Updating Your Asset Allocation for Inflation

If only Federal Reserve Chairman Jerome Powell had been right when he used “transitory” to describe rising inflation in April 2021. Unfortunately, the inflation investors have endured since then has proven to be anything but short-lived.

Many advisors who initially chose to “sit tight” and not make changes to their stock and bond allocations may have now been forced to look toward other assets that have the potential to hedge inflation.  

A Good Inflation Hedge? It Depends.

It can be challenging to identify which investment strategies to employ as inflation hedges without knowing how high inflation may go or how long it will last. Consider how commonly used inflation-sensitive investments have performed across varied environments.

Different Strokes

Note: Asset-class returns are total annualized of various market indexes. LBMA Gold Price PM USD (for commodities); and FTSE Nareit All Equity REITS TR USD (for real estate investment trusts). Inflation is represented by the Consumer Price Index for All Urban Consumers, not seasonally adjusted, Index returns are before management and other fees and expenses. An investor cannot invest directly in an index.

Source: CNBC; Morningstar Direct

As shown above, real estate as represented by the FTSE NAREIT All Equity REIT Index delivered the most positive results during the most recent periods of high inflation in the U.S. when inflation exceeded 5% per annum.

Lessons From History

At the end of June 2020 US inflation hit its highest annual increase since the Great Inflation forty years ago. And while we hope our current inflation won’t be anything like that of the late 70s and early 80s, it’s worth noting how asset classes performed during that period. Stocks, bonds, and traditional assets failed to keep pace with the CPI by a wide margin. However, public and private real estate returns exceeded the inflation rate, once again demonstrating real estate’s historical effectiveness as an inflation hedge.

Major Asset Class Performance During the "Great Inflation”

(March 1978 - September 1981)

Indices: Intermediate U.S. Gov't Bonds are represented by the Barclay's Intermediate Corporate Bond Total Return Index; S&P 500 is represented by the S&P 500 Index; commodity futures are represented by the S&P GSCI Index; REITs refer to public REITs and are represented by the FTSE NAREIT All Equity Index; private real estate is represented by the NCREIF ODCE Index; gold is represented by the Gold U.S. Dollar Spot Price Index. Index returns are before management and other fees and expenses. An investor cannot invest directly in an index.

Inflation Correlation

Also, core private real estate, as represented by the NFI-ODCE Index, proved to be a more effective hedge during the Great Inflation than its publicly traded counterpart (REITs), providing lower volatility, a higher Sharpe ratio, and limited exposure to the gyrations of the public markets. Core private real estate also exhibited a more favorable positive sensitivity (correlation) to inflation during the period.

Sources: Bloomberg LP, Accordant Investments

Can Inflation Benefit Private Real Estate?

We believe that commercial real estate is positioned to benefit from inflation, both in terms of income and appreciation.

First, as inflation drives up replacement costs, real estate owners may benefit from additional appreciation. And inflation can lead to increased income as well. Apartment leases generally renew annually, and rents can be raised to market levels at renewal, increasing property income during inflationary times. Commercial real estate types with long leases often have rent escalation clauses in their leases. Thus, properties with longer leases can benefit from rising rents and income.

Keep in mind, however, that rapidly rising rents, especially for apartments, can make it more difficult for tenants to afford housing. This could potentially increase vacancy rates and impact net operating income. Putting it all together, in our opinion core private real estate can potentially serve as an “all-around” inflation hedge due to some historical trends, which may include:

• Strong historical performance across various inflationary environments
• Durable income that is positioned to rise with inflation
• Potential appreciation that may be further supported by inflation
• Diversifying characteristics, including historically low correlation and reduced volatility

Following Up

Our newest guide, Building a More Balanced Portfolio with Core Private Real Estate, provides additional insights into how this asset class can help you address inflation concerns and potentially improve your clients’ overall portfolio performance.

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Important Disclosures:

Commercial real estate investing includes certain risks including credit, location, interest rate, construction, and regulatory risk. Investors should properly assess and fully understand these risks before investing.

The information contained in this Presentation is for informational purposes only and is not an offer to sell, or a solicitation of an offer to buy, an interest (“Interest”) in a fund or other investment vehicle (collectively as applicable, a "Fund") by IDR Investment Management, LLC,  (“IDR IM”) or their affiliates and subsidiaries.

The information contained herein is subject to change, and may not be reproduced, used or disclosed, in whole or in part, without the prior written consent of IDR-IM.

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