Property and inflation: do they mix?

Many economic forecasters are flagging inflation as an adverse development of which investors must be wary. Chris Bedingfield, principal and portfolio manager at Quay Global Investors, refutes both the likelihood of rising prices and the belief such a scenario would disadvantage property holdings should it occur.

There’s been a lot of talk lately in investment markets about inflation and whether it is likely to increase – and if it does, what this means for investors.

This discussion is especially relevant for investors in property, in particular, listed real estate. Real estate investment trusts, or REITs, are generally seen as a yield investment, and many people believe a rising inflation environment is bad for yield and so they should sell out of such investments when inflation is increasing.

Therefore, for SMSFs with investments in listed real estate, there are two key questions to consider. If we do start to see inflation, is this a good time to liquidate listed property holdings? But also, are we really likely to see rising inflation over the short to medium term?

Inflation and real estate

So, is high inflation a negative for real estate? If we do start to see a sustained increase in inflation, the usual first step by central banks is to increase interest rates. In the short term, this could lead to unsophisticated investors selling out of their listed real estate investments, which would have a negative impact on the value of REITs.

But over the longer term, our research has shown rising inflation is actually good for real estate. For instance, between 2003 and 2006 when the United States Federal Reserve was raising interest rates and inflation was averaging around 3 per cent a year, US REITs outperformed equities. The same was true in the 1970s and early 1980s when inflation was at a historical high – averaging between 7 per cent and 8 per cent a year. Again, during this period, REITs significantly outperformed the index.

To many investors this will seem counterintuitive. But there are very good reasons why this is the case.

One reason is inflation means replacement costs are pushed up, so any new supply will come onto the market at a progressively higher price.

What this means is that over time most real estate trades around replacement cost. However, in periods of higher inflation the replacement cost rises faster, pulling up the capital value of existing assets. For investors, this results in their real purchasing power being protected from the impact of rising inflation.

Another reason is some investors make the mistake of believing real estate is a proxy for bonds and can be treated as a yield instrument. This is not the case. Real estate delivers a return based on both yield and capital growth. Therefore, assumptions about how inflation or interest rates will affect REITs need to take more than just yield into account.

We believe rising inflation is in fact good for real estate investors and the asset class represents one of the best avenues to protect against erosion of purchasing power.

Is inflation imminent?

This leads to our next question: just how likely is it that we are going to see rising inflation?

This is perhaps a bit more challenging to predict. As global investors, we are particularly concerned with what’s happening in the US as rising inflation there will likely trigger similar outcomes in economies such as Australia.

Without doubt, we have just come through one of the most, if not the most, extraordinary years in our lifetimes following the outbreak of the COVID-19 pandemic and subsequent lockdowns around the world. It will take some time for the effects of this to play out and the economic numbers to cycle out of the annual consumer price index (CPI) calculation.

It is therefore likely we will see some periods of rising prices over the next year or two. But is this true inflation? We believe $ not. In fact, the definition of inflation is a continuing increase in prices from one period to the next, that is, a sustained rise in prices over time.

Certainly bond markets are currently suggesting a concern about rising inflation and bonds are often seen as a predictor of economic data. However, this doesn’t mean they are always correct. It’s important to look more deeply.

Another data point to consider is unemployment levels. In the US, the official unemployment rate is still at a relatively high level. In addition, it is probably somewhat suppressed as it doesn’t include people who currently aren’t actively looking for work, but would be if the environment was more positive.

As investors in real estate we are not concerned about the risk of inflation, instead we would welcome it.

As prime-age workforce participation remains at a cyclical low. This suggests there is more than enough labour available to respond to demand pressure as the market improves, which will help reduce inflation.

It is also useful to look at the different drivers of inflation. The CPI basket, which pools the prices of a number of items into a single index in order to measure price changes, is very informative. One of the biggest elements of the US basket, rent, is showing almost no change at all. This covers both rent paid to landlords, and the equivalent ‘rent’ paid by owner-occupiers. Indeed, if we look at US apartments in the big coastal markets, rent is actually falling.

Furthermore, in those places where rents are rising, the supply levels are not just rising as well, but accelerating. This would not be the case if inflation was likely to be a problem.

Finally, let’s look at government debt. This is often believed to be a trigger for inflation and certainly history has shown high levels of government debt can be a problem for inflation.

There’s no doubt we are seeing very high government debt around the world. The US alone approved a $1.9 trillion US government COVID relief package early in the year and Australia’s stimulus package was one of the biggest in the world, behind the US and Canada, as a ratio of gross domestic product (GDP).

So how likely is this to drive inflation? Despite the size of the numbers, it’s worth keeping in mind the ratio of US government debt to GDP is still less than As investors in real half of Japan’s and, as a reminder, Japan continues to fight deflation.

One of the keys to this is whether concerned about the risk households start spending. A major issue in Japan is that Japanese households since of inflation, instead we the 1990s have focused on saving rather than spending, in effect deleveraging from would welcome it. the 1980s credit boom.

We believe this is unlikely to be the case Pricing cycles during the next year or so. It seems more Replacement cost – high inflation likely, as people emerge from COVIDReplacement cost – low inflation induced restrictions, we will see a reaction more akin to that of the Roaring Twenties – consumers keen to get out, spend money and enjoy themselves.

Role of central banks

It’s worth emphasising the fact that central banks have limited impact on inflation. time The evidence suggests interest rates, the primary tool of central banks, do little to help them achieve their inflation targets. Indeed, for the past 20 or so years, most central banks have battled to elevate inflation to their target band.

So as investors in real estate we are not concerned about the risk of inflation, instead we would welcome it. However, we won’t be holding our breath for its arrival.