With inflation increasing at its fastest rate in 40 years, the Bank of England has increased interest rates by 0.75 percentage points to 3%, the biggest hike in more than three decades. The socio-economic implications of this has been felt far and wide, including in Commercial Real Estate (CRE) markets. While inflation has always been a natural occurrence in our economic cycles it is important to recognise its effects are not the same for investors, developers and tenants. Equally, while CRE has typically been considered a good hedge against inflation, this has not been the case across the industry, rather certain sectors are found to be more protective than others.
Historically inflation in the UK has been a result of ‘cost-push’ rather than ‘demand-pull’, with commercial premises often over-supplied and highly leveraged. Unlike in the 80s, this bout of inflation has resulted from supply chain disruptions, global shortages and increases in labor and energy costs. Equally, it is worth noting that unemployment remains at record lows and demand for consumer goods remains strong. As a result, projections anticipate inflation to drop as disruption fades and economic supply moves to meet demand.
Along with inflation, interest rates have also risen. The implications of this on CRE generally depends on whether this is a result of strong economic conditions or reflective of policy makers desire to slow down the economy to reduce aggregate demand. The effects of the latter is especially bad for tenants, which depending on CRE market conditions may translate onto landlords at lease renewal time, as tenants will be less likely to agree to higher rents. Investors often rely on debt and from their perspective the challenge is evaluating how higher interest rates will affect their appraisal, such as accepting lower returns or pushing up rental growth forecasts.
In recent years we have seen a strong, bullish market, with demand outstripping supply, resulting in sharp rises in prices and significant falls in yields, especially in the industrial sector. The main concern is whether record low yields in some real estate sectors can continue to be paid when debt and other costs are rising.
CRE as an inflation hedge
As an alterative investment class, real estate offers an asset-backed investment with fairly visible cash flows. CRE especially provides good income security as occupiers are more likely to cut their dividend before defaulting on their lease, making rental income more bond than equity like. As such, CRE rental levels have barely declined during recessions. Furthermore, where leases link rental uplifts to the Consumer Price Index it can provide investors with further protection. Data provided by Cushman & Wakefield shows that every 1% increase in inflation is associated with a 1.1% increase in total returns to investors.
Equally, rising interest rates under certain market conditions can result in a double-hedge effect where financing costs become higher, especially in construction, limiting development. The implications of limiting supply is that this sets a premium on higher quality, existing assets. This should keep values firm despite socio-economic pressures.
Investing in the right sectors
With inflation running high, the performance of some sectors are able to provide strong returns above inflation, along with attractive risk-adjusted returns. Between 1980-2010 the retail sector kept pace with inflation, however its performance since has been hindered by structural pressures. More recently, it has been the industrial sector that has performed well above inflation. Irrespectively, recognising the disparities between sectors, sub-sectors and different geographical markets, it is generally advisable to invest in assets with pricing power, such as those with strong structural demand and limited supply.
While there remains much to be learned about the impacts of rising inflation and interest rates on CRE, due to its many variables to performance, limited data and issues with historical comparisons, current predictions remain fairly optimistic. Irrespectively, even if prevailing open market rents plummet during a downturn, in any given year, only about one in six leases are renewed, creating a smoothing effect that protects aggregate rental income from a well-diversified portfolio. Therefore regardless of where we are in the economic cycle, CRE has historically remained one of the strongest tangible alternative investments available.