With inflation at 40-year highs and a monetary policy tightening cycle commencing, investors understandably have questions about portfolio positioning as markets and economies reach an inflection point. When it comes to real estate, these questions can be distilled down to a core conundrum: Should I reduce exposure to real estate because of the threat to yields and capitalization rates posed by rising interest rates? Or increase exposure because of real estate’s perceived inflation-hedging properties?
Resolving this conundrum becomes easier if – as with most big questions – we break it down into its constituent parts, take account of the thinking and research that has already been done, and then make reasoned judgments about what makes today different from yesterday – that is, what might handicap past experience as a predictor of future events?
In answering these questions, we looked to dismantle three key myths in the real estate market, while underscoring the reality of the market – and why it’s critical to seek capital growth-driven strategies that can meet the challenge of rising inflation.
Real estate is widely perceived as an effective hedge against rising inflation. But is this view borne out by historical experience? As Susan Hudson-Wilson, author and founder of Property & Portfolio Research and long-time fellow of the Real Estate Research Institute wrote in a 2007 paper, “The conventional wisdom that real estate, as an asset class, is an effective inflation hedge is overly generous.”1 And four years later, a landmark paper commissioned by the UK’s Investment Property Forum (IPF) found that “the observed relationship between inflation and asset returns may be spurious due to missing variables, such as measures of real economic activity.”2
The key contribution of the IPF work was to look critically at the distinction between correlation and causality in the observed relationship between inflation and asset returns. In essence, they asked, if we observe a relationship between inflation and asset prices, is that the product of one acting upon the other, or is it a reflection (coincidence?) of both being acted upon by a third force: real economic activity?
What the IPF research team observed is that periods of elevated inflation are often associated with periods of above-trend economic growth. Hence Hudson-Wilson’s thesis that our conventional wisdom of strong real estate performance being associated with periods of high inflation may really just be evidence that strong real estate performance is driven by strong economic growth – which itself is often accompanied by higher rates of inflation (“demand-pull inflation”).
The IPF researchers noted that even where the statistics implied that property provided a technical hedge against inflation, the data did not necessarily indicate that an increase in inflation would coincide with an increase in nominal returns – that it would depend on the path of GDP growth.3
So what might this tell us about episodes of high inflation absent strong economic growth: i.e., stagflation? The table below helps answer that question: Over the past 40+ years, the annualized performance of US real estate in a high inflation/low GDP growth environment has been less than a third of what has been achieved in a high inflation/high GDP growth environment.
Source: Franklin Templeton, “Private Real Estate as a Hedge against inflation,” December 2021.
The IPF researchers summed it up well: “The High Inflation-Low Growth scenario is particularly bad for property. This implies that cost-push inflation, such as when commodity prices are rising faster than retail inflation, is not favourable.” And as the chart below shows, that’s exactly what we’re facing now: producer prices are rising well ahead of consumer prices.
Source: Office for National Statistics as of December 2021.
So should investors consider exiting the asset class? Definitely not, in our view. What it does mean, though, is that market participants should understand how this asset class – and specific subsectors within the asset class – are likely to be affected by the economic forces that lie ahead, and position themselves accordingly. It’s not going to be as simple as “buy the market” (as it has been, to a great extent, for the past decade) if the broader market may underperform.
Hudson-Wilson’s paper asserts that there are “multiple places for inflation to play a part in determining the total return of a real estate asset – through the growth of rental and other revenue, through the growth of expenses and the issue of who bears those expenses, and through the capitalization rate (initial yield, using real estate lexicon), where income is transformed into value by the capital markets.” All these are areas where an experienced manager can have an outsize impact on investment decisions that will drive performance.
In this environment, real estate investors may also be asking about the share of their portfolio lease streams that include Retail Price Index (RPI) indexation clauses. To that, we would caution against using this metric as a reliable inflation protection indicator without closer examination.
In considering how a subsector of the real estate asset class, or a particular property, may protect investors against the risk of inflation, estimated rental value (ERV) growth is what’s relevant: Are the characteristics of the sector or asset (including local supply/demand dynamics) such that increases in inflation are likely to be absorbed through higher nominal rents when the relevant lease income stream next resets to match the market?
Individual properties may have an indexation feature that insulates them in the near term from an erosion in real income, but that near-term protection can be dwarfed by the prospects for market rents when the subject lease expires. Without corresponding growth in ERVs (market rents), the benefits of a short-term uplift in income (i.e., a move toward an over-rented asset) will simply be offset by a corresponding uptick in the next investor’s (or valuer’s) required yield: In simpler terms, above-market income will be discounted rather than capitalized.
