Commercial real estate (CRE) has long enjoyed a reputation for being a good hedge against inflation, yet even industry veterans might be hard-pressed to explain exactly why. Has it delivered better real (inflation-adjusted) returns during inflationary periods than at other times? Has it outperformed other asset classes during inflationary periods? With inflation at 40-year highs, we decided to perform a data analysis of CRE’s inflation-hedging attributes. Our goal: a definitive answer to whether CRE deserves its golden reputation and a sense of how it might perform this time around.
The answer to the first question is yes: CRE has helped investors retain real value during periods of heightened inflation. 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. However, there’s a wrinkle in the data that contradicts accepted wisdom: CRE performed this way despite rents generally not keeping up with inflation.
The principal reason CRE has served well as an inflation hedge1In this analysis, an “inflation hedge” is defined as an asset with a rate of return that is higher than the current inflation rate. is that in periods of higher inflation, capitalization rates—effectively, the net operating income (NOI) yield investors are willing to accept—have tended to compress. While interest rates typically rise in periods of inflation, cap rate spreads often narrow. This counterintuitive finding is perhaps partly the result of widespread belief in real estate’s inflation-hedging properties: investors put money into asset classes they believe will protect real value.
Understanding how cap rates have contributed to CRE’s inflation-hedging identity is particularly pertinent to modeling potential outcomes for the asset class today. That’s because currently, amid the fastest monetary tightening on record, cap rate trajectories may differ substantially from those of past inflationary periods. As the macroeconomic panorama evolves, owners contemplating operating, refinancing, or selling existing assets, as well as investors considering new opportunities, can benefit from understanding the following dynamics:
- Historically, CRE has outperformed during inflationary periods since 1980. During each of these periods, although rent growth did not keep up with inflation, cap rate compression contributed to outperformance.
- This time, however, macroeconomic conditions could lead to cap rate expansion, which could erode CRE’s inflation-hedging prowess.
- Building owners may be able to maintain and grow real asset value by considering certain value-creating actions.
Historically, CRE has outperformed during inflationary periods
Following losses induced by the COVID-19 pandemic, CRE returns have partially rebounded along with inflation, despite continued softness in the office market. But real risks could be introduced by persistently high inflation and interest rates, the rising cost and declining availability of debt, and possible economic contraction—all of which may lead to cap rate expansion. To prepare, real estate players can start by arming themselves with a fresh understanding of an old piece of industry wisdom.
During the seven inflationary periods from 1980 to 2022,2Inflationary periods are defined as segments of six or more quarters of consecutive inflation higher than the respective decade average. The seven periods within the range of years studied are 1Q 1980–3Q 1982, 1Q 1990–3Q 1991, 1Q 2000–3Q 2001, 2Q 2004–3Q 2006, 1Q 2011–2Q 2012, 4Q 2016–4Q 2018, and 2Q 2021–present. CRE returns, at 11.7 percent annualized, have generally outperformed inflation, their own historical average, and other asset classes, including the S&P 500 and BBB corporate bonds (exhibit). More specifically, CRE outperformed inflation in six of the seven inflationary periods and outperformed its own historical average in five of them. The asset class outperformed stocks in four of the seven periods, and bonds in six of them. Real estate broadly has been a useful hedge against inflation.
In every period, at least one CRE sector—multifamily, office, retail, or industrial—beat inflation. And in six of the seven inflationary periods, the period’s top-performing sector outperformed both stocks and bonds. Picking the right sector based on fundamentals, for those with the foresight to do it, has been a great investment relative to other options in the same time periods.
Historically, even investors that didn’t pick the top-performing sector would have managed to generate real inflation-adjusted returns in most periods. The bottom-performing CRE sector in each inflationary period managed to outperform inflation in six of the seven inflationary periods. The bottom-performing sector also outperformed stocks in four out of seven periods and bonds in five out of seven periods.
