For the first time since the early 1980s, inflation has become an urgent consideration, and there is little room for error as central banks look to in rein in rising costs without triggering recession – a possibility that is very much on the cards.
Regardless of whether we do enter recession, the cost of living crisis and rising energy costs – exacerbated by unpredictable events in Ukraine – will weigh heavily on consumer sentiment as the colder months arrive.
Supply chain disruptions, particularly around the ongoing lockdowns in China and post Covid-19 workforce shortages, compound these pressures.
But enough has been written over the past several years about perma-crises, peak uncertainty, and 'unprecedented' market conditions.
Instead, this piece aims to answer a specific question I am often asked, especially in present circumstances. Namely, whether property acts as an inflation hedge for investors and if so, to what extent?
Property as protection
What is heavily inflation-proof is the income that comes from a well-constructed property portfolio. Across much of mainland Europe – and increasingly in the UK – rental increases are tied to national inflation, giving property owners and operators excellent protection against the erosion of their earnings.
It can be argued that these index-linked rental agreements benefit both landlords and tenants, as they avoid the so-called ‘rent review lottery’ that often locks one party into paying (or receiving) a sub-optimal rent over the term of the agreement, based on the market conditions at the moment a renegotiation took place.
This system will be familiar to those of us residing in the UK, but businesses and landlords are increasingly adopting the continental consumer price index-based increase model. This can be particularly logical for businesses like supermarkets, where their underlying revenue is already linked to CPI.
Rental income also tends to be resilient during times of inflation and economic stress as it is a non-discretionary spend. Most of us have a long list of household expenses we would sacrifice before we stopped paying our accommodation costs, be that rent or mortgage, and commercial tenants are no different.
We now have an answer to the first part of our question: the right property holdings can act as an inflation hedge. But to what extent?
The rising interest costs that accompany inflation can clearly be a headwind for a leveraged asset class. The above scenario, in which our supermarket tenant is happily paying us CPI-linked rent, is only positive provided our own borrowing costs are not spiralling upwards.
Presently, many property companies have longer-term debt arrangements secured when rates were at historic lows and so will not immediately feel the impact of higher interest rates. Further ahead, this will indeed become a problem for some if higher rates persist.
The next issue to consider, and perhaps the first one that comes to mind when most people think ‘property investing’, is capital appreciation. That is, the amount by which a package of land, sticks and bricks goes up in value over a given period.
Again, real estate valuations tend to have a strong long-term correlation to inflation when compared with equities.