Inflation Pressures and Real Estate Opportunities

Market experts say historically low interest rates, coupled with rising inflation, are currently supportive of real estate asset class valuations, creating a “sweet spot” for investment in core real estate.
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Art by Melinda Beck

Fueled by historic levels of fiscal stimulus and loose monetary policy, inflation has surged at its fastest 12-month pace since June 1982—rising to 7% in December, according to the Department of Labor (DOL). As more investors seek protection from the threat of rising interest rates, they are increasingly focused on both real estate and real estate investment trusts (REITs) as alternative return sources.

With a constantly shifting investing environment, real estate is experiencing a dramatic revival, according to J.P. Morgan Asset Management’s most recent “Global Real Estate Outlook” report. In the coming 12 to 18 months, the firm expects to see real estate continue to deliver strong risk-adjusted returns, with a meaningful inflation protection element in a rising rate environment—as long as economic growth continues unabated.

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Historically low interest rates coupled with rising inflation are currently supportive of the asset class’s valuations, creating a “sweet spot” for investments in core real estate, the outlook notes. Since the economic recovery began in late 2020, there has been unprecedented fundraising by non-traded private REITs and an acceleration of institutional portfolio rebalancing. As investors come under increasing pressure to find yield-producing assets, J.P. Morgan says it expects to see capital flows into real estate increase sharply.

According to the Defined Contribution Real Estate Council (DCREC)’s “2021 Defined Contribution Survey,” there is rising interest in investing in real estate among defined contribution (DC) investors, with the median assets under management (AUM) of an investment manager managing dedicated DC real estate strategies increasing more than 50% over the past five years, and overall AUM increasing 24%.

Almost half of real estate investment managers responding to the survey are actively managing DC capital within their real estate portfolios. Another 47% of managers are considering or actively developing offerings for the DC market, suggesting the scale of interest in the DC channel is growing every year.

In the current market environment, investors are worried about whether returns for equities and fixed income will be enough for DC savers and how they can include further diversifiers that will be beneficial in the long term, says DCREC co-president Sara Shean. With more plan customization options available, investors are also paying attention to what is structured in a way that can be easily added into a multi-asset portfolio.

The top reasons investors have shown interest in adding private real estate to their plans were diversification, risk-adjusted returns, inflation and downside protection, Shean says. Private real estate investments tend to hold up well when the market is more volatile. Since they move more slowly than the rest of the market, they don’t fluctuate as much either on the downside or upside and can help to “buffer the ride” in the typical portfolio, she explains.

Additionally, Shean says, there have been great strides by the industry over the past 10 years to standardize many of the operating principles and mechanics to help make offering private real estate more attractive vehicles for the DC market.

Interest within the industry has shown that investors want to be able to add real estate to custom target-date, off the shelf target-date or balanced funds, Shean says. There is typically a combination of both public and private real estate offered together in the DC space for multi-asset portfolios.

In the case of private real estate specifically, because it is an illiquid investment, it’s best to combine it into a multi-asset solution that has liquidity from other options within the fund, Shean says. This buffers the participants from periods where they need liquidity to make transactions.

“Private real estate sits right between fixed income and equity. So it gives you the benefit of income, like fixed income, and it also gives you more upside than fixed income,” Shean says. “It sort of sits right in between there and it’s a very steady ride.”

On a standalone basis for DC plan investors, REITs would work best and are beneficial because they are fully liquid and an efficient way to access commercial real estate markets, Shean says. Since REITS are traded and priced daily, they fluctuate more but tend to outperform private real estate by a small margin in the long term. REITs can also be offered in multi-asset solutions and, in some cases, they pair well with private real estate, which can help when the market is more volatile.

When investors use REITs, they are investing in office property, apartments or self-storage, which are all business- and economy-driven. REITs are not the same as owning a home or townhouse, a common misconception, Shean notes.

Additionally, according to J.P. Morgan, historical performance supports the argument for using REITs for their inflation-hedging and income-generating properties. In 83% of the rising rate periods between 1992 and 2020, U.S. REITs delivered positive total returns, and in 50% of those periods, U.S. REITs also outperformed the S&P 500.

As long as the supply-demand dynamic remains healthy—and the economic rebound is not derailed by new coronavirus variants or undermined by poorly controlled inflation in the coming 12 to 18 months—real estate should provide investors with a consistent source of alpha, income and diversification, J.P. Morgan says.