Is Commercial Real Estate an Inflation Hedge? BY MARTHA S. PEYTON, PH.D., CRE

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1 Is Commercial Real Estate a Iflatio Hedge? BY MARTHA S. PEYTON, PH.D., CRE INTRODUCTION AND FINDINGS Iflatio is amog the worst ightmares deprivig ivestors of peaceful sleep. Iflatio erodes the value of corporate earigs ad roils stock ivestors; iflatio favors borrowers as debt repaymets are made i lower value dollars, ad iflatio pummels cosumers especially those o fixed icomes by depressig the purchasig power of their icomes. With the trough of the last recessio ow almost three years past ad with the recovery characterized by a peculiar set of circumstaces, iflatio ightmares appear to be o the rise. I a effort to quiet their ueasiess, ivestors are reexamiig the capacity of various asset types to offer iflatio protectio, should iflatio become problematic. Covetioal wisdom ad some solid historical research show that commercial real estate does ideed offer iflatio protectio, albeit imperfect. This article examies both iflatio potetial for the Uited States ecoomy over the ext few years ad the capacity of commercial real estate to provide iflatio protectio. FINDINGS The fidigs preseted i this article ca be summarized i four mai poits: First, aalysis of curret ecoomic coditios ad of the drivers of iflatio idetified i up-to-date models does ot justify iflatio fears at this poit i time, despite covetioal wisdom s cotrary view. Secod, U.S. commercial real estate ivestmet performace history is more strogly correlated with iflatio history tha is performace of Treasurys, stocks, bods or REITs. Additioally ad perhaps more importat, commercial real estate performace for five-year holdig periods has beate iflatio over those periods with 84 percet probability. Third, the average basis poit outperformace of commercial real estate versus iflatio has beate Treasurys ad bods, but ot stocks. Fourth, with iflatio likely to cycle at approximately a two percet average, the absolute performace of ivestmets is a more advatageous focus for ivestors tha iflatio protectio, which is a low hurdle. INFLATION OVERVIEW Fear of iflatio is a atural reflex i today s ecoomy because the aggressive moetary ease, ow uderway to support ecoomic recovery, has historically bee difficult About the Author Martha S. Peyto, Ph.D., CRE, is maagig director ad head of Global Real Estate Strategy ad Research for TIAA-CREF. Peyto ad her team are resposible for providig ivestmet research ad portfolio strategy aalysis for the Global Real Estate ivestmet maagemet team ad for related busiesses of the orgaizatio. Peyto joied TIAA-CREF i 1993 ad has 30 years of fiacial idustry experiece. Her prior experiece icludes fiacial executive positios with Marie Midlad Bak s Credit Policy divisio ad Domestic Ecoomics group. Peyto also formerly taught ecoomics at Fordham Uiversity ad Mahattaville College. She is a Couselor of Real Estate ad a member of the America Real Estate Society, the Urba Lad Istitute ad the Iteratioal Coucil of Shoppig Ceters. Peyto eared a doctorate degree i ecoomics from Fordham Uiversity, as well as a bachelor of arts ad a master s degree. REAL ESTATE ISSUES 37 Volume 36, Number 3, 2011

2 to uwid. I the past, whe easy moey remaied i place too log, it cotributed to iflatio. Similarly, fiscal policy i the form of excessive deficit spedig has also cotributed to iflatio at differet times i the past. This history is the foudatio of the famous Phillips Curve relatioship, which shows higher iflatio associated with lower uemploymet rates. Withi the cotext of the busiess cycle, those lower uemploymet rates ca be the result of either excessive easy moey or deficit spedig, or both. With the federal fuds rate holdig at essetially zero sice December 2008, ad with the federal deficit hittig a historically high 10.1 percet of GDP i fiscal year 2009, cocer about iflatio would appear to be ratioal. Covetioal wisdom suggests that the combied fiscal ad moetary stimulus evetually will boost demad beyod the ecoomy s capacity ad thereby igite iflatio. History also shows that commercial real estate ivestmet ca offer protectio from the ravages of iflatio. This history is the foudatio of the uptick i ivestor iterest i commercial real estate whe