UK inflation has given retail investors a strong incentive to find ways of hedging against the effects of price rises. One popular candidate for this role has traditionally been commercial property.
Evidence from the past 40 years of rental growth in commercial property, however, shows that investors should not assume that the same property types which provided an automatic hedge against inflation in the past will do so in future.
It is true that rental growth in the sector as a whole has kept pace with inflation across the past four decades, with both averaging 3 per cent a year. But our recent research suggests this conceals nuances that matter for investors’ returns. Those headline numbers hide significant divergence not only between subsectors but also within various decades and economic cycles.
Commercial property certainly offers plenty of opportunities for the agile investor. Since 1980, we found UK real estate provided periods of rental growth ahead of economy-wide price rises. Between 1986 and 1991 and 2001 and 2008, when inflation increased over several years, driven by rising demand and an upswing in the economic cycle, rental growth was equally robust, on average outstripping inflation in those years.
But these opportunities shift between different subsectors as economic conditions and structural factors come into play. The determining factor in whether rental growth can keep up with inflation is whether price increases are caused by a demand side or supply side shock.
Demand-driven inflationary increases bode well for real estate in terms of hedges against rising inflation, but supply side shocks, such as the UK shortage in food-grade carbon dioxide this year, are historically more difficult to hedge.
Over the next five years we expect some property types will generate above-inflation rental growth, but most will see their rents decline in real terms — and likewise their popularity with investors seeking an inflation hedge.
Which types will thrive and which will struggle? Signs of constrained supply are a good place to start. Central London buildings, as well as other scarce city centre assets, will continue to look attractive on this measure. The undersupply in the residential market is also expected to persist.
It is important to remember that supply can be constrained at a micro-location or asset level, even if the sector more broadly is not. For example, while there are fears that increased remote working will create an oversupply of average quality office assets, this will not apply to “best in class” buildings located near important transport hubs. The supply of new real estate is also today unusually constrained by materials shortages and rising construction costs, although these constraints are expected to ease in the medium term.
Similar short-term considerations have the potential to cause sector-specific inflation. To take an example outside commercial property, the sharp devaluation of sterling following the Brexit referendum pushed up retailers’ input costs at a time when they had little power to pass these on to consumers. That intensified the pressure on retail profitability.
In commercial property, long-lasting structural mismatches between supply and demand enable rental growth to outpace inflation over longer periods. Our analysis suggests these structural factors — such as demographics, technology or behavioural change — are more significant than the cyclical drivers of real estate. Nothing illustrates this more clearly than the rise of ecommerce and the shifting of rental growth from retail to industrial property.
In the retail sector, the majority of rental values kept pace with inflation in the three decades up to 2010 but the rise of ecommerce has significantly damped rental growth thereafter. This trend looks set to continue, suggesting rental growth in the industrial sector, driven by warehousing and fulfilment, will outpace inflation in the coming years — even if supply is likely to respond over the medium term.
Among structural factors, demographics is the most predictable — and it is in residential and healthcare property that population-driven demand will be strongest. As the number of 18-year-olds in the UK rises over the coming decade, student accommodation is set to see greater demand from the domestic population, while an ageing population will fuel demand for retirement and care homes.
Even if inflation turns out to be higher than expected, our sector preferences would be similar, although lease characteristics will become more important.
Some leases include indexation, guaranteeing that rental growth will match inflation, at least within certain bands. Lease length also plays a role. Even where there is no indexation, UK rent reviews are typically upwards-only, offering protection from short-term rent falls. Investors must remember, though, that rents will at some point revert to market rates. One such sector currently at risk is supermarkets, which has recently seen strong investment activity.
While the current rise in inflation has spooked some investors, the evidence of the past 40 years shows that real estate has a valuable role in hedging against it. While this remains the case today, the subsectors that offer protection against inflation change over time. Successful investors must dig deeper into demographic and behavioural changes if they are to keep pace with rising prices and achieve the kind of returns that commercial property is capable of offering.
Himanshu Wani is senior associate in UK Real Assets Research at CBRE Investment Management
Source: Economy - ft.com
