Leveraged investments are particularly vulnerable.
Real estate is supposed to be a great inflation hedge, and it can be, so long as cash flow from rentals can increase fast enough to keep up with cap rate compression.
In a more complex and analytic way, that’s what MSCI’S senior associate Fritz Louw’s recent post, “Real Estate’s Income Risk in an Inflationary World,” is about, especially for leveraged investments.
“For many investors, risk analysis focuses on measuring capital exposure across property types and geographies,” Louw writes. “But with income return making up such a significant part of long-run returns, it may make sense for investors to understand income exposure across tenant types, concentration risk to individual tenants, and the probability of default on rental payments.”
MSCI has found in looking at its Pan-European Quarterly Property Fund Index (PEPFI) that one way of looking at an investment is not just through a cap rate context but one that looks at income from each property.
Louw noted that “across many countries, exposure to industrial and retail was higher when measured by remaining income than by capital value,” while the “opposite has often been true for residential and office.”
“Across countries such as the UK, Spain, and Italy, we have seen consistently higher exposures to remaining income than capital value across all property types,” he wrote. “France and Germany, countries with high exposure in 2021 on both capital-value and income bases, saw the opposite, with significantly less weight to income than capital value. The main drivers of these trends were yield and lease length, which both determined the relationship of remaining income to capital value and varied themselves by property type and country.”
European and US markets don’t necessarily move in tandem, but the principle of taking a deeper look and recognizing variations is the same. Geographic variations in markets here are enormous. That’s why the West and Sun Belt push average values upward, given population movement and shifting demographics.
A deeper focus is needed, as MSCI explains, because “property type can hide a range of economic exposure to tenant industries.” Cap rates result from money flowing into investments and bidding up prices, but that pressure is because of expected rent growths, and they’re tied to what will happen in particular industries. Not just a property type, but the range of companies, industries, and people that occupy given buildings. For example, “The split between consumer discretionary and consumer staples may be particularly important since an asset’s property-type designation as ‘retail,’ for example, may obscure important characteristics about tenants’ industry exposure and how it affects their ability to pay rent.”
That’s why smart investment and examination of inflation means understanding not a general direct exposure to inflation, but the indirect exposure.
If the tenants and what they’ll be able to pass on to their customers or get from their employers as inflation increases.
Randolph is a Multifamily Investment Sales Broker with eXp Commercial servicing Multifamily Buyers and Sellers in the Greater Chicago Area.