Do REIT's provide protection as inflation’s makes a possible comeback?
Inflation on the horizon
In the late 1970s, public opinion polls ranked inflation as the number one problem in the United States. Central bank policy, the abandonment of the gold window, Keynesian economic policy and many more contributed to this period of high inflation. Since then, inflation has steadily declined and has been close to the Fed’s inflation target level. However, worries of inflation are resurfacing in the press and amongst investors as annual inflation surged to 6.2% in October, reaching a 30-year high (see figure 1). According to Nicole Funari, the vice president of research for Nareit, investors who are concerned about potential persistent inflation can protect their portfolio by adding allocations to commercial real estate REITs. This is because the stocks of these companies that own and operate commercial real estate, are a low barrier and efficient way for investors to get exposure to income streams (i.e. leases) that are linked to inflation.
Figure 1: U.S. Annual Inflation Rate
According to Funari, in high inflation periods, strong income returns offset falling REIT prices, and REITs outperformed the S&P 500 by 1.3 percentage points during these periods (see figure 2). In periods of moderate inflation, REIT dividends more than compensated for the higher price returns on the S&P, leading total returns on REITs to exceed the S&P by 3.9 percentage points. In periods of low inflation, REIT returns fall below the S&P 500 as the income portion does not make up for superior price returns on the S&P 500.
Figure 2: REIT Returns Compared to S&P 500 Returns During Different Inflation Periods (1972-2020)
The figure and the accompanying statements beg for two comments. First, if the argument holds that in high inflation periods strong income returns offset falling REIT prices, then why are income returns so high still in low inflationary periods? That seems contradicting. Second, these findings seem to contradict the findings of academic studies, which find either a perverse inflation hedge or little evidence for inflation hedging. For example, Liu et. al. (1997) find that real estate securities provide a worse hedge against inflation relative to common stocks in some countries and are comparable to stocks in other countries. Finally, the studies that do find that real estate serves as a (partial) inflation-hedge, find this only over long-time horizons.
To conclude, while there definitely exists an argument to invest in real estate companies that derive their incomes from inflation-linked income producing properties, there still lacks solid studies that provide consistent findings that REITs provide inflation hedging in the long-run like Nareit claims.