iflatio fears flare up. Researchers have thoroughly examied the questio of whether commercial real estate ivestmet offers iflatio protectio; the uaimous coclusio is it depeds. With these commets as a backdrop, the remaider of this article has the followig goals: Review the path of recet iflatio ad the risk that curret moetary ad fiscal policies will over-stimulate the ecoomy ad igite iflatio; Update measures of the correlatio betwee commercial real estate performace ad iflatio, explaiig the uderlyig characteristics of the asset class that might be sources of iflatio protectio; Offer some aalysis of the prospects that U.S. commercial real estate is curretly positioed to offer iflatio protectio over the ext several years. QUICK LOOK AT LONG-TERM INFLATION HISTORY As show i Figure 1, the U.S. iflatio rate has bee boucig aroud two percet for more tha a decade, both for the headlie all-items cosumer price idex (CPI) ad for the core, which excludes food ad eergy prices. History shows similarly low iflatio i the early 1960s, which accelerated i mid-decade through the early 1980s whe it bega a rocky path dowward. The story behid the history is well kow. The uptick i iflatio that bega i the mid-1960s reflected strog ecoomic growth, bolstered by the tax cuts of the Keedy admiistratio. Fiscal policy later i the sixties provided stimulatio of a differet kid through spedig o the Vietam War without raisig taxes a classic gus ad butter story. I 1973, the first oil shock set iflatio up to almost ie percet for the year, with core iflatio 14% CPI HEADLINE CPI-Core Figure 1 U.S. Iflatio History 12% 10% 8% 6% 4% 2% 0% 2% Source: Bureau of Labor Statistics via Bloomberg REAL ESTATE ISSUES 38 Volume 36, Number 3, 2011

3 risig less sharply but still a material 4.7 percet. The severe 1975 recessio cooled iflatio but oly to a five percet rate i 1976, followig the recessio s trough. I 1979, the Iraia Revolutio igited aother oil shock that set both overall iflatio ad core iflatio ito double digits. That bout was followed by double-dip recessios i 1980 ad 1982 that, agai, pushed iflatio back to more tolerable levels. The 1982 recessio was the most severe post-wwii recessio up to that time. Its severity was reflective of a ew ati-iflatio approach to moetary policy led by Federal Reserve Chairma Paul Volcker. The Volcker era chage i policy was accompaied by a strog uptred i global trade ad broadeig ad deepeig i fiacial markets, both of which also cotributed to the dowward tred i iflatio rates through the subsequet decade ad to the preset. Global trade has expaded both i absolute terms ad also i its importace to the U.S. ecoomy. I 1978, the omial value of exports ad imports were together equivalet to 17 percet of U.S. GDP. I 1999, they were equivalet to 24 percet, ad i 2011, 32 percet. Imports have grow more strogly tha exports, with imports equivalet to ie percet of GDP i 1978 ad 18 percet i 2011, while exports were equivalet to eight percet of GDP i 1978 ad 14 percet i Compositioally, imports of o-auto capital goods ad o-auto cosumer goods expaded the most vigorously; the former was 27 times larger i 2011 tha i 1978, while the latter was 18 times larger. Nomial GDP was seve times larger i 2011 versus The icreasig availability of imports over the period idicated a dimiishig capacity for U.S. producers to cotrol prices. At the same time, competitio from imports also affected U.S. labor markets by costraiig the scope of uios ad dimiishig their power to ifluece wages. I 1983, 23 percet of the U.S. labor force was covered by uio collective bargaiig; i 2011 the proportio was just uder 12 percet. Additioal disciplie affectig U.S. iflatio has come from the operatio of fiacial markets. The Federal Reserve maages short-term iterest rates by targetig the federal fuds rate, which represets the cost of overight fuds. The federal fuds rate achors the short ed of the Treasury yield curve. Treasury security yields are determied by the market agaist the backdrop of the federal fuds rate. Ivestors will calibrate yields o Treasurys to reflect their iflatio expectatios over the term to maturity. Whe ivestors judge iflatio risk to be risig, they will push up Treasury yields which, i tur, serve to depress ecoomic activity ad sed a message to the Fed that