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Is real estate still an inflationary hedge?

Traditionally, investors believed that real estate was a good vehicle for hedging against inflation. But with today's economic conditions, some real estate experts have begun to question whether or not investing in real estate offers protection against rising costs. At the same time, current overbuilding may make real estate purchases attractive investments, even without the hedge factor.

Two top experts, Blake Eagle of the Frank Russell Company and Mike Miles, professor at the University of North Carolina (Chapel Hill), share their views on that subject, as well as on the state of real estate and the economy on the whole.

Do you think that real estate can

be used as an inflation hedge?

Mike Miles: From an academic perspective, we have a specific way of measuring whether or not something is an inflation hedge. We are looking for whether, when there is an unexpected inflation, the returns from the asset respond positively. That is looked at over some specified period.

Intuitively, people thought real estate was an inflation hedge. Over the periods for which we had data, using a standard test, we found that real estate protected against unexpected inflation. The really nice thing was that stocks and bonds showed just the opposite.

Today, the real estate markets are so out of balance that there is no way returns can respond to uptakes in inflation. Right now what we found empirically will not be the case. It already ceased to be the case over the last couple of years, and it certainly will not be the case over the next few years.

If you want to use the acamedic definition of inflation hedge, real estate ceased to be one in the mid-1980s. However, a pension fund, with long-term expectations, should not be measuring whether something is an inflation hedge quarter to quarter. It should care about terminal value and whether that terminal value responds positively with unexpected inflation, in such a way as to provide protection.

There the intuitive argument is still quite strong. Clearly there will be a period of time when oversupply must be used up. But longer term, if real estate still moves up with the cost of materials and the cost of land, those will both be protected by inflation.

If we are looking at about 20 years down the road, real estate is just as good an inflation hedge as it always was. But if we are talking about responses from quarter to quarter, we are going to find what we found five years ago.

Blake Eagle: As an operating investment, real estate is probably not going to be a very good inflation hedge should we experience a round of very high rates of unanticipated inflation.

There is embedded in the property markets of the United States today a structural overbuild, an excess supply. It is a tenant market today. When it is a tenant market, real estate is not going to be a good inflation hedge. When it is a landlord market, real estate is a good inflation hedge.

Furthermore, much of the real estate today is financed with shorter term mortgages that carry much higher real rates of interest than the mortgages used to finance real estate back in the 1960s and 1970s. The last time we had inflation, real estate was a beneficiary. It was a beneficiary on two fronts. First, supply and demand were in much more relative balance. Second, real estate was financed by very long-term, relatively low-cost debt. A significant value of that low-cost debt was wiped out by the inflation.

Owners of real estate benefitted as much by having the underlying debt devalued as they did from the property going up in value because of the managers' ability to pass on increases in costs.

Again, I am looking at real estate as an operating asset. There is the probability that if another rapid round of inflation existed, real estate would benefit. Many investors' expectations are that real estate is a better inflation hedge than financial assets. Therefore in allocating capital to different segments of the market during a period of inflation, it is likely that investors would invest more money in real estate.

More capital heading for real estate would tend to put some kind of a floor on its price. One can conclude that real estate values might not be as severely impacted by inflation as one might expect the financial assets to be. If that observation is true, then property (as part of a portfolio) would act as a buffer or an inflation downside asset, as opposed to its more traditional role of rising in value.

Looking back as to why real estate did so well in the 1970s and early 1980s (during a period of very high rates of inflation), much of it had to do with the fact that real estate supply and demand ratios were in balance. Therefore, managers could easily pass on the increased costs of utilities, janitorial services, real estate taxes, insurance, and so forth.

All those costs go up as an automatic by-product of inflation. The manager could pass those increases onto the tenant because what could the tenants do about it. They could not go anyplace else.

But in today's market, tenants have a multitude of options. If a manager's rental base is not competitive with the marketplace, the tenant will pick up and move or some other competitor will actually pay for the cost of that tenant to move. So the conditions of the marketplace are quite different today then they were 15 years ago. The fundamentals of the market have changed and that does not bode well for managers in an inflationary environment.

Do you think pension funds will

continue to invest in real estate?

