That the current environment is challenging is self-evident. The impacts of supply chain disruption, labour shortages and the rising cost of raw materials and energy have combined to deliver the highest rate of inflation for 40 years.
As a result, central banks are seeking to bring it under control.
As widely predicted, the Bank of England raised the base rate to 1% in May and by a further 0.25% last week – the fifth rise since December. The big question is how aggressive the bank will be on future rate rises and opinion is divided on this, with a wide range of forecasts of where the base rate will be by the end of next year.
This has led to concerns among investors about the potentially adverse impact on yields. Although interest rates are rising, this does not necessarily mean that yields will rise in tandem, particularly with continued rental growth and limited supply in many parts of the market. Nevertheless, investors would be wise to be cautious and conservative with exit yields over the medium term, to manage any possible yield pressure.
Clearly we are experiencing a period of weaker growth and high inflation. But the consensus is that this is temporary and inflation should begin to normalise in 2023. So, it is not likely stagflation will occur, and the inflationary picture is not expected to worsen to the levels that we saw in the 1970s.
Nevertheless, many investors believe property investment provides a good hedge against inflation. This may be true for some sectors and over some time periods, although the reality is more nuanced, with the economy being the main driver of property performance.
Nonetheless, the inflationary environment has left many investors wondering how best to pivot their strategies to withstand and possibly capitalise on it.
As a pure inflation hedge, index-linked or shorter leases are a good bet, allowing investors to capture price growth by adjusting rents more often in response to market conditions. These tend to be more common with operational real estate, such as hotels, which can use dynamic pricing on room rates.
Another worthwhile strategy in a period of high inflation is to focus more keenly on the supply-and-demand fundamentals that drive rental growth. That means greater exposure to green buildings, which command a rental premium, as well as to rapidly growing segments such as life sciences, where there is a huge lack of good-quality, purpose-built space.
It also means greater alignment with sectors undergoing structural change – where a sector is in its infancy and rents are coming off a low base – which can lead to significant and sustained outperformance. The stellar performance of logistics on the back of the strong growth in online retailing is a recent example of this.
It is also true that inflation is a positive for best-in-class real estate. Price pressures will force businesses to cut costs where possible and ‘commodity’ property (and people) will be adversely affected. This in itself will create opportunities for value-add investors – those willing to roll up their sleeves and reposition secondary assets will reap the benefits in the medium term.
So, despite the challenges, we remain cautiously optimistic about the economic outlook and continue to focus on the fundamentals – growth sectors and good old-fashioned drivers of supply and demand.
Manish Chande is senior partner at Clearbell Capital