Should commercial real estate be used as a hedge against inflation?

One major traditional reason for investing in commercial real estate was hedging against inflation, yet commercial properties performed abysmally as an inflation hedge in the early 1990s. Moreover, many observers think inflation is dead. Is hedging against inflation, therefore, also dead as a motive for investing in commercial real estate today? This article briefly examines why I believe the correct answer is, "No!"

Failure as an inflation hedge in early '90s

One clear lesson from the early 1990s is that owning real estate equities is not an effective hedge against inflation if there are large oversupplies of space in real property markets. The market values of all types of commercial properties collapsed after about 1989, even though consumer prices continued to rise slowly but steadily. The only thing commercial properties were a hedge against from 1989 to 1992 was capital gains!

In the past, when supplies of and demands for space in commercial property markets had been reasonably in balance, rents and net profits from providing space normally increased along with other prices. That was not true of income from fixed-rate assets or of common stock values. In the 1970s, when consumer prices soared 112%, the Standard k Poor's 500-stock over, when equity positions in commercial properties were highly leveraged with fixed-rate debt acquired at positive spreads, those rent and net income increases caused by inflation substantially multiplied yields on equity. Therefore, owning commercial properties provided an effective way to protect real asset values during inflationary periods - more effective than owning stocks or bonds.

But the hidden factor in this successful hedging was the balance between supply and demand in real property markets. When massive overbuilding upset that balance in the 1980s by immensely increasing the supply of space, rents no longer moved up with prices in general in fact, rents collapsed because of space surpluses. This convinced many investors that hedging against inflation is no longer a sensible reason to invest in real estate equities.

Is inflation dead?

Another reason for ignoring commercial real estate as an inflation hedge is that inflation itself seems to have calmed down. The average rate of increase in consumer prices was a low 2.36% in the 1960s, rose to 7.09% in the 1970s, was 5.55% in the 1980s, fell to 3.50% in the 1990s (through 1995) and has remained below 3% in the past three years. And many experts claim the current inflation index used by the government is biased upward; hence actual inflation in the 1980s and 1990s has been even lower.

It is widely believed that this slowdown in price increases results from basic changes in the global economy. Firms in each developed nation now must compete with other firms throughout the world, including developing nations with much lower environmental, safety and other standards. And workers in developed societies who receive relatively high wages by global standards must now compete with workers in emerging countries where real wages are still extremely low. Therefore, firms in developed nations find it difficult to raise product prices, and workers in developed nations cannot demand and win sizable wage increases without motivating firms to shift more production overseas. Consequently, consumer prices will probably not rise as fast as they did in the earlier postwar period, and investors need not worry much about hedging against future inflation.

However, two factors cast doubt on this reasoning. One is that the central banks of all the major developed nations are now following the same course for the first time in many years: They are all easing restraints on credit. Except for the U.S. Federal Reserve, these monetary authorities are all trying to help their economies recover from high unemployment or slowing real growth. The Fed had decreased rates in early 1996, but held them steady at the last decision point. Yet U.S. money markets have raised rates recently, because indicators of increasing economic activity portend possible price increases in the future. Central banks are further motivated to ease on credit by the conservative fiscal postures being adopted, at least rhetorically, by the national governments in these nations, who are trying to reduce their deficits through fiscal restraint. But experience proves that, whenever all major central banks ease at the same time, the supply of money and liquidity is sure to expand relative to the supply of real things within the next two years. And that is precisely the definition of inflation.

A second potentially inflationary factor is the rising consumption of food and other basic commodities in Asia. The spectacular real growth of Southeast Asia economies containing more than 1.5 billion people - twice as many as in the United States, japan and Western Europe combined - is stimulating rising per-capita consumption of rice, wheat, fish and other food staples. It is also encouraging people to eat more, the production of which requires more direct human consumption of grand Yet the world's ability to produce of these commodities is limited. Thus, worldwide fish harvests are already falling. Also, China has shifted from a net exporter to a net importer of rice. Price of these basic food commodities have been rising and will keep on doing so. This will affect consumer price levels because food is a key ingredient in all price indexes.

These factors imply that hedging against inflation might soon become a relevant consideration for investors again. Which types of investment are best suited as such hedges depends upon where each type of asset is in its cycle of value movement.

Another consideration is that if inflation will not get any lower, then the long secular decline in interest rates, since they were escalated by monetary authorities in 1982 to stop the severe inflation of the 1970s, is now over. That has major implications for stock and bond prices, which have been stimulated for years by declining interest rates. Therefore, stocks and bonds are likely to appreciate much less rapidly than during this secular interest rate decline, other things equal. So they are also less likely to be an effective hedge against inflation, as they have been since 1982.