There is an exception, of course: very long-term, indexed leases. For these distinct properties, the present value of the residual can, in extremis, become de minimus.
A word of caution, though: Recent experience in the UK has shown that these constructs can bring with them a different set of risks – in particular, legal or regulatory risks. One of the UK’s largest income-generating REIT’s saw its share price cut by more than half between February 2020 and May 20204 as the market contemplated threats to the company’s supposedly secure income streams from a wave of company voluntary arrangements (CVAs) that shook the hospitality, leisure, and retail sectors. That risk will always exist for operational real estate (i.e., subsectors where the use of the property represents a profit centre for the occupier rather than a cost centre).
In any event, long income in non-operational real estate is becoming less and less a feature of the sector. The average lease length in offices (still the largest investable sector in the real estate universe)5 has shortened steadily over the past 40 years (see chart), and in the UK is now just 5.8 years. And while longer leases may still be common in operational real estate, those long leases may prove mirage-like if their security or sustainability are ultimately driven by the success or failure of the underlying business.
Source: MSCI, As of December 2021.
And there’s a further caution for investors seeing current cash flow – in particular, indexed current cash flow – as their safe port in a storm. Much of that instinctive thinking is an understandable response to past experience. Historically, the lion’s share of nominal returns from property (around 70% in the UK) has been derived from income. That’s the fixed income aspect of real estate, long recognized as a hybrid investment instrument. But who wants to be long fixed income when inflation is rising?
Source: MSCI as of December 2021
An upward shift in inflation expectations since late 2020 has hammered bond prices, with global bond markets suffering their deepest downturn since at least 1990.”6 The price of 10-year UK gilts has fallen around 14% peak-to-trough in that timeframe, equating to about 140 years of notional income (calculated from trough yields in 2020).7 This highlights the asymmetric risks of fixed income-type investments as we approach the zero bound – something property investors need to consider carefully as yields in our sector bounce along the floor.
Surprisingly, looking at rental growth in real estate from 1981 to 2013, 11 of 13 subsectors delivered negative real rental growth (with offices being the worst offenders).8 In their work on the same topic, and using IPD (now MSCI) UK All-Property data, the IPF researchers concluded that “There is a clear positive relationship between capital growth and inflation and no obvious relationship between income returns and inflation.”
Yes, income may drive total returns in real estate most of the time, but in periods of elevated inflation, that relationship breaks down. In the high-inflation period bookending the 1970s (1967 to 1981), 63% of total returns from real estate were derived from capital growth rather than income.
Source: IPD, Office for National Statistics, and Oxford Economics as of 2011.
We see strong arguments against choosing this moment to redeploy from value-add/opportunistic strategies into income-driven core/core-plus strategies. How is now the time to pile into standing assets, in pursuit of a modicum of short-term real yield protection (through indexation), at the cost of exposure to the asymmetric risks of mean reversion in yields and escalating exposure to product obsolescence?
Those fortunate enough to own 30-year indexed leases, with strong covenant tenants in secure businesses, are likely safe, in our view. But for more common lease durations, we believe investors will need to look elsewhere for inflation protection that doesn’t come wrapped in other risks. Specifically, they’ll need to consider what drives (the real rate of rental growth) in what timeframe that growth can be captured, what drives expense growth, and who ultimately shoulders those expenses. That’s a crucial part of the mechanism through which, as Hudson-Wilson put it, “income is transformed into value by the capital markets.”9
Growth drives demand, and demand growth married to supply constraints (or sticky supply responses) drives real rental growth. In the current environment, if economic growth (broadly defined) is destined to slow, the imperative is to search for those pockets of economic activity – and related property subsectors – that will thrive even as economies otherwise slow: urban logistics, life sciences, and housing, to name just a few.
The issue of the timeframe in which growth can be captured is an interesting one. Hotels were once the clear winners here, with their nightly turnover allowing operators to reprice space every 24 hours. Now short-term uses are possible for many asset classes (presuming, of course, that the benefits of rebasing rents, aren’t outweighed by the costs of those efforts).
Part of the current appeal of sectors such as rental housing, student housing, or self-storage is the strength of their underlying fundamentals combined with the ability to reprice product quickly (and with modest turnover costs).
