Nick Bloom was catapulted to (research) fame when lockdown hit ... I first came across his work in early 2020 when we were all frantically scrambling for some analysis that would give us a sense of what impact remote working might have and found the report he co-authored in 2015 that examined a case study experiment in China.
He continues to provide some awesome insights on how WFH is evolving and is now one of the most frequently cited academics in the field of econ. Our CEO, Ian Laming, passed me a copy of a report that he had received from the UK IFS - they've kindly allow us to share that piece with you ... please enjoy!
Great piece of (late) analysis on inflation ...
I feel a little sorry for the people who write these research papers. They have worked tremendously hard over many months to produce excellent analysis on the nature of inflation and how to think about it, and then they publish their work just at the point when the focus of the world's attention has pivoted to the disinflationary impacts of a dislocation in the US regional banking system.
To be honest, late or not, the work is worth a read. It's never inappropriate to think about inflation risk... because major inflation surprises, however improbable, tend to have wide ranging consequences for the way investors allocate capital.
These inflation notes have been penned by the BIS and economists at UMass Amherst. They are definitely up there in terms of quant/nerd factor, but the narrative around the quants/data is, IMHO, really quite interesting particularly in the 'sellers inflation' piece. The papers are linked here:
Sellers’ Inflation, Profits and Conflict: Why can Large Firms Hike Prices in an Emergency? (umass.edu)
My interpretation of what I read is that inflation 'shocks' are typically initiated by a wider (unexpected) geopolitical or commodity price shock - they percolate through margins into prices and ultimately reach wages where the net impact depends on labour capacity. A single shock on its own might cause a one off adjustment in the price level and change future wage growth expectations marginally, particularly without an appropriate policy response, but several shocks 'daisy-chaining' together over a period of years (as they did on a grand scale in the 1970s) can outrun monetary policy and this may cause wage and price inflation to become more persistent . This is the 'regime change' that the BIS identify. When this happens monetary policy and markets can get pretty 'wild' (I guess this why so many are now convinced that Powell is Volcker reincarnated - BTW as an econ historian I am a big fan of PV - all 6'7 of him - met him once and have an accompanying story).
In Europe, after such a long period of very low inflation and zero rates, these risks and uncertainties weigh somewhat heavily (as the FT pointed out yesterday), but the different trades offs that inflation risks present us with are clearly at the centre of why investors are still allocating capital to the sector. Yes the market is levered and yield spreads to rates and fixed income might be tight today, but leverage is no where near where it was last time around and if the economy slows the spread might be wider tomorrow. Equally if rates stay elevated the appeal of stable indexing cashflows remains. As we said in a research piece in 2017, our sector is rate sensitive and leverage risk needs to be carefully controlled, but the asset class is also has some inflation optionality. Investors that steer their capital into the right parts of the market (those parts where long term pricing power is strong) and take the right risks should be able to benefit from the optionality and sleep more comfortably at night.
I will leave you in peace to read these wonderful tomes and ponder the ideas at your leisure. As always if you want to discuss inflation, disinflation, credit and asset allocations in more depth please reach out - I am always up for a chat!
WSJ on offices ...
This WSJ article is a balanced perspective on what the key differences are between European office markets and what is currently going on in the US ...
It mirrors our views on the sector ... and is well worth reading ... happy to bore people to sleep with the detail and how energy efficiency plays into these trends if you want to discuss!!
And giving ...
A couple of clients reached out last week after my last outlook file drop - they were wondering if I could summarise the various outlooks I made available to you all ...
I respectfully said that Tristan's (modestly staffed) research team would struggle to cover it all this side of Easter and that, in any case, we couldn't really compete with Bloomberg's army of analysts (and AI bots??) ...
This is the definitive summariser...
BTW if this was done by real people it is a tremendous effort ... a thing of wonder!
The research gift that keeps giving...
Happy New Year ... normal service resumes!
So, every year as an annual ritual I spend some time reviewing the plethora of bank, asset management and adviser 'Year-End Outlooks' that pour forth from our friends, partners and competitors across the investment industry.
This requires visiting all manner of investment websites and it struck me this year that it might be useful to save you all some pain and so I have taken the (diabolical) liberty of consolidating the documents we have collected in one place so that you can view them at your leisure (if that's what rings your bell...)
