Is private real estate an effective inflation hedge?

From

Dugald Higgins

Milton Friedman once famously observed that ‘inflation is taxation without legislation’.

Inflation landed with a thud in Australia in October 2021, with the broad Consumer Price Index rising 0.8% for the September quarter, spiking 3% year-on-year. With the spectre of inflation remaining persistent, investors should rightly consider whether portfolio exposure to the effects of inflation is a concern. For those with exposure to private market real estate, the question regarding its effectiveness as an inflation hedge is pertinent. But is real estate an effective inflation hedge?

Like bonds or equities?

Broadly, commercial real estate can share the characteristics of both bonds and equities depending on the asset and its use. Bond-like income comes from tenant rents, a contractual obligation which features higher in a business’ cashflow priorities than the distribution of company earnings.

Rental income can be either more bond-like or more equity-like depending on the lease characteristics, market demand and tenant covenants. However, while bonds are impacted by a change in discount rate when interest rates move, real estate cashflows are not fixed. This has the effect of buffering movements between yields in bonds and real estate. As shown in the following chart, Australian real estate yields have been relatively independent of bond yields over the past 34 years with general instability in the yield spread.

Inflation is one thing, but don’t forget fundamentals

An asset’s ability to act as an effective inflation hedge cannot be considered in isolation from market fundamentals. For example, in Australian commercial real estate, markets have seen two material cyclical downturns as a result of supply/demand dynamics in the last three decades, as evidenced in the chart below.

Examining year-on-year movements in CPI over this timeframe, while from a total return perspective real estate has been an imperfect inflation hedge, its stability of income has proved to be quite resistant.

With income being a key return component for commercial real estate, it’s important to decompose rental structures. Property cash flows are not fixed and can be sensitive to growth and inflation. Typically, commercial rents are structured with annual escalation clauses during the lease term. While these can vary depending on the macro environment, escalation clauses typically comprise one or more of the following broad characteristics:

  • fixed reviews: generally set between 2.5% to 4.0% p.a.
  • CPI linked: can be subject to ‘cap and collar’ clauses stating minimum/maximum increases
  • market: rent reviews to the prevailing market rate (usually used periodically in conjunction with other structures to adjust for any progressive over/under-renting), and
  • turnover: typically only found in retail shopping centres for major tenants, comprising a base rate and an amount linked to annual store sales turnover.

In properties or portfolios with high numbers of tenancies, typically a portion of the rent roll will expire each year. Given this progressive resetting of rents under varying escalation clauses, there’s usually an element of inflation sensitivity present which should offer some degree of hedging. However, this depends on the prevailing lease structure in place.

Ultimately, real estate assets are not static and it’s incumbent on management to maximise operational value through asset management strategies. Under normal market conditions, these programs should outpace the rate of inflation in all but the most rampant outbreaks.

Don’t neglect debt

Invariably, valuations and cashflows in private market real estate fund assets are sensitive to changes in interest rates given their use of debt. What happens to lenders’ interest rates in this cycle will arguably be as important, if not more so, than movement in nominal rates. The relationship between interest rates and inflation will be critical given we’re inhabiting a monetary cycle never seen before.

Rates in the most developed countries have arguably been held too low for too long. Interest rates are below current inflation, resulting in negative real interest rates. Based on central bank statements, rate rises are expected to slow to avoid sinking economies still struggling to recover from the global pandemic. This arguably means that property markets will remain supported in the absence of any meaningful movement from lenders, independent of official rate movements.

While this macro thematic should be encouraging, the sensitivity of assets which fundamentally use leverage should not be underestimated. Prudent investors should ensure that inflation protection does not neglect capital structuring and ensure they avoid highly leveraged borrowers with limited capacity to pay increased mortgage rates, even if movements are at the margins.

Is there a verdict?

We believe that at a high level, real estate is generally an imperfect inflation hedge. Real estate is highly idiosyncratic at the level of individual properties. Protection will vary across sub-sector, geographic markets and by asset strategy. Assets that generate sustainable, dynamic cash flows should benefit from inflation, but the total returns outcome should be considered. That said, over the long term, real estate has delivered robust returns well in excess of CPI.

Ultimately, whether or not any asset is suitable as an inflation hedge is not just dependant on its characteristics, but also on its position in the market cycle. Markets generally have been the beneficiary of a long secular decline in interest rates, following their escalation in the 1980s to combat severe inflation. Broadly, markets are less likely to repeat the types of returns achieved during this secular interest rate decline (all else being equal). It should also be considered that they may also be less likely to be as an effective hedge against inflation as they have been in past markets until a normalisation of the macro environment is achieved.

Although some assets may exhibit strong resistance to inflation, the other key characteristics of real assets cannot be ignored. Investors should ensure that in their pursuit of hedging, they remain sensitive to the big picture.

We believe that the most important source of systematic risk for real estate is the risk to capital, which is a function of macro-economic growth as well as management activity. From a total return perspective, while the behaviour of real estate funds is in-between bonds and equities, we believe they’re closer to equities. Real estate’s cyclical, growth-sensitive characteristics regarding the capital component tends to dominate the more bond-like risks encapsulated in the income.

By Dugald Higgins, Head of Responsible Investment and Real Assets

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