International Journal of Business and Management Studies,

CD-ROM. ISSN: 2158-1479 :: 05(01):187–196 (2016)

REAL ESTATE INVESTMENTS AND THE INFLATION-HEDGING

QUESTION: A REVIEW

Daniel Ibrahim Dabara, Omotehinshe Joseph Olusegun, Okunola Samson Adewuyi, Ankeli
Ikpeme Anthony, and Adaranijo Luqman Olatunde

Federal Polytechnic, Nigeria

The aim of this study is to examine the inflation-hedging characteristics of real estate investments with
a view to providing information that will help investors in making informed investment decisions. The
theoretical research approach was adopted for this study. During periods of high inflation, it has been
observed that certain investment asset classes not only do not protect the investor’s earnings, but
actually perform as perverse hedges. Real estate has traditionally been perceived as a good hedge
against inflation; however, fears have been expressed recently about whether it really is a hedge against
the background of economic volatility and recession that has characterized many economies. The study
revealed that there is no consensus on the ability of real estate to hedge against inflation. While some
studies showed that real estate performed excellently as a hedge, others showed that it does not, in fact
in some cases; it was even found that it serves as a perverse hedge. The hedging characteristics of real
estate across inflation components (actual, expected and unexpected) were also found to differ
considerably. The study concluded that due to the highly localized nature and the dynamism associated
with the real estate markets, empirical test of various sub property markets with respect to the inflation-
hedging question need to be carried out. Similarly, investors are advised to also consider real estate
investments with strong historical risk-return profiles and diversification benefits rather than
concentrating on solely beating inflation.

Keywords: Hedge, Real estate, Returns, Risk, Investment.

1. Introduction

Mughees (2010) defines real estate as “land and the improvements associated with it,” furthermore, Alabi,
Okunola, Dabara & Odewande (2012) asserted that real estate can be broken down into the following core
groups: Residential, commercial, industrial, recreational, religious, and agricultural. Real estate plays an
important role in reflecting the social, economic, and political conditions of a society; this in turn presents
a compelling opportunity for shrewd investors who desire to create and sustain wealth through viable
investments. Not only does the sector provide many long-term investment benefits, including healthy
income returns, diversification benefits and a hedge against inflation, but also fundamental factors such as
the improvement of the risk/return characteristics of the overall investment portfolio (Thambiah &
Foscari, 2011; Fiorilla & Halle, 2011; Dabara, 2015).
Investments in real estate could be done either directly or indirectly. Direct real estate investments
imply the acquisition and management of physical properties. This involves the purchase of freehold or
leasehold interests in real estate (Holland, 2006). Indirect real estate investment on the other hand, entails


187

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188 Real Estate Investments and the Inflation-Hedging Question: A Review ...

