Real Assets: Sheltering under a roof
Property is limited in its ability to hedge inflation but it can certainly play a role. Rachel Fixsen and Lynn Strongin Dodds report on the diverse strategies to consider
When an asset class comes with a famous adage that promises security – ‘as safe as houses’ – it is understandable that investors will expect just that. Common wisdom tells investors that owning property will provide protection against the eroding power of inflation.
“There are a lot of large investors out there now who are targeting real estate,” says Neil Cable, head of European real estate at Fidelity Worldwide Investment. “Tacitly or explicitly, one of the reasons they are doing it is to hedge against inflation.”
But analysis and debate in recent years has called the assumption into question. This summer, research funded by Deutsche Asset & Wealth Management (and detailed elsewhere in this special report) showed that real assets, including commercial property, offered no more than weak inflation protection – if any at all.
A report published two years ago by the Investment Property Forum (IPF) found that commercial property rents in the UK underperformed inflation. Taking the City of London office sector as a snapshot, rents fluctuated between £40 per sqft and £70/sqft during the period, but they diminished against long-term inflation. Equities were considered a far better hedge when defined as moving with or reacting to inflation.
Striking a chord
“Whilst real estate does provide ways of protecting income from inflation, academic studies have shown that this may only be partial and will depend on the type of property, terms of the lease and prevailing market conditions,” says Douglas Crawshaw, senior investment consultant at Towers Watson.
Major pension fund investors tend to come to similar conclusions.
Earlier this year, Fidelity produced a white paper claiming that real estate Total returns are not highly correlated with inflation. The capital value component of total returns itself was found not to be an effective hedge. But the study shows that income returns have offered material protection against inflation since the 1980s. Since the mid 1980s, the income return on UK property has generally outpaced inflation; between 1985 and 2012, the average income return was 6.8% while RPI averaged 3.6% (see figure 3).
The reaction that Fidelity encountered to its paper indicated the issue had struck a chord with institutional investors.
“It’s certainly the one that got the most interest from clients,” Cable says. “People are concerned about a pick-up in inflation over the next three-to-five years. They are most worried about positioning their portfolio in time, should inflation pick up.”
The issue is not urgent at the moment, however, he says, and investors are still at the data-gathering stage. So, under some circumstances it seems that income can guard against future increases in the cost of living. But what about the capital appreciation?
“The owner of a property can have an income stream that’s linked to inflation for the term of the lease, but there’s no guarantee that the property’s capital value will grow in line with inflation,” says Richard Cooper, senior consultant at Aon Hewitt.
Although the existing lease could be index-linked, the income after the lease expires would not necessarily be, he says. That said, there are ways of taking the capital side out of the property investment equation, in order to leave just the index-linked lease income.
“Some managers are acquiring income strips – buying the right to receive the income from a property for the term of the lease but not the property itself,” Cooper says.
Joe Valente, head of research and strategy at JP Morgan Asset Management, is more persuaded by arguments that capital values reflect long-term inflation trends.
“There is a lot of talk about real estate being an inflation hedge, but the reality is that there are few, if any, perfect inflation hedges that also support attractive risk-adjusted returns,” he concedes. “If inflation goes up by 1% this does not mean the value of the real asset will rise at the same rate. This is particularly true of real estate which is lumpy. However, it can help counter inflation without sacrificing return or significantly increasing risk.
“There is a general misunderstanding about the relationship between property and inflation,” he adds. “Property is not a perfect inflation hedge. It does not offer a one-to-one protection against inflation, it simply follows the basic law of supply and demand.”
When construction costs go up, in line with commodity prices or labour costs, the supply of office, retail and industrial space declines and rents increase, making real estate more valuable, Valente says.
“Property is a good inflation hedge, but over long periods of time and in markets where supply reacts to changes in construction costs,” he reasons.
But, he notes, that this is not the case everywhere. Some markets are particularly bad at adjusting new supply to changes in construction costs. Valente says inflation-indexed leases can be an important tool – as long as the tenant remains in the asset. But he points out that the markets that offer the most inflation protection – namely, the US and the UK – do not have inflation-indexed leases as such.
Some investors are buying into long-lease property funds specifically to generate a long-term real return, Cooper says. They may contain, for example, student property or supermarkets where the leases are linked to inflation.
“The capital value isn’t directly linked to inflation, of course, and elements of an asset’s value that are subject to depreciation, such as the building, will require expenditure to maintain their value in real terms,” he says.
Some investors have turned to alternative real estate-related investments that provide a more discernible link to inflation. An example is providing debt to registered providers of social housing where the debt coupon is linked to inflation. Another is acquiring an interest that is leased back to the housing association with the rent paid on an index-linked basis.
“The problem is that there seem to be quite a lot of players in that part of the market, and prices are being driven up by new entrants,” Cooper warns.
