When it comes to assets with a reputation for protecting a portfolio against inflation – inflation-linked government bonds, commodities, gold, prime real estate – a newly constructed grey-paneled warehouse in the southeast section of London, England, may not be the first thing that comes to mind. But according to Marc Mogull, Chairman and Chief Investment Officer of PineBridge Benson Elliot, that may simply be because, after 30 years of generally low inflation and declining interest rates, many investors have become less conditioned to where and how to look.
Although recent data suggest inflation may have peaked in the US and Europe, Mogull is among the observers who see a quick return to pre-pandemic lows as unlikely. The reasons are many: from rising energy costs, which will likely persist even after the eventual end of the Ukraine war as the Continent accelerates its move toward more sustainable energy sources; to changing geopolitics that decrease supply chains’ focus on low-cost comparative advantage; to the post-pandemic shrinking labor pool; to Brexit frictions. Does that mean inflation will keep running indefinitely at the 4% to 7% forecast for 2023? Probably not, says Mogull, “but if I were weighing the over-under for the next few years against the favored 2% central bank inflation target, I’d take the over.”
Persistent worries about inflation have led, in turn, to persistent attention on inflation hedges, including real estate. And yet Mogull notes that in the present environment many real estate investors are of two minds – undecided about whether they should reduce their exposure to real estate because of the threat to capitalization costs posed by rising interest rates; or increase their exposure because of real estate’s purported inflation-fighting features.
In Mogull’s view, neither side of the argument frames the question quite correctly. In the same way that inflation is not one monolithic phenomenon, but a collection of varied forces working through different mechanisms of the economy, “real estate” or even “prime real estate” are too-general terms that have little bearing on what investors hold, or should be holding, in their portfolios. “Real estate isn’t a reliable inflation hedge,” says Mogull. “It’s the inflation-hedging attributes embedded in select real estate –rather than the asset exposure itself – that we need to be targeting to secure the protection we’re seeking.” It’s in this context that a “last-mile” logistics warehouse in a newly bustling industrial area just 18 miles from Central London may have all the attributes an investor needs.
To better appreciate the importance in today’s environment of a more granular approach to real estate investing, it helps first to review the basic principles of real estate valuation. Where does a property get its value? On the positive side (I in the numerator below, for those who don’t mind revisiting their Introduction to Real Estate class), there is the income a property generates through rents after any non-recoverable expenses, such as energy and maintenance costs, are taken out. On the flip side (the denominator), there’s the present value of the cost of capital for financing the project. This is itself a function of interest rates (hence the abbreviation R), but also the potential future growth in the property’s rental value. In other words, the more income you can expect to earn in rents from your property in the future, the lower your current financing costs will seem in relation, and therefore the smaller the denominator – and, potentially, the higher the value of your property.
Through this one simple equation, we can start to see all the different ways that inflation can affect a property’s value, and, conversely, how a property may (or may not) act as an inflation hedge. Inflation can allow a property owner to charge higher rents, which is good for the property’s value, but also increases utility bills (not so good). And higher inflation tends to correlate with higher financing costs (bad). On the other hand, when inflation is associated with higher economic growth, future rental value can more than offset today’s higher interest rates (also very good).
A last-mile logistics warehouse could check almost all the right boxes. This property in southeast London is designed to coordinate the delivery of packages from large regional distribution centers to their final destinations. This is the costliest part of a logistics chain to service, and therefore offers the greatest opportunity for warehouses in locations that allow distributors to trim those costs through efficiencies and proximity to more end customers. The land underneath the property is thus intrinsically valuable to the logistics sector, which increases the land acquisition costs. But there is an ancillary potential benefit to that: when land represents a significant component of the total development cost (and the ultimate value of the property), there is less sensitivity to building costs, which, in the UK, have reached a 40 year high.1
And these projects could have other positive inflation-fighting attributes. They’ve been built to the highest environmental specifications, including a zero-carbon footprint, which not only aims to help protect against energy inflation today but also takes potential future conversion costs off the table as green standards continue to tighten.
But perhaps most important is how well situated these warehouse properties are anticipated to be in relation to real rental growth, the key denominator-squashing component in the equation above. Despite the likelihood of inflation continuing to run hotter than it has in recent decades, most economists predict that economic growth in the UK and Europe could be equally stubborn in heating back up. Yet, last-mile logistics is one of those “seams” of economic activity, as Mogull puts it, where growth – and with it, real rental growth – is believed to be higher than in the economy at large. It’s part of what’s come to be known in real estate circles as the “Tiger Trade” – as in grr for green and growth.