the market is worried. This disciplie has served to reiforce the Fed s commitmet to keepig iflatio i check. It has evolved through improvemets i tradig techology ad deepeig i the stock of traded Treasury securities over the past few decades. I effect, bod market traders fuctio as the iflatio police force. The two percet iflatio tred that took hold i the latter part of the 1990s was the goal of moetary policymakers ad it was achieved. The lesso leared from this period was that policymakers waited too log to tighte as core iflatio took hold prior to both the 1975 ad recessios. Because of this failure, the iflatio cures were more paiful tha might have otherwise occurred. RECENT INFLATION HISTORY The recet history of iflatio is show i Figure 2. Sice the peak of the last busiess cycle expasio i December 2007, core iflatio has cotiued to hug the two percet tred lie, though more ofte below two percet tha above it. Headlie iflatio has bee more volatile as expected because of ogoig volatility of food ad eergy prices. The story behid iflatio over this period is also well kow. The recessio proved to be the most severe sice the 1930s Great Depressio. The fiacial crisis that erupted i the fall of 2008 pummeled the already weak ecoomy ad pushed headlie CPI ito egative territory while weakeig core iflatio. The weakeig was serious eough to raise the risk of deflatio wherei fallig prices ecourage buyers to postpoe purchasers ad wait for eve lower prices i the future. The official trough of the recessio was deemed to be Jue 2009 ad the headlie CPI did perk up after that, reflectig both the retur of GDP growth i the U.S. alog with strog ecoomic growth i several developig coutries icludig Chia, Idia ad Brazil. Growth i those coutries boosted demad ad prices for atural resources which are reflected i the headlie CPI. Now, roughly three years after the recessio s trough, iflatio fears are buildig. First, the strog growth i developig coutries ad the impact o demad for food ad eergy is ifluecig headlie CPI iflatio. As the middle classes cotiue to grow i the developig world, this pressure oly will get worse. Secod, the moetary policy that helped to restore ecoomic growth i the U.S. REAL ESTATE ISSUES 39 Volume 36, Number 3, 2011

4 6% Figure 2 U.S. Iflatio Past Five Years CPI HEADLINE CPI-Core 5% 4% 3% 2% 1% 0% 1% 2% 3% Source: Bureau of Labor Statistics via Bloomberg has kept the federal fuds rate at essetially zero sice December The historic lik betwee easy moey ad iflatio is a teet of covetioal wisdom; is the Fed agai waitig too log to tighte? Third, the huge federal fiscal deficit is aother risk remiiscet of the 1960s gus ad butter budgets that cotributed to the iflatio of the 1970s. Despite the reasoableess of these fears, curret Federal Reserve Chairma Be Berake espouses cofidece that iflatio is ot a immiet threat ad that tighter moetary policy is ot warrated util the ecoomy is stroger. Why? A good foudatio for the chairma s cofidece is embodied i the chage sice the Volcker years i the ecoomic mechaisms that gover iflatio. Federal Reserve researchers alog with other ecoomists have updated the famous Phillips Curve relatioships that may layme still adhere to. 1 The ew models show that the growth i the iteratioal trade compoet of the U.S. ecoomy as described earlier has made the trade sector a ifluece o the path of U.S. iflatio. The growig importace of trade meas that the supply ad demad that drives prices is ow global supply ad demad. As a result, fewer ad fewer busiesses have the power to raise prices without losig customers to cheaper alteratives produced elsewhere. It meas that cosumers must maage risig commodity prices withi their budgets because they have o pricig power to egotiate higher wages. The fuctioig of these mechaisms explais why the $100-plus/barrel oil shocks of recet years did ot feed through to core iflatio as they did i the 1970s. The Jauary 2012 Federal Reserve Federal Ope Market Committee forecast reflects these fidigs. The forecast shows expected iflatio of o more tha two percet through 2014 as the trasitory effects of recet food ad eergy price spikes dissipate. Reviewig the history of these forecasts shows that the Fed s views o iflatio retai a cyclical patter with the rage of core iflatio from zero