Can commercial property help investors hedge inflation?
UK inflation has given retail investors a strong incentive to find ways to hedge against the effects of price increases. Commercial real estate has traditionally been a popular candidate for this role.
However, evidence from the past 40 years of commercial property rental growth shows that investors shouldn’t assume that the same types of property that historically offered automatic inflation hedge will continue to do so in the future.
It’s true that rental growth across the sector has kept pace with inflation over the past four decades, with both averaging 3 percent per year. However, our recent research suggests that there are nuances in this that are important to investor returns. These headline numbers hide significant divergences not only between subsectors but also within different decades and economic cycles.
Commercial real estate certainly offers many opportunities for the agile investor. Since 1980 we have found that UK property has had periods of rental growth before macroeconomic price increases. Between 1986 and 1991 and 2001 and 2008, when inflation rose over several years, driven by rising demand and an upturn in the economic cycle, rental growth was just as robust, outperforming inflation on average over those years.
However, these opportunities shift between different subsectors when economic conditions and structural factors come into play. The deciding factor in whether rental growth can keep pace with inflation is whether price increases are caused by a demand or supply shock.
Demand-driven inflation hikes bode well for real estate in terms of hedging against rising inflation, but supply-side shocks, such as the UK’s food-grade carbon shortage this year, have historically been more difficult to hedge.
Over the next five years, we expect some types of property to see rental growth above inflation, but most will see their real rents fall – and so will their popularity with investors seeking inflation protection.
Which species will thrive and which ones will fight? Signs of a shortage are a good place to start. Buildings in central London, as well as other scarce downtown properties, will continue to look attractive with this move. The undersupply on the housing market is also expected to persist.
It is important to remember that supply may be limited at the micro-location or asset level, even if the sector in general is not. For example, while it is feared that increasing remote working will lead to an oversupply of average quality office properties, this does not apply to “best in class” buildings near major transport hubs. The supply of new real estate is now unusually restricted due to a shortage of materials and rising construction costs, although these constraints can be expected to ease in the medium term.
Similar short-term considerations have the potential to create sector-specific inflation. Outside of commercial real estate, for example, the sharp devaluation of the pound sterling after the Brexit referendum drove up input costs for retailers when they had little power to pass them on to consumers. That put increased pressure on retail profitability.
For commercial real estate, long-lasting structural discrepancies between supply and demand allow rental growth to outperform inflation over longer periods of time. Our analysis suggests that these structural factors – such as demographics, technology or changes in behavior – are more important than the cyclical drivers of real estate. Nothing illustrates this more clearly than the rise of e-commerce and the shift in rental growth from retail to commercial real estate.
In retail, the majority of rental prices kept pace with inflation in the three decades to 2010, but the surge in e-commerce has dampened rental growth significantly thereafter. This trend is likely to continue, suggesting that warehouse and fulfillment-driven rental growth in industry will outperform inflation in the coming years – even if supply is likely to respond in the medium term.
Of the structural factors, demographics are the most predictable – and population-driven demand will be strongest for residential and healthcare properties. As the number of 18-year-olds in the UK grows over the next decade, the demand for student accommodation from the local population will increase, while an aging population will drive demand for retirement and nursing homes.
Even if inflation were higher than expected, our sector preferences would be similar, although rental properties will become more important.
Some rental agreements contain indexation, which guarantees that rental growth will at least correspond to inflation within certain ranges. The rental period also plays a role. Even where there is no indexing, UK rental valuations are typically only upward and offer protection from short term rental price drops. However, investors need to keep in mind that rents will return to market prices at some point. One of these sectors currently at risk is supermarkets, which have seen strong investment recently.
While the current surge in inflation has scared some investors, the evidence for the past 40 years shows that real estate plays a valuable role in hedging. While this is still the case today, the subsectors that provide protection against inflation change over time. Successful investors need to dig deeper into demographic and behavioral changes in order to keep pace with rising prices and achieve the returns that commercial real estate can offer.
Himanshu Wani is a Senior Associate in Real Assets Research, UK, at CBRE Investment Management