to general equities.

“This is especially so when inflation is in the moderate 3 to 6 per cent range, where listed real estate has historically generated more than double the real return relative to equities. Even with very high inflation (6 per cent and above), listed real estate continues to outperform equities (albeit at a lower relative level than in a moderate inflation scenario).

“It’s also interesting to note that over the past 50 years, inflation has been above 3 per cent more often than below. When it has been below 3 per cent, listed real estate nominal and real returns have been quite a bit lower than in a moderate inflation environment. And contrary to common belief, in lower inflation settings listed real estate returns actually tend to lag equities.

“So as someone with a vested interest in the performance and outlook for real estate, when it comes to inflation, we say ‘take a long view and don’t be fearful’,” Mr Blaess says.