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Inflation Spike Worries Investors, But Could Benefit CRE Returns

As the Federal Reserve approved the largest interest-rate hike in 28 years on June 15, inflation and the potential for recession are huge concerns for commercial real estate investors, and sentiment is starting to move from buy/hold to sell, according to the latest ValTrends report, “Shifting Dynamics.” SitusAMC Insights Senior Director Peter Muoio, PhD, and Jennifer Rasmussen, PhD, Vice President and Head of Thought Leadership and Publications, discussed the first-quarter 2022 survey findings and the outlook for the economy, capital markets, and property types at the Quarterly Valuation Trends webinar on June 15.

“In our view, the intensity and staying power of inflation will depend on several factors,” Muoio said. “One is supply chain disruption – the Ukraine war, the shutdowns in China as a result of latest outbreaks of COVID-19 – have pushed us to a whole new level of supply disruption.” The other factors include skyrocketing food and energy prices; labor market tightness, which is driving wages up; and higher housing costs, both multifamily and single-family. 

In the webinar, the hosts asked attendees to vote on their inflation expectations for one year from now. Some 42% of respondents expected inflation of 5% to 8%, the largest cohort in the survey, followed by 40% who said 3% to 5%. “The attendees today are not expecting any quick correction of the inflation situation,” Muoio said. 

But rising inflation could bolster the CRE market. SitusAMC Insights looked at the correlation between asset class returns and inflation since 1978, when NCREIF data became available, and during periods of high inflation (above 5%). “Commercial real estate provides the greatest hedge against inflation, particularly during periods of high inflation,” Muoio noted. “It really outperformed the other asset classes.” 

Along with inflation, other interconnected trends affecting the market include: 

Risk of recession: Nearly every time the U.S. has experience a significant run-up in inflation, it’s been followed by a recession. In early April and mid-June, the bond market saw an inversion of the yield curve, “and that has been an incredibly reliable indicator of recession,” Muoio noted. 

Supply-chain disruption: China’s recent COVID-19 lockdown tripled the number of ships waiting off the coast of Shanghai in just a few weeks, and the war in Ukraine is disrupting the export of oil, and agricultural and mined goods. At home, increased construction costs are posing a challenge to real estate developers and homeowners but are also constraining new supply and raising existing property values. The supply-chain crisis might lead to a pent-up demand for goods, which could benefit the industrial sector. 

Geo-political instability: “Increasing global tensions present risk for the global economy, but potential opportunity for U.S. real estate,” Muoio noted. The war in Ukraine has sparked a flight to safety, driving long-term yields lower even as the Fed is trying to prop them up, making it more difficult to fight inflation. Escalating tensions between China and Taiwan could prompt a backlash from the West, but it’s hard to sever China from the international trade without crippling the global economy. At the same time, worldwide food shortages could sow instability. All these geo-political concerns may drive investors into relatively safe U.S. assets like real estate. 

The webinar also presented findings from the quarterly survey of institutional investors. Sentiment toward selling CRE rose from 17% to 28% in the first quarter, the survey found. “There was a slight retreat in the preference for CRE as an investment option quarter over quarter, albeit that’s coming off a seven-year high,” Rasmussen said. “Stocks are volatile, and investors have been saying they are going to switch into safer assets like CRE and cash. With CRE providing some level of inflation protection, I think we’re going to see that preference for commercial real estate remain elevated for some time to come.”   

Industrial remained the most favored sector, with 47% of survey respondents selecting it as the best property type, followed by apartments at 21%. Investor sentiment for office improved quarter over quarter, to third place, while retail remained in fourth. Investors were least likely to select hotel as the best property segment. The survey also showed a drop in investors’ perceptions of capital availability, with a much more pronounced drop in debt than equity. “We are starting to see the impact of rising interest rates, which is limiting the debt investor pool,” Rasmussen said. “I think we will see more of a tapering off here in the next quarter.” 

The Val Trends report, “Shifting Dynamics,” offers a deeper dive into the latest proprietary insights on valuation trends and space market fundamentals. Download the free, 28-page report here. To access the ValTrends webinar presentation, click here.  Learn more about SitusAMC’s research and data offerings here.