investing in a product whose performance is based on some measure of property performance; this
includes buying shares or bonds in a publicly quoted real estate company (Glascock, 1991). Dabara
(2015) asserted that one of the reasons for investors’ preference for real estate investments is its seeming
ability to protect the purchasing power of their investment funds. This is predicated on the fact that certain
investment asset classes tend to lose their purchasing power during period of inflation i.e., decrease in
value as inflation increases (Jack, Micheal & James, 1989; Odu, 2011; Dabara, 2014) hence the need for
both individual and institutional investors to first ascertain the inflation-hedging potential of an asset class
before committing their hard earned investible funds to such asset class to avoid loss from erosion by
inflation.
Inflation is generally considered to be the rate of increase in prices over a given period of time (Oner,
2010). In simpler terms, inflation is ‘too much money chasing too few goods’ thereby causing a hike in
prices of commodities. The inflation question vis-à-vis the hedging capability of an investment asset is of
great concern to investors. This is because the ability of an asset class to hedge against inflation provides
a shield to the investors’ funds. In line with the foregoing, an asset is said to be a hedge if it provides a
certain degree of immunization (protection) against a rise in the general level of prices of goods and
services in an economy (inflation) over a period of time (Bodie 1976; Fama & Schwert 1977; Zhe, 2010).
It is imperative that the inflation-hedging question of various asset classes (be it real assets or financial
assets) be examined and analyzed critically and the result of such research be made available to both local
and foreign investors for investment decision making. It should however be noted that the model(s) used
in such analysis is very important so as not to mislead investors.
Generally, Fama & Schwert’s (1977) regression model is the earliest and most widely applied model
in assessing the inflation hedging characteristics of an asset class the world over. Their approach boils
down to an empirical test of the Fisher hypothesis. Fisher (1930) in his famous and pioneering research
work ‘Theory of Interest Rates’ asserted that ‘expected nominal return on an asset is equal to its expected
real return plus expected rate of inflation’. This theory was subsequently adopted and modified by Fama
& Schwert (1977) in their study ‘Asset Returns and Inflation’ which later became the theoretical
framework for subsequent studies on the relationships between asset returns and inflation. However, more
recent studies such as Dabara (2014) observed that the Fama & Schwert’ model was used without
carrying out an initial stationarity test; the author observed that this could lead to the use of spurious
regression results in analysis of such data. Hence it was suggested that an initial stationarity test be carried
out on data series used in such studies to avoid using spurious regression results. Similarly, co-integration
models were found to be more appropriate for testing the inflation-hedging capacities of asset returns that
provided non stationary data series (Mei-ling, 2003).
Vast literature investigates the inflation hedging potentials of various asset classes in both developed
and developing economies. This investigations includes: direct investments in real estate, commodities,
stocks, equities, bonds, real estate investment trust (REITs), gold etc (Oluwasegun & Dabara, 2013).
These studies were carried out in the bid to answer the inflation-hedging question of the various asset
classes. i.e. to determine whether the asset class in question performs well as an inflation hedge or not.
Intuitively real estate has been perceived to be a good hedge against inflation all over the world (Peyton,
2011a). To justify or refute this notion, different studies have been carried out in both developed and
developing economies. For example, both residential and commercial real estate performed favorably as
inflation-hedging properties in developed economies such as the US (e.g in Fama & Schwert, 1977;
Peyton, 2011) and in developing economies such as Nigeria (e.g Bello, 2005, Ogunba Obiyomi & Dugeri,
2013). Similarly, real estate was seen as a good hedge in Austrialia (Leung, 2010) and Korea (Park &
Bangs, 2012). However, in China, real estate was found not to provide inflation hedge (Zhou & Clements,
2010), this is congruent with the findings of Arnason & Parsson (2012) in Sweden. In the study conducted
by Odu (2011), real estate was found to provide a perverse hedge in Lagos, Nigeria. The results obtained
from these studies were observed to be inconsistent. Specifically, the findings on the inflation hedging
question of real estate presented divergent findings, while some studies showed that real estate performed
excellently as a hedge against inflation, others showed that it does not, in fact in some studies, it even
showed that it serves as a perverse hedge against inflation (Dabara, 2014). The hedging potential of real

Electronic copy available at: http://ssrn.com/abstract=2784443

 Daniel Ibrahim Dabara et al. 189

estate across inflation components (actual, expected and unexpected) also differs considerably
(Oluwasegun & Dabara, 2013). Odu (2011) asserted that this disparity can be attributed to various factors
including ‘varying timeframes, fluctuating economic conditions, and differences in microeconomic and
macroeconomic indicators among other things’.
The non consensus with respect to real estate’ inflation hedging question poses great concern to real
estate investors. It generates the question of whether real estate investments actually possess inflation
hedging capabilities. Similarly, should an investor put real estate alongside other relative or alternative
investment media, can real estate perform better? In an effort to address their concerns, investors and
researchers all over the world are re-examining the capacity of various real estate types to offer inflation
hedge, should inflation become problematic. This research efforts is justifiably linked to the fact that all
over the world inflation is among the worst nightmares bedevilling investors (Amenc, Martellinil, &
Ziemann, 2009; Thambiah & Foscari, 2011). This is because inflation has the capability to erode the
value of corporate earnings and devalue the purchasing power of investors (Peyton, 2011b).
It is in the light of the forgoing that this study aims at investigating real estate investments in relation
to its inflation hedging question with a view to providing information that will guide investors in making
their decisions. To this end, the researchers intend to find answers to the following questions: Does real
estate as an investment media possesses inflation hedging characteristics? How has real estate
investments performed relative to other inflation hedging asset classes? What is the implication of
investing in real estate in an inflationary environment? The remaining part of the paper is divided into the
following sections: a critical review of related literature, and summary of findings and conclusion.

