Inflation rise to twice Bank of England target rate puts it back on the agenda. Alex Catalano reports.
Conventional wisdom says that property is a good hedge against inflation. But is it? Recent research by the Investment Property Forum and others shows this is not necessarily true. “Property doesn’t work as a short-term hedge against inflation,” says Angus McIntosh, head of research at King Sturge, who worked on the Property and inflation, IPF summary report, November 2010.
“When you look at property performance, the most important thing is the timing of the cycle when you buy property. Secondly, if there is strong economic growth, that has an impact on the figures. Thirdly, and a very long way further down, is inflation.” Total UK commercial property returns do not move in line with inflation, the IPF’s research shows. In the long-term, property outpaces inflation, giving a positive real return – but equities do far better. What property does well is track economic growth.
But lately, the UK economy has been flat-lining. GDP shrunk 0.5% in Q4 2010 and forecasters predict it will grow a modest 1.8% this year. Meanwhile, the consumer price index jumped to 4.4% in February, although it did ease back to 4% in March. “Now we have the worst of both worlds,” says McIntosh. “We’ve got too much inflation and not enough economic growth. Overall, for property, this is not good.” F&C REIT Asset Management addressed the issue of property and inflation in a report published in February: Property in an inflationary environment – risk or reward?
Sue Bjorkegren, F&C REIT’s head of property research, notes that we have the wrong kind of inflation, driven by rising commodity prices, not by a hot economy. ‘Stagflation’ – a high-inflation, low-growth environment – is particularly bad for property, the IPF’s research shows. As well as weak occupational demand and downward pressure on rents, a weak economy means firms cannot push the entire rise in the cost of their inputs onto their clients. “Economic growth drives real estate demand,” says Nick Duff, senior investment consultant at Aon Hewitt. “Poor GDP growth doesn’t necessarily bode well for property.
But we’re not looking at property on a yearly basis; we’re taking a long-term view. Over the long term, income growth for the right assets can be a good hedge against inflation. Under our central case scenario for modest GDP growth and 3.5% inflation, we think property will do reasonably well.” Since 1947, the starting year for the IPF’s analysis, all of property’s real total return has come from income, not capital growth.
This is true for most years and sub-periods. But rents don’t grow precisely in line with inflation, particularly in periods of unusually high inflation. This could be due to the UK’s long lease structure, the report noted. “With property, it’s about trying to inflation-proof the income stream, which you can do by using RPI-linked leases, and, in a slow-growth environment, by focusing on longer leases,” says Bjorkegren.
“It takes time for inflation perceptions to build into and fall away from the system. So it was not while inflation was accelerating that real estate generated income protection; it was actually in the years after inflation came off its peak that you saw that income surge. If you have shorter leases, you’re not going to see that to the same extent.”
However, the verdict on lease lengths is not straightforward. They can help maintain and protect income, but short leases work well in markets where there is economic growth and demand for property. “The strong trend towards shorter leases increases landlords’ bargaining power if leases are outside the Landlord and Tenant Act’s renewal provisions and there is competition for space,” says Chris Bartram, chairman of Orchard Street Investment Management. “In such situations, rents can be expected to rise more than inflation.”
West End offers ‘super hedge’
One UK market does seem to offer a ‘super hedge’: West End offices. The IPF’s research says this is because it is a prime location where supply is constricted and cannot adjust quickly to demand changes. In contrast, prime City offices are not a good hedge. They do, however, have a “very positive, very significant” relationship with UK GDP growth, according to the IPF.
The IPF’s researchers also found that different property sectors differ in their relationship to inflation. Offices and industrial property are a better hedge against inflation than retail, while prime property is better than the market generally. Meanwhile, it is worth noting that the 4-5% inflation of today is mild compared to the 24% hyper-inflation of the mid-1970s. Moreover, consensus forecasts predict that it will drop back to the 2.5-3% range by the end of 2012.
“Property is not a panacea for inflation,” says Bjorkegren. “Don’t build an investment strategy on inflation protection, because a) it may never happen and b) if it does, there is absolutely no correlation in terms of real estate total returns and inflation.”
Inflation-linked vehicles can take pension funds to ‘sweet spot’
Not surprisingly, investors are increasingly worrying about inflation and protecting income; fund managers say the question comes up at every investor presentation. As the IPF’s research shows, over 100% of the real return for property comes from income rather than capital growth. In other words, income is compensating for a real capital loss. This holds true for both the market generally and the prime segment.
At M&G, fund manager Ben Jones argues that longer inflation-linked leases are a ‘sweet spot’ for investors seeking protection from inflation. “This is an asset class for institutions, given the long-term nature of the investments,” he says. “It is particularly appropriate for UK pension funds. They and their advisers like the long lease story, as it gives them a strong match to inflation risk but without the significant expense of index-linked gilts and their derivatives and without the higher volatility of other asset classes often put forward as inflation matches, such as global equities and commodities.”
M&G has run this strategy for its internal capital for a decade. In 2007, it launched the Secured Property Income Fund, managed by Jones, which has £800m in assets. “Pension schemes are worried about inflation but, given that their liabilities stretch decades into the future, they are less worried about the immediate outlook. They want matching assets, preferably with security,” Jones says. “Long lease property certainly gives them that because our fund’s structure gives a long-term income stream with explicit inflation linkage, based on sound, carefully-selected tenant credits and underlying real estate, aggregated into a well-diversified portfolio, where investors also benefit from the fund owning the underlying buildings.”
The popularity of index-linked investments is growing, and not just with investors. Chris Bartram, chairman of Orchard Street Investment Management, says: “There is a marked increase in occupiers entering into leases with inflation-linked rent reviews, with caps and collars, and often long-term leases as well. Distribution units, supermarkets and banks spring to mind.
“Such tenants clearly expect that rents will continue to be influenced by inflation, and presumably they fear that open-market rents for good, scarce property, may accelerate faster than inflation.” But this is still a thin market and prices for these investments have risen. Nick Duff, senior investment consultant at Aon Hewitt, notes: “We’ve had clients that have put money into food superstores with RPI linkage, but you have to be careful about the structuring. There’s a case for them, but you need to hunt for value. Starting yields of 4% are not particularly attractive. If you’re getting yields of 5-6% with RPI linkage, that’s a different story.”
“You need to look at the pricing entry point, which is worse now than two years ago, since yields have come in so much. But sometimes we want to position property alongside gilts portfolios, so we will look at those types of assets for those clients.” While RPI-linkages protect income, there is still the issue of what the property is worth at the end of the lease. Will anyone want to take the building then, and at what rent? “If the market’s caught up and the rental value is truly there, that’s fine. Ten years is quite a long time; one hopes the market will eventually catch up with it,” says King Sturge head of research Angus McIntosh.