The current market conditions have undermined real estate's status as a hedge against inflation, but some useful strategies can still be found, as Lynn Strongin Dodds reports

Investors can use real estate to hedge against rising prices but interest rate increases can dampen valuations. In addition, supply/demand imbalances will also affect rent reviews. In the current tumultuous environment, there are no easy answers. Inflation is abating and few are willing to predict future price fluctuations.

Andrew Allen, director of research and strategy at Cordea Savills, says: "Over the past 12 to 18 months, investors have been extremely concerned about the spectre of rising inflation and the impact on real estate. However, commodity prices are falling and people are much more concerned with economic growth and the current situation."

The tide began to turn in the summer when fears about a financial meltdown and a sharp deceleration of the global economy gripped markets across the globe. Harry Humble, investment director, property product specialist, for Standard Life Investments, notes: "Inflation is definitely less of a story than three months ago. Commodity prices have come off and the broader economic outlook has been revised downwards. This has dampened real inflation prospects."

Mark Callender, head of property research at Schroders, says: "I think prices will subside for the rest of the year and into the next year. As a result, we have cut our inflation estimates for the euro-zone to about 2.3% and 3% in the UK next year. In the longer term, we expect that prices will remain high because of the supply and demand imbalances."

Property markets across the world have suffered in the current turmoil, but if inflation rises again then investors should be equipped with the different strategies that can be deployed. According to Simon Redman, senior director, head of business development, Invesco Real Estate: "Historically, real estate is seen as a hedge against inflation because it pushes rents up. This does not happen the minute inflation rates rise as there is a time lag.

It is also important to realise that there are differences between the property markets and the lease contracts that are offered. For example, rent reviews on many property leases on the Continent are linked to movements in inflation indices, such as the cost of construction, but there is not the same contractual arrangement in most UK leases."

Callender comments that uncertainty can arise at the end of the lease, which differs depending on the country. It boils down to demand and supply fundamentals. If they are strong, then there is a good chance that the rents on the new lease will match the old one. However, if occupier demand is weak, as it is now, and vacancies rise, this will not be the case. The real economy will exert itself if inflation-driven rents have risen beyond what is justifiable on the open market, at which point the tenant - new or existing - would be able to negotiate a lower rent.

"The other danger is that a slowing economy could leave the landlord with a vacant unit which will then have to be let out at a lower rent. This is currently the fear, for example, in the City of London, which has been hit by a wave of redundancies.

Overall, it is thought that office property investments are better placed to generate consistent above-inflation returns than retail and residential when there is a buoyant economy resulting in higher spending and income. However, if inflation is rising due to higher production costs, as it has been in the past 18 months, it can squeeze the earnings of corporate tenants and impact the spending power of their customers. In other words, nominal rents in properties might rise in line with inflation but the real rents underneath could come under pressure and stall overall growth.

Allen points out that according to the Investment Property Databank statistics, rents do not necessarily keep step with inflation. "If you look at the monthly index dating back to December 1986, the rental value for the UK All Property Index rose from 100 to 195, but the retail price index for the same period increased to 217," he says. "Essentially, commercial rents are not keeping pace with inflation because of the additions to supply."

Supply and demand imbalances are becoming an even greater concern in today's volatile world as certain markets experienced a boom on the back of a strong economy.
According to George Ochs, managing director, real estate and infrastrucure, JPMorgan Asset Management: "Supply and demand issues in certain countries have become much more of a problem than inflation at the moment. In Spain, there was a tremendous overbuilding in the residential market which is not being absorbed because of the downturn in the economy and job losses."

Investors should also be wary of interest rates, which are typically increased to dampen down inflation rates. "History suggests that while a little inflation may be a good thing for property, a substantial period of high inflation can be damaging," says Callender. "This is because governments will increase interest rates and this will choke off tenant demand.

It also tends to put upward pressure on property yields, which depresses capital values."
Aside from the traditional index-linked leases, Callender suggests that there are also other ways to play the inflation game, such as investing in those countries that are major beneficiaries of any commodity boom. In the past two years this has been Argentina, Australia, Brazil, Nigeria, Norway, Russia, South Africa, Saudia Arabia and Venezuela, to name a few. Take the prime office rents in Moscow - they doubled over the 12 months to March 2008 - while both Oslo and Abu Dhabi enjoyed rent rises of 50%, according to figures from CB Richard Ellis.

It is important, however, that before plunging in, investors look underneath the headline prices and analyse the state of the markets. For example, as Callender notes, there is a significant risk that the office market in Buenos Aires may be hit by an oversupply of new space over the next two years, and the Melbourne sector may also look vulnerable.

Also, some of these markets are small, opaque and illiquid. While overall emerging markets have significantly improved their levels of real estate transparency according to the latest Global Real Estate Transparency Index from Jones Lang LaSalle, it still advises caution. "Only the most opportunistic investors will consider semi-transparent markets found in eastern Europe, Latin America and south-east Asia," it notes.