Long ReadSep 27 2022

The value of property in volatile times

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The value of property in volatile times
(Photo by Christopher Furlong/Getty Images)

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.

Capital appreciation

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.

This needs a caveat: because inflation is generally considered ‘bad’ for equity markets, the share prices of listed property companies can also be dragged down by the weight of negative sentiment.

Over the past 18 months in particular the market has provided a partial solution to the issue of listed property companies whose share prices drift below the value of their underlying assets (or net asset value).

We have seen several high-profile examples of private equity firms, like Blackstone, swooping in to buy listed real estate they perceive as cheap.

This generally means sizeable gains for the shareholders of those companies and such deals act as a critical value underpin for those of us investing in the listed property sector.

More tangibly, the world of investible real estate is going through a period of evolution, with the pandemic prompting a particular reassessment of the office, retail and hospitality sectors.

Covid-19 quashed the idea that allowing people to work from home would see productivity dive. Yet businesses continue to recognise the benefits that can be derived from in-office collaboration, and many are eager to lure employees back for at least part of the week.

This means an enhanced focus on high-quality and attractive office space. At the same time, government regulation across the developed world is driving energy efficiency improvements.

The result will be what we are terming the ‘green building super cycle’, characterised by increase in demand for environmentally friendly buildings in major cities, offering state-of-the-art amenities.

As we enter a new university year, student housing also looks interesting. A record number of students were accepted into university or college last year, up 7 per cent from 2020, according to UCAS.

People are – perhaps counterintuitively – also likely to stay in education for longer during times of economic turmoil, as they look out upon an insecure or uncertain jobs market.

High inflation or low, identifying asset classes and sub-markets where demand outstrips supply and where rents can rise should be the umbrella consideration.

During times of volatility, investors are often drawn to real assets like property. Overall, I would argue this instinct is correct – with index-linked and high-quality income key considerations in this environment.

Marcus Phayre-Mudge is a fund manager at TR Property