There are 25 books from a range of sources and I can't profess to have read every page in every book or to have critically assessed all of the different perspectives ... but there are some interesting views, great ideas and some excellent charts. Overall my sense is that the economics community is a little bit too optimistic about the path of growth for this year ... and that the landing we are about to experience is not going to be as 'soft' as they would have us believe.
I hope you enjoy the books and we look forward to catching up with you soon to debate what it means for real estate markets and investment strategy in 2023!
KR - Simon
The Reality Check - the whiff of recession brings with it a change in risk appetite and an opportunity...
The statement that real estate investing is all about ‘credit and cranes’ feels like an over-simplification, but the reality is that ... for the most part ... it’s as true today as it has ever been.
How should we think about ‘credit’ given the inflation uncertainty we are faced with?
Ultimately when we reference credit what we are really saying is that we believe that real estate markets work well when credit conditions are accommodative. Our view of credit conditions is largely determined by the level and stability of real rates. Real interest rates are important because they determine how capital gets allocated. Negative real rates encourage people to invest capital and tend to boost and support GDP growth. Positive real rates encourage people to store capital and slows growth. The choice of a negative or positive real rate inflation is largely driven by inflation risk. Central banks worried about inflation tend to push for a positive real rate seeking to slow the economy, central banks worried about deflation choose a negative real rate.
Chart 1 – Real Rate Outlook in Europe
Ideally real rates should hover around zero with a slight negative (pro-growth) bias to maintain high levels of employment and stable incomes. Rate stability is viewed as particularly important as capital markets are alert to the risk of instability, largely as this raises the risk of central bank policy error as this has, in the past, triggered recessions. Selfishly, a negative (but stable) real rate environment also represents something of a goldilocks environment for real estate investors, as it creates a positive economic tailwind behind leasing, drives allocations in our direction (from bonds) and allows us to safely make use of moderate leverage, which is highly accretive.
Ultimately part of the challenge we face right now is that the current spot (trailing 12-month, quarterly and monthly) CPI has become unstable. Real rates as measured by the different measures of spot CPI have thus become hard to predict. Coupled with this, the popular measures of spot CPI and the market implied levels of long-term inflation expectations have diverged. The data are sending us mixed messages and capital markets are therefore on alert for a policy mistake, fearing an ‘over-tightening’.
The reality is that the answer to the inflation conundrum is partly about looking past the spot metrics and paying more attention to medium term expectations (which are more stable as shown in Chart 1) and partly about refocussing on the effects of rising prices on real incomes and wages. Across a broad range of European countries there are signs that the sudden and unexpected rise in commodity prices associated with the Russian invasion of Ukraine is squeezing real incomes. Wage growth is not offsetting this effect and that this in turn is slowing down economic activity.
Chart 2 – Economic Outlook
The major sentiment and economic leading indicators have all rolled over and we are already seeing some flash GDP data suggesting that Q1 2022 saw the economy flatline. The educated narrative in the economics community has already begun to pivot from a discussion of the risk of policy error to the discussion of different soft-landing scenarios. There is a distinct whiff of recession in the air. If this is the case then investors should look at long term implied inflation expectations to understand real rates, not spot CPI.
In Europe, the discussion of recession risk is starting even before the central bank has begun the tightening cycle. Whatever the narrative, it now seems as if energy price inflation has done some of Madame Lagarde’s job for her. If the current energy price hikes are, as we expect, worth the equivalent of 100-200bps of monetary tightening in Europe, given a steeper EU yield curve and a tightening of credit conditions as economic growth slows, Madame Lagarde may be about to do a ‘Trichet’ and complete a full monetary policy cycle without noticeably raising short term rates. We may not be at the end of the tightening cycle yet, but the implication is that the risk of European policy error may be reducing. Under these conditions the path of real rates will not change substantially. Yield curves may flatten and the probability of inversion rises. Real rates would thus remain negative. This would allow investors to focus on the business of allocating capital.
How should we think about ‘cranes’ given the outlook for the economy?
In practice, when the risk to rates subsides, most risk tolerant investors will quickly turn their attention to the opportunities that a slowdown in the economy might offer. Coming, as it does, at a point where there has been very little construction for 3 years and grade A vacancy is sub 3%, the discussion of ‘how cranes impact our sector’ will resume.