Miles: Negative press is only good news for the people who are the real players. The small investor is going where the negative press is, but the smart investor goes in the opposite direction. Many pension funds, being fiduciaries, will probably be cautious. But that is probably not very smart on their part. They should invest through the down cycle as they did during the up cycle because they may not be smart enough to call the turn in the market.

If real estate is part of your portfolio and you want a long-term position in it, you need to invest in both good times and bad. If you just invest in the up market, you are always overpaying.

Eagle: When looking at a variety of economic scenarios, real estate as an asset class held its own against other financial assets. There were periods of time when real estate returns, adjusted for inflation, were superior to that of financial assets.

Portfolio investors must position themselves for all likely events. The data clearly argues that portfolios should be spread across multiple asset classes, including property. There is a strong portfolio argument for the inclusion of property in a multi-asset mixed portfolio, whether that asset class is a superior inflation hedge or not.

It was an easy sell back in the late 1970s to convince pension funds to put money in real estate because real estate was doing well, the inflation rates were high, and the returns on financial assets were low. But retrospectively, having studied the data, we find that the principal contribution to the portfolio over a 20-year period has been risk reduction through diversification via multiple-asset investments. That is a compelling argument for real estate in a portfolio. Over the long haul, real estate as an investment is first rate.

What types of real estate should

investors be looking at?

Miles: What they are looking at appears to be the very old real estate. Some people are trying to be opportunists in the market while others are retrenching only in stable markets. But people have always done that.

What they should be looking at right now is non-development and less enterpreneurial management. The naive pension funds just getting into real estate should, as they always have, stay away from the entrepreneurial management situations. On the other hand, the more experienced pension funds, which have known controversy, would probably do better in a series of enterpreneurial positions.

Eagle: Given the current condition of the market, there will probably be two basic strategies. First, pension funds will invest in a very high-quality end of the market, when those investment opportunities become available. In the long run, the quality real estate is that which is in most demand by tenants. It is that segment of the market which does well over the long term. The challenge of buying quality real estate is that it only comes on the market periodically, and no one knows when what will occur.

The other segment will be trying to take advantage of the dislocations that are now emerging as a result of the credit crunch. There will be distressed real estate sellers, developers that are overextended, financial institutions that are forced to foreclose under regulatory pressures, former tax-driven syndicates whose purpose for real estate investment no longer exists and will have a need to monetize assets, and corporations that will seek to sell their assets and lease them back as a cheap way to access capital. The year of the junk bond is gone.

Pension funds will be prepared to respond opportunistically to the markeplace when these situations arise. However, they should use a lot more caution, care, and selectivity than when buying in at the high end, which is basically a "slam dunk."

Does the health of real estate run

countercyclical to the economy?

Miles: No, but it is not in perfect sync, either. There is an important distinction there. If it were perfectly countercyclial, it would be the ideal diversification tool. But since it is not perfectly in sync, then it is only a good diversification tool.

Real estate is in the tank, and so is the economy. The inflation hedge was logical and the fact that real estate is a portfolio diversifier is very logical, but not perfectly countercyclical.

Eagle: There is no question that we are in a recessive cycle now. What has happened in this last cycle is that when vacancy rates in a given local market would drop to 3 percent, developers would gear up to build more. It showed that there was some pent up demand for rental space. So the development process would get underway.

When vacancy rates hig 12 percent capital withdrew. The development cycle operated between a narrow band of vacancy rates. A 3 percent rate was a signal to begin development, an indication of pent up demand. When vacancy rates hit 9 and 10 percent, it was a signal that you were overbuilt, and capital would start to withdraw.

In 1985, vacancy rates hit 10 percent, but capital did not withdraw. Vacancy rates in 1986 went up to about 13 percent and capital did not withdraw. In 1987, vacancy rates rose to 20 percent and capital still did not withdraw. The last half of the 1980s was a capital-driven market as opposed to a tenant-driven market. In the process, we structurally overbuilt the marketplace. The average vacancy rate across all property types is about 20 percent.

The marketplace now knows that, and capital has withdrawn on all fronts. That is the so-called "liquidity crunch" that the real estate industry faces today. It is simply a reaction to the overbuilding. It is a cyclical event. The cycle of recovery is going to be much longer because of the significant oversupply. The expansionary phase went beyond its norms. It has to be that the recovery cycle will go beyond its norm.