percet to 2.5 percet ad headlie iflatio from 0.2 percet to 3.6 percet at various times over the past few years. I sum, the iflatio cycle has ot bee elimiated but its peaks are ulikely to reach aywhere ear the experiece of the 1970s. COMMERCIAL REAL ESTATE INVESTMENT PERFORMANCE AND INFLATION Figure 3 shows the correlatio betwee the Natioal Coucil of Real Estate Ivestmet Fiduciaries (NCREIF) Natioal Property Idex (NPI) that measures ivestmet performace o U.S. istitutioal quality commercial real estate ad CPI iflatio. The correlatios cover quarterly data for the period from ; the NCREIF idex data begis i 1978 ad is available oly o a quarterly basis, ecessitatig that the calculatio be limited to this time period. REAL ESTATE ISSUES 40 Volume 36, Number 3, 2011

5 Figure 3 Asset Class Correlatios With Iflatio NCREIF-NPI total retur 0.38 Figure 4 Property Type Correlatios With Iflatio (1978 to 2011) (1983 to 2011) NCREIF-NPI NOI growth yr. Treasury total retur yr. Treasury total retur 0.29 S&P 500 total retur 0.03 NAREIT total retur 0.09 Corporate Bods 0.20 Source: NCREIF, Ibbotso, Bloomberg A correlatio of 1.00 would idicate that the asset class moves i lock step with iflatio while a correlatio of egative 1.00 would idicate the exact opposite; a perfect iflatio hedge would have a correlatio close to The correlatio betwee commercial real estate returs ad iflatio is While it is rather low compared with a perfect iflatio hedge, it beats correlatios betwee iflatio ad every other asset type show i the table. This very simple calculatio is a basis for the coclusio that commercial real estate serves as a iflatio hedge, albeit imperfect, relative to other ivestmets. A further aalysis uses aual data for NCREIF-NPI total retur, for its et operatig icome (NOI) growth ad capital value compoets, ad for idividual property type total retur ad NOI growth compoets. NCREIF data is more accurate o a aual basis tha o a quarterly basis because the distortios related to appraisal timig are greatly reduced. I additio, NOI data is particularly oisy o a quarterly basis with four-quarter growth rates greatly reducig the oise. Results are show i Figure 4. 2 The correlatio of total retur with iflatio is essetially uchaged at 0.40 usig aual data, versus 0.38 usig quarterly data. However, correlatio betwee iflatio ad NOI growth is markedly higher at Figure 4 also shows that the correlatios are ot stable over time. If the high iflatio period of the late 1970s ad early 1980s is excluded, the correlatios are very much lower. For the period, the correlatio betwee NCREIF-NPI total retur ad iflatio is 0.12 while the correlatio of NOI ad iflatio is 0.19, versus 0.40 ad 0.49, respectively, for the period begiig i Source: NCREIF, Bloomberg Yet, there is still some meaigful correlatio with iflatio for the shorter period show i property type performace separately. As shaded i Figure 4, the 0.35 correlatio betwee apartmet NOI ad iflatio, the 0.29 correlatio betwee idustrial property NOI ad iflatio, ad the 0.26 correlatio betwee retail property capital retur ad iflatio are all meaigful. So far, correlatio calculatios do ot seem to provide very strog evidece for the iflatio hedgig capacity of commercial real estate. I fact, the lower correlatios for the later period could be easily misiterpreted to mea that commercial real estate became a less powerful hedge agaist iflatio i more recet years. A more accurate coclusio is that the structural declie i iflatio after 1983 has made correlatio a rather ieffective tool for uderstadig the relatioship betwee commercial real estate performace ad iflatio. HOW COMMERCIAL REAL ESTATE INVESTMENT RESPONDS TO INFLATION Leavig correlatio aside, several characteristics of commercial real estate ivestmets cotribute to its capacity to provide iflatio protectio. They are well described i the Huag ad Hudso-Wilso 2007 article cited above. 3 Most importat is the structure of leases which ofte icludes step-ups i ret over the term of the lease. The most iflatio protective step-ups would call for explicit idexatio to iflatio. Eve without step-ups, leases have a specified term callig for a ew ret REAL ESTATE ISSUES 41 Volume 36, Number 3, 2011