Review of Related Literature

Inflation: Definition, Components and Causes

Inflation is generally considered as a purely monetary phenomenon. It can be defined as a general

increase of price level for all goods. Inflation can diminish people`s purchasing power and erode their
wealth in the long term (Zhe, 2010). The inflation used for such studies are generally divided into three
different components: the actual, expected and unexpected inflation components. Most commonly, the
Consumer Price Index (CPI) [which is the official measurement of inflation worldwide] is adopted as a
benchmark or proxy to measure actual inflation rate (Fama & Schwert, 1977; Zhe, 2010). Expected
inflation is the rate at which people, on the average, believe that the price level will rise i.e. the public’s
expectations for inflation. In various earlier studies, expected inflation is measured using the 90-day
Treasury bill rates, Livingston price expectation (LPE), or Auto Regressive Integrated Moving Average
(ARIMA) as a proxy (Rubens, Bond & Webb, 1989; Wurtzebach, Muller & Machi, 1991; Zhou &
Clements 2010; Zhe, 2010; Park & Bang 2012, Dabara, 2015). Unexpected inflation is a situation in
which the inflation rate is higher than economists, regulators or others anticipated. As with all inflation,
unexpected inflation is good for borrowers, but detrimental to both lenders and persons who save. The
unexpected inflation is derived by subtracting actual inflation from expected inflation and therefore
measures how actual inflation varies from what market participants had expected (Kloosterman, 2009;
Odu, 2011; Arnason & Persson 2012). These 3 components of inflation were observed to react differently
to asset returns in an inflationary environment or economy. An economy can be bedeviled by any of these
components of inflation as a result of different causative factors.
Finkelstein & Camargo (2010) asserted that ‘commodity price pressures, aggressively stimulative
monetary policy, and a swelling federal deficit and debt burden’ could all bring forth inflation. Similarly,
Peyton (2011b) posited that fiscal policy in the form of excessive deficit spending as well as combined
fiscal and monetary stimulus can boost demand beyond an economy’s capacity thereby igniting inflation.
Furthermore, Steinke (2011) submitted that longer period of low prime rates could serve as precursors to
uncontrolled growth in money supply and consequently rising prices leading to inflation. Other reasons
adduced for a potential rise in inflation include: global stimulus efforts implemented by Central
190 Real Estate Investments and the Inflation-Hedging Question: A Review ...

Banks; the rapid growth in money supply; the return of budget deficits; and the weakening of
currencies (Finkelstein & Camargo, 2010; Peyton, 2011b). Fraundorf (2012) asserted that every
type of investor can be affected by inflation: institutional investors, endowments, foundations,
insurance companies, and individual investors could all be impacted. It is evident that one of the
major intent of including any chosen asset class in an investment portfolio by these investors should be
derived from their enduring characteristic which allows it to effectively hedge against eroding the
purchasing power of the investors’ funds, regardless of prevailing inflationary trends. Hence it is
imperative that investors wisely invest in assets that possess certain degree of inflation-hedging
characteristics.

Inflation-Hedging Properties and the Performance of Real Estate Investments in the Global Market

