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QD view – Is property still a good hedge against inflation?

QD view - Is property still a good hedge against inflation?

Real estate has historically been a good hedge against inflation and, with the consumer prices index (CPI) rising to 2.1% in May heightening fears that stagflation could be round the corner, investors may be keen to double down on their real estate investment trust (REIT) exposure.

However, traditional real estate market drivers are not at play this time round. The COVID-19 pandemic has decimated some property sectors and left a huge question mark hanging over others. So where should you look to hedge against inflation?

Schroders published some research earlier this year in the US on equity sector performance in high (3% on average) and rising inflation environments between 1973 and 2020.

It found that only the energy stocks, which are naturally tied to energy prices – a key component of inflation, beat that of equity REITs. The US REIT stocks outperformed inflation 67% of the time and posted an average real return of 4.7%. This makes sense because traditionally price increases are passed through in rental leases and property prices.

But we are not in normal times and this is only true for real estate that is in demand. We have seen in the retail and leisure sectors that high vacancy rates caused by plummeting demand has negatively impacted rents. The office market is likely to be in a state of flux for at least two years as companies work out their long-term strategy for working-from-home and how that will impact their office space requirements.

The obvious sector to look at is logistics, but many are trading at hefty premiums to net asset value (NAV). Urban Logistics REIT (SHED) is trading at a more amenable premium to NAV of around 8% and has strong growth prospects. The social housing and residential sectors could offer some solace, too.

The social housing REITs Civitas (CSH) and Triple Point (SOHO) and recently launched homeless accommodation provider Home REIT (HOME) have annual inflation protection built into the majority of their leases. These are usually capped at 4% and have a floor of 1%.

Interest rates

With high inflation normally follows interest rate rises. Coming out of a (very) low interest rate environment, these would have a negative impact on the value of commercial property. The yield on offer would look comparatively less appealing, especially given the risk, and the foreign money that has flooded into the UK commercial property market in the past five years in the search of yield would start to dry up.

Of course, the question is whether the government can afford to put interest rates up, with the mountain of debt it has taken on in the fight against COVID. However, while the government may be limited in their ability to raise interest rates they could still move up from here.

It is also worth looking at the debt profiles of the REITs, too. Those with short-dated debt that needs to be refinanced in the next year or so are more vulnerable to interest rate rises. Thankfully, most REITs have fixed rate debt with multiple years to maturity.

With the economy continuing to open up after lockdown, using real estate as a hedge against the likely inflation that follows isn’t as straightforward as it historically has been – but it can still work.

QD view – Is property still a good hedge against inflation?

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