Is real estate a shelter from inflation? Not always.

Is real estate a haven from inflation? It depends on. Today’s prices may be too high for certain types of properties to offer much protection against rising prices.

Real estate has a long history as an inflation hedge, based on the principle that income generated by buildings tends to keep pace with consumer prices. A survey conducted by commercial real estate services company CBRE showed that rents in the UK grew in line with inflation from 1981 to 2020. However, the results were very mixed depending on the type of property. Of the 14 property sub-sectors in the survey, half experienced a decline in fixed rents.

Not all investors seem to see real estate as defensive today. Allocations of U.S. real estate equity funds, a guideline for sentiment among professional money managers, have fallen to 2.4%, from 3.1% before the pandemic, according to data from the Emerging Portfolio Fund Research. Global allocations have also fallen. Meanwhile, the influx of listed real estate funds, a better proxy for attitudes among retail investors, is increasing.

Real estate provides the best return when prices rise at a moderate pace in response to healthy economic growth. For listed real estate investment funds, the sweet spot of inflation is 2% to 3.5%, according to UBS analyst Charles Boissier. Under these conditions, owners find it easier to raise rents, while a buzzing economy creates demand for commercial real estate and lowers vacancy rates.

But when inflation rises above 4%, a level that the US passed in April last year and the eurozone in October, some real estate stocks have historically struggled to outperform the broader market. Today’s inflation is difficult to hedge because it is driven by more expensive commodities, labor and energy, which are starting to hurt growth.

The Fed estimates that the economy will grow by 2.8% in 2022, down from the 4% that the central bank predicted in December. If a slower economy reduces the demand for space from tenants, it will be difficult for landlords to raise rents. The outlook for rent growth is important, as higher interest rates may make it harder to keep up with inflation through capital increases.

Recent agreements provide clues as to what types of real estate stocks may be a safer game. Property buyers are most optimistic about housing and logistics, where supply is tight. In the last quarter of 2021, 45% of all investment in commercial real estate in North and South America was in multi-family homes, compared to an average of 28% during the four years before the pandemic, based on CBRE data.

Lack of housing is pushing up house prices in many developed markets, so fewer people can afford to buy and have to rent. Landlords have been able to increase rents in the U.S. by about 18% over the past two years, according to Redfin data. REITs including American Homes 4 Rent and Invitation Homes have performed significantly better than the S&P 500 since inflation reached 4% this time last year.

The picture is more mixed in Europe. German housing stocks including Vonovia and Deutsche Wohnen, which are usually popular with investors, have lagged behind the country’s DAX index this year, as government regulations limit how much landlords can increase rents.

Unemployment is also at a record low for e-commerce warehouses in both Europe and the US, which should make logistics robust. In its first-quarter update, warehouse owner Prologis said they expect to raise rents by about one-fifth in both the U.S. and abroad by 2022, thanks to strong tenant demand.

“It’s definitely there [other real-estate] sectors that will not benefit … because they have no leverage to pull to fight inflation, ”said David Grumhaus, president of Duff & Phelps Investment Management. The outlook for some office and retail assets is poor. Landlords who have high exposure to oversupplied office markets like Manhattan and San Francisco will struggle to raise rents as a shift to teleworking reduces the demand for space. Low quality shopping malls also have very little pricing today.

European office and retail REITs may be an exception, as commercial rents on the continent are usually indexed to inflation. This gives investors protection on paper, although some analysts are skeptical that landlords will be able to enforce increases. Nevertheless, Europe’s major shopping center owners Unibail Rodamco Westfield and Kleppiere have achieved 10% and 12% respectively this year, compared with declines of more than a fifth for US counterparts Simon Property Group and Macerich..

Historically, European REITs have delivered better returns than peers in other regions in times of high inflation, based on a UBS analysis.

Real estate can provide shelter in times of inflation, but only if supply and demand trends are favorable. Real estate investors should be picky about the neighborhoods they buy in.

Write to Carol Ryan at carol.ryan@wsj.com

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