Real estate in an era of inflation

Real estate in an era of inflation

In a climate of rising inflation, real estate investments can offer attractive returns.

Rising prices are now a global concern. And when inflation rears up, there are few places for investors to hide. Real estate could provide a partial hedge. Particularly at a time when there is great uncertainty, not only about inflation and growth, but also about geopolitics, Covid and more.

In times of economic turbulence, people have tended to turn to real assets – including bricks and mortar – as tangible stores of value. A similar logic applies when inflation is spiralling higher. 

Real estate is by no means a perfect hedge against inflationary pressures. But over the long term, rents and property values do tend to rise alongside other prices, giving real estate returns a positive correlation with inflation.

When inflation heats up, there are few places for investors to hide. Real estate could provide a partial hedge.

Of course no period in history is the same. However, we believe the current circumstances provide a backdrop that also looks supportive for real estate, in particular versus other asset classes. This is for several reasons. Firstly, although global growth has slowed, there is pent up demand for commercial and residential property in most sectors. This comes after a two-year period in which the supply of new buildings virtually ground to standstill due to a Covid-inspired hiatus in construction. 

Secondly, while there is uncertainty over whether central banks can strike the right balance between controlling inflation and avoiding recession, there is broad consensus on one point. Inflation is expected to outstrip interest rate rises, particularly in Europe. This imbalance is good for heavily indebted governments as it effectively devalues their debt burden. And it is also helpful for real estate as inflation helps push up rents, while the cost of financing increases at a more modest pace. This dynamic should, in turn, help keep a lid on capitalisation, or cap, rates – effectively the yield on real estate, measured as a ratio of net operating income to property value – and support real estate prices.

In our experience of previous rate hike cycles, interest rates need to rise by more than 150 basis points before that feeds through into cap rates. Today, even after the recent hawkish comments from the European Central Bank, markets are pricing in only 75 basis points of hikes by year-end.1

Pricing power

Location and sector choice are very important when it comes to the inflation sensitivity of real estate. For an investor, it makes sense to focus on areas where rents are indexed to inflation and where tenants are able to afford any likely increases. Some businesses can more easily absorb higher rents than others, particularly those for whom they are only a small fraction of their cost base. And in many cases, it depends on the industry in which they operate. Research by Prologis, for example, shows that in the logistics sector, real estate accounts for less than 5 per cent of the cost basis of firms, and just 25-50 bps of revenue.2

Flexibility in pricing is important too. Hospitality stands out in this regard, with the ability to adjust the cost of hotel rooms, for example, on a daily basis. Of course, they are still dependent on consumers accepting the prices set and we believe the recovery in hospitality will be uneven. But, with pent-up demand after two years of pandemic-related lockdowns and restrictions, we believe that some segments – particularly at the high end – should hold up well. 

In residential sectors, the situation is more complicated. There is a limit to how much people are able to pay in rent, and in some places rents are further capped by regulation (Ireland, for example, has recently implemented a 2 per cent per year limit on residential rent increases).  However, against a general backdrop of housing shortages, the right property, at the right price point, in the right area should still do well.

Green boom

The type of building also matters. Investing in environmentally-friendly buildings provides better protection against rising operational costs. 

In the euro zone, energy prices were 44 per cent higher in March 2022 than a year earlier, accounting for 4.4 percentage points of the overall headline inflation reading of 7.4 percent (see Fig. 1).

Fig. 1 - Energy price surge

Euro zone inflation, % change y/y

Buildings that can cut energy use – through features like innovative design, sustainable materials and renewable sources of power – will be cheaper to operate than those that don’t. Given the current focus on energy prices and on sustainability, and the fact that for most corporations their largest carbon emissions are related to the buildings they occupy, more sustainable buildings will be increasingly the preferred choice.

We therefore expect an acceleration of sustainable initiatives across the real estate industry. That means construction, but the carbon footprint of a new building is almost half its carbon emissions over a life time. So, in a world where most buildings are old (in Europe 40% were built before 1960, and 90% before 19903) it also really puts the onus on retrofitting property to improve energy efficiency. Installing double glazing, which is still far from ubiquitous, better insulation, sensors to use energy only when it is actually required, and on site energy generation are just some of the possible measures. However, there is a long way to go, with only a small minority of buildings currently boasting full “green” credentials. 

Construction costs

While rental growth may provide a cushion against inflation, there is one part of real estate which is not protected from rising prices, and that’s construction. Prices have been very volatile. In the UK, for example, construction material costs spiked by as much as 23 per cent, year-on-year.4

Any development investments in today’s inflationary environment, therefore, need to be considered with great care. However, we believe opportunities can still be found in the right area and with the right time horizon. Overall, our real estate strategy is to limit development projects to 25 per cent of our total portfolio to reduce risk – across the entire economic and pricing cycle. A proactive approach also helps. Given the current inflation backdrop, we are looking to secure fixed-price contracts and order hard materials (such as steel, cement or wood) at an early stage of any construction project, to ensure price certainty on key elements.

Cost increases also impact the maintenance and repair bills for existing properties. In the euro zone, these have risen at a much faster clip than headline inflation and faster than rents too.

The investment horizon is important. Someone investing for 15 years has the relative luxury of time to sit out the current price pressures and focus on the long-term potential of their investment. Those investing over, say, five years are under more pressure, but still have some room for manoeuvre compared to the traditionally more short-term sentiment prevailing in equity or fixed income markets.

[3] “Boosting Building Renovation: What potential and value for Europe?”, European Parliament, 2016
[4] Department for Business, Energy & Industrial Strategy. Data for April 2022.
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