But as we see cost pressures growing, in an increasingly cost-sensitive environment (among occupiers/users), the quantum of these costs, and who bears them, also becomes a critical consideration. Net leases should outshine gross leases, ostensibly favoring sectors characterized by such structures (e.g., most commercial types, at least in the UK and Europe), but again, since users will be driven by total occupational costs, the ability of landlords to sustain rents in the face of increasing operational costs borne by tenants will ultimately be determined by market forces.
As we watch energy costs skyrocket, we’re seeing a noteworthy impact across the various rented housing types. Traditional multifamily dwellings, with their large common areas and accompanying energy requirements, are struggling with eroding operating margins. For student housing, the situation is even more worrying, with utility costs – by far the largest component of operating costs – often included in the rent.
Source: The Unite Group, Annual Report 2021. Grainger PLC, Annual Report 2021. The PRS REIT plc, Annual Report 2021.
Rented single-family housing, on the other hand, has no common areas and consequently has far less exposure to this issue. Moreover, other operating expenses tend to be lower in rented single-family housing than in multifamily (building maintenance, in particular), so these investments have been less affected by rising materials costs and wage rates. And we’ve observed clear demand for single-family product, as discussed in our recent commentary, “The UK’s Build-to-Rent Market Offers Solutions to Investors and Home-Seekers Alike.”
As we enter this altered global environment, marked by rising inflation, rising interest rates, and slowing growth, investors are looking for “protection” in real estate. And in a sector where institutional portfolios are under-allocated by a wide margin, capital flows to the sector are growing and investor sentiment is increasingly bullish.10
Investors are essentially bidding down the risk premium they demand for investment in real estate, in search of a perceived inflation hedge and juicier returns than they can find in fixed income (especially in Europe). And why shouldn’t they? Breakeven inflation has been creeping up since the onset of the pandemic and has spiked since the Ukraine invasion, and real interest rates in the UK and Europe are at historic lows, and deeply negative.
Yet while returns from the real estate asset class have historically derived primarily from income, we’re now confronted by the IPF researchers’ conclusion highlighted earlier: that “There is a clear positive relationship between capital growth and inflation and no obvious relationship between income returns and inflation”12
Successful real estate investors will need a new game plan – one that delivers inflation protection in a low growth environment, in a sector that’s highly exposed to the challenges of the sustainability agenda, and where historically low yields – after more than a decade of quantitative easing – expose investors to an asymmetric array of outcomes as rental growth trajectories plateau and monetary policy normalizes. This new game plan can’t be built around income-driven strategies: It has to be underpinned by capital growth-driven strategies.
These ideas have been shaping our investment thinking for some time now, and are why stagflation, sustainability, and the risks associated with ultra-low property yields remain top of mind. In a stagflationary environment, we’re looking for exposure to “cycle-agnostic growth” or “needs-driven demand,” both of which still need to be underpinned by supportive micro-market conditions. There will be pockets of solid demand even in a weak economy. We’re looking for growth that can outpace – or at least keep pace with – rising inflation: we’re looking for pricing power.
For more insights, please visit our Real Estate Investing page.
1 Private Commercial Real Estate Equity Returns and Inflation. Haibo Huang and Susan Hudson-Wilson. The Journal of Portfolio Management Special Real Estate Issue 2007, 33 (5) 63-73; DOI: https://doi.org/10.3905/jpm.2007.698906
2 Property and inflation, Research Report commissioned by the Investment Property Forum Research Programme, April 2011.
3 Property and inflation, Research Report commissioned by the Investment Property Forum Research Programme, April 2011.
4 Bloomberg Finance L.P.
5 JLL, Global Real Estate Perspective March 2022.
6 Financial Times, Bond markets in historic downturn as central banks battle inflation, published 24 March 2022.
7 Bloomberg Finance L.P.
8 Baum and Hartzell (2012), Global Property Investment, Wiley-Blackwell.
9 Private Commercial Real Estate Equity Returns and Inflation. Haibo Huang and Susan Hudson-Wilson. The Journal of Portfolio Management Special Real Estate Issue 2007, 33 (5) 63-73; DOI: https://doi.org/10.3905/jpm.2007.698906
10 Hodes Weill & Associates, 2021 Institutional Real Estate Allocations Monitor.
11 The real interest rate represents the yield on the benchmark 10-year inflation-linked government bond for each country, as at 25 March 2022, as indicated on Bloomberg.
12 Property and inflation, Research Report commissioned by the Investment Property Forum Research Programme, April 2011.
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