Secular trends drove sector outperformance (or underperformance) in each inflationary period. The office sector had standout performances as institutional investment poured into the asset class in the 1980s and again with the dot-com boom in the early 2000s.3McKinsey analysis of National Council of Real Estate Investment Fiduciaries (NCREIF) data. Retail outperformed in the early 2000s as big-box retailers transformed the shopping landscape before brick-and-mortar retail came under pressure from e-commerce in the 2010s.4McKinsey analysis of National Council of Real Estate Investment Fiduciaries (NCREIF) data. Multifamily generated strong returns in the early 2010s as the millennial generation entered the housing market and a shift away from homeownership fueled rental demand.5McKinsey analysis of National Council of Real Estate Investment Fiduciaries (NCREIF) data. For its part, industrial has posted strong returns since the 2010s as the growth of e-commerce has required new-age distribution centers.6“McKinsey Global Private Markets Review: Private markets turn down the volume,” McKinsey, March 21, 2023.
Cap rate compression is the key enabler of CRE outperformance
A common perception is that CRE’s inflation-hedging power comes largely from owners’ ability to raise rents during inflationary periods. One reason for this perception is that CRE leases protect NOI from inflation in several ways. First, both residential and commercial leases typically reset to market level upon expiration. Second, multiyear commercial leases typically require tenants to pay their proportional share of operating expenses and any future increases. Third, on the retail side, many leases tie a portion of rental income to store revenue, allowing rents to grow with inflation in prices of consumer goods.
However, McKinsey’s analysis reveals that rent growth alone (supported by the aforementioned lease characteristics) has not historically provided a full hedge against inflation. Although rents do tend to increase more quickly during inflationary periods, those increases rarely match the pace of rising inflation point for point. Annualized CRE rent growth averaged only about 3 percent during the seven inflationary periods studied, compared with average annualized inflation of almost 5 percent. Thus, real rents fell.
If rents typically fall behind inflation, then how can CRE deserve its inflation-hedging notoriety? The key factor is cap rate compression, which averaged roughly 20 basis points annually during the periods studied, contributing significantly to total returns. Although the four primary CRE sectors—office, industrial, retail, and multifamily—and their subcategories serve distinctive purposes in the economy and behave differently in many ways, all sectors have reacted similarly to periods of high inflation: cap rates compressed, and rents rose nominally (but not in real, or inflation-adjusted, terms).
Macroeconomic conditions could make this time different
Performance throughout much of the current inflationary period has fit the historical pattern. Elevated CRE returns have been accompanied by overall rents growing at a rate lower than inflation—higher in multifamily and industrial, lower in retail and office. And until recently, cap rates dipped to all-time lows. However, the macroeconomic environment is diverging from the patterns observed in the last seven inflationary periods in ways that could lead to cap rate expansion. Such a scenario could undermine CRE’s ability to hedge inflation this time around, and indeed, in recent quarters, CRE returns have fallen.
One notable difference is that six of the previous inflationary periods analyzed occurred during a roughly 40-year period of gradually declining interest rates.7Jean-Marc Natal, Philip Barrett, “Interest rates likely to return toward pre-pandemic levels when inflation is tamed,” IMF, April 10, 2023. Today, amid monetary tightening that occurred at unprecedented speed,8Jenna Ross, “The pace of US interest rate hikes is faster than at any time in recent history: Is this creating a risk of recession?,” World Economic Forum, October 12, 2022. the cost of debt is rising, and its availability is declining. The vacancy rate—particularly in the office market—is another headwind for investors.9“European commercial real estate: the cracks are starting to show,” Financial Times, April 9, 2023. And an elevated chance of recessionmay contribute to risk aversion.
It could therefore take some time to arrive at the right economic conditions for a return of cap rate compression—which is, after all, a measure of risk tolerance. With the benefit of falling cap rates in question, building owners will need to work harder to maintain and grow the value of their real asset.
Building owners can consider actions to maintain and grow real asset value
In the recent past, real estate players could be fairly confident that well-located buildings, whether residential or commercial, would provide solid returns. Today, CRE must do moreto attract and retain quality tenants amid pandemic-era changes in how people work and live. Persistent high inflation adds even more pressure to manage building operations and leasing optimally and to acquire, refinance, and execute dispositions strategically. In today’s macroeconomic environment, it may be wise for owners to consider the following actions.
Focus on leaner operating costs
Investment models should be sensitized to the possibility of persistent inflation and elevated rates. Asset managers can benefit from reworking NOI optimization models to account for higher operating costs. Likewise, property return models can be updated to incorporate a potentially long-term increase in financing costs.
