Private real estate: A potential hedge against inflation?

May 15, 2023

Institutional investors have long used private real estate to generate steady income and asset appreciation. But given the market dynamics of recent years and quest for yield, retail investors have been joining institutional investors in increasingly utilizing private commercial real estate (CRE) to potentially hedge against inflation and diversify.

Here’s an overview of private real estate as an investment opportunity:

What is private real estate?

Private equity real estate is an alternative asset class composed of professionally managed, income-producing property. Investing in private equity real estate involves the acquisition or financing, and ownership (either direct or indirect) of real estate via an investment fund. Unlike publicly traded real estate investment trusts (REITs), private real estate has had a historically low correlation to stocks and bonds over the past four decades.i

Private real estate as a potential hedge against inflation

Over the past 25 years, private CRE investments’ total returns have performed better on a risk-adjusted basis relative to other large asset classes and have been especially resilient in today’s challenging public markets.ii In recent years, private CRE’s return performance well-outpaced that of publicly traded REITs, as well as stocks and bonds.iii

This resilience has been especially meaningful throughout the Fed’s monetary tightening that began in March 2022, which has led to a rapid rise in interest rates and contributed to the spike in the U.S. Consumer Price Index, which reached the highest level in 40 years in 2022. Heightened inflationary pressures also came from pandemic related supply chain disruptions, labor shortages, and the surge in energy prices, followed by a synchronized global consumer demand recovery.

Why some investors are increasingly considering private real estate

Private real estate’s investment performance is largely attributed to a few factors:

  • Durability of the income stream: The stability of private CRE’s income comes from built-in contractual lease increases. Frequently, rents adjust to escalators linked to inflation or current market rates. This lease structure enables periodic rent boosts, which can provide downside mitigation in a portfolio during inflationary cycles. Inflation leads to rent increases which, in turn generates higher cash flows and property values. For this reason, real estate income growth has performed well in periods of high inflation.

Source: Moody’s Analytics, NCREIF, Clarion Partners Investment Research, Q4 2022. Note: Real estate income = NCREIF Property Index (NPI) net operating income; consumer price index (CPI) measures inflation. Past performance does not guarantee future results. [Indices shown are unmanaged and do not reflect the impact of fees]. It is not possible to invest directly in an index.
  • Relative pricing resilience: In addition to the overall strength of U.S. CRE supply and demand fundamentals, resilient pricing in private CRE, measured by the NCREIF Property Index (NPI), is attributed to quarterly appraisal-based valuations.iv This pricing method has historically reacted more gradually to changing economic and capital markets conditions than publicly traded investments. Over the NPI 45-year record, private CRE has had much more modest value corrections relative to publicly traded REITs, which fluctuate daily. Of course, publicly traded REITs and equities are more liquid than private CRE investments, which generally require a longer investment commitment.
  • Income return record: Over the NPI's inception, the primary benchmark for private CRE, an historical analysis from 1978 to 2023 of the total return components - income and capital appreciation, reveal that the income return has never once been negative.v The income return and NOI growth are substantial drivers of total return and help sustain values when markets are weak.

Forecast for 2023

Over the past decade, institutional investor target allocations to private CRE have risen rapidly given the potential benefits. For 2023, institutions are forecasting a 30 basis-point increase, an acceleration in the pace of increase and the largest annual increase since 2014.

Source: Hodes Weill & Associates. 2022 Institutional Real Estate Allocations Monitor, November 2022, Clarion Partners Investment Research, March 2023. Allocations are based on a survey of 173 institutional investors in 34 countries representing $11.0 trillion in AUM and $1.1 trillion in real estate. 2023F is next year’s estimate. Target allocations = weighted average.

Risks and other considerations

Investing in private real estate entails accepting certain risks and being aware of considerations, such as:

  • Limited liquidity and a long-term investment horizon relative to other asset classes
  • Higher initial investment than stocks or bonds
  • Geopolitical uncertainties
  • Regulatory changes
  • Debt capital availability
  • Elevated construction costs
  • Fee structures and additional costs that may negatively impact performance

Higher costs of capital, along with recession concerns, have led to a broad-based mark-to-market in CRE debt and equity capital markets. Over recent quarters, there has been some transactional and appraisal-based re-pricing, although uneven by sector. Cap rates have expanded modestly overall, excluding the office sector, which has been more significant. The durability of CRE asset values will likely vary by property sector, market, lease term, and risk profile. Current macro risks and market dislocations may also create attractive buying opportunities over the next 12 to 18 months.

During this post-pandemic period of uncertainty, Clarion Partners believes that investors should take a long-term view and remain patient. Given that private real estate cash flows are generally connected to long-term lease contracts, we believe in the durability of the income stream over time, especially for necessity-driven property sectors, such as industrial, multifamily, and retail.

Private real estate can play a role in a diversified portfolio — but it’s not for every investor

This type of investment is not for everyone. Before investing, connect with your financial advisor who will align your investment strategy with your risk tolerance, asset allocation targets and time horizon. Investor qualification thresholds may apply.

There is no guarantee that real estate will be an effective hedge against inflation at all times. Past performance is not a guarantee of future results.