Index-linked property has been very popular recently, he says, with such properties often having good quality tenants and attractive long-lease terms.
“Due to investor demand, they’ve remained relatively expensive in recent years but consequently their values have been resilient as the market’s been weak,” Cooper says.
Mark Bunney, head of indirect property at Kames Capital, believes property is not an inflation hedge, although it is possible to construct a portfolio with strong inflation linkage. He advocates adopting a diversified approach using pooled funds which can be considered either as an alternative to, or complementary to, fixed income products. These include long income, ground rents, property and infrastructure debt, student accommodation and healthcare funds.
“You have to tread carefully because, for example, some long-lease funds look fully priced while ground rent funds are difficult to invest in due to limited stock and some are also keenly priced,” Bunney says.
Ground rents, which are payments to a landlord in return for a long lease, have been dominated by a small number of niche investors who would buy directly from property developers. Over the past 12 months, however, they have gained an institutional following due to the secure income generated from both fixed and index-linked uplifts on a variety of review cycles of between three and 25 years. The market has since become overcrowded, making it challenging to find attractive product.
Long-lease property funds are also in vogue with major fund management groups. They are proving increasingly attractive to UK pension funds as alternative forms of inflation-linked income with which to match liabilities and diversify fixed income portfolios. BlackRock and AXA Real Estate have recently entered the fray alongside established players such as Standard Life, Aviva Investors and M&G.
But while funds traditionally focused on acquiring long-leased supermarkets with fixed rental uplifts, changing market conditions (mainly aggressive pricing and a limited number of opportunities) have forced managers to broaden the scope of their investment strategies.
Dislocation, dislocation, dislocation
BlackRock’s new fund will invest in alternative property sectors, such as student accommodation, healthcare, housing associations and ground leases, as well as traditional assets such as supermarkets and offices. Existing funds have already been moving in this direction.
Properties with shorter leases, though, have not disappeared; in fact, some industry experts are encouraging investors to take another look at this segment of the market, which can include residential, industrial and retail assets. These property types are not only in a better position to increase rents and offset higher cap rates but also to keep pace, if not exceed, the rate of inflation.
This might not be the case with properties such as office buildings that are fully occupied and are sitting on long-term leases of 10-to-15 years. They may struggle when interest rates rise due to the difficulties of increasing rents.
“We like alternative sectors,” says Andrew Hills, director of client portfolio management at Invesco Real Estate. “They provide an investor with a larger universe. They have higher returns compared to other commercial real estate and there is steady growth over the long term. Hotels are a good example in that they can be structured as a pure real estate play with guaranteed cash flows and hybrid leases that can match asset liability strategies.
They can generate around 7% cash-on-cash versus, for example, 4-4.25% for a Tesco supermarket on a 25-year lease.”
Jason Yablon, vice-president of Cohen & Steers, agrees: “There is a shorter lease-drag with hotels because they can reset the room rates daily. We also like industrial real estate investment trusts because there has been a recovery in the occupancy rate as the economy has recovered. Last year we saw the larger firms like Amazon taking more space but this year it is the smaller players who are more tied to housing and have seen an increase in consumer spending.”
Laurent Luccioni, executive vice-president and head of commercial real estate portfolio management at PIMCO, favours regional shopping centres and convenience stores in Europe.
“It is the barbell effect with retail assets on either side of the spectrum,” he says. “They both provide protection against inflation. We believe that hotels can be too cyclical although we would be interested in iconic brands.”
Real estate debt funds have also generated a buzz. According to data provider Preqin, there has been a fourfold increase in the number of Europe-focused debt funds, so that there are now 19 looking to raise a total of €10bn; 12 months ago there were seven funds aiming for €2.3bn.
“We also think the risk-adjusted returns on senior debt are worth considering,” says Crawshaw. “However, investors should consider these [carefully] – and especially those higher up the risk curve – because they can be a riskier proposition than they may at first appear. Senior debt funds provide cash-flow benefits but these may take time to realise.”
Luccioni says: “Given the current dislocation in the European banking system, property debt can represent a good investment. But it is a small portion of the fixed income universe. Investors need to think about the broad universe of fixed income and whether there are more attractive instruments that have greater risk-adjusted returns and can provide a better match between assets and liabilities.”
The days when investors simply assumed a positive real return from property because it was a bricks-and-mortar asset have gone – this is probably as much due to the bruising experience of the sub-prime and broader financial crisis as it is to the growing body of research that has been raising questions about that assumption.
The response has been to seek out more focused exposure to those elements of real estate that do appear to offer inflation protection. That will require more active management of a more diverse portfolio, and a dynamic approach to often smaller, niche markets – as investors recognise that the price paid for real estate cash flows will go a long way to determine what sort of long-term return those cash flows will deliver.