6 cotract upo reewal. If the local property market does ot have a supply glut at the time of reewal, the adjustmet i ret is, at a miimum, likely to catch up to iflatio. Shorter-term leases ca catch up more quickly tha loger-term oes. The assigmet of expeses ca provide further iflatio protectio for commercial real estate ivestors. Some leases pass all expeses through to teats, most commoly the triple et leases o idustrial space, while others pass through oly some specified expeses as i the commo area maiteace charges for regioal malls. Property valuatio is also affected by iflatio through two aveues: NOI growth ad capitalizatio rates, both compoets of property value that ca be described roughly as NOI times the iverse of the cap rate. To the degree that iflatio protectio is embedded i the flow of et operatig icome, property value will be affected as well, without ay chage i cap rates. But, the market capitalizatio rate is itself affected by iflatio through its lik to loger-term iterest rates. 4 Over the cycle, higher iterest rates will materialize as ecoomic growth heats up, creatig egative pressure o property values. But at the same time, stregtheig ecoomic growth also will bolster NOI growth, creatig a positive impact o property values. The stroger the respose of NOI growth to iflatio, the more likely it is that property values will be ehaced rather tha depressed as iterest rates rise with the maturig busiess cycle. Cap rates also are affected by the risk appetite of ivestors. If ivestors expect commercial real estate to offer iflatio protectio, the spread betwee cap rates ad loger-term Treasury rates will tighte compared with spreads o other asset types that offer weaker iflatio protectio, such as corporate bods. HOW COMMERCIAL REAL ESTATE PERFORMS OVER TIME AND VS. OTHER ASSET TYPES The traits of commercial real estate ivestmets described above are most powerful whe there is o supply overhag i commercial real estate markets. Whe local markets build more tha their ecoomies ca absorb, power shifts to teats who ca egotiate very favorable terms o matter what the iflatio eviromet might be. Local markets vary with regard to their susceptibility to supply excesses. These differeces offer commercial real estate portfolio maagers opportuity to costruct portfolios that ca be more iflatio protective by virtue of selectig markets less vulerable to supply excess. There are times, however, whe supply excess is geographically pervasive. The early 1990s was such a period ad commercial property ivestmet performace uderperformed iflatio by a substatial margi. Similarly, the recet recessio hobbled U.S. ecoomic growth, dimiished the demad for space, ad created a glut of vacat space. Durig this period as well, iflatio exceeded NCREIF-NPI total retur. Eve excludig these periods of property market imbalace, the correlatio betwee iflatio ad commercial real estate returs also has bee compromised by the structural chages i iflatio. As described earlier, the path of iflatio shifted materially after the 1982 recessio ad followed a dowward tred through the late 1990s. Commercial real estate performace did ot Figure 5 U.S. Iflatio vs. Commercial Real Estate Total Retur CPI HEADLINE (Dec/Dec % Chage) NPI 4th Quarter Rollig Average 25% 20% 15% 10% 5% 0% 5% 10% 15% 20% Source: Bureau of Labor Statistics (via Bloomberg) ad NCREIF REAL ESTATE ISSUES 42 Volume 36, Number 3, 2011

7 declie i lock step with the structural declie i iflatio because it is idepedet of may of the factors that created the iflatio shift. This has bee to the beefit of ivestors. Over the history covered i this research ad show i Figure 5, ivestors i commercial real estate beefited to the degree that commercial real estate returs beat iflatio regardless of its correlatio. The beefit was measured by costructig portfolios of commercial real estate, Treasurys, stocks ad bods over five-year ivestmet horizos. This time frame recogizes commercial real estate is a relatively illiquid asset class with high trasactios costs that make frequet tradig impractical. Portfolios were created by selectig 5,000 radom startig poits over the period 1978 to 2006; startig poits ed i 2006 to accommodate the five-year holdig period edig i Results are show i Figure 6. Does commercial real estate ivestmet offer iflatio protectio? Accordig to the portfolio results for five-year holdig