Chart 3 – Vacancy & Construction Costs
The dearth of new construction can largely be attributed to the lingering effects of covid. The pandemic disrupted existing construction works and caused many developers to delay construction starts. Now the construction cost inflation we are experiencing is making it harder to justify new building until rents go up, further slowing the pace of activity. Low vacancy will therefore persist and the challenge of developing will not get any easier if economic uncertainty impacts financing markets and risk appetite over the coming 12 months. The prospect of a sudden surge in new supply looks very remote. Development is an inelastic business, so parts of the real estate market could remain acutely supply constrained for several years, certainly over the next 2 years.
Chart 4 – New Development Activity
Short-term supply chain, cost and financing issues may be further exacerbated by tenant needs centred around ESG. We have written extensively about our views on the way in which ESG is accelerating change in our market. The energy efficiency requirements being stipulated by our tenants are narrowing the range of buildings that corporates consider to be acceptable for long term occupation across all sectors and property types. This shift is now being reinforced by regulations that will begin to limit landlord ability to lease buildings with poor energy efficiency ratings.
Chart 5 – ESG Factors
This ESG ‘shock’ is a disruptive change that will reduce the inventory that is available to tenants. In our humble opinion, it has the potential to be every bit as impactful across sector as the impact of ecommerce was for retail assets. What is notable right now is that it is funnelling demand into a relatively small inventory of highly amenitised appropriately accredited buildings when, in true real estate style, the supply of these buildings is at an historic low, particularly in high knowledge cities. Rents will (and are already) going up for these assets. It will not be long before investors begin to differentiate these assets and prices adjust accordingly. Thoughtful investors have been adapting for this environment for some time and this ESG paradigm will remain firmly at the centre of the way we design our strategies and invest capital.
How best to adapt strategically in this changing environment?
The combined effects of post-covid recovery, geopolitics, a climate crisis and ‘tech disruption’ makes it very challenging for investors to control risk. Markets continue to evolve and change rapidly and the outlook continues to be volatile and uncertain. Investors in our asset class in this environment need a clear top-down vision of what makes sense and the ability and platform to get allocated to the right strategy quickly. At the same time they need the discipline, vision and entrepreneurial instincts that will allow them to pivot, adapt and reallocate. Likewise, as the delta between winning assets and loosing assets will be significant, investors will also need the bottom up asset management acumen and reach required to manage the challenges associated with ever changing tenant needs in a broad range of different geographies and across sectors.
Some investors will find this complexity all too much and a few will panic and sell up, but this should be an environment where managers with the requisite skills, platforms and vision to build conviction and execute on their ideas can make profits for their clients. We expect that better equipped investors will stay the course, and those that are well equipped will rub their hands and double down.
Equally, right now, with the economy slowing and risk appetite reducing, we believe the window to take advantage of this opportunity may be opening. As we have discussed we see strong evidence suggesting that economic growth is rolling over and we expect credit is will become harder to find, particularly for risk assets. Our risk appetite leading indicators suggest that the competitive landscape is shifting in our favour.
Chart 6 – Tristan Risk Appetite Index
These windows don’t come along often and they don't remain open for long. History tells us that the RE investors that accelerate deployment into these windows tend to consistently outperform.
The Reality Check... short(ish) comment on inflation...
The horrific situation in the Ukraine has prompted a lot of inbound calls on the subject of inflation, inflation hedging and real estate. I have a history of publishing premature inflation hedging advice so I will resist the temptation to pour out my heart ... please see earlier threads on this subject on this site ... or reach for Jim Reid (vintage 2018)...
The point of this note is not to boost Jim Reid's reputation for foresight (he already has plenty of fans and followers - moi included) or our past perspective ... but rather to highlight some analysis produced by our advisers TSL that is spot on. They make the following interesting points:
1 - 1970s inflation spike flowed from the one-off devaluation of the US$ in 1971 - the US$ deval (of 20%) repriced the entire commodities complex overnight and, as it represented a reference currency devaluation, it was quickly recognised as a permanent change in the price level. It also undermined the world's faith in the reference currency that had additional geopolitical consequences (which rumbled on for nearly a decade).
2 - At the time the US Fed (and the other major central banks) couldn't decide whether it made sense to increase aggregate demand to lessen the real impact of energy prices rise (i.e. boost incomes) or to tighten policy modestly and allow energy price inflation to slow the economy naturally. They vacillated and the net effect (given the boomer demographics below) was a boom that boosted real incomes and validated the price effect - this went straight into wage growth. Without the anchor of gold, this further destabilised the US$. The rest, as they say is history.