Directing capital expenditures to areas that reduce operating costs is always important but is particularly so during inflationary periods. Some investments, such as in energy-efficient windows and HVAC controls, also can help achieve emission reduction targets for buildings and tenants.
Improve tenant experience
In the absence of intervention, real rents fall during inflationary periods. To earn the ability to maintain real rents, smart operators will focus on the features that tenants value most. These might include on-premises meeting spaces in Class A office buildings, which could support tenants’ flexible work strategies. In apartment communities, busy professionals may willingly pay a premium for amenities such as car charging, dry cleaning, and dog walking.
Acquire, develop, and sell properties with inflation in mind
Inflation should be a factor in decisions related to acquisitions, property development, and dispositions. Owner-operators may benefit from focusing on acquisition and development opportunities in a specific geographic area, so they can build market scale and leverage operating cost efficiencies. Similarly, they could consider selective dispositions of assets in markets that do not support scale.
The conventional wisdom that CRE is a good hedge against inflation is borne out by historical data. But because this hedge is an outcome of cap rate compression, real estate investors—current and future—are wise to consider actions tailored to today’s macroeconomic reality. As costs rise throughout the economy, especially for labor and materials, controlling operating expenses is a key to NOI (even if some cost increases are passed through to tenants) because rent increases tend to lag behind inflation. Knowing how macroeconomic forces have historically affected the sector is important, but there’s no substitute for taking preemptive action.
Ryan Luby is an associate partner in McKinsey’s New York office; Shaw Lupton is an associate partner in the Boston office, where Brian Vickery is a partner; and Rob Palter is a senior partner in the Toronto office.
The authors wish to thank Peter Bongsudhiruks, Anna Fu, Vaibhav Gujral, Ricardo Huapaya, Jose Maria Quiros, Mario Rojas, and Surya Tahliani for their contributions to this article.
This article was edited by Katy McLaughlin, a senior editor in the Southern California office.
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How is commercial real estate a hedge against inflation? ›
If demand and supply are in relative equilibrium, rent growth typically keeps pace with inflation. During periods of strong tenant demand indicated by low vacancy rates, and in particular when rent growth is non-linear, commercial real estate can be an excellent inflation hedge.What does inflation hedge mean in real estate? ›
Inflation can result in higher real estate prices as demand increases and supply remains short. During inflationary periods, real estate prices historically keep up when adjusted for inflation, which may be why real estate is considered an inflation hedge.Is real estate still a hedge against inflation? ›
The Historical Effect of Inflation
Historical data shows that real estate has been somewhat effective as a hedge against inflation. On a global scale, real estate in the past 40 years has had exactly 0% real rental rate growth, signaling a perfect hedge with inflation.
Inflation Can Benefit CRE Investment
Higher inflation for a shorter time is generally good for real estate. Analysis at Cushman & Wakefield shows that every 1% increase in inflation is associated with a 1.1% increase in total returns to investors, including REITs, pension funds and individual investors.
Commercial real estate is widely considered to be a good long-term hedge against inflation, as owners may benefit from stable income and the ability to increase rent. Inflation in the U.S. has risen to levels we've not seen since the 1980s.Why is investing in real estate a hedge against inflation? ›
In general, real estate is considered a good hedge against inflation because it tends to keep pace with other surrounding costs that are on the rise. Understanding the various factors that make a home purchase a reliable hedge against inflation can help you determine if it's the right move for you and your family.Why are real assets a hedge against inflation? ›
Real estate works well with inflation. This is because, as inflation rises, so do property values, and so does the amount a landlord can charge for rent. This results in the landlord earning a higher rental income over time. This helps to keep pace with the rise in inflation.What is hedging in real estate? ›
Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. The reduction in risk provided by hedging also typically results in a reduction in potential profits. Hedging requires one to pay money for the protection it provides, known as the premium.How to beat inflation with real estate? ›
- Beating Inflation.
- While Purchasing Power Decreases, Mortgage Payments Typically Remain Steady.
- Inflation Can lead To Higher Rental Income.
- Real Estate Appreciates Over Time.
- Saving Taxes.
- Write Off Business Expenses.
- Take Advantage Of Appreciation.
- Sell Real Estate Efficiently.
Inflation can lead to higher asset prices
As this price of things increases with inflation, so too does real estate. Generally speaking, when inflation increases then housing and other real estate asset prices follow suit.
