August 4, 2022

CRE's Inflation-Hedging Abilities Put to the Test

After performing admirably in Q1, real estate’s inflation-hedging abilities are being put to the test, according to a new report from LaSalle about what will impact commercial real estate in the second half of the year.

“It would be reckless to conclude that real estate will emerge unscathed from capital market chaos or a slowdown in national economies,” LaSalle wrote.

Falling stock and bond indices will likely lead to less liquidity for all forms of private equity, including real estate, and private real estate’s performance tends to lag equities and public bonds, it wrote.

In addition, it seems likely that both core and non-core strategies will face headwinds and tailwinds in the second half of the year, LaSalle also said.

The less accommodative interest rate environment is a challenge to core investors and an exposure to higher construction costs (materials and labor) “will play a part in determining how exposed various sectors and investment styles are to the higher rate and inflation environment,” LaSalle expressed.

“Given all the liquidity still in the system, it is hard’ to see distress manifesting until later in the cycle. Rather than tilting between risk profiles, more important considerations are underwriting and mitigating the relevant risks to each investment style.”

‘Reckless is a Dramatic Word’

So says Jeff Cox, managing partner, Northmarq, who tells GlobeSt.com that “history tells us that real estate performance will be impacted by capital market changes or economic variability.

“But not all capital market or economic changes are alike. Further, not all real estate product types act uniformly to such changes. For example, notwithstanding recent Fed interest rate increases, we remain in a strong job growth market. U.S. jobless claims are the lowest they have been since 1969.

“Additionally, global equity markets gained positive ground in July. So, there are conflicting economic vitality statistics even within our current market conditions. In the net lease sector, we are maintaining a healthy pace of listings and closings, indicating an ongoing demand for net lease product and the stable returns it generates.”

Cox said that real estate, particularly net lease real estate, “has proved very durable during times of market variability. Historically, it has long served as an inflationary hedge. And during times of economic uncertainty, we consistently witness a flight to quality.”

Miranda Dean, senior Associate at Archer.re, tells GlobeSt.com that one way investors navigate the higher inflation and interest rate environment is to shift more of their capital allocation into CRE debt.

“Well-structured debt can give investors greater protection over the principal balance, a long-term inflation hedge, and avoid the potential of negative yields,” Dean said. “Diversification is critical during market uncertainty, and debt can provide greater exposure to a variety of tenants, sectors, geographies, and borrowers, all of which help mitigate risk and support a more balanced income stream.”

RE Not Always the Inflation Hedge

Charles Krawitz, Alliant Credit Union senior vice president, chief capital markets officer and head of commercial lending, tells GlobeSt.com, “Real estate investments may not always serve as the inflation hedge that many are counting on. The stress and strain that consumers are feeling as a result of inflation will, in due time, manifest itself in diminished rents across multiple property types.

“As evidenced by declining savings, higher credit card balances and an uptick in personal term loans, consumers, particularly those making less than $80,000 annually, will be hard pressed to afford increased apartment rents, or be in a position to buy elective merchandise.

“While wages have increased, the impact of inflation on consumer spending is real and there are knock-on effects relating to the demand for industrial space, the viability of retailers, and ultimately the value of the associated real estate.

“Furthermore, raising interest rates have caused borrowing costs to increase and reduced the cash flow potential of underlying properties. The market is currently sorting out the related value consequences associated with these changed prospects.”

‘Cloudy’ Outlook from Yardi Matrix

Paul Fiorilla, Director of Research, Yardi Matrix, wrote last month that the second half of 2022 presents unique challenges given how rapidly conditions are changing as volatility in the 10-year Treasury yield is likely to persist and that “every piece of news is a mixed blessing.”

Good economic news increases the cost of financing real estate while bad economic news provides relief for rates but deteriorates NOI forecasts, Fiorilla said.

“Growth is sure to slow as the pandemic stimulus windfalls shrink and higher prices erode consumer purchasing power,” according to Fiorilla. “The full extent of the deceleration – whether and when it leads to a recession, and how deep the recession extends – is very much in doubt.

“The impact on debt markets depends to a great deal on how the economy performs in coming quarters and whether the Fed successfully manages to slow inflation without creating a sharp recession. However it plays out, clearly the landscape is growing more difficult for the industry compared to the consistent growth of the last decade.”

Investing Requires a Nuanced Approach

Kevin Fagen, senior director—head of CRE economic analysis, Moody’s, wrote earlier this year, at the start of when the Federal Reserve began raising rates, that those seeking shelter in CRE must take a nuanced approach.

“CRE does have many characteristics that offer strong protection – or even outsized gains – during unexpectedly high inflation, but CRE is very diverse,” Fagan said. “In times like these, investors, particularly on the debt side, must adhere to another, even older adage: caveat emptor.”

Four things Fagan said to consider while investing in CRE in times of high inflation are property demand, price, hold period, and capital stack.

With demand, he said that “not all that glitters is gold. Are you investing in an asset or CRE segment with enough demand to push net property revenue in-line with inflation? Is inflation expected to be driven by macroeconomic demand, or mostly some exogenous or structural constraint on the markets?”

With pricing, he said having no breathing room can choke tightly priced assets. “Is there any cushion in the risk premium of your cap rate or loan coupons to absorb a sustained rise in interest rates? When a much greater value decline is implied for every basis point of cap rate rise for the very low cap rate properties, can you get the higher rent growth needed to maintain your property’s market value?”

Patience is a virtue as applied to the hold period, he said. “Can you carry the asset for an unexpectedly longer hold period to ride out the downward pressure of rising rates? Will a reactionary rise in rates occur gradually enough that revenues can quell the impact to values?

Finally, catch the upside if you can when it comes to the capital stack, he advised. “Are you in a debt position that benefits little from rent growth, while also being exposed to greater maturity default risk, lower recovery rates given default, and lower future value of your principal? Or, are you in an equity position with IRRs bolstered by rent inflation, even if exit values are lower on higher cap rates?”

Changing Markets Lead to Opportunity

Cox said that what has played out historically is that changing market dynamics lead to opportunity.

“Profit-taking opportunities are still available to well-informed buyers and sellers due to the liquidity remaining in the system and pent-up demand created during the pandemic,” Cox said.