Can Real Estate Hedge Inflation Risk?
The relationship between prices, interest rates and inflation Is complex, and real estate is not rocket science!
Let’s discuss the European (or the US) housing markets to interpret the correlation. Even though housing prices are likely to be capped in a number of European countries (or metropolitan areas in the US) in the short term because of possibly higher borrowing costs, we believe real estate values will continue to beat upcoming inflation levels. Beyond compare, attractive financing conditions (affordable monthly mortgage instalments, refinancing options) have been key drivers for value preservation in recent years. As a matter of fact, nominal interest rates will probably edge up in the medium term, which could change the mind-set of investors. The key question is whether higher nominal interest rates will result from soaring inflation.
Direct real estate (commercial and residential) may offer investors some protection against a sudden surge in inflation. If nominal interest rates rise because of a projected acceleration in demand inflation, then real interest rates (adjusted for inflation) will remain more or less stable. If a property owner finances his own “bricks and mortar” at a capped rate before inflation surges, borrowing costs will remain unchanged while rental revenues will increase. Consequently, real estate is a potential source of cash flow.
Protection against inflation is undeniably partial for two main reasons: i) there is a time lag between the rise in prices and the rental indexation, often six months or more, and ii) the various indices used for rental indexation do not always fully reflect future inflation. In the event of inflation, growth in rents tends to occur before values go up. Theoretically, property values could be considered as an infinite supply of growing rental cash flows, which is why rents rely on inflation to climb.
In the short term, higher nominal interest rates may spark temporary jitters more in the housing market than in the commercial real estate universe (with or without inflation. We believe this is likely to happen, with investors focusing solely on rising borrowing costs. Indeed, it may take a while before long-term investors can reap the benefits of the impact of inflation on housing values.
As always, there is no consensus on upcoming housing prices and rents. Europe is a good example. In the UK, rents could rise by more than 25% over the next few years[i], outpacing an expected rise in property prices of less than 20%. So rents should rise faster than (affordable) housing prices. And in Germany, the Bundesbank (the central bank) projects that houses in the country’s major cities are overvalued by as much as 30%, thereby fuelling fears of a housing bubble in Europe's largest economy after years of ultralow interest rates . Prices for residential real estate rose by 8% last year in 127 German cities, up from an average of 6.75% per year between 2010 and 2015.
The questions and comments reflect the big real estate picture today, though we need to translate this into everyday business practice and investments.
[i] Source: Royal Institution of Chartered Surveyors