UK inflation hits 5.5% - implications for real estate

The UK Office for National Statistics (ONS) announced on Wednesday that the consumer price index reached 5.5% in January, up from 5.4% in December 2021.

On February 3, the Bank of England already took the decision to increase interest rates from 0.25% to 0.5% in an effort to curb inflation. That was the second interest rate hike in three months.

The central bank has said it may need to increase interest rates further over the coming months but that depends on the direction of energy prices and other imports, plus wages and the level of spending.

As PropertyEU reports in its 2022 Outlook report, for months various firms have been issuing reports into the effect of inflation and linked rising interest rates on their real estate investment strategies.

Principal Global Investors, the US firm, has been asking questions such as will higher interest rates equate to lower investment performance? Which property types are likely to experience the most pain points from higher interest rates? Will spreads between real estate cap rates and bond yields widen in response to higher interest rates? Looking at US real estate, the firm says the relationship between returns and interest rates varied by property type, but all sectors exhibited a positive correlation.

Most people in real estate will point out the positive aspect to a higher cost of living. Jessica Hardman, head of European real estate portfolio management at DWS, said in the firm’s 2022 report: ‘Real estate is a good way to hedge against rising inflation.’

But there is also the cost of financing to consider, plus the cost of construction, and whether demand could ultimately swing more to bonds than real estate if the gap in yields between the two narrow significantly enough.

Inflation is not something that investors in real estate have had to contemplate for around a decade: The last time it was an issue in Europe was 2011 when rates reached 5.2% in the UK.

The UK Office for National Statistics measures inflation via a consumer price index using factors such as the price of clothing, footwear, housing and household services, furniture, and general goods.

BlackRock said in its 2022 Global Outlook report, that disrupted supply chains are adding to the costs of goods and distribution, likely for some years ahead.

‘Out of this, we are seeing a fundamental reassessment of work, which is adding to wage costs in some services sectors, most notably in the US. Unlike recent upswing cycles, this round of inflation is coming from the supply side, rather than the typical later-in-the-cycle demand side pressures. Importantly, real assets remain a potent hedge against inflationary pressures, particularly where there are indexed rents or contracted revenue streams in place.’

Last summer Blackstone said sector selection mattered. ‘Bond-like assets that have long-term leases with limited rent resets are more susceptible as rates rise,’ it said.

The firm added: ‘Unlike traditional bonds that generate fixed cash flows, the income streams from real estate can rise over time. Prioritising assets with shorter lease durations in sectors with strong underlying growth fundamentals can result in faster translation of higher market rents into underlying operating cash flows. Certain assets with longer duration leases, such as net lease properties, often include contractual rent escalators to mitigate inflationary risks.’