Asset selection Investors can turn inflation to their advantage but they need to implement new -strategies and act quickly, say Martin Eberhardt and Sigrun Lüttringhaus

Most European investment managers have little or no experience of how to manage a real estate portfolio in times of inflation. How could they? In most European countries, ongoing high inflation has been absent for the past 30 years.

Although the causes of inflation vary, periods of consistently rising prices frequently create anxiety among the population. This negative view of inflation is often unjustified: Moderate inflation brings with it excellent opportunities alongside the risk. Investments in non-listed real estate vehicles in particular may benefit from increased inflation. Historical data show that in the majority of cases, higher inflation is accompanied by increased asking rents and returns.

Whereas investment managers did not need to provide management skills for times of higher inflation in the recent past, times have changed and what used to be a hypothetical economic scenario has become reality. Rising commodity prices are set to trigger higher inflation. Moreover, opportunities for low-cost production in developing countries have diminished. In countries such as China and Brazil, wages and production costs are currently increasing. This development, combined with a monetary policy that is still lax, is causing product prices to rise in Europe.

A range of economic scenarios can be observed within Europe. In the UK, inflation reached 3.3% in 2010 and increased further at the beginning of 2011. Germany had an average inflation rate of 1.2% in 2010 while enjoying a solid economic recovery. It is safe to assume that inflation in some euro-zone countries will exceed the European Central Bank's target of 2.0% in the next few years.

While a higher but still moderate inflation seems to be applicable, a lot of more extreme viewpoints concerning upcoming inflation can be found. Monetarists in particular predict higher inflation: These economists criticise the purchase of bonds and quantitative easing pursued by central banks.

Two different phases of higher prices can be expected in countries enjoying economic growth: a phase of low inflation in 2011 will be followed by a phase of higher inflation starting in 2012 or 2013. In phase two, construction costs and maintenance costs will rise. At the same time, an increase in interest rates, yields of real estate vehicles and rents will take place, accompanied by a fall in unemployment.

In phase one, the aforementioned effects will also occur, but on a smaller scale. There is no free lunch when it comes to managing real estate in times of inflation. The whole value chain of an investment company has to be taken into consideration in such periods. Two examples illustrate the point.

First, it can lock in favourable financing conditions in the low-inflation phase. At the same time, it can benefit from a higher debt ratio. If parts of the portfolio are financed by borrowing, the burden will be automatically reduced - when inflation rises, the nominal value of the interest and repayments stays the same, but the real value decreases. Thus, timing is a key factor for success as long-term lending that gets locked in too late, ie, in phase two where the inflation rate is higher, is one of the risks to be avoided. Phase two also bears the risk of a negative leverage if interest rates exceed yields.

Second, there are many opportunities to generate profits in times of inflation. In phase one, real estate buyers can take more chances, for example in the form of development projects. It is also advisable to purchase class-A buildings with expiring leases in order to participate in rising demand and higher rents. In phase two, there will be a significant market supply of (almost) fully let property. Since timing is key to success, buyers need to be quick when inflation is rising.

Some types of real estate derive considerable benefit from inflation. In the case of retail property, such as shopping centres, higher inflation will often be accompanied by higher rents since the rents of such properties are based on turnover, and store sales are likely to increase when inflation is on the rise. Investors can benefit from higher inflation rates via indexed rents and reletting the building at a higher price. It is thereby important to negotiate indexed rents early enough.

Rents that feature CPI adjustment are one of the main prerequisites for success. More-over, the lease period, the project development timeframe, asset management and especially tenant relationship management - in short, professional real estate management - is the key to realising higher rates of return in times of higher inflation.

Martin Eberhardt, head of real estate strategic analysis and planning, and Sigrun Lüttringhaus, real estate strategic analysis and planning, Union Investment