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Sure, inflationary pressures are piling up, but investors will be doing a lot better for themselves with a few good real estate picks. Image Credit: Shutterstock

A rising interest rate and inflationary environment has historically been good for real estate performance. But above all, it is understanding investor demand and long-term secular trends that should be the focus when seeking to deliver superior investment returns.

Investing in multiple regional real estate markets and investing in both direct real estate and REITs (Real Estate Investment Trusts) can help make the most of real estate’s diversification benefits. Many private real estate investors worry about rising interest rates increasing the cost of debt and resulting in a decrease in value.

However, with funds that focus on institutional quality real estate, where most investors use little or no debt, the cost of leverage is not as significant a driver of real estate value compared to private real estate owners. What we experience is that there is little to link institutional real estate values with interest rate rises. Historically, commercial real estate returns, especially in the US, have been excellent during times of rising interest rates when linked to economic growth.

Investor demand and economic growth have a much greater influence on real estate values than interest rates. In short, while monitoring interest rates as part of the overall environment is important, there are other more relevant factors to consider when assessing real estate value.

Real estate offers stability and is perceived to be a good inflation hedge which, in an environment where there is equity market uncertainty and fears of rising interest rates and inflation, helps support strong investor demand. It is this investor demand that has a more significant effect on value than inflation.

That ultimate hedge?

That said, real estate returns are more highly correlated with inflation than stocks or bonds – clearly a positive in an inflationary environment. This is, in part, derived from leases creating a revenue stream that can adjust to inflation. It is why investors use real estate as an inflation hedge.

In the US, a deeper analysis of historic information shows that commercial real estate has typically outperformed during periods of high inflation. Similar trends can be seen in Europe and Asia.

While interest rate and inflationary pressures have some influence, having a better understanding about how we use real estate to consume, live, innovate, and connect – CLIC – allows us to match uses with secular trends that create long-term real estate demand. This approach is one that better represents the evolving range of opportunities that real estate offers investors.

For example, changing consumer behavior, changing demographics and ongoing urbanization all create a shift in demand patterns for real estate. People need real estate for many different reasons. Understanding how we live and work, connect and consume can not only help uncover new investment opportunities, but also identify real estate products that may have limited depth of demand.

As related to sustainability and the environment, real estate is an asset class where it is possible to affect a direct, demonstrable impact while adding investment value. A key reason to invest in real estate around the world is that trends are not all the same. We see different opportunities in different markets.

Different ways to inflation

For example, on the face of it, inflation in the US and Europe look like similar trends. However, it pays to look in a bit more detail. In the US, inflation is primarily due to business demand supply imbalance, labor shortages and expanding money supply.

In Europe though, the main contributor to inflation is energy costs, which have obviously been exacerbated recently. While inflation drivers and the prospect of interest rate rises around the world differ, what is consistent globally is investor demand supporting real estate values and in many sectors, occupier demand exceeding supply supporting rental growth.

Real estate returns are driven by human needs. How these combine with the influence of various global structural trends and economic cycles determines current and future demand. Investing globally offers an opportunity to over and underweight regions and countries depending on where we expect the strongest returns to be generated.