That is the way all markets work. Markets have worked like that for 2,000 years. There is not anything any of us can do about it other than pass the lessons of this cycle on to the next generation. And they will pay absolutely no attention to it.

What do you think will

happen in the future?

Miles: There will be less people in real estate; I can forecast that for certain. The interesting question will be who will do what to whom. Will syndicators become property managers and bid for contracts of existing property managers? Will bank lona officers from banks that are no longer solvent become property managers or appraisers? There are a lot of people who will need to find new jobs.

It will not just be that some people will be laid off and that is it. It is more complicated than that. Some people will be moving in on other people's turf.

Many people have been talking about how developers are now moving into property management and their companies are getting more into property management, but I have not seen any of that. I have not seen many of the top developers out managing property.

They have not made their move yet. I would like to know where they plan to move, but I don't know that. I just know that there will be a lot less people in the whole industry. A lot of people will lose their jobs and then displace others.

We are not ging to get the shakeout in real estate right away. People will not just quit real estate to do something else. Real estate has been too rewarding and too much fun. Real estate people have too much learning invested in it. So they will not leave graciously. It will be very painful to walk away.

The asset management and consulting fields are more desirable than they were in the past. The best people will migrate to those professions. Some will be crowded out by the new people. There are too many people going into those fields. They all cannot live there.

Eagle: The real estate industry is no longer a growth industry. It grew way beyond its ability to manage its own affairs during the 1980s. It is like any other industry that gets too big, it must go through a down sizing.

There is a job shortage in the U.S. currently. Many of the nontechnical or marginal people, those that are not managers, finance people, top developers, and so forth, will shift off into other jobs. But we will also export a lot of our talent. The need for design, construction, and development expertise, as well as capital and street savvy will clearly be in demand in other places around the world.

One of the problems of the real estate industry is that it has too many smart people. So there is a tremendous amount of our talent and expertise, cumulative knowledge, that has built up over the years in this business. That can be profitably exported to other nations around the world.

The surplus in the marketplace, in terms of human resources, will have to be absorbed by other sectors of the economy. But that has happened many times before and it will happen many times again in all segments of the economy. The automobile industry is not what it was 10 or 15 years ago. Yet the U.S. economy today is more diverse and does not depend as much on automobile manufacturing.

For the great majority of the owners of assets today, the name of the game is to asset manage and property manage those holdings. That is where the developers see the future of their business. They want to bring the full brunt of their resources to those disciplines. There will be a redirection towards maintaining the quality and competitiveness of the assets already in their portfolios. This means retaining the tenants they have and working very hard to get new tenants to keep their buildings occupied.

In order to accomplish that, they will need to be supreme property managers and asset managers. They will need to work for the user of the property as opposed to the capitla suppliers. It is a big change in the marketplace that will bring the market's balance back into equilibrium.

The skill levels of managers will be subject to scrutiny, and I think the marketplace will pay for topnotch managers. We are moving into the decade where property management will be one of the highest paid and most coveted of skills. Good property and asset managers will be very much in demand.

I am taking a longer view--that is why I sound less bleak about the future. Many people are concerned about next month and next year. I do empathize with them. The short-term outlook is not good.

If we look at real estate in the big-picture context, we have a structural access of about 20 percent, which is driving down rents and causing investment values to be slightly impaired. That is one way to look at it. The other way to look at it is that 80 percent of the market is doing just fine. That is four times the 20 percent that is doing bad and must be deal with. That 20 percent is probably the total surplus, the overcapacity of the industry at large.

So over time, what we need to do is work that 20 percent off. The developer or deal maker whose livelihood is now tied to that overcapacity has very serious short-term problems. But to the long-term players--developers with assets in capital, financial institutions with resources, and pension funds who are multi-asset class investors--this is just part of the cycle. They are fully prepared to deal with that. They have the resources to ride through it. Depending on who you are talking to and where they are positioned in the market, their outlook may be a lot different.

When do you think we will be

pulling out of this period?

Miles: I may not see it in my lifetime. I think there has been a fundamental change. The short-term part of this will be over in three or four years. But there is a long-term portion also, which because of certain underwriting, tax abuses, and foreign capital flows will not come back to the industry in the next five or ten years.

