TIPS vs. REITs: The better inflation hedge battle

After more than three decades working with real estate, I've learned a thing or two about the trade.

You kinda have to after you’ve developed enough properties, negotiated enough leases, and borrowed enough money through various interest-rate cycles.

Along the way, of course, I’ve watched the cost of land, labor, and material move higher and higher. The greenback just isn’t worth what it used to be, with $1 in 1990 having the same purchasing power as $2.56 today.

Even so, I’ve also seen how inflation isn’t always real estate’s enemy. In fact, the right properties in the right locations with the right management can actually benefit from inflation as:

And in the case of top-notch real estate investment trusts (REITs) – as my regular readers know full well – those higher cash flows can translate into higher dividends for faithful shareholders.

But as much I appreciate REITs, they're not the only publicly traded category that can serve as an inflation hedge. There are also assets like Treasury inflation-protected securities, or TIPS.

The latter is designed to preserve purchasing power. The former is designed to grow it. So they serve distinctly different investment roles.

That leads many people (particularly retirees) to wonder which one is better, especially as prices continue to rise.

So let’s discuss both TIPS and REITs – and why there might be room for each in your portfolio.

The REIT vs. TIPS debate is especially timely considering the bond market, which is flashing warning signs these days.

After months of government bonds selling off, Treasury yields are sharply higher thanks to everything from inflation concerns to federal deficits to more fiscal stimuli now being discussed. And all of this has increased borrowing costs even further.

The 10-year is actually approaching levels we saw during the 2008 Financial Crisis. And long-term yields have climbed toward multiyear highs.

That matters since the 10-year Treasury can be considered the world’s most important interest rate. Mortgages… corporate debt… commercial real estate financing… all of these (and other) kinds of credit are influenced by it.

So when the risk-free rate approaches 5%, it changes the game:

On the plus side, this does make some other assets more attractive… like TIPS, which are U.S. Treasury securities with principals that adjust alongside the Consumer Price Index (CPI).

When inflation rises, so do they; and interest payments are then calculated using that modified principal. So, unlike REITs, they offer explicit, U.S. government-backed inflation protection.

That does mean their yields weren’t nearly so attractive during ultra-low-rate eras like we saw in 2020. But those days have passed for now, with TIPS currently offering some very appealing numbers along with a price stability REITs just can’t compete with.

We saw how far shares of real estate companies could fall during 2008, 2020, and the 2022-2023 period as interest rates rose. It isn’t always fair or logical how that happens, but that’s Mr. Market for you all the same.

That’s why TIPS have a clear advantage for those most interested in principal stability and inflation protection.

Yet there’s a downside, too, since TIPS don’t grow. They have no rents to raise, occupancy to encourage, acquisitions to add, or cash flow to reinvest.

REITs, when well-managed, can increase their adjusted funds from operations (AFFO) per share – and therefore their dividends as well. This means they’re not mere yield-based investments.

They're operating businesses backed by real estate.

Now, some of these operations do better than others at protecting investors from inflationary forces. Take net-lease REITs such as Realty Income (O) and Essential Properties Realty Trust (EPRT), which work with pretty long leases.

Contracts like that tend to offer significant stability. However contractual rent escalators can also lag sudden spikes in inflation. So, as always, there’s a give and a take.

Back when Treasury yields were near historic lows, equities and real estate were the best places to generate meaningful income. But today’s calculations are different.

The hurdle rate has been raised. REITs have a lot to compete with now that Uncle Sam is offering such attractive yields with essentially no credit risk.

This means investors have to be more selective than ever if they want to come out ahead.

For instance, consider buying a high-quality REIT yielding 5% with AFFO per share that’s growing around 4% annually. If its valuation multiple remains roughly unchanged, your potential long-term return will be about 9%.

That's attractive. Probably worthwhile, too.

But compare that to a REIT with an overleveraged balance sheet. Under these higher-rate conditions, it might have a 6% yield, but its AFFO is probably declining and its dividend is at risk.

Back before Treasury yields rose, it was easier to get duped by unwise management decisions and poor property placements. But I consider these more “difficult” times a great chance to learn a thing or two about wise choices.

This is the time to demand nothing less than quality investments.

It’s also the time to realize that demanding nothing less than quality investments should be our normal way of operating.

This brings us right back to our original question of whether to own REITs or TIPS. Which one is the wiser choice?

To answer that question, imagine two retirees, each of whom have $10,000. One buys TIPS; the other a diversified basket of high-quality REITs.

When purchased appropriately and held to maturity, TIPS provide certain inflation protection and known real yields. And both of these are valuable attributes.

At the same time, while that $10,000 REIT portfolio could drop to $8,000 during a bear market… each individual company should keep growing anyway. In which case, investors who hold onto them through the volatility should not only see their stock prices bounce back – and then some – but they should also collect faithful dividend increases that add up very nicely over 10 or 20 years.

So why not own both?

Really, I think that framing the debate as an either-or determination – TIPS vs. REITs – misses the larger point.

After all, most investors, no matter their age or occupational status, need a balance of both growth and stability. So TIPS can serve as a portfolio’s anchor while (the right) REITs (at the right price) can act as its engine.

That’s a balance I can live with.

Especially in these turbulent times.

Happy SWAN investing!

Brad Thomas
Editor, The Wide Moat Daily