Kiran Patel explains why inflation is coming and what investors in property should do to mitigate its effects
The Bank of England stated in its last quarterly report in February that it anticipated inflation to rise further in the near term and could remain above its 2.5% target for the next two years before falling back towards the end of 2015. The European Central Bank believes inflation will fall to 1.8% in the euro-zone in 2013 and be at 2% in five years’ time.
These opinions must be respected, but the fact remains that Cordea Savills has seen an increasing number of requests from investors for inflation-related mandates. The fear and anticipation of inflation is still very real.
Is there a chance that inflation could be higher than anticipated by Europe’s central banks? If there is, how do you realign your property portfolios, given average turnover figures mean it can take three or four years to implement any significant changes? What can investors do now to protect themselves from inflation? Which tenant profiles and property sectors will do well in an inflationary environment?
Economic growth is certainly subdued at present in Europe and that does tend to put a dampener on wage-push inflation in the economy. But on the monetary side, there are quite a few factors pointing to possible inflation. Across the developed markets generally we are seeing loose monetary policy with negative interest rates, typified by the significant, co-ordinated global action through quantitative easing due to growth concerns.
Recapitalised banks are beginning to lend again, albeit modestly, and this will increase price pressure, but we have yet to see interest rates, bond yields and rents move higher.
Quantitative easing has accelerated fund flows into real assets including property. Risk appetite has increased but inflation hedging vehicles are also in strong demand.
It is hard to ignore low interest rates alongside quantitative easing of unprecedented levels. Around 38 countries are actually pursuing negative real interest rate policies. The US, UK and euro-zone have been firmly in negative real interest rate territory since 2010. The leading central banks of The Fed, Bank of England, the European Central Bank and Swiss National bank have all roughly tripled the size of their balance sheets since 2007-08. Central banks seem to believe they can control inflation should it appear in the future, but history shows us they do not have a great record in restraining themselves from printing money.
Looking at 100 years of history in the UK highlights that when governments and/or central banks pursue a policy of negative real interest rates, inflationary pressure is not too far behind. Figure 1 shows there is a very strong inverse correlation between the two.
On the whole, real property returns are reasonably correlated with inflation, which you might expect given property’s attribute of being a ‘real’ asset class. Figure 2 shows this has been true since 1960 except in three instances. During the secondary banking crisis in the early 1970s, property returns plummeted as inflation soared above 20%, while excessive over-development caused the property slump in the early to mid-1990s. The downturn from 2007 was caused by another financial crisis – the credit crunch. So rising inflation has often had a limited impact on real property returns.
The evidence does point to equities performing best when there are sharp rises in inflation. Companies can raise their prices quicker than rents can be raised. One has to wait for a rent review or lease expiry to pick up the full benefits, albeit some would come through the annual/quarterly valuation adjustments.
But property performs more strongly than bonds in times of inflation. According to IPD, All-Property Initial Yields have stayed reasonably steady around the 4-8% mark since the mid-1960s and are currently around the mid-point of 6% pa (figure 3). However, the yields on 10-year government bonds over the same period have been more erratic, rising to a peak of nearly 18% in the mid-1970s, as inflation soared and crushed the capital value of bonds before, trending downwards to the current sub-2% level, thanks to the bull market they have enjoyed over the last 25 years. In times of inflation, bonds – always seen as the risk-free rate – should be the highest yielding of the asset classes. But despite the prospect of inflation ahead, yields have been compressed to historically low levels.
The yield gaps between assets are also strongly influenced by inflation. Both yield gaps (the difference between property and bonds, and between property and equities) are strongly correlated to inflation, at 0.82 and 0.71, respectively (figures 4 and 5). This information helps us understand pricing dynamics between asset classes.
So, equities are the most favoured asset class in times of inflation, although property is a winner compared to bonds. This only holds true provided inflation remains relatively stable and predictable, say in single-digit figures. In time of hyperinflation, all these asset classes suffer.
If reflation does happen – and we believe there is a 60% chance it will do so in the medium term – what steps should investors take to protect themselves? How should they reshape their property portfolios? There are several attributes to property assets that will benefit from reflation. These include:
• High beta, cyclical sectors, particularly prime offices;
• Leases where rents are set to open market value;
• Inflation-linked leases;
• Secondary locations where risk premiums look attractive;
• Distressed property as bank balance sheets are cleansed;
• Mispriced shorter leases/development situations.
In choosing assets, investors need to assess how sensitive an asset is to inflation. The UK’s regions, for example, tend to be much more sensitive than London. The provinces have more public-sector workers who bargain wage rises collectively with inflation an important reference point. However, London and the South East are dominated by the private sector, which is driven more by the market forces of supply and demand, and internationally so in the case of London. Figure 6 shows the correlation of rental growth in the regions and various property sectors. The highest correlations to inflation were in the East and West Midlands, Yorkshire and Humber and South West, whereas offices in the West End of London had the lowest correlation (31%).
Variations in geographic correlations can be seen elsewhere in Europe, too. For example, the correlation of office rental growth in various German cities to inflation over various dates to 2011 of Berlin at 0.71, Frankfurt at 0.65 and Munich at 0.54 all had the highest correlations, but other cities were much lower: Dusseldorf 0.04; Stuttgart 0.11 and Hamburg 0.26
Some companies are more inflation-oriented too and much more reliable when it comes to paying index-linked leases. Utility companies, for example, are in a good position to pass on inflationary price rises to consumers. Supermarkets are also a reliable sector when it comes to paying index-linked leases. There are lifestyle sectors such as hotels, healthcare and leisure properties that can also offer index linked characteristics. Transport sectors can include car parks, airport buildings, petrol stations, car showrooms and motorway service stations. Residential sectors would incorporate social housing, student accommodation and retirement housing. Alternatives, such as waste and recycling plants, are an evolving sector. All of these come with risk in the areas of:
• Income streams not paid as anticipated;
• Residual or vacant possession capital value risk as the lease moves to expiry or upon tenant default;
• Rental value not keeping in line with inflation and therefore causing over-rentedness;
• Liquidity risk whereby some asset classes have limited appeal and therefore have an in-built pricing discount.
Pricing these factors should help investors design the most appropriate portfolio for their risk or return target. Investors need to decide now whether they should have a property strategy to protect themselves in a reflationary environment given the time it takes to adjust a property portfolio. They need to invest in property assets considering the attributes outlined above. Cordea Savills is certainly embracing this approach. We are looking to adapt our portfolios to a reflationary environment, having executed 16 RPI deals in the last three years.
It is not absolutely certain that inflation will rise in the next few years. Not all the indicators point towards that. But investors would do well to view their current property portfolio through a prism of inflation risk and, if they believe inflation is an emerging threat, begin to restructure it to ensure it is suitably protected.
Kiran Patel is CIO at Cordea Savills