Text: Matthias Pink

Inflation in Germany and other parts of the world has reached its highest level for decades. While this may be partially attributable to temporary effects, the probability of a sustained period of higher inflation appears sufficiently high to us to prepare for such a scenario. On a macro level, the first important question is whether there is actually a causal relationship between inflation and rents or property prices. In our estimation, most (scientific) studies come to a clear conclusion on this: there is no robustly demonstrable causal relationship when looking at typical holding periods of real estate investors. Consequently, total returns from property are also not dependent on inflation. In other words, whether property acts as protection against inflation for a specific holding period can only be determined in hindsight and, even if it appears to do so, this can actually be attributed to other favourable conditions (e.g. strong population, employment or economic growth) and not to inflation itself.

Real estate as an asset class does not protect against inflation but protective measures can be taken at portfolio and property level
As an asset class, then, real estate does not offer inherent protection against inflation. At portfolio level or at an individual property level, however, it is possible to apply at least partial protection. Both in terms of portfolio management and when making acquisitions, investors can take measures to brace themselves against a period of higher inflation (summarised in Table below).

Indexed leases are surely the best instrument for owners to hedge their income against inflation. A portfolio comprising exclusively indexed leases would be perfect and ideally with indexation clauses that provided for annual and complete adjustment of rents in line with the consumer price index. The fact that inflation rates may exceed rental growth rates over the coming years also favours longer lease terms. Conversely, non-indexed leases should have the shortest possible lease terms since, with long-term leases, inflation may mean that the increasing costs actually exceed rental income in the worst-case scenario. The risk of rising costs can be reduced with triple-net leases, whereby tenants bear the cost of repairs.

An indexed lease only provides good protection against inflation if the tenant concerned can actually pay the rising rent in times of high inflation. This is most likely to be the case with tenants whose costs are either not increasing to the same extent as general consumer prices or those who can pass on their own increased costs due to inflation on to their customers in the form of higher prices. Owners are always on the safe side with public-sector tenants in this regard (rising prices also mean rising tax revenues). Consumer goods manufacturers with strong brands are also likely to be a good choice owing to their typically high level of pricing power.

Turnover leases, which are commonplace in the retail sector, also offer a certain level of protection against inflation since rising prices translate into rising turnover and, in turn, into higher rents. However, this is only the case if this positive effect on price is not offset by a negative effect on volume, i.e., customers buy less of the product owing to the increase in prices. The fast moving consumer goods segment (food, drug stores, etc.) is very robust in this regard, as is the luxury segment.

Properties offering better inflation protection will become more expensive
Since properties fulfilling the specified criteria are more attractive from an investor’s perspective in times of rising inflation expectations, these are also likely to become relatively more expensive. As some of these advantageous characteristics appear more frequently in certain property market segments more than others, there would then be price shifts on a macro level. In contrast with the commercial sector, for instance, leases on apartments are not indexed for the most part. This in itself suggests a declining price differential between commercial and residential property. As another example, the entire local supply property segment is likely to hedge cash flows relatively well against inflation owing to the stronger pricing power of tenants and could, therefore, become (even) more expensive.

New builds or completely refurbished properties also become more attractive than older stock in an inflationary environment owing to their lower operating and maintenance costs both in absolute terms and relative to the rent. Hence, existing properties generally become less attractive, particularly if the contractual rent is below the market rent. The longer the leases on such properties, the further into the future the associated income potential lies and hence the lower the present value of the cash flow in an inflationary environment.

Regardless of the characteristics of the property being acquired, the high inflation rate and sustained low interest rates support higher loan-to-value ratios upon acquisition or refinancing. In any case, it is completely rational to take on loans in such an environment. This brings us back to the macro level. In no other asset class can investments be financed via borrowing to such a high degree and on such favourable terms. Should expectations of inflation strengthen, even more capital than to date is likely to flow into real estate.