Will private real estate remain a safe inflation hedge despite rising interest rates?

For an asset class seen as an inflation hedge, but also one sensitive to higher interest rates, how did the global real estate market balance 2022’s high inflation/high rate environment?
The real estate markets are just beginning to understand and cope with the ramifications of both higher interest rates and higher inflation. The story will become clearer in 2023. Property ownership hedges inflation when rent growth is higher than expense growth, and when inflation pushes up the value of hard assets. However, higher interest rates can upend that strategy if rising debt costs erode the cash flow achieved from rent growth.  

Higher rates are also already putting upward pressure on capitalization rates, which for many years have been compressed by the enormous liquidity available to the real estate sector. If that capital moves to alternative investments, or the Fed’s balance sheet reductions suck liquidity out of the system, the resulting higher cap rates may negatively impact property values.  

There are so many variables that investment performance is hard to predict, causing an appropriate slowdown in transactions. Buyers and sellers are only just beginning their price discovery journey. Despite all the noise, real estate will still be an effective inflation hedge for well managed properties in growth markets.  

Although rates have risen in 2022, deal prices have remained comparatively high. Which sectors drove demand, and which continue to struggle?
Demographics, high employment, and consumer strength are all driving demand for space, resulting in outstanding property performance and higher prices. Even during the recent months of economic uncertainty, we’ve seen growth in jobs, retail sales, and rents, albeit at a slower pace than in 2021.  

The multifamily and industrial sectors have outperformed and will continue to do so. The more-than-doubling of mortgage rates this year means that most American households can no longer afford to purchase a home, benefiting rental housing. The need for enhanced supply chains and last-mile delivery continue to boost demand of warehouse-distribution facilities. Hotels are thriving as family vacations and group meetings have resumed after a two-year, COVID-driven hiatus. Even the retail sector is benefiting from an increase in in-store shopping. A recession in the next 18 months, or even just widespread fear of a recession, could dampen hotel and retail performance. The problem child is the office market. Working from home arrangements may not be a permanent change, but a hybrid workforce is likely here for the long-term, significantly reducing demand for office space.

Looking forward, should these factors subside, what state do you believe the 2023 real estate market will be in?
Real estate is facing a triple threat: high interest rates, inflation, and recession. While inflation may abate in 2023 and a recession, should it come, will hopefully be short-term and relatively benign, we are entering a new long-term market-based interest rate regime that will have a major impact on the industry. The Fed artificially reduced interest rates since the Great Recession, and now rates are reverting to historical norms. The resulting capital market volatility is reducing expected returns on existing deals and precluding the ability to accurately project cash flow on new deals.  

Once we settle into the next ‘new normal’ in 2023, more predictability will allow capital to flow again. But the transition from here to there will be painful for many investors. The good news is that through all this turbulence, the tight job market will sustain space demand against fixed supply, even in a recession. A quarter of a million baby boomers will likely retire every month over the next few years, and companies will be scrambling to replace them.  

Will ESG factors continue to be an asset for property owners should yield expectations remain low or a liability?
Irrespective of capital market volatility, property owners will continue to focus on ESG, prioritizing the environmental component. Real property is responsible for about 40% of global energy use and a third of all greenhouse gas emissions. The industry is responding by reducing fuel and water consumption and better managing waste, thereby managing costs. Additionally, many developers are also using more sustainable building materials.  

Public REITs (real estate investment trusts) have taken a leadership role in developing and reporting on ESG initiatives. But these investments have a clear, positive impact on the bottom line: ESG-focused real estate companies that offer environmentally friendly space and a focus on safety and wellness attract more tenants. This is especially true in the office sector where tenants are increasingly demanding LEED certifications, better air flow, and well-lit working environments.  

Owners are also becoming laser-focused on the vulnerability of their properties and neighborhoods to severe climate conditions such as flooding, fire, heat, wind, and drought, not only to reinforce the physical asset, but to manage the rising cost of insurance. We are certainly at the beginning of a long-term trend of incorporating ESG principles into all real estate investment and operating processes.

About
Joseph Rubin is a Consultant in the firm’s Real Estate Services Group. Joseph has over 35 years of experience in the real estate industry supporting his clients’ most important decisions. He has worked with family-owned businesses, REITs, private equity funds, and major financial institutions to develop strategy, improve governance and operations, and manage credit risk.

EisnerAmper is a leading full-service accounting and advisory firm with a dedicated Real Estate Services Group of more than 450 professionals providing a wide array of audit, tax, and advisory services to the real estate community, including REITs. Beyond traditional services, we provide cost segregation, real estate forensics, transaction consulting, hospitality advisory, due diligence for acquisitions, analysis of investment opportunities, and operational consulting services, among others.