Is property the best hedge against inflation? ›
Consider Real Estate
It often acts as a good inflation hedge since there will always be a demand for homes, regardless of the economic climate, and because as inflation rises, so do property values, and therefore the amount a landlord can charge for rent. Because real estate is a tangible asset, however, it's illiquid.
Interest rates have a significant impact on commercial real estate markets, whether they're high or low. When interest rates are higher, investors can expect to see slower growth fundamentals and potentially lower property values during these times due to decreased cash flow opportunities.How does commercial real estate impact the economy? ›
A severe commercial real estate crisis could lead to a prolonged economic downturn, with widespread defaults, bankruptcies, and job losses affecting the economy. This may result in reduced consumer spending, slower business growth, and further declines in property values.How does inflation affect leases? ›
Inflation also increases the price of everything, which means less rental property competition. As a result, landlords often raise rent prices based on demand before inflation. Are leases affected by inflation? In some cases, yes.Why is inflation bad for real estate? ›
When inflation is high, the costs of materials also increase. That means it may become especially expensive for construction teams to build new homes or renovate existing homes. Ultimately, those high costs could spill into the housing market and lift home prices for new builds.Is it good to hold real estate during inflation? ›
As a byproduct, inflation can lead to higher home prices and creates an environment in the real estate market that usually sees higher mortgage rates and fewer buyers. The effect is overall positive for investors who already own assets in real estate or have a real estate IRA.Does inflation help or hurt real estate? ›
Real estate as a hedge against inflation
Other investments, such as stocks, typically react negatively to rising inflation, but property responds proportionally, often increasing in value as inflation creeps up.
Collectors. Historically, collectibles like fine art, wine, or baseball cards can benefit from inflationary periods as the dollar loses purchasing power. During high inflation, investors often turn to hard assets that are more likely to retain their value through market volatility.How do you hedge against rising interest rates? ›
- Invest in Collectibles Such as Fine Wine. ...
- Invest in Short Duration Stocks. ...
- Buy Hedged Bond Funds. ...
- Buy TIPS. ...
- Buy ETFs. ...
- Explore Embedded Options. ...
- Use an Interest Rate Cap. ...
- Use Interest Rate Floors.
Commodities like gold, oil, and even soybeans should increase in price along with the finished products that are made with them. Inflation-indexed bonds and Treasury Inflation-Protected Securities (TIPS), tend to increase their returns with inflationary pressures.
Is real estate a good long term investment? ›
Reliable Long-Term Investments
Real estate lends itself as a reliable long-term investment, and you could earn some significant wealth if you expand your real estate portfolio over time. You could own several passive income properties, or double down on your REIT investments.
Frequently Asked Questions About Stagflation
Does real estate perform well during stagflation? Yes, real estate is one of the top performers during stagflation. This often has to do with a slowdown in new construction. In addition, the trend of fewer people buying new homes means more renters.
Income from real assets is generally linked to inflation. As prices rise, so too does income. During economic upswings, real assets such as real estate and infrastructure tend to do well as demand increases, rents rise, and utilisation improves.What are the 3 common hedging strategies? ›
There are several effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options, and volatility indicators.What are the three types of hedging? ›
The three types of hedge accounting remain: cash flow; fair value and net investment hedges.What are the three hedging strategies? ›
There are three common hedging strategies: diversification, options trading, and futures contracts. Each strategy has its own advantages and disadvantages depending on your individual needs and goals as an investor.Who is most hurt by inflation? ›
Low-income households most stressed by inflation
Prior research suggests that inflation hits low-income households hardest for several reasons. They spend more of their income on necessities such as food, gas and rent—categories with greater-than-average inflation rates—leaving few ways to reduce spending .
While no one's exactly clear on the exact number for inflation in 2023, most agree that it will continue to trend downwards.Does real estate appreciate faster than inflation? ›
Increases in average home prices have far exceeded the rate of inflation. Home prices have increased 1,608% since 1970, while inflation has increased 644%. Throughout 2021, the inflation rate jumped 7.5% – nearly 4x the Federal Reserve's target inflation rate of 2%.What does it mean to hedge against? ›
hedge against something. to do something to protect yourself against problems, especially against losing money.
What factors affect commercial real estate? ›
- Location is Not the Only Driver of Commercial Real Estate Value. Real estate is about location, location, location. ...
