With inflation running at its hottest pace since the 1980s, the Federal Reserve raising interest rates over the next two years, and growing worries about a looming recession, how will real estate be expected to perform in this new environment?

Actually, this state of affairs may make some real estate investments—whether they are made through direct purchases of individual properties or real estate investment trusts (REITs)—a smart move going forward.

Real estate was the best performing sector in the S&P 500, after energy, in 2021, rebounding from a relatively weak 2020, when it was the worst, albeit with a 4.9% return. From the beginning of this year through May 9, the real estate sector lost 17.7%, while the S&P 500 lost 16.3%.

What should financial advisors advise their clients to do?

As it happens, financial advisors are pretty bullish on the sector. According to a recent survey conducted for the National Association of Real Estate Investment Trusts (Nareit), 83% of them recommended REITs to their clients, and suggested an allocation of 4% to 12% to the sector in client portfolios.

Indeed, REITs tend to perform pretty well during periods of rising rates, according to John Worth, Nareit’s executive vice president for research and investor outreach. “When we look at 12-month periods since the early 1990s where the 10-year Treasury was rising, you see positive REIT returns 85% of the time,” he says. “In general, for long-term investors, there’s no reason to deviate from holding REITs in your portfolio during a period of rising interest rates.” In addition to scoring positive returns, REITs act as a diversifier to both stocks and bonds while also providing income and capital appreciation.

The main reason interest rates are rising, Worth notes, is the positive expectations for economic growth, and this benefits real estate investment trusts. “More economic growth means rising rents and higher occupancy rates, which flows through to positive REIT earnings,” he says. In 2021, REIT earnings increased 25% above 2020 earnings to their highest on record.

REIT balance sheets are also “resilient to rising rates and really well prepared for an increase in interest rates,” he says. The average term on REIT debt is eight years. The interest expense as a percentage of operating income is near its historic low. And REITs’ use of leverage has declined dramatically. It is also now near an all-time low.

REITs have also meaningfully outperformed the broader stock market during periods of moderate and high inflation, Worth says.

“There’s a real case to be made for owning REITs for a lot of reasons, but providing some inflation protection is part of that story,” he says. “You have a lot of leases with CPI adjustments built-in, so you are getting automatic increases. Historically, rents have kept pace with inflation, so we see operating income increasing at or above the rate of inflation. You also have the value of the asset appreciating. And in cases where you have fixed-rate debt, which is very common, the real value of that debt is decreasing as inflation goes up. So the combination of those factors provides a level of inflation protection.”

The Commercial Market And The Return To The Office
Despite many offices being vacated during the pandemic—and many workers continuing to work at home—the commercial office market has held up surprisingly well. One of the main reasons is that the vast majority of rent continued to be paid during the pandemic, Worth notes. “The offices were empty, but the tenants were paying rent.” Many companies were also able to sublet their space to other firms.

Still, the long-term future of the office remains in doubt. Indeed, according to Worth, that is “by vast consensus the single biggest question in commercial real estate.”

“Corporate demand for office space is still low due to work-from-home policies,” notes Andrew Lucca, executive vice president at KeyBank Real Estate Capital. “Office vacancies increased during the pandemic, as many companies chose permanent remote work. Now, the question is: Do companies still need all that space? Many businesses have cut costs in corporate real estate because they can efficiently run their business remotely. It will be interesting to see how it all unfolds.”

Worth, for one, is optimistic.

“What is off the table are the doomsday predictions from back in mid-2020,” he says. At that point, some people believed companies were going to abandon offices altogether. “We may see some of that, but it’s going to be few and far between. I think employers and employees are going to find they really need to spend some meaningful amount of time together. Does that imply less need for office space? The question then becomes, how much less demand? There may be some reduction in the need for office space, but I think that has been wildly overestimated.”

Worth also notes that both the office and retail markets are being bolstered by a lack of new supply, which supports rents on existing properties. “The level of new construction in office and retail as a percentage of the existing stock has been running below 1% annually since 2011,” he says. “That muted supply has supported both of those markets.”

Repurposing Office Space
“One of the things we’re likely to see is some creative repurposing of office space,” says Rick Sharga, executive vice president of marketing at RealtyTrac, a leading provider of foreclosure information for investors, consumers and real estate professionals. He notes that one of the mayoral candidates in Los Angeles is talking about converting unused office space there into affordable housing.

“I wouldn’t be surprised to see some buildings that used to be exclusively office evolve into some sort of hybrid of office, retail and even residential units,” he says.

Sharga says there is a “Tale of Two Cities” story going on in the office market. The central business districts in the traditional hot metro areas like New York and San Francisco have not fared as well as suburban and secondary markets in either sales volume or price increases. So they may offer relative bargains going forward, he says.