Cyclical positions of three types of assets

If all major investment assets are divided into three classes - stocks, bonds and commercial real estate equities - these classes exhibit differential price movements in time. That has been decisively proven by experience over the past five years. As of late April 1996, stocks are in an upward surging portion of their value cycle caused by a flood of liquidity into mutual funds and stock markets. This surge comes after a bull market that started in 1982 and is by now unusually long.

Many investors now recognize an increasing risk of value declines in the stock market, but they are fearful of missing out on the further increases that will occur before any "correction." Moreover, institutional investors operate on a herd mentality and are rewarded on the basis of their quarter-to-quarter performance. So they continue driving up prices of common stocks beyond levels justified by earnings, as reflected in falling price-earnings ratios. They rationalize by saying, "Where else can we put the money?" and reveling in ever-higher stock prices.

This flood of liquidity into stocks is quite analogous to what happened to commercial real property markets in the late 1980s. Billions of dollars flowed into those markets from institutions looking for someplace to put the large amounts of capital they were being paid to invest. These investors continually ignored increasing signs of over investment emanating from space markets, such as rising vacancy rates and falling effective rents, because they were being rewarded with large fees from placing capital.

The major difference between the commercial real estate market of the late 1980s and the stock market of the mid 1990s is that putting more capital into real estate not only drove up the prices of existing properties but also funded massive new development. The resulting additions to space supplies of all types in turn undermined the economic performance of existing properties, eventually causing an overall collapse in values.

In contrast, the current deluge of capital into Wall Street has not increased the supply of stocks, in spite of surging initial public offerings. Why not? Because many firms are buying back their own shares. And the massive flow of liquidity into stocks has not greatly expanded the productive capacity of the firms concerned, thereby undermining their current performance in product markets. Rather, that increased liquidity has mainly driven up stock prices.

Yet it is hard to believe that stock prices can rise indefinitely in relation to increases in corporate earnings causing an expanding risk of some value correction. Already, the yield on the Dow Jones Industrials down to about 2%, compared yields of 8% to 10% on prime commercial real properties.

In contrast to stocks, market values of most commercial properties, except retail, are in the rising part of their own cycle, and will remain so as long as the economy continues to grow and new space construction remains low. These conditions are likely to prevail throughout 1996 and could last through 1997 or even 1998, depending upon whether the economy experiences a recession. True, there are some remaining disaster areas in commercial property markets, such as office space in downtown Los Angeles and Dallas and retail space almost everywhere, but tightening property markets are witnessing rising prices and values in many parts of the nation.

As time passes and rents continue rising across the board, new development will begin picking up again, as it already has in apartment and industrial markets. But the likelihood of massive additions to supply of all types, like those in the late 1980s, remains low for at least two more years and perhaps longer. in addition, current low mortgage rates enable owners of commercial real estate to increase their returns on equity by even modest leveraging at a positive spread.


To put it simply, investing some part of an institutional portfolio today in well-selected, commercial real property is betting that this asset class will not experience as big a drop in values in the near future as corporate stocks or bonds. It is hard to believe that the probability of a big near-future drop in values is nearly as great in selected types of commercial real properties, excluding retail, as it is in stocks. Therefore, well-chosen commercial property is a hotter present hedge against future inflation. And inflation is still worth hedging against.

Some institutional investors will undoubtedly say: "Yes, but if we put money into real estate today and stocks continue rising rapidly for another six to nine months or a year before experiencing any big correction, we will miss that big increase and our performance ratings will fall. And we are so smart we can get out near the top just before the correction comes. Besides, the correction may not be that big; we may wind up with higher stock values after it is over than we have today." This is what japanese investors said about japanese stocks when the Nikkei Average hit 25,000. They were right as it rose to 29,000, but then it hit 16,000.

The most difficult art in forecasting is correctly calling turning points in established trends, before they happen. The case for investing in commercial real properties today rests upon the low probability of a near-future downward turning point in their value cycle compared to a much higher probability of at least a temporary downward turning point in the value cycle of corporate stocks. That case also rests upon belief that there is a higher probability of a turning point in currently low rates of inflation than most observers now recognize.

Unfortunately, there is also a non-trivial probability that anyone with the guts, or the foolhardiness, to try calling economic turning points in advance will prove to be wrong, at least in timing. Whether this article falls into that category gory you must estimate yourselves for now, though it will ultimately be determined by the actual course of events.

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