3 - The inflation effect persisted for nearly a decade - until Mr. Volcker choked it off by jacking real rates in 1981 and, most importantly, re-established the concept of central bank credibility.
The UK went through all of this ... but on steroids .... the UK currency was already struggling after multiple devals in the 1960s and the UK validated prices in the 'Barber boom' in 1972 - that in turn led to an even bigger set of problems in the mid/late 1970s. That said the UK then is not the UK now and as someone that actually remembers the 1970s ... I think this FT/JP Morgan headline is a little rich...
BTW - the bible for what this looked like in the UK RE market is Peter Scott's book - 'The Property Masters'.
The point is that for people that are really thinking about inflation - understanding the cause/effect is important, as is the subsequent policy approach to any shock. Simply screaming 'stagflation' and then heading for the hills is not an effective response. The lessons of the 70's suggest that in the event of a 'one-off' shock to prices than threatens to unanchor inflation, then policy makers have to quickly affirm a 'tightening bias', drain the punchbowl and allow inflation to squeeze real incomes... it might seem harsh but it is better than reprising the Volcker Fed!
The tightening bias has been affirmed and the punchbowl is already being emptied. Real incomes will therefore feel the squeeze. The question for investors then becomes around managing the risks of being wrong ... if you are worried ... then remember that typically people cluster around real assets ... because stocks/bonds don't hedge the risk...
I am travelling to the West Coast next week to see clients and for my first proper conference in 3 years! And as ever available for calls...
The Reality Check... people are focussing on the wrong shock - supply shortages matter more than demand uncertainty ...
Although recent events suggest that managing Covid-19 remains a headache for us all, the baseline data that is coming through suggests that as restrictions lift and life normalises, people return to the office.
Morgan Stanley AlphaWise WFH Survey Analysis
The data suggests that pre-covid office working patterns are normalising, but that expectations have changed and that both employers and employees have learnt from 2 years of enforced experimentation and evolving their working practices. The key themes emerging from agility experiments that consistently rank at the top of the 'learning' list are:
- That employees and employers both value the cultural, social and career benefits of working collectively very highly. This requires them to collaborate closely in person with each other in a properly amenitised, high quality, well located workspace.
- That employees value the ability to choose to operate flexibly in pursuit of a better work/life balance, managing their face to face collaborative time more dynamically in response to their own personal circumstances. Employers understand that this is a valuable talent acquisition and retention tool and are willing to offer some flexibility in response.
It seems clear that if the combination of flexibility and office work is balanced carefully and proportionately, accommodating a little of each is a net positive, particularly in an environment where talent is scarce.
Culture and collaboration were already core to many business employer brand propositions pre-covid in high knowledge sectors and the concept of 'flex or gig working' was on the rise, so this is not a revolutionary change. That said, the marginal 'option' to work more flexibly is now far more fully ingrained into business practice and so it will not be easily taken back and, given the ongoing ‘war for talent’, we should expect it will endure in the post covid working environment.
The ‘optionality’ outcome is, nevertheless, really important because it impacts the way tenants think about space use. Optionality drives a highly flexible pattern of use. Employers tend to specify core collaboration days and, even if they don’t, the data suggests that staff tend to choose the same days to be in (so that they can maximise the benefits of collective collaboration). In practice, this means that if everyone attends the office on Monday, Wednesday and Thursday, or the firm specifies days/times then, on those days and at those times, the office will likely be at full capacity. If full capacity is reached on any one day (let alone 2 or 3) then it makes it challenging operating with less space, particularly if your space is old and/or poorly configured. Equally, if staff also attempt to cram 5 days of collaboration and meetings into 3 office days, then the office may be stretched to (or beyond) its limits, requiring a shift in the balance between desks and flexible spaces, more meeting and comms space and better amenities (which all require more investment in spaces, not less).
The evidence suggests that once a tenant has given their staff the optional right to choose, office based businesses cannot rigidly control occupancy, limiting the ability to make large scale space and cost savings. Given the marginal importance of rent cost relative to talent retention and acquisition in businesses that have a growth oriented mindset, this 'lost opportunity' may simply pass un-noticed as wed normalise and businesses expand. Such firms are far more likely to focus on the quality of space, design flexibility and amenity of their space.
