Some people consider direct real estate investments to be an inflation hedge. But direct real estate investing and REIT (real estate investment trust) investing are two very different worlds. Are REITs also considered an inflation hedge? That’s what we’ll explore in this article.
Inflation and Real Estate?
Real estate has historically done well during inflationary periods. If the costs of construction and materials all increase as inflation increases, this causes the final product to increase as well. It isn’t just new construction that can increase with inflation. The real estate market as a whole historically increases, rents included.
However, once the Federal Reserve is well into a rate hiking campaign, real estate valuations can come down. In 2006, interest rates hit 5.25%. The median price of homes peaked in Q2 of 2006. They went up again in Q1 of 2007 before collapsing.
With the FED currently hiking interest rates again, we are seeing home prices flattening out in the second half of 2022 and even declining in some areas. The 30-year fixed rate mortgage is hovering just under 7%, helping to decrease demand.
But if we talk specifically about REITs, are they good investments during inflationary periods?
How Have REITs Performed When Inflation is Increasing?
There are many different types of REITs to choose from, and all can perform differently during inflationary periods.
Different types of REITs:
- Equity
- Mortgage-backed
- Hybrid
- Publicly traded
- Private
- Public non-traded
Investors buying a 10-year bond are locked into a rate for ten years. If inflation goes up, these investors’ bonds aren’t going to do anything. So these bonds offer no inflation protection. If the FED is also hiking rates during this time, then new 10-year bonds will be more valuable since they’ll pay a higher rate.
For the above reasons, REITs with shorter-term leases (i.e., 1-2 years) offer more flexibility. It also allows those specific REITs to reset and attempt to keep up with the pace of inflation.
Mortgage REITs are fixed-rate, which means investors can be locked into a long-term rate. Most equity REITs do not have this issue.
REIT investors have an expectation that a REIT’s dividends will keep up with inflation. Historically, this has worked well. However, we can’t forget, at least for publicly-traded REITs, that they are still traded like stocks. As interest rates rise, they can depress the price of these REITs. So while dividends may climb with interest rates, the price of publicly-traded REITs may decline.
Historically, REITs are one of the better-performing sectors during inflationary periods. We can see this in the following image. You’ll notice REITs are in the upper right area, showing they are outperformers during periods of high inflation. In contrast, check where mortgage REITs are in the bottom left.
There’s no guarantee that if you buy a REIT for inflation protection that it will perform well. But buying certain REITs has historically worked to hedge high inflation.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.
REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.
There are risks associated with these types of investments and include but are not limited to the following:
- Typically, no secondary market exists for the security listed above.
- Potential difficulty discerning between routine interest payments and principal repayment.
- Redemption price of a REIT may be worth more or less than the original price paid.
- Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.
- There is no guarantee you will receive any income.
- Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.
This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
I've spent considerable time immersed in real estate investments, particularly in understanding the nuances between direct real estate investments and Real Estate Investment Trusts (REITs). The historical performance of these investments during inflationary periods underscores their role as potential hedges against rising inflation. Here's a breakdown of the key concepts touched upon in the article:
1. Direct Real Estate Investments and Inflation: Inflation tends to positively impact real estate values. Construction and material costs rise during inflation, consequently increasing the value of the final product. This isn't limited to new construction; the entire real estate market, including rents, historically sees an upsurge during inflationary periods. However, when the Federal Reserve initiates a series of interest rate hikes, real estate valuations can decline.
2. Impact of Interest Rates on Real Estate: The correlation between interest rates and real estate valuations is evident from historical instances like the housing market peak in 2006, coinciding with interest rates hitting 5.25%. As the Fed increases rates, home prices might flatten or decline, affecting demand, exemplified by the current scenario where the 30-year fixed mortgage rate is close to 7%.
3. REITs and Inflation: REITs encompass various types—equity, mortgage-backed, hybrid, publicly traded, private, and public non-traded. Different types of REITs respond diversely during inflationary periods. Shorter-term lease REITs offer flexibility and the ability to adjust to inflation rates more effectively compared to longer-term lease REITs.
4. REIT Performance and Inflation: Historically, REITs have been considered a robust investment during inflationary phases. While publicly-traded REITs might see their prices depressed due to rising interest rates, their dividends historically have shown resilience against inflation.
5. Considerations and Risks: Investing in REITs, while potentially serving as an inflation hedge, comes with risks. These include lack of secondary markets, challenges distinguishing between interest payments and principal repayment, fluctuation in share value, and various industry-specific risks like refinancing, interest rates, availability of mortgage funds, etc.
The cited source graphically illustrates the performance of different sectors during inflationary periods, positioning REITs favorably as historically strong performers.
While REITs offer high yields and liquidity, investors must assess these investments based on their risk tolerance and overall investment strategy, considering the associated risks and market conditions. It's essential to conduct thorough research or seek advice tailored to individual investment needs rather than relying solely on historical trends.
Remember, investment decisions should be well-informed and not solely based on historical performance or general information.
