Vested Shorts: Can commercial real estate hedge against inflation?

by Parth Parikh
May 21, 2023
2 min read
Vested Shorts: Can commercial real estate hedge against inflation?

Market Snapshot

Stocks ended the week lower on Friday, despite the S&P 500 and Nasdaq composite having their best weeks since March. However, the gains did not last as White House negotiations over the debt ceiling hit another dead end. Markets breathed a sigh of relief when Fed chair Jerome Powell said interest rates might not need to rise as much as expected. 

According to Bank of America’s latest survey, investors are becoming increasingly bearish, with 60% of respondents expecting a weaker economy. Many investors are choosing the relative safety of big tech, resulting in a week-long price rally for Apple, Netflix, Google, Microsoft, Meta, and NVIDIA. 

Can commercial real estate hedge against inflation?

Historically, commercial real estate (CRE) has been considered a strong hedge against inflation. Since 1980, CREs have outperformed other asset classes during 6 out of 7 inflationary periods. However, rising interest rates make the current inflationary period different from others. Prices of CREs have declined for the first time since 2011, according to data from Moody’s Analytics. Leading the drop was the office sector following four consecutive quarters of falling prices (see Figure 1 below).

CRE refers to various business-related properties such as malls, offices, warehouses, apartments, restaurants, hotels, and healthcare facilities. You can invest in these properties by investing in real estate investment trusts (REITs). However, their performance depends on the underlying sector’s growth and geographic location. Historically, two sectors have had lower returns due to slow rent growth during inflation. These are:

  • Office: In 2022, Office REITs were the worst-performing property sector. As more people continue working from home, office vacancies have reached a 30-year high of 12.9%. This sudden reduction in demand has led to lower rent collections and a drop in prices. As a result, office REITs have declined more than 25% this year
  • Retail: The US has the world’s highest square foot of retail space per capita. During the ’80s, the country had over 2500 malls. Today that number is less than a thousand. The rise of e-commerce combined with the pandemic has significantly depressed their valuations. Returns from retail REITs declined more than 13% last year

Therefore, investing in CRE (especially offices and malls) may not guarantee a hedge against the current inflation. Earlier this year, Brookfield Corp (BN) defaulted on loans tied to two of its office properties in LA. The interest rate hikes of the past year raised the risk of CRE borrowers defaulting on their loans. Banks and insurance companies hold the majority of these loans, and a concerned Fed is increasing oversight of these institutions.

Alternative Investments made easy