How does real estate provide a hedge against inflation?

By definition, a hedge is a type of investment that helps protect owners and investors against the decreasing purchase power of money when inflation hits. Our research into the historical inflationary trends, coupled with our team's experience, shows that commercial real estate (CRE) investments can act as a hedge in times of above-average inflation.

Two major indicators of inflation, the 1980 Consumer Price Index (CPI) and the Producer Price Index (PPI) rose to 7.9% and 10.0% in February 2022, the steepest yearly increase since February 1980.

Inflation can meddle with the CRE market in many ways. But a 2011 study titled Inflation and Real Estate Investments concluded that 'real estate can be considered a perfect hedge against inflation, under the strong assumption that future rent growth and discount rates move in line with expected and actual inflation rates.'

Keeping in mind that most CRE investments usually earn money through cash flow and appreciation, there are mainly four ways they can act as a hedge against inflation:

One: A property's inflation resiliency largely hinges on the dynamism of marking rents to market. Shorter leases enable property owners to change the rental rate of any new leases to keep on pace with rising inflation — renting an apartment unit for $1,250 to a new tenant instead of the previous rental rate of $1,100, for instance. This can help protect the true value of cash flows and subsequent investor returns.

Two: On top of the fixed-lease term, some CRE leases may include negotiated annual rent escalations to keep up with inflation.

Three: The underlying business model of the tenant can also bolster the strength of the property's ability to hedge against inflation. For example, although retail owners cannot usually adjust rents as quickly as a hotel or multifamily building, many retail leases include 'Percentage Rent,' which essentially translates into a supplemental rent payment that is directly tied to the gross sales of the tenant, be it a Walgreens or Starbucks. When inflation increases the costs of their own goods and services, many of these additional costs are pushed on to the consumer through increased prices on the final product. Provided that that demand doesn't fall by more than the amount of price increases, gross sales of the tenant would rise, which in turn would increase the Percentage Rent paid to the property owner.

Four: For properties financed with long-term fixed-rate debt, when rents go up, net cash flows (what is left over after servicing debt and reserving for capital expenditures) increase, all else equal.

Overall, what typically differentiates a hard asset like real estate from a soft asset like stocks and bonds is the lever owners can pull to control the NOI. A property that has more of these levers generally offers more control to the owner to change the financial outcome and cash flow during inflationary hiccups instead of letting the economy decide the real returns on investments.