For decades, there has been a debate over whether property investments serve as an inflation hedge or they are instead a “perverse” hedge.
During the recent low inflation era, this question was moved to the background, as the yield differential between real estate and bonds were the driving factor for real estate investments; inflation was only of minor consideration when investing in property.
According to our assessment, we have transitioned from a low-inflation world to one of structurally higher inflation. Therefore, we view the recent inflationary surge not as a one-off occurrence nor transitory, but rather as the consequence of structural shifts in the economy. This means also that further inflationary waves are likely to follow, albeit we still cannot assess at this stage whether they will be larger or smaller as the first wave that is just receding.
Structural inflationary pressures
We see the following drivers of this fundamental change in the inflationary picture:
First, there is a change in the geopolitical landscape due to the shift from a unipolar US dominated world to a conflict-laden multipolar world. The breakout of the war in the Ukraine is thus only a symptom and not the main reason of the inflationary surge.
Unfortunately, we are facing a world with major political and military conflicts, as the explosive situation in the Middle East documents. The trend towards rearmament and shift toward “war economies” increases the demand for energy and raw materials. At the same time, this leads to less efficient global value chains due to reshoring and nearshoring of processes.
Secondly, the demographic situation has changed; we are only at the beginning of a wave of baby boomer retirements. This trend is also accompanied by the desire of Generation Z and millennials to work less and or part-time.
Unemployment rates are close to record lows in many countries. There is a major shortage of qualified workers in many sectors worldwide. It can be assumed that technology will remain a deflationary factor due to AI and robotisation. The shortage of qualified workers in many places is nevertheless likely to worsen, as technological changes will not be able to offset the demographic effects as quickly. So wage inflation is expected to remain elevated.
Thirdly, accelerating climate change is associated with inflationary effects. The decarbonisation of the economy leads to additional costs and less efficiency in production. In the German-speaking world, for example, advanced technologies for cost-effective, clean energy generation, such as nuclear power, are being abandoned for ideological reasons.
At the same time, climate change is also leading to increased government investment and support for those in need. From a debtor’s point of view, inflation helps to bear the financial burden better and comes at just the right time for political decision-makers. Consequently, higher inflation is even politically desirable. We assume that they will soon be accompanied by other means of financial repression, such as yield curve control or incentives for investor to hold government bonds.
Inflation is also always subject to cyclical influences. As a result, we will see phases of disinflation, as is currently the case in Europe. In such periods there will be those who claim that the battle against inflation is over. Some believe they are back in the old world of low interest rates and low inflation. However, investors and investment managers should use such phases to gear their portfolios towards structurally higher inflation and the next wave of inflation.
Higher capitalisation rates as a result of the first wave of inflation
Higher inflation has an impact on capitalisation rates as well as on the income and costs of a property. However, which effect predominates also depends on the past
and the buffer of net yields against higher nominal interest rates.
Three years ago, we used a four-phase model to describe the adjustment of real estate values to structurally higher inflation. We still think that this framework remains valid to characterise the transition process and have organised it into four phases:
- Shock from interest rates and negative inflation surprise
- Economic slowdown/recession
- Adjustment to new equilibrium
- Inflationary growth
The psychology of market participants must be taken into account. We must bear in mind that the consensus in 2021 was that inflation had largely been defeated and that the negative interest rate environment in Europe could continue for years to come. Accordingly, real estate has historically had disproportionately low capitalisation rates, so the abruptly higher inflation served as a psychological shock.
Capitalisation rates had to rise significantly along with bond yields, which led to sharp devaluations that are already continuing in most markets. The following
phase is one of the economic slowdown as a result of rapidly rising interest rates, typically leading to weaker rental markets.
The disinflation trend then allows interest rates to be lowered in the third phase. Depending on the interest rate situation, the repricing of the capitalisation rates should then be completed in the third phase. In this phase, capitalisation should reflect the new level of structurally higher inflation.
Real estate should benefit from next waves of inflation
If we are correct in our expectations, further waves of inflation are likely in the near future, or inflation will remain sticky. Contrary to the negative experiences from the first wave, we assume that inflation will now have a more positive effect on the return prospects of real estate. One reason for this is that the now higher capitalisation rates should reflect a new inflationary world and have less upward correction risks. On the other hand, cash flows are likely to react positively to inflation, as they did during the first wave of inflation.
Another factor that is likely to affect rental market prospects in the medium term is that the number of new construction projects launched fell sharply due to the inflation shock during the first wave. A smaller increase in supply generally leads to a stronger upward trend in market rents.
