Are investors right to look to UK real estate amid rising inflation?

UK real estate has seen increased interest from investors seeking shelter from rising inflation. We look at the strengths and weaknesses of the strategy and point out what investors should look out for.

03/05/2022
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Authors

Mark Callender
Head of Real Estate Research

Often seen as a good hedge against inflation, some investors have recently been looking to UK real estate for shelter.

History has given us good reason to have faith in the view. However, we would warn investors not to be too simplistic.

Some inflationary scenarios could still put real pressure on real estate returns and not all sectors will be as resilient as others.

Why are investors looking to UK real estate to combat rising inflation?

One of the attractions of commercial real estate is that rents tend to keep pace with inflation. This reflects the fact that faster inflation will typically feed through to corporate sales and profits. Real estate tenants, therefore, can generally afford to pay higher rents, at least in nominal terms.

In the UK there is a good correlation between commercial rents and inflation. Correlations have a maximum possible positive score of 1, at which point two assets would move in lock-step. Since 1971, UK commercial real estate rents have had a correlation with inflation of 0.6.

However, while there is a significant correlation, the connection is not guaranteed.  Rents reflect the balance between the demand and supply of space. Rents may fall - regardless of the rate of inflation - if there is a recession, or a structural decline in demand (see - the fate of high street department stores), or a building boom.

How do real estate income and capital values behave when inflation is rising?

Real estate capital values and total returns are driven partly by rents and partly by changes in the yields used by valuers. A fall in real estate yields will add to capital values and total returns and vice-versa. A rise in real estate yields will have a negative impact. 

The potential for rental growth means that real estate yields are not mechanically tied to government bond yields. Even so, government bond yields do have an influence.

Real estate yields rose when inflation took-off in the 1970s, although to a lesser extent than bond yields. There is a big difference between rental yields and total return. At 0.1, the long-term correlation between real estate total returns and inflation is considerably weaker than the correlation between rents and inflation.

Looking ahead, a lot will depend on whether the current bout of inflation leads to an upward wage-price spiral. This would force the Bank of England into a sharp increase in interest rates. In our view UK real estate would start to look expensive if 10-year bond yields rose to 2.5%, or higher.

Could the environment cause a rise in distressed sales of real estate?

Historically real estate capital values were quite sensitive to changes in short-term interest rates, because both developers and investors were highly geared. However, that changed after the Global Financial Crisis.

New regulations like Basel III meant that it became prohibitively expensive for banks to lend on speculative projects. In addition, investors learnt that debt is a double-edged sword, amplifying a fall in capital values.

Where real estate investment trusts (REITs) typically had loan-to-value ratios of 60-70% before the GFC, they are now generally between 20-30%. Furthermore, fixed rate loans have become the norm over the last five years, so most REITs should initially be insulated from rises in interest rates.

We do not expect to see a big increase in distressed sales over the next 12 months, although some private property companies and foreign investors with high levels of gearing could come unstuck.

What types of UK real estate are likely to perform best in a high interest rate environment?

Real estate is a chameleon asset class. It sits somewhere between fixed income and equities, depending on whether rents are rising or falling.

As we mention above, bond yields may start to put upward pressure on real estate yields. If that does happen, in general we expect that those sectors with the strongest demand and supply fundamentals and best rental growth prospects will be less affected.

For example, we would expect multi-let industrials, prime offices and retail parks to be less affected than shopping centres and secondary offices.

Although index-linked leases are unusual in the main commercial sectors, they are common in certain sectors such as budget hotels, car showrooms, nursing homes and supermarkets. Even so, while investors in these properties stand to gain from higher inflation, capital values will still be influenced by wider movements in bond yields and real estate yields.

There is also a danger in sectors with weak demand and supply fundamentals (e.g. car showrooms) that rents will drop to open market levels, once current leases expire.

Authors

Mark Callender
Head of Real Estate Research

Topics

Real Estate
Alternatives
Private Assets
Inflation
UK
Investment Trusts
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