Can commercial real estate help investors hedge against inflation?
However, evidence of commercial property rental growth over the past 40 years suggests that investors should not assume that the same property types that provided automatic hedge against inflation in the past will do the same in the future.
Indeed, for the past 40 years, rent growth in the entire industry has kept pace with inflation, with an average annual growth rate of 3%. But our recent research shows that this obscures the nuances that are critical to investor returns. These headline numbers not only hide significant differences between sub-sectors, but also hide significant differences within different decades and economic cycles.
Commercial real estate undoubtedly provides plenty of opportunities for flexible investors. Since 1980, we have found that UK real estate provides a period of rent growth before prices rise across the economy. During the period from 1986 to 1991 and from 2001 to 2008, driven by rising demand and rising economic cycles, inflation rose within a few years, and rent growth was equally strong, surpassing the inflation of these years on average.
But with the development of economic conditions and structural factors, these opportunities have shifted between different sub-sectors. The decisive factor in whether rent growth can keep up with inflation is whether price increases are caused by demand-side or supply-side shocks.
In terms of hedging against rising inflation, rising demand-driven inflation bodes well for real estate, but supply-side shocks, such as the United Kingdom Food-grade carbon dioxide shortage This year, it is harder to hedge in history.
Over the next five years, we expect rent growth for certain types of properties to be higher than inflation, but real rents for most properties will fall—again, they are popular with investors seeking an inflation hedge.
Which types will flourish and which will struggle? Signs of limited supply are a good starting point. The buildings in central London, as well as other scarce central assets, will continue to be attractive by this measure. The lack of supply in the residential market is also expected to continue.
It is important to remember that supply may be restricted at the micro location or asset level, even if the broader sector is not. For example, while there is concern that the increase in remote work will lead to an oversupply of office assets of average quality, this does not apply to “first-rate” buildings located near important transportation hubs. Today, the supply of new real estate is also unusually restricted by material shortages and rising construction costs, although these restrictions are expected to be alleviated in the medium term.
Similar short-term considerations may lead to inflation in certain sectors. Taking examples other than commercial real estate as an example, the sharp depreciation of the pound after the Brexit referendum has pushed up the input costs of retailers, and at this time they have little ability to pass these input costs to consumers. This has increased the pressure on retail profitability.
In commercial real estate, the long-standing structural mismatch between supply and demand has caused rent growth to exceed inflation for a longer period of time. Our analysis shows that these structural factors—such as demographic, technological, or behavioral changes—are more important than the cyclical drivers of real estate. Nothing illustrates this more clearly than the rise of e-commerce and the shift in rent growth from retail to industrial real estate.
In the retail industry, most of the rental values ??have kept pace with inflation for the 30 years to 2010, but the rise of e-commerce has significantly suppressed rental growth since then. This trend seems to continue, indicating that, driven by warehousing and distribution, rental growth in the industrial sector will exceed inflation in the next few years-even if supply may respond in the medium term.
Among the structural factors, the demographic structure is the most predictable-population-driven demand will be the strongest in the residential and healthcare sectors. As the number of 18-year-olds in the UK increases in the next ten years, the domestic population’s demand for student accommodation will increase, and the aging population will drive demand for retirement and nursing homes.
Even if inflation is ultimately higher than expected, our industry preferences will be similar, although leasing characteristics will become more important.
Some leases include indexation, ensuring that rent growth matches inflation, at least to some extent. The length of the lease also has an impact. Even in the absence of indexation, rent reviews in the UK are usually upwards to prevent short-term rents from falling. However, investors must remember that rents will return to market prices at some point. One such industry currently at risk is the supermarket, which has recently seen strong investment activity.
Although the current rise in inflation has frightened some investors, evidence from the past 40 years shows that real estate plays an important role in hedging inflation. Although this is still the case today, the sub-sectors that provide inflation protection will change over time. Successful investors must understand demographic and behavioral changes more deeply if they want to keep up with rising prices and reap the kind of returns that commercial real estate can provide.
Himanshu Wani is a senior assistant in UK real estate research at CB Richard Ellis Investment Management Company