According to Zhe (2010) hedge, in financial terms, is a strategy to reduce risk exposure to a certain
situation in the market. As inflation will always erode the purchasing powers and value of assets, a hedge
against inflation means a retaining of purchasing powers or the value of assets. The concept of inflation
hedge suggests that investors’ earnings could yield a return that change with inflation rate changes, i.e.
what we could purchase or the wealth we own does not decrease through time. This assertion is consistent
with the position of Tarbert (1996) who demonstrated that one of the purposes of any hedge is to offset or
nullify risk. Furthermore, Kloosterman (2009) observed that assets which do not perform well as inflation
hedges, will exhibit return patterns that are negatively correlated with inflation. Therefore, the
effectiveness of an asset class in providing inflation protection is measured by its ability to reduce or
offset the loss in purchasing power resulting from inflation (Wurtzebach, et al., 1991).
Conner (2010) posited that the ‘real’ nature and ‘income characteristics’ of real estate make a strong
intuitive case for real estate’ ability to hedge against inflation. Property owners benefit not only from
rising asset values, which over the long term tend to track increases in replacement costs, but also from
increasing rents. Unlike bonds, which typically pay a fixed coupon, property cash flows generally offer
some protection against inflation, since most property leases contain rent escalation clauses and/or pass
expense increases through to tenants. This observation was congruent with the assertion of Ruhmann &
Woolston (2011) who asserted that real estate can provide a partial long-term hedge against inflation
contingent on their properties which are driven by two main factors: Rent or lease payments (which
typically increase with inflation in growth markets) and Land values and building costs (which also
typically rise with inflation).
Peyton (2011a) and Fiorilla & Halle (2011) further explained this notion by observing that several
characteristics of real estate investments contribute to its capacity to provide inflation protection; most
important is the structure of leases. The authors revealed that lease term is crucial in that rents are re-
negotiated at renewal. They also observed that if the local property market does not have a supply glut at
the time of renewal, the adjustment in rent is likely to catch up to inflation. They noted that shorter-term
leases can catch up more quickly than longer-term ones; this assertion was also confirmed by Amenc,
Martellinil & Ziemann (2008). In Nigeria, as well as in other parts of the world, rent review clauses have
steadily become a norm for any real estate investment. In more developed countries, the intervals are
longer, say, 5 -15 years for leases. However, in developing and unstable economies like Nigeria, with a
constantly increasing rate of inflation, the intervals within these rent review periods are relatively short.
Cash flows therefore move in step with overall price inflation and are protected from cash erosion
(Dabara, 2015). On the other hand, the assignment of expenses can also provide further inflation
protection for real estate investors. Some leases pass all expenses through to tenants, most commonly the
“triple net” leases on industrial space, while others pass through only some specified expenses as in the
common area of service charges and maintenance charges (Peyton, 2011b).
Conner (2010) identified the following as real estate’s fundamental investment characteristics: high
cash yields, low correlations with stocks and bonds and a hedge against inflation. The author further
explained that the principal arguments for including real estate (i.e., fully-leased, income-producing
 Daniel Ibrahim Dabara et al. 191

properties with little or no leverage) have included the following: Market Portfolio, Diversification, High
Yield, Attractive Long-term Performance, and Potential Inflation Hedge. Voigtlander & Demary (2009)
on the other hand offered some explanations as to the ability of real estate to hedge against inflation. The
author proposed that offices protect only partly against inflation, because worsening economic
perspectives (inflation) alleviate the demand for office space. The authour further stated that retail
property does not provide an inflation-hedge because retailers cannot shift inflation to customers. The
opinion of Voigtlander & Demary (2009) notwithstanding, there is a general consensus in literature that
real estate possesses certain properties that gives it the ability to hedge against inflation (Amenc et al.,
2008; Peyton, Park & Lolito, 2008; Conner, 2010; Ruhmann & Woolston, 2011; Payton, 2011a;
Fiorilla & Halle, 2011; Thambiah & Foscari, 2011).
The performance of real estate in markets across the world usually varies at any given time, for
reasons that include local economic factors and supply dynamics (Fiorilla & Halle, 2011). A number of
researches discovered divergent results with respect to the hedging capability of real estate. For example,
Fama & Schwert (1977) submitted that private residential estates in the U.S. were the only form of
investment that provided a complete hedge against expected and unexpected inflation when compared
with government debt instruments and returns on human capital. In Singapore, it was established that
commercial properties provided a complete hedge against inflation, as a matter of fact; the authors found
that returns from commercial real estate increases at a faster rate than the increase in the inflation rate
(Sing & Low, 2001). In a similar study carried out by Quingping (2008) in Taiwan, the author found that
residential properties was able to hedge against inflation in the long-run. Voigtlander & Demary (2009)
carried out a similar study covering Canada, USA, Finland, France, Germany, Ireland, the Netherlands,
Sweden and the UK. The authors found that investment in real estate equities does not provide a hedge
against inflation. Ma & Liu (2010) investigated the inflation hedging capacity of residential properties in
Australia; result from the study suggested that investments in residential real estate does not provide a
hedge against inflation in Australia. Similar tests had been conducted in: New Zealand (Zhou,
Gunasekarage, & Power, 2005), Hong Kong (Ganasan & Chiang, 1998; Mei-ling, 2003; Liu & Zhou,
2009; Zhe,2010), Switzerland (Hoesli, 1994; Hamelink & Hoesli, 1996; Liu, Hartzell & Hoesli, 1997),
China (Chu & Sing, 2004; Zhou & Clements, 2010), Canada (Newell, 1995), Sweden (Arnason, &
Persson, 2012), Korea (Park & Bang, 2012) and Nigeria (Bello, 2004; Bello, 2005; Odu, 2011; Akinsola,
2012; Ogunba, et al 2013; Dabara, 2014; Dabara, 2015). The divergent findings of the above studies
showed that there is no consensus with respect to the performance of real estate as a hedge against
inflation. This lack of consensus could be attributed to property type, location of property, realisable rate
of returns, varying timeframes, fluctuating economic conditions, and differences in microeconomic and
macroeconomic indicators among others (Odu, 2011).

