By Jennifer Perkins, Portfolio Manager, Principal Real Estate Investors
This is the fourth and final installment in a series of blog posts in which I'm highlighting the compelling reasons why private commercial real estate should be included in an investor's portfolio. Just to recap, in my last three blogs I discussed: how private commercial real estate can serve as a potential source of income; how the investment in tangible commercial properties can increase portfolio diversification and aid in dampening return volatility; and how it can increase the potential for improving total portfolio returns adjusted for risk. In this blog post, I'd like to discuss another compelling reason to include commercial real estate as part of an investment portfolio - how private commercial real estate can serve as a possible defense against unexpected inflation.
For more than seven years since the global financial crisis, the U.S. economy has been stuck in a recovery mode and a low interest rate environment. Following a contentious U.S. presidential election, whereby Donald J. Trump won a stunning victory, financial markets have been hitting historic highs. Moreover, President-elect Trump's pro-growth agenda, which includes corporate and consumer tax cuts, deregulation, and keeping companies and jobs here in the United States, has fueled inflation prospects. Citing economic progress, the Federal Reserve (Fed) recently raised interest rates for the first time since 2015 and signaled that more rate hikes will be on the horizon in 2017 with inflation moving toward the Fed's 2% target rate.
All of this talk over the implications of the prospects for rising inflation brought to mind an elementary school game called the "three-legged race" in which the goal was to run in lockstep with your partner in order to cross the finish line first. Well, if you were like me that wasn't always the case, but I tried my best nonetheless. My point though is that just like the three-legged race, on a comparative basis, private commercial real estate moves closely in line with core inflation. Moreover, private commercial real estate has exhibited a relatively high correlation to consumer price index (CPI) moves when compared to other traditional asset classes. Looking at correlations over a long time-period (supported by the chart attached), private equity commercial real estate is indeed a front-runner against other traditional asset classes such as equities and fixed income in the example of the three-legged race!
In a period in which growth and interest rates are on the rise, inflation really isn't a bad thing if experienced for good employment fundamentals, wage growth, and generally better growth prospects across the U.S. economy. However, unexpected inflation in which prices for some or all goods move higher and at a faster rate than expected can negatively impact investment portfolios as returns are unable to keep pace with rising costs of goods and services. That said, the U.S. economy is entering a period of expected inflation in the near term. As we enter a period of rising interest rates based on the recent comments of Fed chair Janet Yellen, the strength of the underlying fundamentals of the commercial real estate marketplace should carry private commercial real estate forward and produce solid income and total returns for investors. However, if inflation starts creeping up faster than expected, how would private commercial real estate fare in this type of environment? Private commercial real estate could potentially be a good hedge against this unexpected inflation.
For one thing, anticipated inflation is already underwritten in the cash flow projections supporting current market values for brick and mortar properties. Typically, multi-year cash flow projections are a fundamental component of determining current property values. These projections incorporate anticipated rising costs generally consistent with annual CPI increases. With such expenses anticipated to increase each year, most leases factor this in and annual rent increases are generally part of the lease contract with tenants. Some rent increases occur each year, others at certain points in time during the lease term, but on the balance sheet, increases in the gross revenue line should maintain a solid net income line as growing expenses are incurred at the same point a growing rental income stream is occurring. Therefore, today's value of properties in the private commercial real estate sector already has rising rent and expense considerations underwritten.
Another reason why private commercial real estate can hedge against inflation is that cash flow projections of properties incorporate capitalization (cap) and discount rates reflecting investor returns demanded by the marketplace. The cap rate is reflective of the income return investors will likely achieve while the discount rate is reflective of the anticipated total return over the holding period. Exit or terminal cap rates are also incorporated in the valuation such that the demanded return by the next purchasing investor at the point of sale is also anticipated. As such, returns are driven by the spread-to- risk-free rates like 10-year Treasurys. Underwriters should be using terminal cap rates at the sale date that are reflective of the anticipated interest rate environment at that point in time, thus incorporating inflation.
Finally, private commercial real estate can act as a potential hedge against unexpected inflation as real estate is a hard asset and increasing material costs to reproduce existing assets help support property values. As material costs such as steel and concrete increase, the cost of replacing the existing structure also rises. If unanticipated inflation occurs, this is a good potential hedge, because the cost to replace existing buildings helps buoy market values and serves as a potential hedge when it comes to unanticipated inflation.
In summary, since private commercial real estate is a hard asset, it offers investors several benefits including relatively lower volatility, steady income, portfolio diversification and in the road ahead a potential hedge against unexpected inflation. The bottom line is that investors should keep in mind that private commercial real estate could potentially safeguard against unexpected inflation eating away at your investment portfolio.