Ultimately, the data suggests that in a high collaboration, high productivity setting where the office provides significant amenity and talent development benefits, the impact of agility of the level of current tenant demand is likely be a one-off, contained effect. In some businesses where flexibility was already an accepted norm, it may even be negligible.
While we cannot definitively state that some firms will not radically change their needs and shed space, we do now believe that we can now model the effect of agility into our overall demand estimates with more conviction. When combined with our supply forecasts, this allows us to draw clearer conclusions about the forward looking path for vacancy rates and rents. In turn, this brings us to our analysis of supply.
The ESG-led supply shock is going to be far more important that a demand-led optionality adjustment...
Recent macro-events suggest to us that the long-term supply-side effects are frequently misread when investors are confronted by a demand shock. No one cared about the second order effects of supply chain disruption 18 months ago when the world was locking down, yet today as demand normalises, people are realising that cutting supply chains creates bottlenecks that are difficult to remove quickly and this is having a profound effect on costs and prices. This effect is most pronounced in markets with inelastic supply-chains. Shipping costs rose five fold in the Summer, but the effect on the energy sector has also been notable. Energy is facing an ongoing secular shift to lower long-term demand, but despite the demand concerns, supply-chain disruption means that oil prices hit five year highs and doubled from the levels seen in the Spring of this year. Demand matters, but you cannot ignore the effect of supply on prices in inelastic markets.
Real estate supply is highly inelastic, particularly in office, and, in our view, the supply dynamics that are in play in office markets are significant. There are two specific supply constraint effects visible:
- a short-term halt in construction activity that is being triggered by a reduction in risk appetite from developers/investors and also by rising construction costs.
- a long-term effect that reducing the stock of assets for lease, associated with tenants increasing their focus on ESG and raising energy efficiency standards, forcing poor quality obsolete office buildings out of the leasing (and into the repurposing) market more rapidly than expected.
In practice, both the short and long run shifts will contribute to a reduction in the stock of ready to occupy high quality buildings in Europe over the next 3 to 5 years and potentially beyond. The short-run effect has already begun to change the expected path of short-term office vacancy. Our analysis of pipeline developments for 2022 and 2023 shows a 10% reduction in programmed office construction, which given a current vacancy rate of 7% and a modest bounce back in leasing activity associated with pent-up demand in 2022 is expected to mean that office vacancy rates will peak in the next 6 months at no more than 7.5%. To put this into context, this is the lowest peak vacancy level in European office vacancy cycle in the last 40 years. If tenant demand normalises to its pre-Covid levels, our forecast for office vacancy in Europe for 2024 is below 5%.
Tristan's Office Vacancy Forecast (Top 30 European Markets)
These dynamics and the lack of new construction will significantly limit the availability of grade A assets with high energy efficiency ratings and low carbon footprints during 2023 and 2024. Right now, brokers estimate that the stock of available ‘for lease’ Grade A assets is under 2.5% of total stock. As tenants crowd in to try to lease energy efficient highly-amenitised space, the Grade A vacancy number will reduce. It seems highly likely that the stock of Grade A for lease will be negligible until new development activity restarts, which given a 2 to 3 year construction lag means that Grade A supply will be close to zero in most markets until 2024 or 2025. In many markets it is possible to count the stock of ‘net zero’ offices that are ready to occupy in the next 2 years on one hand. In practice, given rising construction costs, we still may be using one hand to count NZC buildings with in 2025.
In addition, data on energy certification (see Savills chart below) suggests that a very significant proportion of the total stock of existing offices falls below minimum performance standards that tenants are starting to demand. In many markets, minimum energy efficiency standards are being written into government policy and regulated. EPC's are far from perfect measures for ESG purposes, but the data implies that a significant proportion of the built stock will need to be upgraded in the next 10 years, and moreover, that large number of tenants will be forced to trade up their office space or work with their landlords to upgrade space upon lease expiry. Tenants may shrink their space needs, the challenge they will face is that ESG factors means that the supply of buildings that they can lease will shrink even faster. 90% of the demand doesn't fit into 50% of the stock.
Energy Performance Certification by Office Market (Savills)
In the key innovation hubs where demand is growing rapidly and supply is constrained, scarcity has the potential to drive rental growth for well located, properly amenitised assets with high energy ratings. We can already see evidence of this in our portfolio in London, Birmingham, Dublin and Barcelona. Increasingly, it also seems likely that, given the lack of new supply and less construction activity, rising demand will spill-over from Grade A into a broader range of good quality, certified ESG assets.
