Investors must focus on income and indexation to maintain real estate's inflation hedging role in their portfolios. They must also note that its hedging potential is not universal, as Ulrich Braun reports
As the global financial crisis has intensified in recent weeks and commodity prices have retreated in the face of fears of a worldwide recession, the spectre of inflation has also faded to some extent from the radar screens of central bankers and economic policy makers. But with governments and central banks pumping billions of dollars, euros and pounds into the financial system, concerns that inflation will reignite further down the road are lurking in the background.
Earlier this year global inflation returned to levels last witnessed in the early 1990s. Rocketing oil prices called to mind memories of the oil shocks of 1973 and 1979/80. The investment asset classes that tend to outperform in a high-inflation environment include gold and real estate. As well as being more tangible than assets such as equities and bonds, bricks and mortar also offer the attraction of indexed rental agreements.
Credit Suisse's economists forecast that global inflation is likely to be 5.8% this year, up from 3.7% in 2007, and that this should ease to 4% by the end of 2009. If inflation does increase, investors face the prospect of the value of their assets being eroded in real terms and asset classes are increasingly being scrutinised for the protection they offer against rising prices.
Many studies have shown that equities offer little protection from inflation. They only demonstrate a degree of resistance in cases of demand-driven inflation, when the economy is firing on all cylinders and corporate earnings are on the rise.If, however, economic growth stalls at a time of high inflation, then the real-term losses in value caused by inflation are compounded by price losses. Stagflation, where sustained economic stagnation is combined with high inflation, is therefore also a very tough environment for real estate investment.
Indexed rents provide inflation hedge
The inflation protection offered by real estate investments is primarily due not to price performance, but to income in the form of rent. In many countries, rents are in one way or another linked to inflation, though the rules vary considerably from place to place, as does the suitability of real estate investments for inflation hedging.
Europe - Rents in Germany are adjusted to inflation as soon as a certain threshold is reached. In the UK, rents are reviewed in line with market levels every five years, with modern tenancy agreements only allowing for upward adjustments, while in France the annual review is based on the official construction cost index. In Switzerland, commercial tenancy agreements are normally linked to the consumer price index, whereas in the residential segment the approach is still cost-based, ie, rent adjustments are determined by movements in the variable mortgage rate of the cantonal bank in question.
North America - In the US, fixed percentage ‘bumps' - often between 2-3% per year - over the term of five to 10 years are typically written into contracts, although adjustments in line with the official consumer price index are also possible. In Canada, fixed rents for the entire five-year term are the norm.
Asia-Pacific - Rent adjustments in Australia are a combination of fixed rent increases, inflation indexation and/or a biennial adjustment in line with market rents (generally only upwards). In Japan, rents are fixed for the first two years, beyond which the law provides for reasonable adjustments. No adjustment mechanism is provided for during the term of tenancy agreements - normally running for two to three years - in Hong Kong. In Singapore, rents are fixed for the three-year duration of the agreement, and if the option of another three years is exercised then they are raised to market levels.
Of course, rent agreements can only deliver inflation protection if vacancy levels are relatively low. This can be seen in figure 2, which compares the overall return on real estate investments in the US with the inflation rate. Since 1978, real estate returns have consistently beaten inflation, other than in 1990-94. Those years were a period of very weak growth when vacancy rates rocketed to an average of nearly 19% across 54 real estate markets, compared with a long-term average of 14.5%.
Investors or developers?
As inflation protection only works where occupancy rates are high, not all real estate products are equally suitable for security-minded investors. The benefit is much greater for investor rather than developer products. Examples of investor products include Swiss and German real estate funds, REITs and real estate investment companies in many developed markets. It is also important to note that real estate investment companies which do not have REIT status in Hong Kong, Singapore and Japan, more commonly act as developers.
Real estate companies in emerging markets are generally classed as developers, where no income is earned as long as the properties are under construction and, at the same time, the firms are to some extent exposed to inflation on the cost side. The degree of inflation hedging afforded by investor products also varies, as protection is greater where rents are indexed to consumer prices.
Open-ended German real estate funds are the biggest category of unlisted real estate investments and create and redeem units daily, arriving at unit prices by dividing the net fund assets by the number of units. The net fund assets consist of the market value of the property held by the fund and the cash held in it, less all liabilities and provisions. Changes in unit prices therefore largely mirror the value of the underlying real estate. As figure 3 shows, open-ended German real estate funds have delivered above-inflation returns in each of the last 30 years, indicating that they make a good hedge against inflation.
The situation is rather different for listed real estate investment products such as REITs, which respond much faster to developments in the underlying real estate markets and in the financial markets, thus explaining their greater volatility. Listed stocks have much greater exposure to movements in interest rates, which are initially unfavourable during periods of high inflation.
US REITs do offer relatively good protection against inflation in the long term. The inflation-adjusted total returns on US REITs over the last 30 years have averaged 8.5% per year in dollars. They have proved to be very stable in three periods of high inflation (1973-74, 1979-83 and 1989-93).
Only in the early 1990s did US REITs undergo a correction, due to high inflation rates coinciding with weak economic performance.Commodity-driven global inflation has cooled, at least temporarily, because of the global economic slowdown. Price pressures could pick-up again, however, particularly on the back of a growth in demand for commodities from the major emerging markets.
Increasing numbers of investors have discovered real estate as an asset class over recent years and this interest remains in place around the world, thanks in part to the relatively good inflation protection bricks and mortar provide.