2022 has proven to be challenging for investors, as the year began with much volatility and uncertainty in the global markets. The economy entered a turbulent time as interest rates moved up and inflation concerns became top of mind for investors. According to the Bureau of Labor Statistics, the Consumer Price Index (CPI) was up 8.3% in August over the prior 12 months. This was the 16th month in a row where the inflation rate reached 5% or higher. Inflation rates have soared to levels last seen in the early 1980s.
Inflation is defined as the decline in purchasing power over time. In the current environment, inflation has been driven by shortages of labor and supply, along with a rise in demand for goods and services across the economy. The Federal Reserve has imposed a succession of steep interest rate hikes this year in an effort to tame the inflation rate. The ideal investments for hedging against inflation include those that maintain their value during inflation or increase in value over time.
This week’s chart focuses on the relationship between commercial real estate (CRE) returns and CPI year-over-year (YoY). With the exception of the volatility that markets experienced during the global financial crisis and the COVID-19 pandemic, commercial real estate returns have kept pace with yearly changes in the inflation rate.
Over the long term, commercial real estate is an asset class that has historically generated predictable cash flow. Some of the underlying leases have the option of raising rents alongside CPI. Shorter-term leases, such as multifamily, can quickly adapt to rising costs by increasing renewal and new lease rents as inflation increases over time. For longer-term leases, such as office and retail, many lease agreements include annual base-rent adjustments that are tied directly to changes in CPI.
The recent divergence observed between inflation and commercial real estate returns could be signaling a higher risk of recession. The deviation has been partly driven by higher market volatility, along with increasing risk premiums and aggressive interest rate hikes. Rising interest rates are beginning to put some upward pressure on capitalization rates, which are highly correlated.
The capitalization rate (or cap rate) is a measure of return on investment that can be expected for a commercial real estate property. The cap-rate spread represents the difference between the cap rate of commercial properties and current interest rates. This spread is generally higher in times of economic turmoil, and lower in times of growth and stability.
Key Takeaway
Commercial real estate investments can provide a good hedge against inflation over the long term because of the cash flow they generate. Tangible assets such as CRE tend to appreciate in value proportionately with inflation. Rents and property values are highly correlated with rising consumer prices. Fixed-term leases of commercial real estate loans allow rents to keep pace with inflation through rent increases. CRE remained relatively stable during the pandemic due to the stable cash flow in the asset class, even amid times of high economic instability.
Investors are looking to commercial real estate as a hedge for inflation, in addition to providing portfolio diversification. Long-term investments in CRE can serve as a cushion against inflation because they provide reliable returns compared to stocks and other higher-beta investment options. While economic conditions have weakened since the start of 2022, commercial real estate properties continue to perform. Despite some increased uncertainty, the overall outlook for commercial real estate remains favorable.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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