Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

Commercial property and inflation: hedging your bets

As the rhetoric around inflation has increased, so too has scrutiny around commercial property – an asset class typically perceived to offer an inflation hedge.

 

But it’s complicated

Firstly, there are questions around what measure of inflation property is meant to hedge against – the difference between CPI and RPI, for example, is 0.7% p.a. over 30 years. The time horizon of inflation also matters: do investors require a very long-term hedge, or should they only hedge when real-term values are most under threat? Also, what attribute of performance is meant to be hedged? While most investors cite capital values, institutions sometimes need to match inflation-linked liabilities – meaning rental values are more important.

Let’s not forget too that property is a very different asset class from 30 years ago, in terms of sector weights, income security (shortening leases) and sector characteristics (the changing nature of retail, for instance).

At best a partial hedge

A perfect property hedge would be one that is highly correlated to inflation or exceeds it. But commercial property has offered, at best, a partial hedge. Analysis[1] shows that, historically, offices had a very good correlation with inflation. The industrial sector was also correlated but less strongly, while retail had a much weaker relationship. Our own analysis of rental and capital values using the MSCI sample since 1981 suggests only residential and parts of the alternative sector have offered growth in real terms.

More importantly, it would seem performance in real terms only selectively improves over periods of higher inflation. Between 1987 and 1992, when CPI inflation averaged 5.2% p.a., retail and industrial rental values grew in real terms, meaning All Property rental values just about matched inflation. But capital values, except for industrial, did not. While the period between 1993 and 1998 (with CPI at 2.2% p.a.) yielded real-term capital value growth in all the main sectors, between 2008 and 2011 (when CPI inflation averaged 3.3% p.a. and the economy emerged from the financial crisis) no property sectors performed in real terms.

One of the reasons for the performance divergence could be the drivers of inflation. Under demand-pull inflation, where GDP growth is stronger and occupational demand growth higher, property sectors should perform better and therefore offer more of a hedge. Cost-push inflation, however, is more challenging. While it does not result in higher occupational demand, it may well increase the costs faced by occupiers. Nominal performance would therefore, at best, be unaffected by the drivers of inflation but still be eroded in real terms or, at worst, see depressed capital values as inflation peaks.

This suggests to us that measuring hedging at the All Property level may be useful in theory but lacks relevance in practice.

Potential strategies under an inflationary scenario

There are explicit hedges that can be pursued where rents are linked to inflation – inflation-linked leases, for example, although scarce are still available.

There are also implicit hedges, where supply and demand factors are the differentiator. As mentioned above, the office and industrial sectors have historically offered the better relative hedge among the traditional sectors. But today, offices are readjusting to lower levels of corporate demand and – although we are relatively optimistic about the sector over the medium term – we do not expect strong performance in the near term. Retail is expected to underperform too, and its occupiers may also face greater pressure from a cost-push scenario. Industrial therefore remains our preferred sector with a robust occupational story driving rental values.

Within the alternative sectors, we see the best prospects from build-to-rent (BtR) residential and student accommodation, where we expect capital values to grow between 2.5% and 3.5% p.a. all else being equal, with performance supported by needs-based demand and – in many locations – a shortage of good quality supply.

Strategies weighted to industrial and parts of the alternatives sector should offer better inflation protection, in our view, with outperformance growing under a demand-pull scenario but resilience offered against cost-push. We believe office and retail strategies, at least in the near term, would struggle in comparison.

There are other approaches to risk, though, which allow more sensitivity to inflation. Shorter leases, in a demand-pull scenario for example, offer an opportunity to readjust to prices more frequently. Operational risk could, we believe, offer net operating income growth in excess of inflation.  Deliberately removing the protection and structure of a lease so that the investor’s revenues are aligned with the operator’s is becoming more common. It is strategically important in offices (management contracts), retail (turnover leases) and for self-storage assets within industrial. Finding the right segment, the right operator and the right structure is of course vital. This will be key to differentiating investors.

In summary, while resilience to cost-push inflation is likely to be limited, resilience to demand-pull inflation is likely to be wider, but it will not come from the same property sectors as previously.

Ultimately, the ability to hedge rests on pricing power. Needs-based or structurally strong sectors can provide this. In a world where specification and occupier engagement increasingly matter, we believe investors that can attract and keep occupiers, by what they offer and how they offer it, will mitigate inflation risks.

 

[1] Property Market Analysis, June 2021.

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