Direct RE

Advantages

1. Competitive Returns: Over multi-year horizons, property’s total returns (rental income + capital growth) often exceed bond returns.

   • Example: IPF data from the 1990s onwards showed real estate yields outpacing gilts in stable periods.

2. Low Correlation: Property correlates less with equities than gilts, improving diversification.

   • Supported by Norges Bank (2015), which found property boosted Sharpe ratios.

3. Steady Income: About 50% of property returns are from contractual rental income, providing stability compared to the fixed coupon from gilts.

4. Inflation Hedge: Over the long term, property rents and asset values tend to rise with inflation, offering partial protection (IPF 2011).

5. Control: Direct ownership allows active decisions like refurbishments and tenant mix, unlike passive equity or bond holdings.

Disadvantages:

1. High Transaction Costs: Stamp duty, legal fees, and brokerage erode net returns, particularly with short holding periods.

2. Illiquidity: Property sales take months; unlike tradable bonds or equities.

   • Example: Commercial real estate market froze during the 2008 GFC.

3. High Management Time: Active management demands significant time (“95/5 rule”: most effort goes to the worst-performing assets).

4. Specific Asset Risk: Tenant defaults and location risks require diversification across sectors/regions, needing large capital.

5. Appraisal Bias: Appraisal-based valuations smooth real volatility, potentially misrepresenting risk. (Highlighted by Garay & Lee.)

6. Large Lot Size: Real estate is lumpy; significant capital is needed to achieve diversification, unlike easily scalable bond investments.

Conclusion: In the long run, direct property often outperforms gilts due to stable income and capital growth, but investors must account for illiquidity, management complexity, and high costs.

Definition:

Hedge if:

(1) Real returns > inflation

(2) Returns respond to inflation period-by-period

Reasons for Conflicting Evidence:

1. Data Issues

• Hard to separate expected/unexpected inflation → under/overstate hedging ability

• Total return = income + capital gains

  • Capital values: Appraisal smoothing hides short-run response

  • Lease structures:

    • Upward-only reviews delay inflation pass-through

    • Step rents/fixed increases disconnect from current inflation

    • CPI indexation common in EU (e.g. Germany’s 3–5% thresholds)

• IPF (2011): Long-run alignment (rents & capital) with inflation, short-run weak

1. Different Periods

• Strong hedge in 1970s, weak in 2010s

• Sector/country/decade matter

  • CBRE/NCREIF: Prime assets (e.g. Central London retail, industrial) better than secondary sectors

1. Methodology Matters

• Correlation: Historically high (~0.7), but weaker since 2000s

• Regression: Measures inflation’s explanatory power

• VaR: Assesses downside in inflationary episodes

• Co-integration: Long-run alignment despite short-term noise

• IPF (2011): Key comparative study across methods

1. Missing Variables

• Inflation alone ≠ full driver of returns

• GDP growth, interest rates, and RE cycles crucial

  • Hoesli (2008): Inflation link exists, but GDP stronger

  • High inflation + low growth = weak RE returns

Empirical Summary:

• Short-term: Weak/unreliable hedge

• Long-term (5–10 yrs): Partial protection via income & capital

• By sector: Prime retail & industrials > offices/secondary retail

• Conclusion: RE is an imperfect but reasonable long-term hedge; not a pure inflation shield — depends on leases, GDP, and occupancy