Academic journal article The Journal of Real Estate Research

Real Estate Returns and Inflation: An Added Variable Approach

Academic journal article The Journal of Real Estate Research

Real Estate Returns and Inflation: An Added Variable Approach

Article excerpt

Michael T Bond*

Michael J. Seiler**

Abstract. This study analyses the inflation hedging effectiveness of residential real estate over the 1969-94 period. The results indicate that residential real estate is a significant hedge against both expected and unexpected inflation. These results indicate that since financial assets are not good inflation hedges in periods of high unexpected inflation, including real estate in a portfolio should decrease the variance of the portfolio returns. These results were made possible by the use of the Added Variable Regression Method (AVRM), a measure which has yet to be employed in this context. There are nine variables included in the AVRM framework which are also found to have significant explanatory power relative to residential real estate returns.


The reason for holding a diversified portfolio of assets is to decrease the volatility in returns when market factors change and to provide an investor with a positive real rate-of-return. Since diversification can be achieved without real estate, why should investors hold real estate in their portfolios?1' Financial assets, such as common stocks and bonds, have been found to be poor performers when inflation is higher than expected.2 Therefore, if real estate is an effective hedge against unexpected inflation, then it should likely be included in efficient portfolios.

The purpose of this study is to determine the inflation hedgeability of residential real estate and the implications that result relative to the inclusion of real estate in efficient portfolios. Residential real estate returns will be related to inflation, both anticipated and unanticipated, and noninflationary components using an added variable methodology which has yet to be used in this area of research. By separating returns into these various components, the inflation hedging effectiveness can be better understood.3

The next section reviews the relevant literature. The third section contains the explanation and reasoning for employing the added variable methodology. The fourth section describes the data set. The results are presented in the fifth section. The final section discusses the implications of the results.

Literature Review

A voluminous amount of literature exists concerning the ability of securitized real estate to hedge inflation. Studies by Gyourko and Linneman (1988), Goebel and Kim (1989), Murphy and Klieman (1989), Chan, Hendershott and Sanders (1990), Park, Mullineaux and Chew (1990) and Liu and Mei (1992) are prime examples. However, little work has been done on the inflation hedgeability of unsecuritized real estate. Thus far, only papers by Fama and Schwert (1977), Fogler, Granito and Smith (1985), Hartzell, Hekman and Miles (1987) and Rubens, Bond and Webb (1989) have attempted to rigorously examine this issue.

Fama and Schwert (1977) test the inflation hedgeability of residential real estate, Treasury bills, corporate bonds, government bonds, common stocks and labor income. They conclude that private residential real estate is a complete hedge against both expected and unexpected inflation. However, several problems exist with the data. First, the only type of residential real estate considered is FHA-insured single-family homes. Second, a lag relationship exists between when the FHA collects the data and when the data is reflected in the Consumer Price Index (CPI). Finally, the results of the study are probably due to a high correlation between the return on residential real estate and the rate of inflation.

Fogler, Granito and Smith (1985) study the relationship between real estate returns and the inflation rate. Two possible explanations are offered for the observed positive relationship. The first is that there is a positive relationship between the two variables. Second, it is the result of changing investor expectations concerning the inflation hedgeability of real estate. …

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