Direct RE

Advantages

1. Competitive Returns: Rental income + capital growth > bonds over long term → IPF (1990s onward): property yields > gilts

2. Low Correlation: Diversifies portfolio → Norges Bank (2015): improved Sharpe ratios

3. Steady Income: ~50% of returns from contractual rents; more stable than coupons

4. Inflation Hedge: Long-term rent/capital growth track inflation → IPF (2011)

5. Control: Direct management (refurbs, tenant mix) vs passive bond/equity holdings

Disadvantages:

1. High Transaction Costs: Stamp duty, legal, broker fees reduce net returns

2. Illiquidity: Sales take months → 2008 GFC: market freeze

3. Management Time: “95/5 rule” – worst assets consume most effort

4. Asset-Specific Risk: Location/tenant risks → need costly diversification

5. Appraisal Bias: Smoothing understates volatility → Garay & Lee

6. Large Lot Size: Not easily scalable like bonds; needs large capital

Conclusion

• Long-term RE offers returns, inflation hedge, and diversification

• But comes with high friction: illiquid, effort-intensive, costly

• Best for long-term, well-capitalised investors—not frictionless like bonds/equities

Definition:

Hedge if:

(1) Real returns > inflation, to preserve purchasing power

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

1. Data Issues

• Expected vs. unexpected inflation hard to separate → distorts results

• Returns = rental income + capital growth

  • Capital values: Appraisal smoothing hides short-run volatility

  • Lease structures weaken inflation link:

    • Upward-only reviews delay inflation pass-through

    • Step/fixed rents disconnect from actual CPI

    • EU CPI indexation helps (e.g., Germany 3–5% thresholds)

• IPF (2011): Weak short-run response, but long-run alignment

2. Periodic, sectoral and regional variation

• 1970s: Strong inflation hedge

• 2010s: Weak linkage due to low inflation & QE

• Sectors/countries vary

  • CBRE/NCREIF: Prime retail & industrials > secondary offices/retail

3. Methodological Differences

• Correlation: High (~0.7 historically), lower post-2000

• Regression: Inflation explains some variation, not all

• VaR: Captures downside during inflation shocks

• Co-integration: Long-term link despite short-term divergence

• IPF (2011): Highlights mixed results depending on method

4. Missing Variables

• Inflation ≠ sole driver

  • GDP growth, interest rates, and RE cycles more impactful

  • Stagflation: High inflation + low growth = weak RE returns

• Hoesli (2008): GDP stronger predictor than inflation

Conclusion

• Short-term: RE is a weak/unreliable hedge

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

• Best in prime sectors (e.g., Central London retail, industrials)

• RE is imperfect but reasonable long-run hedge, influenced by GDP, leases, occupancy