Why real estate investors should not panic about inflation

Inflation fears are back, but mitigating forces should not be underestimated, says Jose Luis Pellicer, head of investment strategy and research at M&G Real Estate.

Jose Luis Pellicer: real estate remains a strong prospect despite inflation fears

The first few months of 2021 have been highly unusual in the otherwise steady world of government bonds. US treasuries and 10-year gilt yields have jumped by 90 basis points and 330 basis points, respectively.

The various covid-19 vaccines, the US’s economic stimulus package and a collective, global desire for an end to this pandemic have created fears of a general rise in inflation.

Some investors are spooked. They wonder if the ‘lower for longer’ interest rate environment is coming to an end. What are the potential consequences for real estate? Is the gap between property and bonds sufficiently wide today to compensate for the fact that real estate is an illiquid asset class?

In my view, real estate continues to offer a potentially attractive premium over bonds, while the factors driving potential inflation are likely to be temporary. Even if inflation proves to be more persistent, due to stronger-than-expected economic growth, real estate could benefit.

Why there is fear

Some investors appear convinced that we are about to embark on an inflation spiral, based on a few key principles.

One is the unprecedented fiscal stimulus which has boosted overall liquidity. Biden’s $1.9 trillion package is the best example of this, though the European Union’s €750 billion bailout, as well as the vast amounts of quantitative easing that central banks have injected into their economies, mean there is a lot more cash swirling around within the global money supply.

Another is a perception that the world is ready for a big party. Many people have accumulated savings during lockdown and are itching to spend money on activities such as eating out and overseas travel after vaccination against covid-19. Sudden consumer spending on a massive scale has the potential to drive inflation.

A third is that shipping costs have soared. Pressure on supply chains has increased the cost of shipping cargo and certain commodities by up to 50 percent in the last six months. That cost is likely to be passed on to consumers through higher prices of goods, further contributing to concerns about inflation.

Long-term outlook

While all these issues are valid, the forces mitigating against inflation should not be underestimated. For real estate investors, it is important to look at the medium to long term. Over this timeframe, I believe many of the issues generated out of the covid-19 crisis are likely to be one-offs.

After the release of pent-up demand as respective economies emerge from lockdown, I believe people will largely return to familiar patterns. Our initial spending spree will soon be tempered by the reality of what is in our pockets. Not everyone has accumulated savings to spend.

Unlike the US, not all countries are aggressively stimulating their economies. The EU Recovery Fund represents a far more modest approach and is targeted towards countries such as Spain and Italy, where the corporate sector has been particularly badly affected. In Germany, by contrast, consumers tend to have plentiful savings – at an average savings rate of 10.6 percent per annum since 2000 – but are traditionally more frugal with their money.

Another consideration is that not all the capital injected by central banks will have filtered directly into the wider economy – it has often simply been used to survive during the various lockdowns.

Business expansion will be limited

Some parts of the corporate sector have been severely bruised. Amazon and Netflix have enjoyed a profitable pandemic, while companies in the leisure sector such as Hilton Hotels and British Airways have fared badly. Credit conditions are also subdued, which implies limited business expansion in the short term.

Fundamentally, the damage caused by the pandemic could lead to inflationary pressures subsiding as stimulus packages unwind.

Interest rates are likely to remain low in the near term. The Fed has indicated its intention to keep interest rates near zero until after 2023, even if inflation goes above its target in the near term. This confirms the Fed’s dovish stance on inflation, with any potential rise seen as short-lived as opposed to sustained.

Bond yields are also subject to long-term downward pressures. The volume of pension savings continues to exceed investment opportunities, with high demand for low-risk assets placing downward pressure on bond yields. This is a result of demographics, with more people saving for retirement as well as the proportionate rise of Chinese pension saving and greater regulatory capital demands on banks to hold bonds.

The pressure of excess savings is compounded by increased income and wealth inequality compared to the 1990s. With the uber rich accounting for a bigger proportion of overall global wealth, there is a lot more cash among high-net-worth individuals being saved and seeking investment. However, across society in general, while individuals are able to save small amounts, their aggregate savings are far smaller.

Effect on real estate

In my view, even if inflation fears are justified, they are likely to be short-term. But even if they were more sustained, I believe real estate is in a favourable position. Property still has a margin of safety. Yields in the sector remain well above bond yields, even in hotly competed sectors in markets like Europe and Asia, where interest rates have been lower for longer. Therefore, in my opinion, property still reflects good relative value as an investment.

Real estate offers potential protection against persistent inflation too. Though not a perfect hedge, real estate can offer inflation protection across the long term, with rents and therefore values likely to rise alongside general price levels. If supply remains under control and development finance is subdued, real estate with income growth potential reflects a strong investment play, with or without the impact of higher inflation rates.

While inflation bulls are right to consider its impact, inflation is predominantly a US phenomenon and, in my view, not a major cause for concern in the broader real estate industry. I think the elements that underpin a potential rise in inflation will not be relevant in 18 months’ time. The relative value of real estate continues to appear strong and I believe the asset class is likely to remain resilient to any potential spikes in inflation due to the long-term nature of its investment horizon.

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