periods, commercial real estate returs beat iflatio i 84 percet of the 5,000 radom portfolios created for the aalysis. O average, the outperformace was 698 basis poits. Short-term ad log-term Treasurys as well as corporate bod portfolios beat iflatio more frequetly tha commercial real estate but with smaller degrees of outperformace. Stock performace beat iflatio slightly less frequetly tha commercial real estate but with a larger degree of outperformace o average. To compare these results, the probability of outperformace is multiplied by the average basis poits of outperformace i the third colum of the table. The probability-weighted outperformace of commercial real estate was 583 basis poits, secod oly to stocks at 923 basis poits. But, of course, there are caveats associated with these results. Most importat, the performace history available to evaluate iflatio protectio was a period domiated by the structural declie i iflatio that bega i Because iflatio was tredig dow, the iflatio expectatios embedded i log-term bods was geerally above the iflatio that actually materialized. This explais why log-term bods outperformed iflatio for 93 percet of the 5,000 portfolio scearios. Lookig ahead, it is ot possible for iflatio i the years ahead to repeat the path show i the history examied here. Iflatio is simply too low ow to tred dowward without igitig a deflatio morass. As discussed above, iflatio is curretly ichig up toward a expected two percet average with the potetial to gyrate cyclically aroud that rough average. The upward trajectory is welcomed as a idicatio that deflatio risk has dimiished. At such low levels, ivestors ca do better by targetig absolute performace i cojuctio with dowside risk tolerace rather tha targetig iflatio protectio. With a two percet expected average, the latter is simply too low a hurdle. CONCLUSIONS The key to commercial real estate ivestmet performace is to costruct portfolios that are protected from supply excesses that impair the iflatio protectio otherwise associated with commercial real estate. Historically, commercial real estate has hadily beate iflatio except durig periods of severe supply gluts brought about by too much costructio or a collapse i demad. Those Figure 6 Asset Class Ivestmet Performace vs. Iflatio (5-year holdig periods, 5,000 radom startig years; data draw from performace history) % of 5,000 avg bps of probability-wtd % of 5,000 portfolios avg bps of probability-wtd that beat iflatio outperformace outperformace that do t beat iflatio uderperformace uderperformace NCREIF-NPI total retur 84% bps 16% (234) (39) bps Short-term Treasury total retur 91% bps 9% (35) (3) bps Log-term Treasury total retur 93% bps 7% (76) (6) bps S&P 500 total retur 79% 1, bps 21% (348) (73) bps Corporate Bods 98% bps 2% (53) (1) bps Source: Ibbotso, Bloomberg, NCREIF, TIAA-CREF Global Real Estate REAL ESTATE ISSUES 43 Volume 36, Number 3, 2011

8 periods have bee ifrequet o a atioal basis. For local markets, imbalaces have bee more prevalet, reflectig local market characteristics. Ivestors ca beefit from focusig o these characteristics to build commercial real estate portfolios that promise stroger returs alog with beatig iflatio. Editor s ote: This article updates iformatio first preseted i a paper published by the TIAA-CREF Global Real Estate Research Group. REFERENCES Huag, H. ad S. Hudso-Wilso, Private Commercial Real Estate Equity Returs ad Iflatio, Joural of Portfolio Maagemet, Special Issue, Martiez-Garcia, E. ad M.A. Wye, The Global Slack Hypothesis, Federal Reserve Bak of Dallas, Staff Papers, September Peyto, M.S., Capital Markets Impact o Commercial Real Estate Cap Rates: A Practitioer s View, The Joural of Portfolio Maagemet, Special Issue, ENDNOTES 1. For example, see Martiez-Garcia, E. ad M.A. Wye, The Global Slack Hypothesis, Federal Reserve Bak of Dallas, Staff Papers, September These calculatios update similar calculatios i Huag, H. ad S. Hudso-Wilso, Private Commercial Real Estate Equity Returs ad Iflatio, The Joural of Portfolio Maagemet, Special Issue, Ibid. 5. See author s article o capitalizatio rate models i The Joural of Portfolio Maagemet, Special Issue, REAL ESTATE ISSUES 44 Volume 36, Number 3, 2011

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