Real Estate as an Inflation Hedge: New Evidence from an International Analysis

In response to the COVID-19 pandemic, high levels of debt, and military conflicts, central banks have significantly expanded the money supply, leading to a global economic slowdown. In October 2022, inflation in the eurozone climbed to 9.9% year-on-year. In response, central banks such as the Federal Reserve and the European Central Bank have rapidly tightened monetary policy to curb massive inflation through higher interest rates. Despite the significant slowdown in inflation, the measures do not appear to be sufficient to fully contain inflationary pressures, and further policy tightening is therefore likely. Against this backdrop, this paper aims to improve our understanding of the inflation-hedging properties of listed and direct real estate compared to other asset classes. These properties are likely to be particularly useful for long-term institutional investors (especially pension funds, which typically operate under inflation-related liability constraints) and private investors for whom real capital preservation is a minimum objective. Therefore, this project will make a clear contribution to the academic literature on the effectiveness of real estate as an inflation hedge and provide important practical insights.

This project expands the literature by considering nonlinear features of inflation hedging at both the long-run and short-run levels. Most of the existing literature combines the framework of Fama and Schwert (1977) (which distinguishes between expected and unexpected components of inflation) and the cointegration technique (which distinguishes between long-term equilibrium and short-term dynamics) (e.g., Hoesli and Hamelink, 1997, Liu et al., 1997, and many others). However, all of these studies assume a stable equilibrium that can be violated by changes in monetary policy and business cycles.

To address this issue, we incorporate a regime-switching process into the long-run process (in the error correction term). To reflect the time-varying nature of long-term and short-term inflation hedging properties, we use impulse response functions to represent the response of different asset classes to an inflation shock. In addition, we will examine the inflation hedging capabilities of real assets in both private and public markets. Due to limited data on the investment performance of commercial real estate, the inflation-hedging characteristics of commercial real estate in the private market are still very limited and often prone to distortions related to the way real estate indices are constructed in the private market. Specifically, this paper aims to determine the hedging capability of an important asset class, namely listed real estate (LRE), using data from 1990 to 2022 for the major European countries in terms of LRE market capitalization, but also for the US, Japan, and Australia. In addition, the hedging capability of LRE will be compared with that of other asset classes. The results should provide important insights for investors seeking to allocate resources more efficiently in these turbulent times, both in the short and long term.

The relevance of this project for investors remains high. Investors are directly affected by high inflation. After a very long period of virtually no inflation, this issue has become very important again in 2022. Investors want to be able to base their decision-making on scientific findings that take into account both the latest data and the various methodological improvements that have been discovered in recent years. This paper attempts to do just that by analyzing the inflation-hedging capabilities of listed and direct real estate, as well as other major asset classes in Europe, but also in the US, Japan, and Australia. Four key practical features of our study will be:

• Recognizing the different effects of inflation on listed real estate compared to direct real estate
• Understanding the differences in inflation hedging between real estate and other asset categories
• Comparing the response of asset prices to inflationary changes in both times of economic strength and times of economic stress
• Highlighting the different effects of inflation on asset returns depending on the investor's time horizon, i.e., both short-term and long-term

This research project is supported by the European Institute for Quantitative Investment Research (INQUIRE).