Why does real estate stand up in an inflationary environment?

4 min read 12 Jan 22

Inflationary forces are affecting many economies around the world, and though many factors appear temporary, the longer they persist, the more embedded inflation could become. What could this environment mean for real estate?

Inflation is high – but there are mitigating factors

A rapid resurgence in demand, increasing energy prices and supply chain problems are putting pressure on the cost of living, with inflation now at its highest level in a decade in both the UK and Germany1. While economists differ in their views about the duration of above-average inflation, the longer these pressures persist, the more embedded inflation could become. In response, the Bank of England has increased UK interest rates for the first time in more than three years.  

On the continent, the inflationary landscape is more varied. Though Germany (which accounts for around a quarter of overall eurozone inflation) is pushing 5%, in France, where the level of people in employment is at a record high2, it is closer to the European Central Bank’s (ECB) 2% target. According to ECB policymakers, conditions to raise eurozone interest rates are unlikely to be met in 2022.  

A further inflationary concern relates to the level of cash swirling around within the global money supply, thanks to unprecedented fiscal stimulus, and the potential for sudden consumer spending in a big way. Yet data on savings rates in the US and most European countries suggests that the money lining people’s pockets may have already been spent, with savings rates already back to pre-pandemic levels3. Soaring energy bills could also curb households’ spending power, tempering inflation potential to a certain degree.

Real estate still reflects attractive relative value 

For investors, a key question is whether the era of low interest rates is coming to an end and what this could mean for real estate. Is the gap between property and bonds still sufficiently wide to compensate for the fact that real estate is an illiquid asset class? Unlike before the global financial crisis, when the spread appeared negative in a number of prime markets, the chart below suggests that the gap is currently above average, so property is likely to remain attractive even if interest rates rise.

“Property yields remain well above government bond yields so property is likely to remain attractive even if interest rates rise.”

In our view, the amount of debt in the system is likely to limit how much interest rates could rise and any increases are likely to be implemented at a gradual pace in order to support continued economic recovery. What’s more, interest rates are rising from incredibly low levels which means, on balance, they are likely to remain low for some time yet, setting the scene for higher real estate prices.

This should also continue to support the relative value of real estate versus other investments, such as developed country government bonds, since property yields remain well above bond yields even in hotly competed sectors in markets like Europe and Asia, where interest rates have been lower for longer. 

Real estate offers some defence against persistent inflation

Whether inflation proves to be transitory or not, real estate can offer some inflation protection over the long term, thanks to its characteristics as a real asset. Though not a perfect hedge, real estate’s essential function commands a price – rent – from occupiers who require and attach real value to this finite supply of space. If general price levels in the economy rise over time, property prices (and rental values), similarly, should stand to rise over the medium term. This has played out historically, including during the high inflation period of the 1970s and 80s.

Real estate with annual rent reviews explicitly linked to inflation benchmarks such as the Consumer Price Index (CPI) can offer protection against rising interest rates, by design. Long leased property such as supermarkets, for example, generate the majority of total returns through income as opposed to capital gains. Therefore, not only does income stand to rise with inflation, but capital values are proportionately less exposed to the potential erosion effect of rising rates.

Real estate stands up in an inflationary environment

In a strong economy, like that seen during the initial recovery, real estate typically performs well, and with inflation increasingly driven by demand-side pressures, nominal rents and capital values could stand to rise. The prospect of runaway inflation is far from inevitable, in our view, but even if it were to persist, real estate can offer protection over the medium- to long-term, particularly if leases are inflation-linked. 

1 Office for National Statistics, Federal Statistical Office, November 2021.
2 Trading Economics, Q3 2021.
3 Federal Reserve Economic Data, Trading Economics, Q3 2021. Note that this does not take household wealth into account.

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.

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