Using REITs As an Inflation Hedge

Summary: Real estate can provide diversification against stagflation — a mix of inflation and slow growth. Might we see that in the future? Either way, REITs are always worth a look. Click through for some thoughts on adding real estate to your portfolio.

Historians are making comparisons with the frustrating markets of the 1970s. In January 1970, the Dow Jones Industrial Average opened at 809. It closed the decade at 839, which represented a decline of 49%, adjusted for inflation. Few asset classes did well other than gold, silver and farmland (which rose 14% a year on average).

However, some residential real estate soared, such as properties in California, which tripled in value. But performance varied across the country, with many areas depressed. Real estate investment trusts, a newish vehicle established in 1960, also stumbled badly in 1973 and remained volatile. A whopping two-thirds of highly leveraged vehicles went bankrupt at that time, leaving only 69 still operating.

Meanwhile, modern REITs have developed over the past 30 years and have often flourished during periods of climbing interest rates. From 1992 to 2021, they delivered 16.55% during rising rate periods. Nervous investors are now beginning to ask, “Could REITs help carry our portfolios through a likely inflationary stretch ahead?”

REIT rules

The beauty of REITs is that investors can invest in diversified commercial real estate portfolios without the burden of managing individual properties themselves or the risk of concentrated ownership. The IRS sets the ground rules: REITs must return at least 90% of their taxable income in dividends to shareholders and must hold at least 75% of their assets in real estate or cash.

They come in various flavors:

• Equity REITs own the underlying real estate and deal with the associated management tasks.
• Mortgage REITs do not own property. Instead, they own debt securities backed by the property. They often pay higher dividends but they also have higher risk profiles.
• Hybrid REITs are a mix of the two, owning both commercial properties and mortgages.
• Publicly traded REITs change hands on an exchange, where they offer transparency and liquidity.
• Publicly nontraded REITs, while registered, are not traded on an exchange and can therefore be illiquid.
• Private REITs, which may be neither registered nor listed, are the riskiest of the group.

REITs also span a wide range of commercial property sectors:

• Office.
• Industrial.
• Warehouse.
• Retail.
• Lodging.
• Residential.
• Health care.
• Storage.
• Data centers.
• Timberland.

Recently, some of the most popular and profitable REIT sectors have been residential, laboratories and life sciences, logistics, and some retail, especially outdoor malls. Some types of real estate have been particularly impacted by the social and lifestyle upheavals of the COVID-19 pandemic. For example, office leasing is being disrupted by the work-from-home movement, with office REITs affected accordingly.

Potential for REITs today

The era of the 1970s is long over, thankfully, and the inflation landscape is different. REIT proponents argue now that real estate investments may provide some shelter in the storm of rising rates, rampant inflation and stubborn stagflation. They remind us that property values increase along with labor, land and construction materials. The more it costs to erect new buildings, the more valuable those already standing become.

Rising construction costs act as a brake on development. And they do not seem likely to dissipate soon, given the supply chain issues dogging the building industry. The consequences of more expensive inputs may result in less available real estate altogether; less supply gives landlords new pricing power to raise rents. The news is even better for shorter-term rentals, such as hotels, storage units, apartments and billboards. Those landlords can raise rents relatively quickly.

The REIT story has some compelling elements for today’s economy. Dividend yields (such as those measured by Vanguard’s VNQ) have been steadily rising over the past year. But many REITs, particularly those not publicly traded, can be volatile, so consult with your financial advisers about risks before making any investment.

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