We have learned certain lessons. It will be 10 years or more before we commit some of those types of abuses again. There will be new types of abuses that will create opportunity.

The 1986 Tax Act was a good tax law. It was good for the country. Long term, it was good for the real estate industry. But short term, it was rather unpleasant. The 1990 tax laws are just ridiculous. They are too complicated and do not solve the problems.

So between taxes and spending cuts, we did not solve the problems, and we made it more complicated for business people. It is ridiculous that someone with more children should pay more taxes. You can be sure that we are going to see still more tax change.

Eagle: I have looked at a lot of different economic forecasts from a lot of different people. The one thing you can be absolutely assured of about anyone's forecast is that is absolutely wrong. There is no one, not the greatest economist in the world, the visionary, or the mathematician, who can tell you what is going to happen tomorrow. All they can do is use the past as basis for making some future forecast.

In 1981, Ronald Reagan called the Soviet Union "the evil empire." In 1990, Mikhail Gorbachev was given the Nobel peace prize. I do not know anyone who predicted that. Nor do I know anyone who predicted Saddam Hussein would march in the take Kuwait. I doubt Kuwait had any idea.

So, what will the future hold for us? How quickly we work out of this structural overbuild is now up to economic growth. If we have slow economic growth through the 1990s, 1 or 2 percent a year, then we have a protractedly long recovery cycle.

If, however, we have very strong economic growth, and there are many people who predict that, then there will be a much shorter recovery period. The range of probabilities is something like two to three years on the short end and five to eight years on the long end.

There are two schools of thought on the economic growth of the U.S. One is that the U.S. empires is in a declining stage and will never be able to re-ignite itself into the powerful industrial nation that it once was. Therefore we can expect economic growth in the 1990s and on into the next century along the lines of what Europe has experienced over the last 30 or 40 years.

One of the reasons for that forecast is that we have such a huge national debt, that we financed our great lifestyle of the 1970s and 1980s by borrowing, and we must pay that back in one way or another. Therefore high levels of economic expansion are unrealistic.

The second school of thought says that because the U.S. population is getting older, it is moving away from a consumption concentrated, economy to a savings economy. We will accumulate vast amounts of capital. The "boomers" are now in their 40s. They bought all of the BMWs, houses, and all the creature comforts that they want. They are now paying that debt off and increasing the savings of the county. As a result of all that, we will have phenomenal economic growth during the 1990s.

I tend to agree with the latter theory. Also, this is a county of immigrants. I think we will open up our borders to people. The U.S. has the greatest political structure for economic growth.

If you take those two extremes, I would say we will fall somewhere down the middle. My bet is, it will probably take five years for the real estate markets to come back to normal.

What industries do you think

will be doing well in the future?

Miles: Environmental consulting firms and mercenary soldiers will do well. Professors will do poorly. We should start putting our money where we need it most, which is with second-grade school teachers who hold the future with the lives of our youth. Some day we are going to wake up to that.

Eagle: The computer industries will continue to do well. We have the intellectual, political, and economic environment for the incubation of that. We are also the leading nation in medical research. That will be a big part of the U.S. economy. They are leaders in their field, not followers. We are super-skilled in financial services and agricultural production, and we export that around the world. And we are clearly the leaders in capitalism and democracy.

We made the combination of capitalism and democracy work in tandem as the pillars of a nation for over 200 years. No other country in the history of the world has been able to survive 200 years of the same political structure. Nor the whole world wants to democratize and become free-market based economies. No one knows that better than the United States. We have a tremendous opportunity to take that knowledge and export that around the world. That will be no small task.

We will continue to be one of the world's largest manufacturing countries. Most people have forgotten that the largest manufacturing company in the world is still General Motors. The largest airplane manufacturing company in the world is still Boeing. The largest computer company in world is still IBM.

These companies simply have more competition to deal with on a global basis than they have had in the past. They have access to virtually unlimited resources, both human and capital resources.

Our industries have a great deal going for them, both to serve our own economic needs and to develop the opportunities overseas. We just need to become a little more competitive.
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Title Annotation:Asset Mnagement; Frank Russell Co.'s Blake Eagle and University of North Carolina, Chapel Hill professor Mike Miles
Author:Gorman, Bridget
Publication:Journal of Property Management
Article Type:interview
Date:Jan 1, 1991
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