Estimating the Impact of Inflation on Commercial Real Estate Returns

Figure 1: All Property Real Total Returns and Inflation/GDP Growth

How does inflation affect commercial real estate (CRE) returns? The left panel of figure 1 shows all property real total returns plotted together with CPI inflation. In 1990, inflation reached a high level at 5%, and real total returns declined during the same time. After that, from 1994 to 2007, inflation stayed low, and returns were relatively high. But during the GFC, returns and inflation moved together. Based on the historical data, there is no clear relationship between inflation and returns. Several reasons contributed to that.

1. The cause of inflation matters. If inflation is driven by strong economic growth, it would benefit CRE returns due to rising rents, lower vacancy, and rising income growth expectations.
2. But if inflation is caused by a higher cost of goods and stagflation occurs, this type of inflation can hurt investment returns. Vacancy is higher and landlords find it harder to push through rent increases and interest rates may be higher. A higher general rate of inflation in the economy means that things look even worse in real terms.
3. The impact also depends on if landlords can pass inflationary pressure to tenants. If there is oversupply on the market, it’s difficult for the landlords to increase rents when facing rising inflation.
4. A key part of the relationship is the link between inflation and interest rates. If rising inflation leads to rising interest rates, that may push up cap rates and lower returns.
5. Whether inflation is supported by economic growth largely affects the impact of inflation. In the right panel of figure 1, total returns are plotted against real GDP growth. There is a much more obvious relationship between GDP growth and property returns than there is between inflation and property returns. This is because there are different types of inflation, which makes it challenging to estimate the impact.

We did some quantitative analysis, to figure out the long run sensitivity of real total returns to inflation when we allow for what was happening to GDP growth. Table 1 shows the results for each of the sectors. The numbers in the table are not correlation coefficients. In the regression analysis, besides having inflation, we also controlled for GDP growth and risk premium. To interpret the results, take office for example. The long-run sensitivity of real total return to CPI inflation is -1.47. That means, when everything else being equal, a one percentage point increase in CPI inflation will lead to a 1.47 percentage decline in office real total returns. The negative relationship with inflation probably comes from the link between inflation and long-term interest rates.

Total returns are not only affected by inflation, but they are also affected by GDP growth, which has a positive impact on returns. This corresponds to what we said above. If higher inflation is driven by higher GDP growth, then the impact of real total returns can be positive; but if we have cost-push inflation with weaker GDP growth, then higher inflation will have a negative impact on real total returns.

We put together an example with three economic scenarios -- baseline, upside, and upside with higher inflation. Comparing baseline to upside scenario, inflation increases from 2.38% to 2.6%. From the sensitivity analysis, rising inflation would lead to lower returns. But in the upside scenario, the GDP growth is higher, which is positive for returns. The combined impact of rising inflation and stronger GDP growth is shown in the bar chart. The dark green bar shows the overall impact in the upside scenario, relative to baseline. They are positive across all sectors despite rising inflation because it is supported by strong economic growth.

What if inflation grows even higher, without stronger economic growth? This would be consistent with higher inflation being due to a mix of higher GDP growth and higher cost growth (i.e. a mix of demand-pull and cost-push). In the “upside with higher inflation scenario”, inflation reaches 3%, while the GDP growth is the same as that of the upside scenario. Relative to baseline, in the upside with higher inflation scenario, the overall impacts on office and industrial returns are negative, while retail and multifamily sectors are more resilient. Note that these results are different from the baseline. The result here doesn’t mean the retail sector will have higher returns than the industrial sector in the next three years.

The purpose of this analysis is to show that, if we are in a controlled environment, when everything else is equal, which sector’s returns were more sensitive to inflation. The impact of higher inflation on real total returns depends on what kind of inflation it is or, to put it another way, on the GDP growth/inflation mix. In our upside scenario, the combination of higher growth and higher inflation would be a plus for total returns, but that could easily change if we have under-estimated inflation.