Investing in real estate has long been one of the top strategies to preserve wealth during inflationary periods. Investors in previous decades could only choose between physical real estate and a limited number of real estate investment trusts (REITs). In fact, the first REITs in the 1960s primarily consisted of mortgage companies.

However, today among REITs there’s almost an unlimited number of variations or options from which to choose.

In considering the various challenges and opportunities presented by investing in real estate, we have recommended REITs that have broad international exposure in various real estate classes (residential and commercial), to arm investors’ portfolios with comprehensive protection against inflation. We examine our specific recommendations below, in “Portfolio Updates.”

With such an excellent array of choices beyond buying physical property, investors can now buy exposure to REIT funds, in domestic and overseas markets, simultaneously or independently, as well as pick a focus of commercial and residential, or both.

In addition to investing in commercial real estate through ownership of stock in publicly traded equity REITs, investors can also invest in illiquid real estate assets. We don’t recommend that option, though, for the average retail investor given the higher risks, such as shares in private equity real estate investment funds (including non-listed equity REITs).

Regardless, these choices come at an opportune time, because financial services firms predict inflation could start as soon as 2015 (see Chart A), which means investors only have about one year to rebalance or insulate their portfolios from inflation.

Chart A: Financial Services Firms are Predicting 2015 as a Start of Inflation


All of these real estate choices beg several questions. How can you perfectly craft a real estate inflation hedge? How much exposure can you afford to international real estate, commercial or residential, and which areas are better inflation hedges? And how should portfolios be balanced along other inflation fighting strategies?

Of course, REITs themselves have been excellent at wealth preservation.

Consumer price inflation (CPI) in the US was 13.5 percent during 1979, the worst inflationary year since 1947. Dividend income from REITs traded through the stock exchange averaged 21.2 percent that year, and total returns amounted to 24.4 percent, more than preserving for REIT investors the purchasing power lost to inflation.

Inflation averaged 11.6 percent per year during 1978-1980, the worst three-year period in six decades. Again, however, publicly traded equity REITs outpaced inflation with income and total returns averaging 12.2 percent and 23.1 percent per year, respectively.

The period 1974-1981 was the most inflationary eight years in the history of the Consumer Price Index at 9.3 percent per year, but equity REIT returns easily preserved purchasing power, with income and total returns averaging 10.2 percent and 16.3 percent per year, according to a 2011 paper, aptly entitled “Inflation and Real Estate Investments,” by various academics at the Wharton School at the University of Pennsylvania.

A History of REITs, Inflation and Portfolio Allocation

When considering the various inflation protection options during historical inflationary periods, Wharton academics Brad Case, Susan Wachter and Richard B. Worley, found the two assets providing the most dependable inflation protection have been commodities and equity REITs, with commodities providing total returns that equaled or exceeded inflation during 70.4 percent of high-inflation semesters and equity REITs close behind at 65.8 percent.

Stocks and Treasury inflation-protected securities (TIPS) have provided somewhat weaker inflation protection by this measure, with stocks protecting purchasing power during 60.8 percent of high-inflation six-month periods and TIPS even lower at 53.8 percent.

By the study’s measure, the weakest inflation protection among this group of assets has been provided by gold, which successfully protected purchasing power during only 43.2 percent of high-inflation six-month periods.

The Wharton study considered various portfolio options and how they would perform through historical periods of inflation. While there were more optimal asset allocations that used commodities, the higher exposure entailed significant directional risk or volatility. Quoting the report:

“Investors seeking to eliminate directional risk altogether (at least on an expected basis) could have instead chosen a portfolio comprising a 54.1 percent allocation to TIPS along with 21.8 percent in commodities, 14.5 percent in equity REITs, 6.4 percent in stocks, and 3.3 percent in gold.

Across the entire historical period, this portfolio would have generated real returns averaging 7.1 percent per year with 11.3 percent volatility, for a strong Sharpe ratio of 0.52; the portfolio would also have provided very dependable protection against inflation, with nominal returns covering the inflation rate in 75.4 percent of high-inflation periods.

