Brickowner Blog

What Really Happens To Property During Inflation

Written by Jennifer Stacey-Clear | Jul 4, 2022 10:12:51 AM

Inflation has soared to multi-decade highs across the UK, mainland Europe and the US, which has prompted central banks to finally unwind more than a decade of near-zero per cent interest rates. The implications for property investors are nuanced. Real estate provides inflation protection but also introduced some risk. Astute investors will look to capitalise on the former and mitigate the latter.

In this article, we examine inflation’s catalysts, the outlook for inflation and interest rates, and the impact of this macro environment on property investment.

Inflation’s pandemic roots

The recent inflation surge is predominantly pandemic-driven. At the onset of Covid-19 back in early 2020, central banks and governments injected huge monetary and fiscal stimulus, to support economies, corporates and households. This global co-ordinated response spiked demand in the economy while supply was disrupted by periodic lockdown restrictions, which limited trading, investment and manufacturing output. This supply-demand imbalance pushed up prices across the board. While supply-side pressures have persisted, demand has softened as pandemic-era government stimulus has expired and economic growth has weakened globally.

In the UK, the annual rate of inflation soared 9% per cent in April, a fresh 40-year high, according to the Consumer Price Index (CPI), as measure by the Office for National Statistics (ONS). At the same time, UK economic activity is weakening. GDP declined by 0.1% in the month of March, while expanding by 1.3% across the first quarter, separate ONS data sets show. Economists forecast inflation will peak at above 10% in the autumn, with UK GDP expected to flatline in Q2. These projections are a recipe for stagflation, which lowers business investment and jobs growth while higher prices destroy demand, reducing growth further in a negative feedback loop.

Pandemic and geopolitics skews upside interest rate risks

There are also additional upside inflation risks. The outlook for inflation – and the pace of subsequent monetary tightening – will be dependent on the evolution of the pandemic and Russia’s war in Ukraine, which has spiked energy, commodity and fertiliser prices, inflaming inflationary pressures. These developments supported the Bank of England’s (BoE) decision to raise interest rates for the fourth consecutive month in May by 0.25 percentage points to 1%.

Sustained global inflationary pressures could prompt the BoE to increase rates by 50 basis points at the June 16 meeting, with economists forecasting a Base Rate of up to 3.0% next year. In this environment of higher interest rates, soaring inflation and weakening economic growth, property investors must be discerning on where to deploy capital.

Property as an inflation-hedge

Real estate is often cited for its inflation-hedging properties. However, a more discerning analysis reveals the asset classes inflation-protection naunces, this is better understood through the lens of leases, sectors, and leverage – which show variations in how inflation translates into property investment performance..

Leases

The efficacy of lease inflation protection can depend on the duration of elevated inflation and timing of lease events. For example, legacy leases with upward-only five-year rent reviews or inflation-indexation will only provide investor protection if inflation pressures remain elevated for three to five years (or more), to allow time for indexed lease structures and rent reviews to come into effect. In shorter duration inflation environments, rent reviews and indexation triggers may not synchronise with temporal inflation swings.

Sectors

Inflation plays out differently between and within property sectors. For example, in the logistics sector, investors still suggest inflationary pressures have not fed into rental growth, which remains supported by strong occupancy demand, limited supply (due to the pandemic slowing new developments), and occupiers’ preference to re-domesticate supply chains. In addition, sustained e-commerce demand has also provided some inflation insulation, although this may be starting to lose momentum.

In the retail sector, inflationary headwinds have been fierce (e.g., due to disrupted supply chains and depressed foot traffic to retailer locations). Retailers’ ability to pass on inflation to consumers in higher prices risks weakening already slowing demand. There are exceptions. Brands that benefit from high consumer loyalty (e.g., Apple iPhones) and retailers which benefit from inelastic demand (e.g., supermarkets) are better placed to weather inflation. However, Apple’s recent “buy now, pay later” interest free loan scheme shows that even top tier brands are concerned by weakening forward sales outlook.

In the residential sector, landlords’ ability to pass on inflation in rental growth varies by housing type and region. For example, social housing leases are indexed on a CPI-plus basis, which provides some inflation protection but typically less than market rent inflation increases structured into private property market leases (particularly in affluent UK submarkets).

In property development, The Bank of England is expected to keep raising interest rates over this year and next, which will increase borrowing rates for funding linked to residential development. However, developers can hedge the volatility through interest rate swaps and will look to offset this increase in costs via increased sales prices.

Leverage

The interaction of leverage and property investment performance is also important. Higher interest rates will increase debt service costs for loans structured on variable interest rates. It increases the cost to repay mortgaged assets. Higher interest rates can be mitigated by fixed-rate loans (which do not vary with movements in the Base Rate) and interest rate hedging contracts. However, fixed-rate loan margins will be higher at the point of refinancing in an elevated high interest rate environment. Interest rate hedging contracts add to investors’ financing costs but provide predictability in an uncertain macro environment.

Managing the downside risks

Investors need insight into the investment case, business plan, lease and tenancy profile, and operator capabilities to accurately assess the impact of inflation on individual properties and portfolios. Higher inflation can increase capex costs under the agreed business plan, as the cost of labour, materials and refurbishment increase. There are also indirect risks, such as tenancy inflation risks in commercial properties. Companies most vulnerable to inflation risks are those with high input costs (e.g., increased labour and raw material costs) and an inability to pass on costs (e.g., food manufacturers). It is, therefore, necessary for investors to stress-test the underlying fundamentals of each asset and not rely on sweeping sector generalisations.