Real Estate As A Hedge Against Inflation

Real estate is sometimes considered to be an inflation hedge. One of the ways it does this is through the mechanism of adjusting rents; what the landlord will sign the lease for in order to cover the downside cost to operate the building. On the upside, real estate begins to accommodate the additional cost necessary to construct new competition in the market.

Because inflation is reflected in the cost of building materials and labor, when market value is lower than replacement cost, there will be no new supply of buildings causing prices to increase due to a shortage of new competition in the market. However, when market value is greater than replacement cost, this is the time to build.

More specifically, product types such as office leases typically have an escalator or “recovery of expense over an expense base” clause that allows for increases in expenses to be passed along to the tenant. This tends to protect the landlord to keep passing on expenses. More importantly, real estate needs tighter markets for the landlord to still do this. If you look back at the 1990’s, real estate was a very poor hedge because the markets fell apart.

Today, U.S. construction levels remain historically low (with the exception of the multifamily property sector) as the real estate industry continues to absorb the existing supply in the markets.

Grant Palermo is a Master’s Candidate in Real Estate Finance & Investment at New York University.

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