ANALYSIS: Property investors brace for risk of deflation

With deflation rearing its ugly head in the eurozone, property investors are beginning to brace themselves for the possibility of a long-term economic downturn.

With inflation dropping to new lows in the eurozone, a growing number of financial experts are sounding the alarm of increasing deflation risks in the world’s third-largest economic area. International Monetary Fund managing director Christine Lagarde deems the situation so serious that she has called on the ECB to 'act pre-emptively to stall further declines in inflation.' For its part, the OECD has warned of 'serious deflation risks' in the eurozone in its economic outlook for 2014.

While most investors so far appear to be ignoring the risks, there are signs that some are taking action, say market watchers. 'Demand for financing with variable interest rates is increasing,' says Andreas Pohl, member of the board at commercial property financier Deutsche Hypo in Hanover. However, most market participants are ignoring the risk, says Helge Scheunemann, head of research at JLL Germany. 'For the majority of investors deflation is of no concern.'

Lost decade in Japan
New data released by Eurostat show that prices for goods and services have fallen at an alarming rate in a number of countries, calling to mind the long and devastating economic downturn during the period of deflation in Japan dubbed ‘the lost decade’ by economists. In Greece, deflation has already taken a hold with prices falling 2.9% year-on-year. Prices have also dropped in Portugal and Spain, albeit at a considerably lower rate, and stagnated in Italy and France. Overall, the inflation rate in the eurozone has dropped to just 0.7%, well below the rate of 2% deemed healthy by the ECB. Even Germany, Europe's economic stalwart, is beginning to feel the pressure with the rate of inflation down at 1.3% and industrial output shrinking two months in a row due to reduced demand from neighbouring countries.

'The eurozone is in danger of slipping into deflation,' says Peter Bofinger, professor of economics at the University of Würzburg and a member of the German Council of Economics Experts, a government think tank. 'A period of deflation follows in the aftermath of a credit bubble with households and investors drastically cutting back on spending in order to reduce their debt,' explains Michael Voigtländer, real estate economist at the Institut der Deutschen Wirtschaft (IW) in Cologne. That forces companies to reduce their prices for goods and services and lay off employees which leads to further cuts on spending, weakening demand even more.

Downward spiral
This is exactly the scenario that is playing out in a number of European countries. Debt-burdened governments are cutting back on public spending while private households in Spain and the Netherlands are holding on tightly to their money after their residential real estate markets imploded.

'Deflation is a vicious downward spiral with serious effects on the commercial property market,' says Günter Vornholz, professor of real estate economics at the EBZ business school in Bochum. 'In order to cut costs, companies scale down their office and retail space, sending rents and property values down.'

But investors can shield themselves against deflation. 'Interest rates will fall in a deflationary environment,' says Voigtländer. Central banks will ease interest rates and flood the market with cheap money in a bid to restart the economy. Already, the ECB has cut back its prime rate to 0.25%, signalling further reductions are on the way.

Variable interest rates
'Property investors expecting deflation should consider financing with variable rates in order to profit from further interest rate declines in the future,' says Andreas Trumpp, head of research at Colliers International in Germany. A growing number of investors are implementing this strategy, says Deutsche Hypo board member Pohl. 'There is growing demand for financing with variable rates, often combined with hedging against unexpected interest rate hikes.'

Long-term rental agreements with a duration of 10 years and more also provide protection against deflation. However, during 2013 investors in Germany began to move away from core properties with long-term leases after prices rose higher than rents, sending yields below 5%. Instead, a growing number of buyers opted for core-plus or value-add office and retail buildings with short-term leases or higher vacancy rates rendering higher yields. According to data compiled by Colliers International, only 55% of the €19.1 bn that flowed into German commercial real estate in the first nine months of 2013 went into core assets in major cities like Berlin, Hamburg, Frankfurt and Munich.

Nevertheless, in a deflationary environment, core properties can yield attractive returns when financed with variable rates currently below 2%, says JLL’s Scheunemann. 'If investors have enough equity capital to push the LTV to 60%, they can net returns above 6% with core objects.'

Richard Haimann
Correspondent Germany