By Marcus Phayre-Mudge, fund manager, TR Property
2022 saw inflation burst back into public and market consciousness. The UK has been bruised by a series of upheavals since the Covid-19 pandemic, in the form of supply chain issues, labour shortages, and an energy crisis caused by unpredictable events in Ukraine.
But since the advent of the pandemic, enough has been written about peak uncertainty, perma-crises and “unprecedented” market conditions.
Instead, the goal of this article is to answer a question that had fallen out of fashion for many years, but that I’m now often asked: Does property act as an inflation hedge and if so, to what extent?
During inflationary periods, investors are drawn to real assets like property. This is partly because as the price of materials and labour rises, creating new buildings becomes more expensive, driving up the value of existing property stock. So far, so good in terms of our ‘inflation hedge’ argument.
On the other side of the fence, the rising cost of borrowing that inevitably accompanies inflation can clearly be a threat to what tends to be a leveraged asset class.
Property equities – REITs or funds like TR Property that invest in REITs – also have a strong short-term correlation to wider equity markets, thus the dramatic downturns we have seen in the sector in 2022 – a year that has proven challenging for stock pickers. But over the long term, property equities act as a sort of hybrid between stocks and bonds, due to their virtue of producing income, much of which is index-linked and therefore inflation-proof.
Across much of mainland Europe – and increasingly in the UK – rents are tied to national CPI, giving landlords and investors excellent protection against the erosion of their earnings. These index-linked rental agreements can be particularly logical for businesses like supermarkets, where their underlying revenue is strongly correlated with inflation.
Rental income also tends to be resilient during times of 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 and commercial tenants are no different.
We now have an answer to the first part of our question: the right property holdings canact 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 that our own borrowing costs are not spiralling upwards.
Presently, some property companies still have longer-term debt arrangements secured when rates were at historic lows and so will not immediately feel the impact of higher interest rates. This could become more of a problem if higher rates persist.
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. Meanwhile, government regulation across the developed world is driving energy efficiency improvements. The result will be what we are coining the ‘green building super cycle’, characterised by an increase in demand for environmentally friendly buildings in major cities, offering state-of-the-art amenities.
However, our major sector overweight at TR Property remains logistics and industrial where we see demand stemming from firms bringing their supply chains closer to home, as well as the on-going evolution of the omnichannel retail environment. We firmly believe that rental growth and development gains will remain a feature of this asset class.
High or low inflation, the identification of asset classes and sub-markets where demand outstrips supply and where rents can rise should be the umbrella consideration. Down-turns like the one which we’ve experienced through 2022 also provide opportunity for investors to pick up property equities at a discount.
During times of turmoil, investors are often drawn to real assets and real estate. Overall, I would argue this instinct is correct – with index-linked and high-quality income key considerations in this environment.
About TR Property
TR Property is a FTSE 250-listed investment trust which invests in the shares of property companies and property-related businesses across the UK and Europe, as select physical properties in the UK. The Trust has been managing client investments since 1905, and it has focused purely on property since 1984, searching for the most promising and profitable companies.