Inflation on the rise

Real estate finance professionals play down the impact of rising inflation. By Doug Morrison.

Not so long ago, inflation hardly merited serious discussion among lenders and investors, but 2017 could be the year when its impact is felt across the UK real estate industry.

The latest Consumer Price Index went from 1.6 percent in December to 1.8 percent in January. While rising air fares, food prices and fuel costs have stoked inflation, the falling pound has supported manufacturing exports and boosted tourism to the greater good of the economy.

According to the latest Office for National Statistics statement, buoyant consumer spending and manufacturing output kept the UK economy growing at 0.6 percent in the final quarter of 2016; a brisk performance that confounded many forecasters who feared recession following the outcome of last June’s EU referendum.

The Bank of England now expects the UK economy to grow by 2 percent in 2017 although, when presenting its inflation report in February, its governor Mark Carney warned of “Brexit twists and turns” along the way. He also indicated that investment by British businesses would fall in the coming year, which suggests they will not be helping the real estate industry by taking on new premises. Concerns over inflation are no doubt behind these mixed messages from the Bank.

There is also the threat of inflation in the US market, stoked by the policies of Donald Trump, having an impact this side of the Atlantic. Infrastructure spending and a shift towards fiscal policy could lead to so-called ‘Trumpflation’, which could have a knock-on effect for European markets.

As Jon Neale, JLL’s UK head of research, declares, rising inflation – and potentially market interest rates – will be “the main economic story of 2017”.

We’ve had the good news, says Neale. The negative side of the story will emerge this year, as hedging mechanisms expire and import prices increase. The most obvious impact will be on retail, where companies will be forced to pass on the increase, reduce their margins, or both. Alongside rising fuel prices, this could start to erode business confidence generally.

There is also widespread concern among economists that if inflation continues at the current rate, alongside an expected squeeze on wages in 2017, then consumer spending is likely to fall and hit the economy – with retail property again in the immediate firing line.

But as Paul Clark, chief investment officer at The Crown Estate says: “I’d always be wary of pulling out one single factor. Retailers, for example, have a number of changes on the horizon which they are going to have to adapt to, such as business rates and the living wage.”

He adds: “In the near term, we can expect some increase in inflation, but broadly within acceptable margins to the Bank of England given that interest rates are set to remain at an historic low for the foreseeable future – even with a predicted raise later this year.”

Clark’s neutral assessment sums up the mood of many in the industry who take comfort from the weight of capital – equity and debt – seeking a home in real estate at a time when there is a positive, inflation-adjusted yield gap between property and bonds.

Even so, the old theory of property as a hedge against inflation is destined to be tested once again and yet barely a year ago – just before the EU referendum vote – investors were contemplating deflation and negative interest rates in some European markets.

In fact, there has been an increase in inflation in parts of mainland Europe, notably Germany where annual inflation has reached 1.7 percent. The German situation is usually attributed to the recovering oil price but Sabine Barthauer, director at German bank Deutsche Hypo, believes the current stable economy allied to high employment is also an important factor.

“This creates pressure on wages and prices,” she says. “As interest rates rise, real estate prices will tend to fall and the bank conditions tend to rise. Of course, commercial real estate financing cannot be separated from this development either, especially as our industry is facing increasing regulatory requirements. However, we must also take into account that the increasing competition in commercial real estate financing could lead to opposing effects.”

In other words, margins may well come down because of the competition among lenders, regardless of inflation.

“At present, it’s unclear whether rising inflation expectations are having a huge impact on the markets,” says JLL’s Neale. “Swap rates have gone up 80 basis points since September/October; gilt yields have behaved in a similar way. This puts us back in a similar position to before the referendum, so at present this should not lead to anything more than a marginal increase in debt costs. However, I suspect given the risks around Brexit and its impact on business generally, lenders will be ‘risk-off’ and will be rather more selective.”

Neale adds: “Given the rising amount of dry powder in the debt funds, I’d imagine this will lead to even more demand for prime or long-income assets, of which there is a limited supply. ”

Two asset managers with plenty of dry power are AEW and Natixis, after completing a second close in January with French and international investors for their joint Senior European Loan Fund II. They have raised €400m for the fund so far, and a third close is due in the first half of 2017 with a target to reach total commitments of €750m.

“Continually investors are committing new capital to commercial real estate debt funds,” says Hans Vrensen, head of research and strategy at AEW Europe. “This is driven by the fact that if you are a fixed-income investor, net yields on corporate bonds after adjusting for inflation are close to zero.”

According to Vrensen, debt investment represents a sound, pragmatic move for many fixed-income investors in the current inflationary environment. “There won’t be any upside like with the equity, but you are very unlikely to lose any capital. That’s why new fixed-income and mixed asset investors continue to come into the European real estate debt space.”

As for “the traditional question many of our clients always ask”: in the long-term, is property really an inflation hedge or not? Says Vrensen: “The answer is not straightforward, as the historical evidence so far is not conclusive and mixed for different periods and markets.”