The assumption you often hear in CRE is that real estate provides a good hedge against inflation. The idea is that rents can go up with the cost of living, allowing landlords to keep value through improved net operating income.
Consulting firm McKinsey did an analysis to see if the common wisdom was correct. And it was, well, the result at least, but not the rationale.
“According to McKinsey’s analysis, CRE outperformed inflation, its own historical average, and other asset classes (including stocks, bonds, and gold) during most of the last seven periods of elevated inflation,” the firm wrote. “However, there’s a wrinkle in the data that contradicts accepted wisdom: CRE performed this way despite rents generally not keeping up with inflation.”
Woops. What happened? And how does matching inflation work then?
The answer, according to McKinsey, is cap rate compression. Capitalization rates are effectively the net operating income yield investors will accept. In higher inflationary times, with rising interest rates, cap rate spreads frequently narrow.
Through seven inflationary periods from 1980 to 2022, CRE returns outperformed inflation and other asset classes. “In every period, at least one CRE sector—multifamily, office, retail, or industrial—beat inflation,” McKinsey wrote. “And in six of the seven inflationary periods, the period’s top-performing sector outperformed both stocks and bonds.”
When cap rates fall, assuming that NOI hasn’t changed, property values have increased.
McKinsey speculates that the cap rate compression might happen because people expect that real estate is supposed to hedge against inflation, and so they put money into the asset class. “Historically, CRE has outperformed during inflationary periods since 1980,” the firm wrote. “During each of these periods, although rent growth did not keep up with inflation, cap rate compression contributed to outperformance.” Annualized rent growth was 3%. Annualized inflation was 5%.
But conditions today are not what they were even five years ago, let along 40. The U.S. has faced the fastest tightening of monetary supply through interest rate increases and quantitative tightening in history. Cap rates may act differently because lease increases have slowed substantially, and investors are holding a lot of capital on the side waiting to see what will happening. Without the flood of capital, investors aren’t bidding up asset prices, keeping cap rates down.
If cap rates expand, the ability of CRE to outpace inflation will face a challenge. According to McKinsey, there are a few things owners and operators can do to mitigate that change. One is focus on leaner operating costs, which increases NOI. Rework optimization planning for higher interest rates. A second is to improve tenant experience by paying attention to what tenants value most, which can attract people willing to pay more. Third, make inflation a factor in planning acquisitions, property development, and dispositions.