"Real estate is a hedge against inflation," a phrase spoken with the same conviction that Sir Isaac Newtown said, “…what goes up must come down.” (Excluding real estate, of course.) For the record, salt and gold are also a hedge against inflation, and they are a lot easier to own so long as you are not storing them under your mattress.  And yet, real estate promoters love to speak of the mythical real estate hedge that protects investors from inflation like shields on The Starship Enterprise, all the while soaring to new heights in value.

While it is true that real estate possesses specific characteristics that, when combined correctly, can outperform during periods of inflation, it is not true that all real estate outperforms during inflationary periods, and some of it does quite badly.

They Aren’t Making More of It

There is a finite amount of land, even less so that is developable, and an even smaller amount with high-quality improvements.  It takes years to develop new buildings, so supply reacts slowly to changes in demand. When inflation erodes the purchasing power of cash, making each $1 worth less, investments in assets with limited supply tend to do better.  They rise in value with inflation. In this sense, real estate behaves a bit like a commodity.

In addition to the finite amount of land on the planet, property is almost always a vital economic input.  Being a platform for other businesses is another characteristic it shares with commodities.  Land is needed to farm, warehouses are needed to store products from the farms, and offices and retail stores are needed to provide the infrastructure for the markets where those products trade.  People need roofs to sleep under.  And in the 21st century data centers are needed to store pixels and bytes.  These qualities create long-term, consistent demand for real estate, which is more than we can say for tulips in 1637 or crypto yesterday.

Problems occur when there is too much supply.  Markets have a nasty habit of building more of everything than what is needed when times are good, and when times are bad, supply exceeds demand.  The oversupply is often temporary; demand catches up, and the market balances.  Although temporary, market equilibrium can take a very long time; temporary does not mean brief.  If an investment has not established a durable income stream before the market overbuilds, that real estate will suffer inflation like a pair of concrete boots at the end of the pier and temporary will feel like drowning.

As I have said, limited supply and a vital economic input are not unique to real estate.  This is basically the definition of a commodity, and there are plenty of commodities in the world.

Secret Weapon

Unlike a commodity, real estate produces cash flow.  Gold and salt can be exchanged for cash when there is demand, but the cost to store them may outstrip the appreciation during the lean times.  The right real estate generates cash.  There is little downside to holding a cash-flowing property during periods of inflation.  Operating cash covers expenses; it can be used to improve the property, acquire new tenants, or amortize debt, and if you’re lucky, a little mailbox money will come your way at the end of the day.  Cash flow is an excellent quality in any market.  Still, it is precious during periods of inflation when investment demand may dip, and holding onto a simple commodity increases your basis but does nothing to provide a return in the interim.  In this case, cash-flowing real estate is far superior to most basic commodities.

Cash flow is excellent, but an asset’s net cash flow is still at the mercy of costs, which rise during periods of inflation.  Wages, materials, taxes, and insurance all increase with inflation.  Fortunately, most real estate revenue structures allow them to reset periodically to adjust for inflation and demand.  Typically, these rental increases are contractual and require little, if any, additional investment on behalf of the owner.  Of course, new tenants and renewals have some revenue acquisition costs.  The key here is managing that exposure so you are not replacing every tenant simultaneously.  That's going to be ugly.

In addition to operating costs, interest rates, which are the cost of debt, have a very tight correlation to inflation and will rise with it.  Interest rates are significant because debt is a crucial input to most real estate investment returns, and its cost is usually one of the most significant investment expenses. During periods of inflation, floating rate debt, loans with interest rates that reset to market periodically, can bury an investment if revenue is not growing at the same rate.  And debt that needs to be refinanced at the wrong time is just as bad or worse.  Not only does your borrowing cost increase, but debt may not be present.  Bueller….Bueller…..Bueller, did somebody say office loan?

The Fix

Long-term fixed debt.  If there is a secret ingredient to using real estate to protect your capital against inflation, that’s it.  The ability to fix your cost of borrowing for periods of five, ten, and even forty years is a significant tool in the fight against inflation and is typically very accessible to real estate.  As I said, cash flow is excellent, and rising cash flow is even better; add fixed costs to the mix, and you get improving margins.  And that is as good as it gets.

Now, this is only relevant if your investment is leveraged, but most real estate investments are.  Sponsors bring debt to the capital stack at a lower rate of return to the equity, and the profits from improved income flow to the investors. When you have floating rate debt, any revenue increases will almost certainly be eaten up by rising interest rates.  When the interest an investment is paying on its debt is below the market cost of the debt, you have a hedge against inflation.

Debt, of course, is a double-edged sword.  It might even have a third edge.  Enough debt will increase equity returns materially.  More debt increases risk.  In a spreadsheet, the more debt you have, the better the equity return looks, so managers and investors tend to lay it on pretty thick.  The risk is that when asset value declines, those losses hit the equity first, and if you have too much debt, those declines wipe out the equity. There is a big difference between losing 10% of your equity and still owning the asset and losing 100% of your equity.  Lenders don’t typically let you retain ownership after all the equity is gone.  If you have a good asset that is not overleveraged, the investor lives to fight another day and maybe even recover those losses. 

A spoonful of leverage helps the equity returns go up, and too much leads to obesity, diabetes, and early death.

