Can European real estate help investors hedge portfolios against inflation?

Hedging your portfolios against inflation with real estate investments is rather similar.

Europe’s inflation outlook

With European inflation at record levels – tracking highs not seen since the early 1980s – investors are looking to preserve real returns in their portfolios with real estate. Rather like the mint leaves in a mojito, real estate property types with stronger rent growth and shorter leases may elevate an asset allocation cocktail to preserve and grow income.

Led by spikes in energy and food prices, eurozone inflation rose to a record high of 8.9% in July while it was even higher in the United Kingdom at 9.9% in August. These current inflationary pressures are driven primarily by cost pressures caused by supply shortages as a result of global supply-chain disruptions. Tight labour markets resulting in higher wages and elevated consumption has also led to upward pressure on inflation.

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Recent developments in the energy sector because of the conflict in Ukraine have also created additional upward pressures on prices and increased the uncertainty around the timeframe for inflation to revert to pre-Covid levels. For investors accustomed to decades of quiescent inflation and easy monetary policy, there is a sense of urgency to increase portfolio allocation to asset classes that may provide some inflation mitigation.

Real estate as an inflation hedge

At present, a lack of robust real estate data for the eurozone limits our analysis of the relationship between property performance and inflation in Europe. With data on commercial property starting from 2001, the high inflationary period of the 1980s that most resembles current inflation is not included. But what we can read from this period is that property performance has outperformed inflation 61 out of the 81 quarters we analysed – results consistent with similar analysis for the US and the UK.

Analysing UK property data shows more robust and statistically significant relationships between inflation and property returns across all sectors between 1986 and 2020. We observe the strongest relationship in residential property, but we also find a significant correlation with inflation in the industrial and hotel sectors.

Residential and industrial property

In the residential sector, shorter lease length is probably the most important factor behind the strong relationship between inflation and residential property – with the caveat that institutional ownership in this sector has been historically low until recently.

However, we also get a strong, positive relationship between the owner-occupied U.K. residential market and inflation, particularly during the high-inflation period of the 1970s and 1980s. But we estimate residential demand shows less elasticity to prices given the essential nature of shelter.

The strong, positive correlation between industrial property and inflation perhaps points to the shorter duration of leases in the U.K., which have allowed landlords to push rents up upon renewal.

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Selection matters

As the UK data reveals, owning the right properties that can potentially grow rents in excess of inflation is key to offering mitigation as prices rise. Like with the mojito, substituting in ingredients such as cucumber or lemon may create a new taste, but they won’t achieve the traditional Cuban highball – selection matters.

The UK data reveals a stronger relationship between property performance and inflation, particularly in the residential sector. This suggests properties that have occupier demand, driven by structural growth, are better positioned to generate future rent growth in an above average inflation environment, like that which we are currently experiencing.

Cyclically sensitive demand drivers are likely to come under pressure if the economy reacts negatively to a prolonged high-inflation environment. That’s why we believe mixing a blend of structurally resilient property types, with leases that reset more frequently, may allow investors the ability to tailor a portfolio of commercial property that could generate rent growth and keep pace with inflation (maybe even exceed it) in the coming years.

No silver bullet

There are no quick fixes to hedging your portfolio against inflation, but the right mix of commercial properties may offer some mitigation.

Property selection, lease duration and structure are inherently important factors that determine the extent to which real estate may provide some preservation for investment performance.

The eurozone’s diverse economies and growth drivers suggest that investors should be able to find an appropriate combination of property types and leases to help add some hedges against inflation to their portfolios. Commercial real estate doesn’t offer magic bullets. But a judicious mix of tenants, assets, and leases may leave investors well-positioned to deal with periods of heightened inflation.

Indraneel Karlekar is global head of research and strategy, Principal Real Estate

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