Concerned About Inflation? Consider Real Estate Over Commodities.

Concerned About Inflation? Consider Real Estate Over Commodities.

Peter Brunton, CFA, Chief Investment Officer

Did you know the M2 monetary supply – the amount of dollars held in cash, savings, and money market accounts – grew 25% last year?

The concept of inflation is simple. More dollars chasing limited or finite assets equals higher prices. Commodities, and specifically oil and industrial metals, are typically considered hedges against inflation because they are finite assets that often experience increased demand.

Despite the Federal Reserve’s insistence that any rising inflationary pressure would be temporary, commodities have generated double-digit returns so far in 2021 after years of underperformance. This is likely because the market is pricing in the impacts of rising inflation given the high likelihood of a $2 trillion green energy and infrastructure package being passed.

While we agree inflation is a long-term threat, commodities may not be the best solution:

1. Fossil fuels will come under pressure over the long-term with a green energy-fueled infrastructure package. They might represent a good trade, but poor investment.
2. Prices on industrial metals have already skyrocketed over the last year.
3. Commodities are supply/demand based but don’t produce tangible income or earnings which make them very difficult to value.

If we can’t turn to commodities, what’s the alternative? The answer is income-producing real estate.

In particular, we recommend considering funds that directly own commercial real estate. We favor this option over publicly traded REITs – the stocks of companies that invest in real estate – as they are subject to the volatility of the stock market.

Like commodities, income-producing real estate is impacted by supply and demand given the rising and potentially prohibitive costs of construction. The primary difference is that commercial real estate produces consistent, tangible income. In fact, over the last 20 years, the annual yield on commercial real estate has never dipped below 4% and has eclipsed 6% for seven of those years.*

The value of commercial real estate is ultimately tied to the net operating income of the property. When it comes to apartment buildings, rents are typically adjusted to the market value of the local area. As inflation ticks up, those market values increase. In high-demand areas, rents increase even faster. Further, commercial leases are typically written to include periodic rent escalators which are tied to the Consumer Price Index.

Additionally, the income potential for commercial real estate consistently increases with inflation. In fact, over the last 25 years, the net operating income of the commercial real estate benchmark has substantially outpaced inflation.*

That said, not all commercial real estate is created equal. Some sectors of the market such as office and retail have been dramatically impacted by the COVID-19 pandemic. As such, it’s key to be selective when reviewing your options. Areas we have focused on include:

1. Apartment buildings in areas with high job growth – primarily the Sun Belt. These areas often see rental increases substantially higher than inflation.
2. Distribution centers that are centered on e-commerce.
3. Triple net retail. These are leases where an investment grade company is responsible for paying the lease and covers all maintenance, property taxes, and insurance. A good example would be a drugstore like CVS.

High-quality commercial real estate should be a staple in your portfolio. Learn how to access these investments by booking a meeting with your advisor.

*Benchmark = NCREIF ODCE index. Data courtesy of Bloomberg and Blackstone BREIT investor deck. Past performance is no guarantee of future performance and is illustrative as it is not possible to directly invest in a benchmark.