Real estate and inflation

Real estate and inflation: We would rather be owners

Much has been said and researched over time regarding real estate as an inflation hedge, yet most of the data and analyses have been mixed and inconclusive. We're fully mindful and concerned about the potential for inflationary pressures to increase in today’s global economic climate, and so we have been very active in our thinking about how inflation will affect our investment decisions.

Background on real estate investment trusts (REITs) and inflation

On the surface, real estate seems like a logical candidate to be an "inflation hedge" for many. In a simple argument, real estate can be said to be a hard asset that would most likely maintain its value as inflation increases, similar to a troy ounce of gold. Going one step further to understand how real estate is valued, and how inflation may impact valuations, we boil the process down to two key variables: capitalization (or cap) rates and cash flow.

Cap rates

The fact that cap rates (which act as discount rates for real estate) have typically risen during periods of increasing inflation, and caused a decline in real estate asset values, may contradict the argument for real estate as an inflation hedge. Historically, however, cap rates have not increased one-for-one with inflation. In fact, in this cycle, any increase in cap rates may be more muted than in past cycles as real estate is currently trading below replacement costs.

Cash flow

The fact that the majority of lease rates rise from contractual rental-rate increases at or above that of the Consumer Price Index (CPI) or the mark-to-market on shorter-term lease structures (such as in lodging, self-storage, and apartments), appears to support the argument for real estate as an inflation hedge. We believe this cash-flow increase should apply upward pressure on real estate values.

In addition to cap rates and cash flow, other drivers typically shift during periods of rising inflation. These include:

• increased development (new supply)
• higher demand (rising occupancies)
• increased debt costs

Such increases in business activity, typically associated with rising inflation, have historically created a strong cycle for real estate owners. As vacant space becomes scarce, REITs tend to gain leverage to increase rental rates, fueling greater cash-flow growth. The downside, however, occurs as this strength incentivizes new development activity, which can potentially flood the market and drive lease rates downward.

Finally, increasing debt costs provide another headwind to real estate values. As inflation rises, so does the cost of debt, which can be viewed as a raw material cost for real estate owners. As debt matures, real estate owners may be burdened by refinancing costs, pressuring their profitability.

In the following table, we used empirical data to quantify returns for various asset classes into nine historical inflationary environments. The data indicate that there is no clear winner within either fixed income or equities for various inflationary cycles. However, REITs generally do stand out as a solid performer when inflation is low but rising, similar to our current environment.

Data: from Barclays Capital, Bloomberg, MSCI, and Russell, as of May 5, 2011.

All index returns include dividends, net of taxes where applicable. Inflation environments are defined based on monthly year-on-year change in CPI-U since 1970, with “low” defined as below 25th percentile, “high” as greater than 65th percentile, “falling” based on when 12-month slope is more negative than -0.1, and “rising” based on when 12-month slope is more positive than 0.1. Shaded cells in table show values that are more than ±1 standard deviation from row mean (blue is more positive, gray is more negative).

Performance data shown are the average of the monthly index returns that fall into each category. The number of months per category were: low and falling, 7 months; low and stable, 67; low and rising, 53; moderate and falling, 39; moderate and stable, 116; moderate and rising, 15; high and falling, 50; high and stable, 23; high and rising, 5 months.

Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index.

Past performance is no guarantee of future returns. Diversification may not protect against market risk.

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Below is a summary of  typical supporting and contrarian arguments for real estate as an inflation hedge.

Supportive Inflation-linked leases: Rental contracts rise one for one with increases in CPI. Mark-to-market of lease rates: This is particularly supportive within shorter-duration leases. Increasing demand provides higher occupancy and better pricing power. Higher raw-material costs increase replacement cost of existing real estate.

Contrarian Increasing cap rates lower asset values. Rising debt costs reduce net cash flow. Active development increases supply and may put downward pressure on rental rates.

Our conclusion: REITs offer a genuine inflation hedge in today's environment

While it can be difficult to precisely forecast and quantify the exact impact of each variable mentioned above, we believe that real estate could act as an inflation hedge within the current environment. While we don’t believe that REITs are a panacea for inflation, we strongly believe there is value in holding real estate in today’s environment should inflationary pressures increase.

While historical data are inconclusive and anecdotal evidence varies, we believe we can fundamentally differentiate today’s opportunities from those realized in the past. If several of the contrarian items listed above were not present in today’s environment, we believe cash-flow growth for real estate would be very strong. 

The chart below is an example of how rental rate increases grow in excess of inflation.

Today’s real estate market looks particularly compelling

Although historical data analysis can be overgeneralized, we believe that key differences between cycles highlight  interesting opportunities for real estate investors in today’s environment. For example, today’s very restrictive lending practices are generally suppressing new supply, which has historically been the Achilles’ heel of the real estate cycle.

Furthermore, through our active approach to bottom-up fundamental analysis, we invest in companies that we believe are better suited to benefit from inflationary pressures. For instance, we are currently biased toward companies that feature some of the following characteristics, among others:

• shorter-term leases
• contractual CPI rate increases
• low variable-rate debt exposure
• longer-term debt maturities
• portfolio re-leasing opportunities
• new development strategies

Ultimately, we believe that pertinent differences in today’s environment, coupled with active bottom-up analysis within the REIT asset class, could provide a meaningful hedge to increased inflationary pressures.

• Delaware Global Real Estate Securities Fund fact sheet
• Delaware REIT Fund  fact sheet

• Delaware Global Real Estate Securities fact sheet
• Delaware U.S. Real Estate Securities fact sheet

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The views expressed represent the Manager's assessment of the market environment as of April 2012, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the manager's current views. The views expressed are general in nature and do not relate to a particular mutual fund.

Carefully consider a Fund's investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Fund's prospectus and, if available, its summary prospectus, which may be obtained by visiting www.delawareinvestments.com or calling 877 693-3546 800 362-7500. Investors should read the prospectus and, if available, the summary prospectus carefully before investing.

Investing involves risk, including the possible loss of principal.

IMPORTANT RISK CONSIDERATIONS

REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations.

A REIT fund's tax status as a regulated investment company could be jeopardized if it holds real estate directly, as a result of defaults, or receives rental income from real estate holdings.

Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.

REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations.

A REIT fund’s tax status as a regulated investment company could be jeopardized if it holds real estate directly, as a result of defaults, or receives rental income from real estate holdings.

A Fund may invest in derivatives, which may involve additional expenses and are subject to risk, including the risk that an underlying security or securities index moves in the opposite direction from what the portfolio manager anticipated. A derivative transaction depends upon the counterparties’ ability to fulfill their contractual obligations.

Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.

Liquidity risk is the possibility that securities cannot be readily sold within seven days at approximately the price at which a fund has valued them.

Narrowly focused investments may exhibit higher volatility than investments in multiple industry sectors.

“Nondiversified” funds may allocate more of their net assets to investments in single securities than “diversified” funds. Resulting adverse effects may subject these funds to greater risks and volatility.

All third party trademarks cited are the property of their respective owners.

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