Can REITs Be a Hedge Against Inflation?

Inflation is the gradual increase in prices that results in a decrease in purchasing power. It is a sustained economic trend that can erode the value of certain investments and savings over time. As a result, investors seek investment vehicles that can protect their wealth against this economic reality. Real Estate Investment Trusts (REITs) are among these vehicles, often acknowledged as a reliable inflation hedge. Since real estate is known to be effective in preserving value and generating returns during inflationary periods, REITs also offer similar benefits.

A REIT is a company that allows investors to pool money to invest in income-generating properties without the need to directly own and manage physical assets.

With inflationary pressures still elevated, certain real estate sectors show potential to perform well despite rising costs. Key inflation-specific metrics, such as the Consumer Price Index (CPI), currently at +0.2%, suggest that real estate assets, particularly those with income-generating potential, may offer resilience in the face of inflation as we move into the upcoming year.

This article explores REITs as an inflation hedge by examining the past performance of REITs during inflationary periods. We’ll discuss the role of some investment strategies in mitigating inflation risks to your portfolio.

Inflation and Its Effects on Investments

The threat of rising inflation has been a cause of concern for investors since the start of the COVID-19 pandemic in 2020. As a result, many investors look for assets that can help preserve purchasing power and protect their wealth from the eroding effects of inflation.

While real estate is often considered a reliable inflation hedge, it’s important to compare it to other assets that serve similar purposes. Stocks, for example, act as a hedge in sectors that can pass on costs to customers, like the energy and retail sectors. Stocks also offer growth potential that may outpace inflation, but they often demonstrate higher volatility, especially during economic downturns.

In contrast, real estate income derived from rents paid by tenants can be particularly reliable in periods of high inflation. Due to the escalatory nature of lease agreements, rental income often adjusts more quickly to changing economic conditions than other forms of investment income, like dividend payouts from stock.

Certain fixed-income products, like Treasury Inflation-Protected Securities (TIPS), are specifically designed to adjust to inflation. However, standard bonds with longer maturities do not automatically adjust for inflation and may be more vulnerable to inflationary pressures. These bonds often offer lower yields compared to inflation-resistant assets like real estate.

While each of these inflation hedges has its benefits and drawbacks, making them suitable for different economic conditions, real estate stands out for its potential to offer both capital appreciation and income that may adjust with inflation. However, real estate investments also come with risks, such as market volatility, high upfront costs, and potential liquidity constraints, which may not make them suitable for all investors.

What are REITs?

REITs are companies that own, operate, or finance income-generating real estate. They can be classified into three types:

Equity REITs primarily invest in and own income-producing properties, generating revenue through rent collection and property appreciation.
Mortgage REITs invest in and own mortgages, mortgage-backed securities, and other related assets. They generate revenue by collecting interest payments on these investments.
Hybrid REITs invest in both real estate properties (equity REITs) and mortgage loans (mortgage REITs).

There are three common types of REITs based on how they purchase and sell their shares:

Private REITs: Private REITs operate as private placements for a select list of accredited investors only. Therefore, they are considered private investments. Generally, private REITs are neither traded on the stock nor registered with the U.S. Securities & Exchange Commission (SEC).
Publicly traded REITs: Publicly traded REITs issue shares that are listed on national securities exchanges, including the New York Stock Exchange, and are regulated by the U.S. SEC. Individual investors can buy and sell such shares in the stock market.
Public Non-Listed REITs (PNLRs): PNLRs are registered with the SEC but are not listed on public exchanges. While they offer some transparency and regulation, they lack the same liquidity as publicly traded REITs, typically requiring a longer holding period.

REITs allow investors to pool their capital to purchase income-generating real estate properties and build a diversified investment portfolio. By law, REITs are required to distribute at least 90% of their taxable income to shareholders in the form of dividends, providing a steady income stream for investors. While REITs offer access to real estate investments, it’s important to note that transparency may vary, especially with non-traded or private REITs, which may have more limited disclosure compared to publicly traded investments.

The value of publicly traded REITs may fluctuate based on the overall real estate market, the performance of the underlying properties, and broader stock market conditions. As publicly traded assets, REITs can be influenced by general market sentiment and economic factors that affect the stock market as a whole.

REITs History of Strong Returns: Historically, real estate investment trusts (REITs) have provided a potential hedge in inflationary environments because their underlying properties’ value tends to rise with inflation. Landlords can potentially capture higher rents when inflation is higher to maintain their purchasing power. In addition, as inflation rises, the cost of new construction also goes up. This further squeezes the supply and potentially drives up prices even more. Moreover, REITs have delivered competitive total returns based on high-dividend yields and capital appreciation. In fact, amidst current economic conditions, the annual total REIT returns for the U.S. reached 11.4% in 2023, according to the FTSE Nareit All Equity REITs index.