Moreover, the risk-adjusted returns of this portfolio would not have depended on the inflation rate: during high-inflation periods real returns would have averaged 6.0 percent with 10.4 percent volatility, while during low-inflation periods both real returns (8.3 percent) and volatility (12.0 percent) would have been commensurately higher, resulting in no difference in returns on a risk-adjusted basis (i.e. Sharpe ratios).”

Chart B: Inflation Protection Success Rates by Property Type

Source: Wharton School Study

As the above Chart B shows, the two property sectors that provided the most effective inflation protection with returns greater than or equal to inflation during high-inflation semesters were self-storage (81 percent) and residential (77.8 percent). These two property types are characterized by short lease terms, and therefore frequent lease turnover and renegotiation.

Lodging, the third property type characterized by short leases, demonstrated a success rate of 68.3 percent, less than the equity REIT industry as a whole (71.4 percent). Shopping centers, too, provided inflation protection dependability above that of the industry as a whole (73 percent), but the other two retail property types, regional malls (69.8 percent) and especially free-standing retail (61.9 percent), fell short of the industry average, as did other property types including office (69.8 percent) and health care (68.3 percent).

Real Estate Inflation Protection: Past is Not Always Prologue

Though clearly real estate has outperformed historically during inflationary periods, not all modern REITs may perform as well in the future. Some of today’s REITs aren’t totally immune to the effects of inflation, since they can be negatively impacted by rising interest rates. If a REIT borrows heavily to finance acquisitions, for instance, it will find its cost of financing rise along with rates.

However, less leveraged REITs and those that operate in other countries won’t be as heavily impacted as interest rates drift higher. They also have the ownership advantage of raising rents when the economy heats up, increasing cash flows along with the pace of inflation.

Historically, property prices have also kept track with inflation, generating capital appreciation in addition to growing cash flows, as we have illustrated.

According to a 2012 report, entitled, “Real Estate: Focus on Growth, Yield and Inflation Hedging,” by private equity firm KKR, “Investors may use REITs to gain exposure to real estate, but we believe they should heed their many shortcomings, such as high correlation to other financial stocks, which in 2011 stood at a sizeable 86 percent.” That’s also why we have recommend diversification into international real estate, and low leverage REITs.

In looking at commercial property, the KKR report also noted that similar to investments such as venture capital, manager selection in the real estate market can make all the difference, and there can be disparities of returns in low rate environments, as a result of property types and locations, as well as due to the effect of leverage, as we have previously noted. “We do think selectivity is warranted at this stage in the cycle. Specifically, today we feel that a decent chunk of the prime, or core, global real estate asset class is fairly valued and, in some cases, outright expensive,” the report stated.

The report concluded that international exposure in real estate continues to be attractive, given sovereign bond market yields at multi-decade lows (and in some cases, multi-century). With the outlook for capital growth subdued, yield has become a core driver of investment returns (see Chart C below).

Quoting the report: “While real estate yields have tended to follow bond yields lower in many markets, the spread between real estate and sovereign debt yields remains high, offering generous compensation to investors for the additional risk associated with real estate. Across 11 major global markets, spreads between real bond rates and prime-grade office market yields are, on average, 195 basis points wider now than in Q4 2007.”

Chart C: Yields Spreads Between Prime Office Assets and Government Bonds, 2007 vs. 2012


Moreover, Prudential Securities found the US contains the largest amount of institutional-grade commercial real estate (CRE) by value, at $6.8 trillion. Japan ranks second at $2.7 trillion, followed by China ($1.9 trillion), Germany ($1.6 trillion) and the UK ($1.4 trillion). At the small end of the scale is Bahrain, with a CRE market of $14 billion, followed by Bulgaria ($16 billion), Ecuador ($16 billion), Vietnam ($21 billion), and Oman ($28 billion).

Looking ahead, the distribution of CRE is set to change over the next decade, because the Asia-Pacific region will grow much faster than other regions. Currently, Asia-Pacific trails Europe and the US/Canada in total size, but Prudential finds that by 2021 the Asia-Pacific region will contain the largest share.

