Inflation, recession – or both? Real estate investing through the market cycle

Read this to understand:

• How inflation and the threat of recession are impacting real estate markets
• Why inefficiencies in the pricing of risk are occurring
• Where investors should look for opportunities in such an environment

UK inflation hit 10.1 per cent in July according to the Office for National Statistics, a 40-year high. Once considered endemic to a bygone era in markets, inflation is expected to reach 13 per cent later this year, a level few investors will have experienced. The impacts will be felt far and wide across the real estate market.

Take occupiers, who are facing indexed rent rises in line with their maximum caps, while also shouldering the weight of non-rental cost increases. On the supply side, development costs have significantly increased. According to the Department of Business, Energy & Industrial Strategy, year-on-year prices for all building work rose by 26.4 per cent between June 2021 and June 2022, with non-residential new work rising 29 per cent. This will limit supply of new projects beyond those where construction has already started.

Yet, arguably, residual values have yet to take account of these demand- and supply-side shocks.

Throw in different levels of inflation across Europe – from 5.8 per cent in France to 8.7 per cent in Germany and 12.8 per cent in Poland – and the picture becomes even more confused. This variation in headline inflation, as well as its impact on individual countries and sectors, could cause significant polarisation across European real estate.

The Bank of England announced a half per cent increase in interest rates, from 1.25 per cent to 1.75 per cent, at its Monetary Policy Committee meeting on August 4, but this will not tame short-term inflationary pressures. We are in a new phase of the market cycle, one where inflation is here to stay. As such, investors need to revisit their pricing models.

Interest rates have already increased in the US and UK, while the European Central Bank announced on July 21 the first increase in the euro area for more than a decade, bringing an end to the era of zero rates. With the prospects for growth becoming more challenged, it wouldn’t be unexpected to see a combination of these economies tip into recession. Perhaps the more salient question is whether the recession they are likely to experience will be deep or shallow, short or prolonged.

Ultimately, this will be determined by the ability of each to absorb rate increases, alongside the wider impact of monetary tightening and stimulus withdrawal. The US has more to unwind, albeit from a position of relative economic strength. The UK would appear to sit somewhere in the middle, with Europe in a very different place and a set of unique issues to overcome.

For real estate, the historic correlation of performance to GDP does not bode well when sitting on the precipice of a recessionary environment. As we work through a downturn, total returns can be expected to come under severe pressure.

Which begs the million-dollar question: where should investors be looking for opportunities?

The market is very much in a transitional phase, moving from a ten-year period of yield compression to one of yield expansion. For those with a low appetite for risk, long-income real estate continues to offer relatively attractive returns through this phase of the cycle. Indexation offers some level of protection against inflation, whilst less exposure to cyclical sectors should lower the volatility of capital values.

More fundamentally, we believe opportunities will arise from inefficiencies in the pricing of risk. Valuing real estate has become increasingly complex, with models taking account of more variables than they ever have. It is one reason why the investment market has slowed considerably in recent months.

As is often the case when markets become twitchy, a migration to safer assets is likely. These will be aggressively priced, while those viewed as inherently riskier will be heavily discounted. Adding another layer of complexity, the sector is reappraising building stock through a net-zero lens. It is not inconceivable well-located real estate previously considered high-quality, prime assets will become vulnerable to sustainability-related obsolescence.

These more nuanced views of risk will lead to mispricings and opportunities. As a result, we can expect increased polarisation as this phase of the cycle progresses, whether driven by risk appetite or expected returns.

There is potential for active equity investors with an absolute return approach to perform well, supported by tighter supply caused by lower construction levels. As the market continues to adjust to this phase, those combining agility with an active equity overlay are most likely to capture the returns that best reward investors.

This article was originally published in Property Week.