Use property as an inflation shelter

Reader alert: This is Part 2 of a series. Read Part 1.

For investors, finding an investment that keeps up with inflation is serious business: the cost of living just keeps rising. An investment that captures the rate of inflation in its return is a necessity.

Real estate is often known for being a reliable hedge to inflation because rents generally rise with inflation. But not all real estate property, and not all real estate investment products, are good at hedging inflation.

According to a 2007 report in the Journal of Portfolio Management by Haibo Huang and Susan Hudson-Wilson, office buildings and multi-family apartments are the strongest hedges against inflation, whereas retail properties’ have less muscle.

Between direct investment in the real estate property through private equity or limited partnerships and indirect investments through real estate securities (i.e. REITS), the hard asset does a better job as an inflation-hedge. This is because REITs trade on public exchanges, and while this improves its liquidity, it also makes them susceptible to price fluctuations, thereby reducing its ability to hedge.

But Doug MacDonald, RFP, at Vancouver-based Macdonald Shymko & Co., disagrees REITs have no inflation-hedging abilities.

“REITs will go up and down with the market but that’s noise. Over the long term—five years plus—if the cash flow stays the same, the value will be there,” he says “The REITs index in 2008 was at $12 to $13 and then fell all the way to $7 because everything fell. Now it’s back at $14 to $15. And while the REIT price was all over the map, it was still throwing cash flow at me.”

Diversification

“Historically, real estate securities have had low correlation to other asset classes,” says Joe Rodriguez, senior portfolio manager, Invesco Global Real Estate Fund. “However, at times, including the last several years, correlation between all asset classes increased,”

Data from first quarter 1990 through second quarter 2011 shows correlation between the MSCI World Equity Index and the FTSE EPRA/NAREIT Developed Index to be 0.75.

Although, real estate securities’ (i.e. REITs) correlation to equities has grown closer, it is still not one-to-one, primarily as a function of how the underlying assets are valued. This is based, among other things, on the local market and the leases for the buildings, says Carey Escoffery, real estate financial analyst and advisor at DCL Equity Partners Inc. Corporate equity, by contrast, is valued by a different set of factors.

“The real estate investors tend to be more in tune with the fundamentals and value of the underlying assets. This is likely realized due to the stability and relatively foreseeable contractually generated cash flows (rents) that the underlying asset produces, versus the ever changing micro and macro variables that influence the performance of a consumer dependent company,” adds Escoffery.

Also, real estate’s low correlation to bonds further strengthens its position as a portfolio diversifier. As real estate property valuation is influenced by the local market, the correlation between countries will differ. For example, during the second quarter of 2011, while Hong Kong’s property valuation advanced due to the strong flow of Chinese tourism, parts of Europe lagged as a result of unresolved sovereign debt issues.

“The main fact to consider is that adding global real estate with correlation below one will improve the return risk profile of a portfolio,” says Som Seif, president and CEO, Claymore Investments. “Anytime you can add an asset class with below one correlation, you’re adding value to your risk adjusted performance.”