Investor Fears Inflated

Finding quality properties in tighter markets should take precedence over inflation concerns

November 1, 2012

Conventional wisdom suggests that commercial real estate is a good hedge against inflation. But since inflation is expected to remain at about 2 percent per year for the foreseeable future, commercial real estate investors are advised to look at the overall performance of a property or pooled investment fund rather than its utility as an inflation hedge, says Martha Peyton, CRE, managing director and head of Global Real Estate Strategy and Research at TIAA-CREF in Newport Beach, Calif.

If inflation is expected to remain at 2 percent in the next couple of years, why are some people so worried about it?

In the fall of 2011, I wrote an article for Real Estate Issues magazine dealing with this very point. The disproportionate concern over inflation stems from a misunderstanding, a paranoia really, about the importance of the short-term federal budget deficit and the long-term federal debt problem. The discussion about inflation is tied into a mind-set that high government debt leads to inflation and is therefore bad. The Federal Reserve in September said that it anticipates that inflation over the medium term likely would run at or below its 2 percent objective. If inflation does accelerate, commercial real estate performance has the potential to accelerate with it.

So commercial real estate investors don’t have to consider inflation as an issue now?

Since the early 1980s, hedging inflation has been a relatively minor point when portfolio managers consider how much to allocate to commercial real estate. This is because inflation in recent years has been very modest and commercial real estate returns have been relatively strong. According to research by TIAA-CREF Global Real Estate that compares how well various asset types perform as inflation hedges, among 5,000 portfolios with five-year holding periods, but with random starting years from 1978 to 2011, the National Council of Real Estate Investment Fiduciaries Property Index’s total returns for commercial real estate beat inflation 84 percent of the time, and by a huge 698 basis points, on average. This was higher than the S&P 500’s record of 79 percent, although it did not exceed short- and long-term Treasuries or corporate bonds, all of which had scores over 90 percent.

What factors should commercial real estate investors pay attention to?

A commercial real estate investor should choose quality properties in locations where demand is strong and supply is controlled, regardless of the inflation environment. If there are three projects within a mile of the property an investor wants to buy that will start construction next month, he might want to consider another investment, because he has a much better prospect of making a good return if he chooses a tight market.If there is inflation, an investor will be better off in a relatively tight market like New York where inflation associated with faster job growth and rising demand for space will push rents up because vacancy rates are low. But in Atlanta, where vacancy rates are high, increasing demand will need to absorb excess space before rents can increase. Only if the market is tight do you get a nice bang out of inflation.

Hortense Leon is a Miami-based freelance business writer who has been covering commercial real estate for 20 years.