Inflation-Hedging Characteristics of Real Estate, Relative to other Inflation-Hedging Asset Classes

Vast literature investigates the inflation hedging characteristics of various asset classes, including: direct
investments in real estate (Fama & Schwert 1977; Bello, 2005; Leung, 2010; Odu, 2011; Ogunba, et al,
2013; Dabara, 2015), commodities (McVey, 2010), stocks (Omotor, 2010; Nwode, 2012; Akinsola,
2012), equities (Ahmed & Cardinale, 2005; Voigtlander & Demary, 2009; Alexander & Shaun, 2009),
Bonds (Lomelino, Gillett & Komarynsky, 2010; Arnason & Parsson, 2012), real estate investment trusts
(Kloosterman, 2009; Zhou, 2009), gold (Worthington & Palahvani, 2007; Beckmann & Czudaj, 2012)
etc. These studies were carried out in a bid to establish which of these assets is/are the “perfect”
investment that hedges inflation effectively. In one of such researches, Alagidede & Panagiotidis (2007)
observed that in Nigeria a 1% rise in goods prices (rate of inflation) elicits 0.12% rise in stock returns.
Thus the stock market only provides a partial hedge against rising inflation in Nigeria. Similarly, Amenc,
et al., (2009) examine the inflation-hedging properties of real assets (commercial and residential real
estate) and its implication for asset-liability management decisions. The results of the study suggested that
real estate and commodities have particularly attractive inflation hedging properties over long- horizons,
which justify their introduction in pension funds' liability-matching portfolios.
192 Real Estate Investments and the Inflation-Hedging Question: A Review ...

CBRE-AD (2011) opined that on a relative basis, real estate is less volatile than other competing
asset classes and delivers higher returns, consequently outperforming other asset classes. Additionally,
real estate adjusts in the long run to provide protection in highly inflationary environments. This
characteristic lies in contrast to many competing asset classes which see their valuations dramatically
eroded by inflation. Real estate is an asset class that has performed well on an absolute basis and in
relation to other asset classes. This explains why in constructing a portfolio, it makes sense to include real
estate in order to maximize an investors risk and return profile (CBRE-AD, 2011). In line with the
foregoing, Conner (2010) argued that real estate’s long-term performance is still competitive with stocks
and bonds on an absolute risk-adjusted basis and that property yields are attractive and better, especially
when compared with other fixed-income instruments. Fiorilla & Halle (2011) on the other hand justified
the inclusion of real estate in a managers’ portfolio relative to other asset classes, base on the fact that real
estate enables investors to tap directly into the economy’s cash flows more directly than stocks or bonds,
which are filtered through the performance of companies. The authors submitted that publicly held real
estates in the U.S. has produced compelling returns over the past 10 years, despite the impact of the Great
Recession, outperforming stocks and bonds during that time.
The inflation hedging potential of real estate notwithstanding, studies that refute real estate’
outstanding performance as an inflation hedge, relative to other asset classes abound. McVey (2010) for
instance, asserted that for investors who keep their eyes on a shorter time horizon (say, 6-12 months),
commodities are better than real estate as an inflation hedging investment option. CBRE-AD (2011)
submitted that a key argument in favor of stocks in a mixed-asset portfolio relative to other asset classes
(real estate inclusive) is that they provide more liquidity than hard assets like real estate. In their opinion,
Lomelino, et al. (2010) asserted that from an implementation standpoint, inflation-linked bonds are
superior to other assets from a risk-based capital perspective. The authors explained that for an insurance
company, inflation-linked bonds provide the most complete inflation hedge in most economic conditions.
They believed that from a practical standpoint, inflation-bonds are much easier to implement, hence a
better investment choice than other inflation asset classes such as real estate.
Ultimately, different inflation hedging asset classes do have positive and negative aspects, it was
observed that there is no single inflation hedging asset that will work for every investor in every situation.
Hence, investors should exercise caution in the inclusion (or otherwise) of any asset class in their
investment portfolio. As to the question whether real estate performs as a better hedge relative to other
investment media, it is advisable that rigorous empirical research on all alternative investment options be
carried out (taking into account certain peculiarities such as: location, investment period, inflationary
trends, realisable rate of returns, varying timeframes, fluctuating economic conditions, and differences in
microeconomic and macroeconomic indicators, etc) and the result of such research work should serve as a
guide to investors with respect to the inclusion or otherwise of any investment media as an inflation-
hedging investment asset in any investment portfolio.