Meanwhile, in the overall real estate market scene, Scotia Bank in a September 2013 international ranking of property markets confirms that the United States maintains its position near the top, “with inflation-adjusted home prices rising 8 percent y/y in Q2. Demand is being bolstered by moderate job growth and near record housing affordability, while low inventories and fewer distressed sales are supporting prices.”

Aggressive monetary policy easing, which has anchored short-term interest rates in many countries near historic lows, alongside pent-up demand are helping to reinvigorate global property markets, Scotia Bank found. Despite the sluggish pace of economic activity and elevated financial market volatility, inflation-adjusted home prices strengthened year-over-year in the second quarter in the majority of countries, the bank report concluded.

Chart D: The Top Property Markets Around the World



Portfolio Updates

In our Survive Portfolio, Vanguard Global ex-US Real Estate (NSDQ: VNQI) is an exchange traded fund (ETF) that focuses on REITs that own office buildings, hotels, and other real estate outside of the US.

This ETF presents a potential value play for longer-term investors who want to efficiently add exposure to real estate and international diversification to their portfolios. REITs act as a proxy to the real estate market and allow investors to gain exposure without having to actually buy property. REITs tend to have more interest rate risk than regular stocks and are similar to bonds.

This is because real estate is often purchased using financing (debt) and not directly using available cash. A potential rise in interest rates could create much larger payments for a REIT and force its management company to raise cash by diluting shareholders or liquidating overleveraged assets at a loss, which may cause volatility.

The fund holds a collection of 470 REITs and other property investment firms located in 35 countries, providing the broadest exposure to global real estate. Roughly 82 percent of its holdings come from developed markets. The ETF’s portfolio is 20.8 percent invested in Europe, 72 percent invested in Asia Pacific and roughly 7 percent in the Americas.

Given its global scope, the ETF also has very little correlation to US REITs, which have experienced a dramatic run up thanks to the hunt for yield. VNQI is up 15.55 percent over the last year versus the S&P 500’s total return of 18.25 percent. IShares International Dev Real Estate is up 14.98 percent, and SPDR Dow Jones Int’l Real Estate is up 14.51 percent. Vanguard Global ex-US Real Estate is a buy up to 63.

Established in 1937, Mitsubishi Estate (Japan: 8802, OTC: MITEY) is Japan’s second-largest real estate developer. Mitsubishi Estate’s (MEC) real estate operations include property management, architecture, research and design.

The company, which is in our Thrive Portfolio, has three core businesses: office and commercial property building, residential real estate and international real estate. MEC also operates a diverse field of businesses related to real estate, including an office building business centered on the Marunouchi district in central Tokyo, a retail property business, a residential business and a hotel business. MEC owns Japan’s tallest building, the Yokohama Landmark Tower, as well as the Sanno Park Tower and Marunouchi Building in Tokyo.

While most of MEC’s real estate holdings are prime buildings in Japan, its international real estate business includes properties in the US, the UK and extends to countries in Asia such as China and Singapore. We believe investors should have larger exposures to Asia given the incredible growth in residential and commercial property markets that will take place there over the next 10 years.

Mitsubishi Estate has generated total returns over the last 3 years of 69.28 percent, and year-to-date total returns of 26.81 percent. Net income rose to 17.1 billion yen ($174 million) in the three months ended June 30 from 11.9 billion yen a year earlier, the company said in a statement to the Tokyo Stock Exchange. Revenue gained 16 percent to 227.8 billion yen.

The results bring Mitsubishi Estate a step closer to achieving an increase in full-year profit for the first time in three years. Its inventory of apartments fell to 56 units in June, the lowest level since at least 1998, the company said. The operating profit margin for Mitsubishi Estate’s residential division rose to 3.6 percent in the first quarter from 0.5 percent a year earlier. Mitsubishi Estate  expects profit margins to double to 6.9 percent by March 2014.

Operating profit from the residential business grew to to 2.2 billion yen from 297 million yen in the first fiscal quarter. Operating profit from the office business fell 6.4 percent to 26.7 billion yen, after Mitsubishi Estate closed some office buildings. Mitsubishi Estate is a buy up to 2,900 (JPY).