Real estate investors have one big question today: Could rising inflation and interest rates hurt property values and real estate returns?

Our answer: We don’t see historical evidence that returns should suffer, especially short-term. We don’t expect property values to fall as rates and inflation potentially rise, except under one scenario—as is the case for many asset classes, real estate could suffer in the event of stagflation (inflation coupled with slow economic growth). But we think stagflation is unlikely.

Instead, we expect inflation to be relatively short-term and for the U.S. economy to remain robust, supporting rent growth. Also encouraging for real estate investors: At the moment, the real estate yield spread to fixed income (the cap rate¹ spread) is historically wide, so there is a cushion should interest rates rise.

No evidence higher inflation damages real estate returns, but recessions do

There is no historical evidence that higher inflation hurts returns, even though inflation can lead to central bank rate hikes., current cap rates have a very wide spread relative to risk-free fixed income (the equity yield premium), giving investors a cushion.

U.S. historical data² suggest that property values do not necessarily decline even when the equity yield premium goes to zero. Considering past periods when real estate values have declined, we also find that when there is a decline, it often occurs with a long delay after a major economic catalyst.

In the late 1990s, for example, it took two years from when U.S. Treasury yield spreads inverted before cap rates began to rise. In the mid-2000s, it took four years. Since late 2017, there has been no cap rate expansion, although we saw a brief period of depreciation in 2020.

So when have real estate values actually declined? Looking at past periods of decline over the last 55 years, U.S. real estate failed to deliver positive annual real returns six times, including in the early 1980s, early 1990s, late 2000s and very briefly in 2020. These periods share one common denominator: a U.S. recession (Exhibit 1). The chart shows real estate total return, but had we charted appreciation, it would look similar.

As much as we may perceive property values to be pricey, historically a broader economic catalyst has been associated with real estate depreciation

EXHIBIT 1: Real estate typically performs well in high inflation environments

Source: Moody’s, Bureau of Labor Statistics, NCREIF; data as of September 30, 2021.
*Year-over-year change in NCREIF Property Index (NPI) and year-over-year change in CPI as of December of each year.

Real estate has performed well under high inflation, but inflation is not necessarily a positive

It is also worth noting that inflation is not necessarily a positive for real estate. Real estate performance is historically more closely tied to economic growth than to inflation.

The correlation between real estate returns and inflation is 0.4, although this drops significantly when you exclude the hyperinflationary late 1970s, shown in the upper right of Exhibit 2 (when real estate performed well).

Real estate performance correlates strongly with economic downturns, as we’ve discussed. But the inflation-real estate performance relationship has a pretty poor fit in most other periods (Exhibit 2).

Most of the time, inflation and real estate performance have a poor correlation

EXHIBIT 2: Rolling four-quarter NCREIF returns vs. y/y CPI inflation

Source: Moody’s, Bureau of Labor Statistics, NCREIF; data as of September 30, 2021.

We find real estate returns have a slightly positive correlation with inflation, which may help drive income growth. But ultimately, other underlying fundamentals really drive real estate returns.

Deep dive: When the theoretical real estate pricing-inflation relationship breaks down

Looking at the relationship between real estate pricing and inflation from a more theoretical perspective makes the same point but also highlights a risk. Real estate yields are represented by k in the following equation:

k = RFR + RP – RG + d

Next, we break k down into its components. Real estate yields are made up of:
RFR, the nominal risk-free rate, with long-dated Treasury bond yields typically the proxy
+
RP, the risk premium
-
RG, expected nominal rental growth, a function of nominal GDP growth and property supply
+
d, expected depreciation or capital expenditures (capex).

Returning to the real estate yields equation k = RFR + RP – RG + d, a rise in one component (RFR) would likely be offset by a decline in another (RG). That is, if RFRs rise due to improving nominal GDP, this change should go hand in hand with improving occupier demand. That will likely lead to upward pressure on RG—and higher rents in turn should offset the impact of higher bond yields on real estate yields.

A natural hedge, and a risk

Inflation is part of this equation, being part of the risk-free rate and generally associated with expected rental growth. As such, real estate prices benefit from the fact that what we’ve laid out above is a natural, if imperfect, inflation hedge—provided inflation expectations in bond markets are reflected in nominal rental growth.

There may be a breakdown between inflation, as reflected in bond markets, and the way inflation is reflected in real estate occupier markets. When that occurs, it can undermine this hedge. Stagflationary conditions (inflation rising simultaneously with stagnating GDP) are one potential cause, but not a scenario we expect to see.

Conclusion

Our current expectations are that the increase in inflation is likely to be relatively short-term and that GDP growth should remain robust. In turn, we don’t expect stagflation to undermine real estate’s long-term natural inflation hedge. And, as highlighted above, real estate’s current above-trend risk premium—the wide spread between real estate and bond yields—suggests a generous pricing cushion if GDP expectations, and hence rental growth expectations disappoint.

¹The cap (capitalization) rate, a measure of real estate returns, is a property’s annual net operating income as a percentage of its market value. It is the expected annual rate of return on a property.
²NCREIF Property Index, 1978-2021.