For investors with a longer-term outlook, Sharga says there are some sectors of the commercial sector that represent a little more risk but potentially more reward than other commercial properties. That includes hotels, particularly limited-service hotels such as Marriott’s Fairfield Inns and Hilton Garden Inns. Some of those properties, he says, are available for less than a premium price right now because they are owned by small investors looking to exit.

Residential Real Estate
If any real estate sector faces potential headwinds it’s the residential market, which is coming off a 19% year-on-year increase in prices of existing homes, according to the widely followed S&P CoreLogic Case-Shiller U.S. National Home Price Index. At the same time, the average rate on a 30-year fixed rate mortgage as of May 5 had jumped to 5.27%, up from 3.22% in January, according to Freddie Mac.

Nevertheless, “the overall health of the residential market is very strong, and we definitely continue to be in a boom,” says Barry Habib, founder and CEO of MBS Highway, a Holmdel, N.J.-based provider of real estate data and marketing tools for mortgage loan officers. “We do not see a downturn with prices declining. Maybe the rate of increase will abate, which is a good thing, but we don’t see it headed the other way. Will I make money on my investment? Yes.”

Habib’s firm is forecasting high-single-digit appreciation over the next year, mainly due to rising demand not made up for by supply. “If you look at demographics, the crop of first-time home buyers over the next 12 months will be greater than last year’s but not as high as it’s going to be over the next couple of years,” he says. On the supply side, however, “we have significantly underbuilt by as many as four million homes—and we’ve never built more than two million homes in a year. It’s going to take a long time for that imbalance to work its way out.”

Habib acknowledges that buying a home in today’s market, what with skyrocketing home prices and mortgage rates amid limited inventory, is a lot more challenging than it was a few years ago. But if you’re lucky enough to buy a home, “the future is very bright for your investment to be protected and able to grow at a pretty reasonable rate of return,” Habib says. “Even if prices appreciate by only low single digits, with 10% down, that’s equivalent to a 40% or 50% return on your investment.”

The opportunities are even better for cash buyers, who still make up a sizable share of the market, particularly for high-priced homes, Sharga says. “If you are looking to invest in residential properties right now, a rising interest rate environment ironically gives you a competitive advantage over traditional home buyers,” who need mortgages to finance their purchase.

Multifamily And The Rental Market
The residential market, of course, also drives the multifamily and residential rental sectors, as many people who can’t afford to buy a home are left to rent. That market may be even hotter than residential and is expected to stay that way. In 2021, year-on-year rent growth topped 13.5%, more than double any previous year.

“If you buy a home, you should be in a very good position to rent it out and see a significant return based on price appreciation, amortization, and the amount of rent you’re able to charge,” Habib says, particularly in buildings with four or fewer units. “Financing is very attractive” in that niche, he says, while it gets more expensive the larger the property.

Sharga notes that the same demographics driving demand in the single-family housing market are propelling the rental market as well.

“Over the next several years we’re going to be looking at pretty high numbers of households being formed. At the same time, we are dealing with a 10-year undersupply of both single-family and multifamily construction,” he says. “So if you are able to buy these properties right now as an investor, you have a pretty ready market to rent them out.”

Watching The Fed
Perhaps the biggest risk in real estate is that the Fed raises interest rates too high and too fast, throwing the economy into recession.

“It is inevitable that Fed decisions will eventually impact the industry,” says KeyBank’s Lucca. “The general concern around inflation is uncertainty about how much it will grow and how long it will last, especially given the current crisis in Ukraine. Typically during these periods, investors look to long-term investments, such as real estate. Investors are watching closely and ready to adapt to change.”

“At some point, inflation has an impact on [consumers’] spending and their ability to save money for a down payment or afford a rent payment,” Sharga says. “With U.S. GDP 70% dependent on consumer spending, you could have a consumer spending-driven recession. And the Fed could overcorrect and cause a recession that could lead to job losses and a negative impact on both residential and commercial markets. So even though things are looking good right now from a supply-and-demand standpoint, there are some storm clouds we need to keep our eyes on over the next 18 to 24 months.”

For his part, Nareit’s Worth is “fairly optimistic that the Fed is going to proceed in a very cautious manner and that we are not going to see them derail growth.”

But even if the Fed does, that won’t necessarily spoil the party, because recessions usually lead to lower interest rates, which is positive for real estate, particularly residential properties.

“Every time the Fed has tried to fight inflation, they have sent us into a recession, and in eight of the last nine recessions we’ve seen accelerated appreciation of real estate values afterward,” Habib says. “That means rates will probably have a chance to improve and real estate should hang in there pretty well as it always has during recessionary periods.”

Of course, no investment—no matter how positive the premise—is a guaranteed lock. Sharga says investors should “discriminate your risk tolerance” among different sectors should something unanticipated happen.