REITs as a Hedge Against Inflation

When inflation increases, the cost of living also rises, as do rental prices. This allows property owners to increase rents and maintain their purchasing power. For REIT investors, this translates to passive income that can potentially offset the increasing costs associated with inflation.

Property sectors with sustainable cash flows protected by long-term leases and rent escalation provisions offer income resilience during inflationary periods. Many investors evaluate real estate sectors such as multifamily, industrial, healthcare, senior living, net-lease properties, or grocery-anchored retail centers.

Portfolio managers can choose from a wide variety of property sectors, including long-term (e.g., commercial properties, industrial warehouses), mid-term (e.g., office buildings), and short-term (e.g., hospitality), based on their preference for lease duration. This is similar to how bond portfolio managers adjust their portfolio’s duration based on changes in interest rates.

Longer leases typically have annual rent escalators calculated based on the change in consumer price index (CPI), or they can be fixed-rate annual bumps, ranging between 2% and 4%. REIT sectors with shorter lease durations allow landlords to reprice leases more frequently, often annually or less.

Pros and Cons of Using REITs as an Inflation Hedge

REITs have become increasingly popular investment vehicles due to their unique blend of features, combining the benefits of real estate ownership with, in the case of publicly traded REITs, stock market liquidity. Non-traded and private REITs, while less liquid, offer investors other advantages, such as reduced exposure to daily market volatility. Here’s a detailed look at the primary advantages and potential drawbacks of investing in REITs.

Pros:

Income Growth Potential: Many REITs benefit from leases with built-in rent escalators, allowing property owners to raise rents in line with inflation. This feature can help REITs generate growing income over time, potentially enhancing returns for investors as property revenue increases with market conditions.
Diversification: REITs offer a cost-effective and efficient means of diversifying your portfolio while providing a steady income. This way, you also gain exposure to a wide range of property sectors and reduce risks associated with economic fluctuations.
Potential Real Estate Value Appreciation: Economic shifts can affect property values; however, REITs show potential for asset value growth, even as inflation rises. According to data from the U.S. Census Bureau, during the period of high inflation of about 9% between 1975 and 1981, home prices nearly doubled, rising by about 90%.

Cons:

Market Volatility: Publicly traded REITs can experience significant price fluctuations due to changes in broader economic conditions, stock market trends, and interest rate movements. Additionally, shifts in demand for specific property types can impact REIT performance, contributing to overall market volatility.
Sector-Specific Risks: REITs are subject to sector-specific risks that can impact their performance. For example, Retail REITs may experience a decline in income as foot traffic declines due to the rise of eCommerce, whereas commercial real estate REITs are often more sensitive to economic cycles. Similarly, office REITs could lose ground to self-storage REITs as people reorganize to create viable home offices.
Operational Risks: As an investor, you have little decision-making power and are at the mercy of the REIT’s property management team. REIT investors face various risks due to potential management decisions, such as selecting poor property locations, failing to maintain high occupancy rates, or experiencing tenant defaults. Additionally, market fluctuations can further impact a REIT’s financial performance, potentially affecting long-term returns for investors.

How to Choose Inflation-Resistant REITs

Here are some practical tips to consider when you are investing in REITs as an inflation hedge:

Key Factors to Consider: Consider investing in REITs that focus on sectors less impacted by inflation, such as residential and healthcare properties. These sectors tend to provide more stable cash flows and are often resilient during economic fluctuations. Look for REITs with strong fundamentals and diversified portfolios in these areas to help mitigate inflation risk.

Additionally, publicly traded REITs demonstrate strong long-term hedging protection against expected inflation in the U.S.

Lease Structures: Lease duration is critical to building price sensitivity into a REIT portfolio, similar to how falling or rising interest rates affect price or duration sensitivity in a bond portfolio. Therefore, investors may consider REITs with inflation-linked leases, which are tied to fixed rates or the CPI, as these features can help support cash flow stability in an inflationary environment.

Diversification: Diversification plays an important role in building a well-rounded inflation protection strategy. REITs with a diversified portfolio across different property types and locations can benefit from spreading risk. For example, a REIT that includes a mix of residential, commercial, and multi-family properties may be better positioned to withstand economic shifts, potentially providing more stability and resilience against inflationary pressures.

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REITs tend to perform well during periods of high inflation for several reasons. The underlying assets of REITs are real estate properties whose rents are often tied to inflation, allowing for increases in lease contracts. Additionally, inflation usually occurs alongside strong economic growth, driving demand for properties. This increased demand translates to higher occupancy rates and income generation, making REITs an effective hedge against inflation.

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This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees, and other expenses. This literature must be accompanied by and read in conjunction with a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results, forward-looking statements and projections are not guaranteed to achieve the results described, and your actual returns may vary significantly. Investments in private placements are illiquid in nature, and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice, and you should consult with your tax advisor, as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.