Asset selection Property can provide an effective hedge against inflation but to do so it must possess key -attributes, as Nick Winsley explains
Investors are becomng more concerned that the UK could be entering a period of higher inflation. These worries are backed up by the comments of the Bank of England in its Inflation Report (February 2011): "CPI inflation is likely to pick up to between 4% and 5% in the near term and to remain well above the 2% target over the next year or so."
In the UK, most defined benefit pension schemes have long duration liabilities that are normally linked to the retail price index and limited to 5%. As such, inflation ‘protection' is a key driver in investment strategy. This liability-driven investing has created greater interest in bond-style instruments, which give better predictability in matching returns with liabilities.
Since 1981 inflation-linked gilts have provided investors with the ‘perfect hedge', when held to maturity, in that their income and capital growth match inflation. However, with yields at relatively low levels, following a period of high demand, investors have looked to alternative assets, such as real estate and infrastructure, to provide the types of income streams normally associated with bonds.
Although the hedge that these assets provide is not perfect, as the income growth does not match inflation exactly, the premium yield provided should significantly compensate for the imperfection.
Real estate is commonly regarded as having inflation hedging characteristics. However, because of depreciation, not all properties subject to leases with regular rent reviews will provide an income stream that correlates with inflation. The negative effects of depreciation on income from a property will counter the positive effects of rental growth and therefore reduce the asset's effectiveness as an inflation hedge.
Real estate is subject to two main types of depreciation - economic and physical. Economic depreciation occurs as a result of a change in the wider economic environment whereas physical depreciation is asset specific and occurs throughout the life cycle of a property as its structure and plant and machinery are subjected to wear and tear and its design and technology become dated.
Figure 1 shows how the rental value for a specific property will fall, relative to the market rent, as it depreciates.
It is increasingly common for occupational leases to have rent reviews linked to inflation. While this ensures that the income stream increases with inflation it does not address the issue of depreciation, which is essentially being deferred to lease expiry.
Therefore, any real estate investment strategy that aims to provide a better inflation hedge should seek to mitigate depreciation as far as possible. This can be achieved by acquiring lower depreciating assets and/or assets that are subject to long leases ("ground leases") under which the leaseholder is liable for depreciation.
Ground leases are normally long leases (100 years plus) that were historically granted to facilitate development of land by the leaseholder. They take many forms, such as joint ventures, fixed income or variable income, with the initial rent normally being a proportion of the underlying property's rental value.
Lower depreciating assets
A lower depreciating real estate asset is one where the loss of value as a result of the impact of depreciation is reduced, often because it incorporates less plant and machinery. These assets have similarities with infrastructure assets, such as toll roads and airports, where planning and site availablity restrictions provide a barrier to entry and the monopoly-like characteristcs produce longer predictable cashflows that are relatively less exposed to the economic cycle. Typical examples will include supermarkets, high street shops and car parks.
For example, prime UK supermarket rents were £9/ft2 (€10/ft2) in the early 1990s compared with £30/ft2 today. An agreed rent of £9/ft2 linked to RPI in 1990 would have increased to £15/ft2 today - below today's prime rent level. By contrast, the rent of a prime city building in 1990 at £55/ft2 linked to RPI would have grown to £100/ft2 today - significantly above today's prime rent which, coincidently, is £55/ft2.
Therefore, if you had acquired the supermarket in 1990 you would be confident of re-letting the property at a rent of £15/ft2 with minimum capital expenditure, therefore producing a stable recurring cashflow. By contrast a 20-year-old city office would require either refurbishment to replace the plant and machinery and relet at the prime rent or complete redevelopment.
This illustrates how some sectors of the market should be better at matching inflation than others.
The key difference with some ground leases, compared with occupational leases, is that the leaseholder may be liable for the depreciation of the asset under the terms of the ground lease. Irrespective of the lease terms the leaseholder will be commercially incentivised to maintain the property in order to protect their investment.
When you have a ground lease with regular rent reviews linked either to RPI or market rent and where the rent is low - essentially an over-collateralised bond - the depreciation for which the investor will be liable is in effect negligible because it is deferred so far into the future.
Provision of institutional funds that target inflation linked returns is a concept developed and launched within the last five years. While inflation protection was not originally at the core of these strategies it was provided, in part, by the inherent characteristics of real estate and in part by inflation-linked leases.
Investment consultant George Henshilwood commented that "any asset class which offers the prospect of equity-like returns with a different return pattern is attractive to pension funds."
By way of illustration, figure 2 is a comparison between the total returns for All Property (CBRE Monthly Index) since 2005, and typical total returns for Fund A - a long lease bond style non-inflation proofed fund and Fund B - a typical inflation-linked ground lease fund.
During the trial by fire period that was 2007-10, most funds did ‘what they said on the tin'. The most secure ground rent funds delivered solid returns as investors sought secure income streams, while those with more property risk suffered.
In conclusion, property can provide a better hedge against inflation where the issue of depreciation is addressed either through the acquisition of properties with low depreciating characteristics or those that are subject to over-collateralised ground leases that put the obligation on the leaseholder.
Nick Winsley, investment director, AEW UK