If

If you own the right real estate, you own a commodity.  If you know what you’re doing with that real estate, it generates revenue.  And if you understand finance, you can fix your interest expense over a long period of time and increase margins.  So, if – if – if, and yes, real estate protects your investment against inflation better than other types of assets.  However, you can miss the mark on any one or, god forbid, all of these, and real estate is no better a hedge against inflation than that $1 in your bank account.  In fact, it is worse.  Your cost basis will increase as the value declines, and you will quickly get into trouble.  And all of a sudden, the hedge is getting sheared. 

Many investors have not experienced a period of inflation like we just saw over the last three years.  Hopefully, lessons were learned.  Now, with the real estate market down, the intelligent investor is ready to jump back in. 

Cap rates and yield are two very different things.  One is set by market demand, and one is created by smart management.  And yet, a large segment of the real estate investment community believes they are one and the same.

Cap rate is the market price to acquire a real estate revenue stream.  It is typically based on the next twelve months of income, hopefully most of which is contractual, and it tends to be aspirational in the short-term, a best-case scenario.  The value an investor creates is the spread between the market price and the actual yield it returns.

Yields are both the actual historical return on investment and the detailed projection of a business plan. Because cap rates are a function of the market and as such are outside anyone’s control, a savvy investor must estimate the future revenue and determine if it creates enough value to justify the market's price today.  Over time, you evaluate if the actual yield has sufficiently rewarded you for the initial investment. 

Mind the Gap

A good rule of thumb is that the lower the cap rate, the closer it will be to the actual yield, and the higher the cap rate, the more significant the gap.  Lower cap rates imply higher-quality revenue and higher-quality properties.  Therefore, you have fewer vacancies and lower ownership costs.  High cap rates imply just the opposite.  You show me a 12% cap rate, and I will show you a 1970s office building. 

High cap rates are a great time to add value.  That property will never generate a 12% annual return, but if you can improve the revenue stream to the point that someone will pay a 6% cap for it, you created a tremendous amount of value.  The same is true for low cap rates; if you can generate a 7% yield on a 4% cap rate, you have created value.

Achilles Heal

All too often, investors and those trying to separate them from their money treat cap rates as if they are as certain as treasury bond yields.  When, in fact, they are a highly subjective indication of investor demand.

The belief that there is a correlation between cap rates and treasury yields is a myth born from the fact that real estate debt is largely priced off the ten-year U.S. Treasury.  Some believe that if the ten-year rate is 5%, real estate should trade at some spread above that.  The idea is not wrong; investors are just using the wrong metric.  It is the yield that should trade at a spread over the ten-year.  Cap rates are just a function of demand and supply within the real estate market.  And that is a very different market than the debt market.

It seems reasonable, even intuitive, to most that a rising cost of debt should reduce investor demand.  Thus, cap rates should rise, and prices should fall.  But supply is the other side of this seesaw, and pricing stays flat if supply falls with demand, which is precisely what is happening in the opening act of 2024.  Investment demand has fallen, but supply has decreased almost as much.  The inventory for sale is so low right now that cap rates are holding up better than treasuries. 

Little Liars

Cap rates are cunning; they tell you something about the market’s balance of supply and demand.  The balance between the amount of capital chasing deals and the number of qualified investments.  But they are silent on whether or not investors are overpaying.  They tell you nothing about the underlying balance of the supply of properties and tenant demand.

When cap rates are low, below what an acceptable return would be, the investor is betting the market will appreciate, either through revenue growth or price appreciation.  An appreciating market should be a good time to invest.  The market will tell you this right up to the point that it changes direction, which can be sudden and severe.

After the market lures you in with promises of growth, it scares everyone away when prices start to decline.  The fear that it will decline further, that cap rates will increase more, outweighs the good sense that a lower price today for what you were prepared to buy yesterday is a good thing.  Investors become focused on trying to buy the bottom and miss the chance to buy a good return out of fear for the market’s fluctuations over the short-term.

Under the Hood

The only acceptable valuation method for a prospective investment is carefully analyzing all future cash flows against the basis in your investment, which we have defined here as yield.  In order to see through the beguiling song of the cap rate an investor must dig deep into the supply of comparable product within the competing market and develop an opinion about the future of revenues and expenses.  They must attempt to predict the yield the property will generate over time.

Most importantly, they must distinguish between physical supply and demand within the market and the supply and demand of investments and capital.  The lie that cap rates are telling you is that they are the same thing. That cap rates represent the physical supply and demand of property and tenants, when in fact they are driven by an entirely different thing, capital.

High Noon

Over the last decade, many real estate operators and investors haven't added much value.  They did not grow yield or improve the asset.  However, because the capital market demand drove down cap rates, the market increased the spread between price and yield for the investor.  Demand grew aggressively because more and more capital entered the market looking for investments.  After the dramatic interest rate tightening by the Federal Reserve, capital exited the market, and there is no doubt that caused demand to decline.  However, so did the supply of investments, and the market adjusted prices down but not significantly, at least not yet.

The capital market sets the price for real estate, and we call that cap rate.  The investor creates value by growing the spread between the yield they are earning on the investment and the cap rate the market is willing to pay for it.  Cap rates can tell you a lot about the market, but yield is the ultimate judge of whether or not you have created value.  Please do not mistake one for the other.  Mr. Market doesn't care about your capital when it sets a price, and it often goes off its meds and behaves erratically.  Yield is the truest measure of return; and it is a painful high noon prairie sun.

Sincerely,