- Interest Rates. ...
- Economic Outlook. ...
- Population and Demographics. ...
- Supply and Demand. ...
- Property Market Performance. ...
- Size and Facilities. ...
- Aesthetics and Deferred Maintenance.
Easy Render. Recessions are periods of economic downturn marked by a steep decline in the gross domestic product (GDP) and typically high unemployment rates. While recessions can hurt various sectors of the economy, one area that is often affected is commercial real estate.What is the downside of commercial real estate? ›
Cons of commercial real estate investment include their significant cost and management intensity. In addition, market risk, vacancy risk, and interest rate risk can put additional pressure on commercial real estate prices.How does commercial real estate appreciate? ›
One of the reasons is that rents increase with inflation, and commercial real estate's value is built upon those rents. If the rents double, then the value of the property doubles – it's that simple.
Commercial real estate provides rental income as well as the potential for some capital appreciation for investors. Investing in commercial real estate usually requires more sophistication and larger amounts of capital from investors than does residential real estate.What percentage of the economy is commercial real estate? ›
According to the Commercial Real Estate Development Association (NAIOP)'s 2022 Economic Impacts of Commercial Real Estate report, the commercial real estate contribution to GDP in 2021 in the US was approximately 1.2 trillion dollars—or about 5% of the total US GDP of 22.99 trillion dollars.What happens to rental properties during inflation? ›
The effect of inflation on debt- When home prices increase, it lowers the loan-to-value of property mortgage debt. In other words, the rental property equity goes up, but your mortgage payments remain the same.Is rent causing inflation? ›
Economic policymakers closely watch rent prices, not only because consumers spend a big portion of their budgets on housing, but also because the category is a major contributor to inflation. Shelter is the largest component of the Consumer Price Index, making up about 30 percent of overall inflation.Is rent factored into inflation? ›
Rents have always been important in measures of inflation, due to their outsize share in most household budgets: They comprise a little over 30% of the headline consumer price index, and about 40% of the core index.What is the most common hedge against inflation? ›
- Gold. Gold has often been considered a hedge against inflation. ...
- Commodities. ...
- A 60/40 Stock/Bond Portfolio. ...
- Real Estate Investment Trusts (REITs) ...
- The S&P 500. ...
- Real Estate Income. ...
- The Bloomberg Aggregate Bond Index. ...
- Leveraged Loans.
What asset is the best hedge against inflation? ›
Gold, Precious Metals, and Commodities
Precious metals such as gold have been historical favorites for hedging against inflation due to their scarcity, tangibility, and historically negative correlation to paper money. Since 1979, the purchasing power of the US Dollar has declined by 77%.
Most commercial real estate leases are structured to include annual rent increases, which helps protect property owners from the increase in expenses due to inflation. Thus, existing real estate assets can serve as tremendous hedge against inflation.Why housing is a good hedge against inflation? ›
Buying a home can be a hedge against inflation primarily because: As inflation rises, so should the value of your home. The loan-to-value (LTV) ratio of your mortgage will decrease as your home's value increases over time. In other words, your fixed-rate mortgage payments stay unchanged while your home's equity rises.Where do you put money when inflation is high? ›
- Real estate. Real estate is almost always an excellent investment and should be at the top of your list. ...
- Savings bonds. ...
- Stocks. ...
- Silver and gold. ...
- Commodities. ...
Holding long-term fixed-rate investments, such as long-term bonds, fixed annuities, and some types of life insurance policies, during inflation can be bad because their returns may not keep up with inflation.Why is rising interest rates bad for commercial real estate? ›
Commercial real estate drops in value as higher interest rates make borrowing costs higher.How do rising interest rates affect commercial real estate? ›
Higher cost of debt is putting increased pressure on new real estate development due to difficulty locating financing sources that fit within a project's capital stack. It's also causing compression in building valuations across commercial sectors.Why does real estate do well with inflation? ›
You want your property to be working for you, not the other way around. Real estate is a stable asset that beats recession. Real estate becomes an asset if it has cash flow—through rents. Investors hedge or leverage that inflation is going to help them because inflation is what pushes rents up (paywall).Does inflation help or hurt the real estate market? ›
Inflation may dampen housing demand and cool down prices.