These same principles can be applied to other sectors of the economy as well when searching for properties with more of the attributes investors are looking for and fewer of those they’re not. For example, many investors have traditionally been attracted to commercial real estate for its fixed-income-like attributes – the ability, through long-term leases with stable tenants, to lock in a dependable income stream over extended periods of time. This was especially appealing during an era when the costs of financing and refinancing a project were generally trending down. However, in an era of higher inflation, long-term leases can become a burden that prevents rental income from keeping pace with rising costs. Indexing a lease to inflation can help ameliorate this, but only if the growth in tenants’ industries allows them to continue to afford the periodic rent hikes. If not, it will mainly serve to increase turnover and vacancies, potentially blowing large holes in the building’s cash flow.
For these reasons, attention has been shifting to other parts of the market where the tenants are (much) smaller, leases are short by design, and turnover costs are modest, delivering an ability to re-price the space more frequently. These include sectors like rental housing (where, in addition to the perpetual supply constraints on suitable sites in popular neighborhoods, rising home mortgage rates are spurring higher rental demand) as well as student housing and self-storage.
Single-family rentals are another potentially attractive area. As attractive as large rental properties can be, they do have one problem: greater vulnerability to rising energy prices. Such projects, after all, tend to have large common areas that need to be heated and cooled (and for student housing, utility costs are often included in the rent). Single-family housing has no common areas and lower operating expenses, so it’s less impacted by rising materials costs and maintenance wage rates.
“Prime” office space is another area of focus, although the definition of the term has evolved somewhat in recent years. “One thing that’s changing historical thinking is the accelerating pace of product obsolescence,” says Mogull. In particular, occupiers’ ever-increasing sustainability requirements have drawn legacy owners into what he calls a “value-destroying green arms race,” which can erode a property’s internal rate of return if owners aren’t careful about how they manage the conversions and interruptions to cash flow. Mogull favors a selective approach that looks at properties on the more opportunistic end of this race: “brown” buildings with heavily discounted acquisition prices that leave plenty of room for a full-on green makeover. Barring that, it can be more favorable to start fresh with new builds, while maintaining a long-time focus on scarce city-center locations, which, as always, should appreciate faster than suburban and exurban spots.
Building a real estate portfolio that’s resistant to inflation can sound very defensive: investing in properties resistant to rising energy and wage costs, in locations where the land represents a higher percentage of the value; focusing on lower-margin parts of the market, where per-tenant income is lower but pricing power is higher; and venturing gingerly (for now) into eliminating the carbon footprint of much existing built space, which represents a huge potential future opportunity. And yet, at the core of any good inflation-hedging strategy is another element that is all about going (and staying) on the offensive: tapping into those seams of economic growth that can ultimately trump any of the more corrosive attributes of rising interest rates and costs.
The good news, for those with discretionary capital, is that as the current cycle of slowing demand and higher refinancing costs grinds on, and more properties in distress hit the market, starting valuations are also coming down, providing an even more solid foundation on which to build an all-weather strategy. Finding properties that check the right boxes “won’t be difficult this year,” Mogull says. “The challenge will be combining the power of patience with the courage of conviction to make the right investment choices.”
1Data as of 19 November 2021, RICS Construction materials cost increases reach 40-year high (rics.org)
This material was prepared by PineBridge Benson Elliot for educational purposes only. The information contained herein may not be replicated, reproduced, distributed or provided to any other party without the prior written consent of PineBridge Investments. Opinions expressed herein are solely those of investment manager and may differ from the views or opinions expressed by other areas of PineBridge Investments. This material is for informational purposes only and does not constitute: (i) research or a product of any research department, (ii) an offer to sell, a solicitation of an offer to buy, or a recommendation for any investment product or strategy, or (iii) any investment, legal or tax advice. Any opinions, projects, forecasts and forward looking statements contained herein are speculative in nature, valid only as of the date hereof and subject to change. All investment strategies involve risks, there can be no assurance that the investment objectives of any particular strategy will be met in any particular circumstances. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed and no independent verification of the information has been obtained. See Global Disclosure Statement for more information.
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