US commercial real estate no longer an inflation hedge, says McKinsey

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Commercial real estate may no longer be an inflation hedge, McKinsey suggests

Year-to-date, Prime US REIT OXMU has fallen 44%, Manulife US REIT 43% and Keppel Pacific Oak US REIT 30%. But United Hampshire US REIT ODBU is unchanged since the start of the year. There is another seven months to go, so anything can happen, but here’s why this trend has persisted for the first five months of the year.

According to McKinsey, US commercial real estate (CRE) has outperformed during inflationary periods since 1980. During each of these periods, although rent growth did not keep up with inflation, cap rate compression contributed to outperformance, McKinsey’s research found.

This time, it’s different. Part of the reason is because of the accelerated rate of interest rate hikes by the Federal Reserve. “Currently, amid the fastest monetary tightening on record, cap rate trajectories may differ substantially from those of past inflationary periods,” McKinsey says.

Based on McKinsey’s research, during the seven inflationary periods from 1980 to 2022, annualised CRE returns were around 11.7%. Hence, CRE outperformed inflation and other asset classes such as the S&P 500 and investment grade bonds.

In fact, CRE outperformed inflation more often than not in six of the seven inflationary periods and outperformed its own historical average in five of them. Generally – and there are a few sub-sectors in CRE - the asset class outperformed stocks in four of the seven periods, and bonds in six of them. Real estate broadly has been a useful hedge against inflation.

The principal reason CRE has served well as an inflation hedge is that in periods of higher inflation, the net operating income (NOI) yield investors are willing to accept have tended to compress. Hence, although interest rates typically rise in periods of inflation, cap rate spreads often narrow. The rationale for such a phenomenon is because “investors put money into asset classes they believe will protect real value,” McKinsey reasons.

McKinsey’s analysis reveals that rent growth alone has not historically provided a full hedge against inflation as rent increases rarely match the inflation rate. Annualised CRE rent growth averaged about 3% during the seven inflationary periods studied, compared with average annualised inflation of almost 5%, McKinsey found.

However, cap rates compressed by around 20 bps a year during the periods studied, contributing significantly to total returns. In addition, not all CRE sectors outperformed during inflationary periods, although at least one category does.

Rising cost of debt, and declining availability of funding coupled with elevated vacancy rates of the office market is a headwind for investors, McKinsey says.

Hence, persistently high inflation and interest rates, the rising cost and declining availability of debt, and recession, may all lead to cap rate expansion.

The sector that some market watchers are studying is grocery retail which has remained relatively stable, with higher occupancy rates than office.

On March 29, the National Retail Federation (NRF) issued its annual forecast, anticipating that retail sales will grow between 4% and 6% in 2023. In total, NRF projects that retail sales will reach between US$5.13 trillion and US$5.23 trillion this year.

Non-store and online sales, which are included in the total figure, are expected to grow between 10% and 12% year over year to a range of US$1.41 trillion to US$1.43 trillion. While many consumers continue to utilise the conveniences offered by online shopping, much of that growth is driven by multichannel sales, where the physical store still plays an important component in the fulfillment process. As the role of brick-and-mortar stores has evolved in recent years, they remain the primary point of purchase for consumers, accounting for approximately 70% of total retail sales, the NRF says.


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