One of the more frequently cited arguments for investing in property is that "real" assets like property and say, agriculture commodities, hold their value better than paper assets once paper assets start to have their value eroded away by inflation. Commenting on the reasons why commercial property continues to attract investors in 2012 despite falling commercial property values in some major advanced markets, including the UK, property experts Jones Lang LaSalle points out that at present the attraction of fixed assets is being boosted by expectations that global inflation is going to rise over time.
The expectation is that all the quantitative easing that central banks have gone in for in the UK, the US and Japan is "bound" to lead to inflation and to the steady erosion of the buying power of major currencies. The picture, however, is more complicated than simply assuming that all property prices will rise if inflation rises. The gap between property values in the major cities of the world (London, New York) and property in "secondary" and "tertiary" cities is widening all the time as investors, anxious about more financial stress in markets, look for "safe havens".
It is also important to realise that inflation is no friend to the revenue streams that commercial property generates, and which is one of its most outstanding merits in the eyes of investors. As inflation erodes the purchasing power of money it simultaneously erodes the value of the rent that investors receive from property. So there are two factors that work against property rental income in an inflationary environment. There may well be nominal capital growth through periods of high inflation, but what that translates into in terms of real growth is an open question. Writing in FT.Com, Daniel Thomas warned back in June 2011, when fears of deflation had faded and rising commodity prices, particularly in food and oil, were generating rising inflation around the world, that property bulls were getting carried away.
"Investors need to be wary about relying on real estate as the pure inflation hedge that it is sometimes portrayed as," he counselled.
Part of the problem is that when institutional investors in particular are worried about inflation and start selling out of government bonds and fixed interest investments ? areas where inflation is obviously going to destroy returns - they generally look at retail property like shopping malls and at commercial property, with prime office blocks having pride of place in their thinking. In point of fact, as Thomas notes, industrial property such as warehouses and factory premises have historically provided the strongest hedge against inflation, rather than either retail or office space. It is the property class that has the strongest performance correlation with inflation.
Part of the problem, as we have already noted, is that inflation hammers rental income and rents make up an important part of the total returns delivered by property as an asset class. Thomas points out that City of London rents can move between ?40 per square foot to ?70 per square foot, depending on whether the economic cycle is in a boom or a bust phase. He cites analysis from HSBC Bank which finds that there is "little evidence to show that rental income outperforms or matches inflation."
Capital values too, are not linked in any hard sense to the onward march of inflation. Instead they are much more subject to at least two other factors, one being the readiness of banks to lend to potential purchasers and the other having to do with people's expectations regarding interest rates.
There is no argument against the obvious truth that low interest rates are a boon to the entire property sector, but low rates have to be set within the appropriate economic context to be understood. The "fog" in the market that has prevailed through 2011 and the start of 2012 has made companies reluctant to undertake major projects. This includes a marked reluctance to upgrade their head office. Companies are sitting tight. Those that are seeing their current leases coming to a natural end or to an agreed break point are much more tempted to seek a short term renewal of a year or two on their current lease rather than to commit to a major new office purchase or rental.
With landlords struggling to find quality tenants, companies with a good track record can almost write their own ticket with landlords, so short lease renewal terms tend not to be too onerous, which again, reinforces the lack of momentum in the market. As well as removing demand, this trend also shows just how illiquid and difficult investment in real estate can be.
On the plus side, once economies move into an inflationary period, it becomes very much easier for commercial landlords to build automatic inflation linked rate increases into their agreements with tenants. A article by Standard Life, in the February edition of Pensions Age, designed to highlight the attractions of commercial property allocation strategies for pension funds points out that ?upward only? rent review clauses in UK commercial property contracts, and index-linked property leases in Europe, have done a lot to protect and enhance rental income for investors.
One of the stronger arguments cautioning against the idea that property is a reliable hedge against inflation is the performance of the US housing market. Granted, the US housing market is having a torrid time at present and is still in the process of bottoming after the US sub-prime crash. But putting that aside it is worth thinking about a few basic facts. One of the most followed indicators of US residential property values in the US is the Case-Shiller indices for various US cities. Elliott Gue, writing for Investing Daily, cites the Case-Shiller 10-City Home Price Index to show that had home prices in the US kept pace with inflation, they would have had to at least double in the 23 years from 1987, In fact they have gone up by only 150%. That might sound like a lot, but the average annual rate of inflation in the US since 1932 is 3.4% according to the specialist inflation site, Inflationdata.com[1].
An investment of $100,000 in 1932, compounded at that rate would have to achieve ?230,000, or better than 230% growth just in order to keep pace with inflation. Of itself the shortfall between the 150% gains actually achieved by US housing and the 230% required to match inflation over the 23 year period, suggests that property can be considerably less than perfect as an inflation-hedge.
However, the picture for the UK is rather more encouraging. The property specialist Grosvenor, in its Global Outlook: September 2009, noted that the UK IPD All Property Returns (the most followed index on property values) averaged 11.7% a year since 1997, while inflation has averaged 6.8% over that time. While this might seem on the face of it to add credence to the view that property is a good hedge against inflation, Grosvenor adds a cautionary note. There are two kinds of inflation, expected inflation, during periods of low inflation where the general expectation is for inflation to be around 2% to 3%, and unexpected inflation, which occurs when some external shock, such as an oil price crisis, causes a sudden spike in inflation.
Grosvenor argues that property provides a partial hedge against expected inflation, but shows very little resilience in the face of unexpected inflation. In fact property values can crash badly if economies become destabilised by external shocks, as we saw through the 2008/2009 crash, when London property prices fell sharply. From the end of 2003 to the peak of the UK property market in mid-2007, average commercial property prices rose by 43%. This was wiped off almost completely by the end of 2009. Property, as has been demonstrated many times, is vulnerable to cycles of boom and bust, so talk of it as a "hedge" needs to be treated with caution.
[1] Inflationdata.com
Courtesy??Anthony Harrington?via?QFINANCE?(EconMatters author archive?here)
Read the first two of this 3-part series on commercial real estate:
Commercial Real Estate Heading for a Deep Freeze?
Commercial Real Estate: A Two-Speed Market
The views and opinions expressed herein are?the author's own, and do not necessarily reflect those of?EconMatters.
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