Is real estate a good inflation hedge for pension schemes?

For defined benefit scheme managers, higher inflation means higher interest rates. This is bad news for fixed income investments, which often make up a significant proportion of DB scheme pension plans and means many of these scheme managers will be looking for investments that can offer a hedge against inflation.

Clearly, price inflation presents a risk to pension scheme assets, and scheme managers will be keenly monitoring their bond portfolios and interest rates in the coming months.

In my view, the commodity price spikes fuelling current inflation are a one-off, and we can expect recent inflationary pressures to subside. However, those concerned about the erosion in the value of long-duration, fixed interest assets may want to review their current allocations.

Price inflation presents a risk to pension scheme assets, and scheme managers will be keenly monitoring their bond portfolios and interest rates in the coming months

Hedging alternatives

If plans are under-allocated to real assets and inflation-linked assets, which many are, with a sizeable weighting to fixed income assets instead, they will be on the hunt for the right hedge or diversifier.

So, the question is for scheme trustees and plan sponsors, and scheme managers, what is the most suitable inflation hedge? 

Gold is often cited as a classic hedge, but is its safe-haven status not tied to times of crisis and lower inflation?

Index-linked government bonds are a perfect inflation hedge, but they are expensive and have a relatively small market.

In equities, investors can pick individual companies whose revenues and costs are inflation-linked, such as real estate investment trusts, or are commodity producers like energy and metal production.

The real estate ‘hedge’

Because real estate has little observable short-term correlation between the consumer price index and property rental growth, we must acknowledge that it is not a ‘hedge’ in the literal sense of the word, like a financial instrument such as a Treasury inflation-protected securities or index-linked gilt.

Instead, a longer-term link between property rents and general price inflation does exist. In other words, accessed via direct ownership, or indirectly via pooled private property funds or listed Reits, property rental income and thus prices will offer longer-term inflation protection instead.

Hence investors looking for inflation protection from real estate need also to have appropriate longer-term perspectives.

Such real estate strategies are described as ‘core’ and are largely about selecting assets in location and property sectors where the structural trends are most favourable, such as demographic changes, technological advancement, and environmental, social and governance factors.

Taking a look at the opportunities in real estate, we expect income from residential and logistics in particular to protect against inflation over the mid to long term, as these sectors benefit from those key systemic long-term trends, while retail and hotel rents will struggle to harness these trends to the same effect.

This leaves offices. The pandemic has accelerated occupier requirements and thus functional obsolescence, and it is only the most modern, ultra-flexible and sustainable office buildings that will offer investors inflation insulation. In contrast, office rents for more average and outdated accommodation will fall by the wayside, and lag far behind other prices.

This means that trustees and scheme investment officers seeking long-term insulation from inflation should tilt their portfolios in line with wider societal changes, particularly from logistics and residential real estate, but also offices where the asset quality can live up to more stringent post-pandemic occupier requirements.

While retail (yes, physical retail does have a future), hotels and office redevelopments are unlikely to deliver on the inflation rental protection front, shorter-term ‘value add’ opportunities for outsized returns do exist, but will also have accordant high idiosyncratic risks around stock/project selection.

Paul Stewart is head of European research and strategy at Barings Real Estate