Is real estate a good inflation hedge?February 13, 2013 / By
Global inflation is low at present, but the risk of future price increases is growing. The quantitative easing measures being undertaken in the United States and relaxed monetary policy in the UK, Europe and Japan pose a potential threat to low inflation. Financial markets are pricing in a rise in US inflation, demonstrated by the negative interest rate offered by the 10-year TIPS (Treasury Inflation Protected Securities).
The Reserve Bank of Australia is not forecasting a significant rise in domestic inflation over the next few years, nor does the spread between the nominal and inflation linked government bond rate imply a significant rise. But the outlook is not without risks. Gold is widely recognised as an inflation hedge and the bullion price has doubled since the onset of the Global Financial Crisis at the end of 2007. So some investors are worried.
If we take the Sydney CBD office market as a case study, investment returns (income plus capital growth) are positively correlated to inflation (approximately 0.47 between 1981-2012). This outcome reflects the fact that most leases are inflation-linked through fixed annual increases which afford the landlord not only inflation protection, but also income growth in real terms (for example CPI plus 1.5%).
The relationship between inflation, rental growth and capital values in the office market is complicated by construction and vacancy cycles. In the mid-1970’s, for example, prime gross effective rents in the Sydney CBD rose by 8 – 9% p.a. despite a vacancy rate rising to 13%. Inflation at the time was 14% p.a. to 17% p.a.
Conversely, the inflation rate and the vacancy rate can work together to compound the impact on rents if they move in opposing directions. This was the case in the Sydney CBD between 1980 and 1983. At this time, the Sydney CBD vacancy rate fell to very low levels (below 5%), and inflation rose to double digits. The combined effect was a significant rise in effective rents (over 20% p.a.). Inflation can therefore have a significant impact on income, and subsequently total returns of commercial property.
Since 1993, when the Reserve Bank of Australia introduced a policy of inflation targeting, the monetary authorities have been relatively successful in stabilising prices. As a result, changes in inflation have been a far less significant driver of rental growth over the past 20 years. Changes in the vacancy rate have become a much more reliable driver of financial performance. Between 1971 and 2012, annual changes in prime gross effective rent in Sydney has a + 0.36 correlation with the inflation rate and a negative 0.59 correlation with the vacancy rate. So both factors appear to be important. However, for investors who are concerned about rising inflationary pressures and a return to the 1970s, real estate begins to look increasingly attractive as a defensive asset class.
Figure 1: Relationship between inflation and the Sydney CBD office market
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