As the cost of living soars, so the potential knock-on effect of interest rate rises travel up the agenda. Experts wonder what this means for real estate.
It is not something that investors in real estate have had to contemplate since the Global Financial Crisis of 2008: inflation. In the years immediately following the GFC, rates reached 3.8% in the US, 3.2% in the Eurozone, and 3.6% in the UK.
Now there is a set to be an explosion of comment among investors as inflation rose throughout 2021 and are forecast to rise even further in 2022.
Blackstone and Principal Global were among well-known asset managers that started to issue special reports on the subject from summer 2021, tacking the question of the best strategy when inflation become an issue. Expect many more such reports.
Blackstone said last summer that sector-selection mattered. ‘Bond-like assets that have long-term leases with limited rent resets are more susceptible as rates rise,’ it said. Sectors facing tenant demand headwinds, such as US regional malls and urban office buildings, may not be able to command near-term rent increases that can keep up with inflation.’
But the firm added where investors could seek safety: ‘Unlike traditional bonds that generate fixed cash flows, the income streams from real estate can rise over time. Prioritising assets with shorter lease durations in sectors with strong underlying growth fundamentals can result in faster translation of higher market rents into underlying operating cash flows. Hotels effectively have one-night leases. Other sectors, including apartments and warehouses, also tend to have shorter-duration leases. Certain assets with longer duration leases, such as net lease properties, often include contractual rent escalators to mitigate inflationary risks.’
High inflation triggered Principal Global Investors to ask questions in the last quarter of 2021 such as will higher interest rates that typically follow high inflation equate to lower investment performance? Which property types are likely to experience the most pain points from higher interest rates? Will spreads between real estate cap rates and bond yields widen? Looking at US real estate, the firm said the relationship between returns and interest rates varied by property type.
Most people in real estate will point out the positive aspect to the issue of high inflation eroding the value of cash/income. Jessica Hardman, head of European real estate portfolio management at DWS, said in the firm’s 2022 report: ‘Real estate is a good way to hedge against rising inflation.’
But there is also the cost of financing to consider, plus rising cost of labour and materials during construction, and whether demand could ultimately swing more to bonds than to real estate if coupons are raised to attract more investors that otherwise might decide to keep more in cash if interest rates rise.
Despite quite dramatic rises, investors such as BlackRock do seem to be paining quite a benign picture of things. In its 2022 Global Outlook, the firm says: ‘Inflation is likely to be elevated but in control.’
‘Unlike recent upswing cycles, this round of inflation is coming from the supply side, rather than the typical later-in-the-cycle demand side pressures. Importantly, real assets remain a potent hedge against inflationary pressures, particularly where there are indexed rents or contracted revenue streams in place.’
Mark Callender, head of real estate research at Schroders, argues that real estate is only a partial hedge for inflation. ‘While rents should broadly keep pace with inflation, capital values and total returns are sensitive to interest rates. A lot therefore depends on whether central banks decide on a sharp, or modest tightening of monetary policy over the next 12 months.’
He adds: ‘A big hike in interest rates, in response to a wage-price spiral, would have a knock-on impact on real estate yields and depress capital values and returns. A limited increase in interest rates might have no impact, particularly if rents are rising in most parts of the market.’