Investment Implication of Real Estate in an Inflationary Environment

Some studies have showed that real estate investments can offer protection from the ravages of inflation.
This has traditionally prompted investor’s interest in real estate when inflation fears flare up (Peyton,
2011a). Real estate presents a compelling opportunity for investors today. Not only does the sector
provide many long-term investment benefits, including healthy income returns and a hedge against
inflation, but fundamental factors such as the improvement of the risk/return characteristics of the overall
portfolio as well as the provision of diversification benefits (Thambiah & Foscari, 2011; Fiorilla & Halle,
2011; Dabara, Ankeli, Odewande, Guyimu, & Adeleke, 2014).
Conner (2010) and Peyton (2011a) observed that the case for investing in real estate looks
particularly attractive when viewed in the context of the current market environment, although it is not
without risk. The authors posited that perhaps the most obvious reasons why real estate merits inclusion
in an investment portfolio are derived from both cyclical and noncyclical factors – specifically, the
 Daniel Ibrahim Dabara et al. 193

favorable long-term outlook for real estate demand, from both users and investors, property cash flows
and real estate’s potential inflation hedging characteristics. The liquidity of real estate provides investors
the most efficient means to obtain exposure to real estate markets globally. The ability to trade daily not
only provides a useful tool for investors to create tactical allocations to the sector and global regions, but
it also provides a means to efficiently rebalance allocations as market conditions change. The ability to
rebalance investments makes portfolios more efficient (Fiorilla & Halle, 2011). Having real estate in a
portfolio will also help offset the effects of inflation over time, thereby preserving an investor’s
purchasing power (Mughees, 2010).
Peyton (2011a) suggested that the key to real estate investment’ performance is to construct
portfolios that are protected from supply excesses which impair the inflation protection otherwise
associated with real estate. The author reiterated that investors may benefit more by focusing on real
estate portfolios that promise stronger returns rather than concentrating on only beating inflation.

Summary of Findings and Conclusion

The study examined the inflation-hedging question of real estate investments. The study showed that
there is no consensus with respect to the hedging ability of real estate in the global market (this could be
linked to the fact that real estate markets are highly localized and dynamic). The study further suggested
that the ‘real’ nature and ‘income characteristics’ of real estate make a strong intuitive case for real estate’
ability to hedge against inflation. The real estate’ cash flows generally offer some protection against
inflation, since most property leases contain rent escalation clauses and/or pass expense increases through
to tenants. Similarly, the ability of real estate rental and capital values to appreciate with time provides a
basis for it to co-move with inflation. There is also no consensus as to whether real estate performs better
than other investment media. However, there are compelling reasons to invest in real estate. One of such
reasons is tied to real estate’s risk-return as well as its diversification characteristics. It is imperative that
an investor have up to date and reliable information on the performance of real estate before committing
investment funds into real estate. This could be realized through empirical test of various sub property
markets with respect to its inflation-hedging question.

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