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QD view – riding out stagflation

The bad news just keeps mounting up and the economic outlook is getting gloomier. Inflation has shifted from being a post-COVID legacy to a global problem, while ominous economic predictions keep piling up.

A fall in UK GDP was revealed this week and was followed by another interest rate hike by the Bank of England as it attempts to get a handle on inflation, which it predicts will reach 11% in October. As stagflation looms large, there are a couple of real estate plays to try to ride out the storm.

Performance on par with 2021 is going to be difficult to achieve but investing in low-risk sectors such as high-end offices feels like the way to go. Prime real estate is going to be in a much better position than secondary. A newly built, centrally located office with high energy efficiency performance has the right characteristics for leasing tension that will make it easier to re-let if space was to become available.

Office occupiers are increasingly moving to a ‘flight to quality’ after the pandemic altered the function of the office. In many cases the office has become a hub for collaboration and businesses must work harder to entice workers back to the office. Location, amenity, and design has become a lot more important. As too has the sustainability of buildings as corporate responsibility for climate change ratchets up the agenda. Supply of these types of offices is tight and in the current market conditions, is not going to be added to any time soon. That should trigger rental growth – the holy grail in this market.

Great Portland Estates recently forecast positive rental for the year ahead across its portfolio of prime London offices of between 0% and 5%, having recorded a record leasing year in the 12 months to March 2022.

Higher interest rates, which some commentators say could reach 3% this year, presents a potential opportunity in the residential sector. Higher rate will likely choke off demand for owner-occupied homes and in the process boost demand for rented homes.

As ‘generation rent’ enter their 30s and family life, demand for rented houses (not the flats that are commonly associated with the private rented market) should rocket.

The sector is still in its infancy in the UK, especially compared to Germany and the US, and will likely stay a small part of the overall housing market given the UK’s obsession with owning your home. But the proportion of 35-44 year olds living in private rented homes has risen from 17% to 30% in the last 10 years.

The number of purpose-built rental homes has increased with demand over the last few years and is forecast by Savills to take off over the next five years.

PRS REIT specialises in building this type of product and now has a portfolio of 4,616 homes, which is 98% let, and a pipeline to deliver 822 more. Developer Harworth Group, which has a huge landbank of both residential and logistics land, is upping its exposure to build-to-rent (BTR). At its capital markets day this week, chief executive Lynda Shillaw said it could scale up its BTR portfolio, from its current 3,000 pipeline, as demand increases and the owner-occupied market slows.

Riding out the looming stagflation isn’t going to be easy, but there are defensive and opportunistic plays in the real estate sector.

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