Generalised office uncertainty may prove to be temporary, the greater challenge will be acquiring the skills required to manage the ESG risk properly...
Given the long shadows cast by retail, investors are understandably cautious on the office sector and the tone of the conversation in the investor community remains uncertain. While most LPs accept that good quality core offices are not on the same path as secondary shopping centres, and everyone knows that the market is tilted to the buyer, it is hard to gain conviction, particularly if you aren’t directly leasing buildings and seeing real time data points that allow you to triangulate and untangle the ESG and supply complexity.
Equally, even if you can unbundle the data, there is a limited number of skilled value added managers who have the ability to measure the costs associated with ‘greening’ an asset, can price the detailed capex requirements, juggle tenants and execute a complex ESG-upgrade business plan under such time pressure.
As a result, many may decide to forgo the office opportunity and buy even more sheds and beds at historically lower and lower yields. It’s hard to criticise this choice, but ultimately the crowds and the prices make will make it increasingly hard to outperform. People seeking mid-teens IRRs in the B&S space will need to forecast significantly higher rents or lean on some combination of granular assets, more financing risk and/or development risk. The reality if that there is no easy path to mid-teens IRR’s. Every strategy has its own risks and execution challenges.
Have a great weekend!
The Reality Check ... Transitory or Persistent?
So a few days ago I was rummaging through some research that we have presented at prior advisory board meetings, when I came across this slide from our Spring 2017 meetings :
5 years on it still resonates. We continue to use exactly this data to help clients think about the effects of inflation risk and how it might shift allocations to our asset class.
I also saw this chart today:
I was struck by this chart as it serves to remind us that not all price rises are persistent, particularly in markets where supply is relatively elastic.
This brings me to this piece of research from the BIS - the gist of which is that in the long run everything is transitory... I wish life were that simple!
Ultimately the market doesn't have the luxury of 'forever'. Investors may be able to look past today's spot CPI, but they are acutely sensitive to the risk of inflation over the next few years, particularly given the current levels of real yields. This inflation risk is often viewed through the lens of risks around central bank policy error. If investors think that central bank error is likely and that this may lead to a persistent rise in CPI, then they will look to hedge that risk now.
Real estate attracts capital in these moments in time because supply tends to be relatively inelastic over the short to medium term. But in practice, the efficacy of this 'hedge' is really a function of the scarcity supply at your entry point and the persistence of supply inelasticity (i.e. how much gets built in response to the capital that flows in to take advantage of rising rents).
Sadly, if supply varies over time (which we know it does), no one has the luxury of thinking like the BIS - timing and entry point matter.
Have a great weekend!
The Reality Check … Inflation Surprises Inbound?
The spectre of inflation has returned. US CPI came in last week at 5%. German CPI hit a 29-year high in September. Right now, we don’t quite know what the future holds but the debate on whether rising prices are transitory or persistent, secular or cyclical is heating up. So is the inflation hedging debate.
Headlines aside, there is no need to panic just yet. As this chart from the ever-excellent John Authers’ Bloomberg blog shows, we are still some way from a return to the 1970s. The consensus expectation is that inflation pressures are higher than they have been for some time but that they are transitory, thus the risks to long term expectations are low and stagflation is not seen as being a threat.
Even so, when it comes to portfolio decisions, ultimately what most investors really care about is the risk that the consensus is wrong. This is largely about surprises and the risk of central bank errors. A surprise that makes it hard to predict prices and causes inflation expectations to become unanchored is ‘bad’, not least because it makes central bankers very likely to err and raises the risk of ‘stagflation’.
That said, it is difficult to precisely delineate ‘unanchored’ or determine a bad inflation ‘event horizon’. The data suggests that the probability of bad surprises increases significantly if CPI exceeds 4% and remains anchored at the level for more than 12 months.
As this Oxford Economics charts shows, although we are passing 4%, stagflation is not an issue today. However, as the four charts below from Oxford Economics, Capital Economics and BAML show, the performance and diversification effects of inflation risk passing 4% and persisting at this level, can be very significant at the portfolio level. The Bloomberg headline on '60/40 portfolios' may have dramatized the situation, but investors are highly sensitive to the risk of high inflation and thus, at current CPI levels, given the risk they are still likely to contemplate an allocation response.
One of the most common moves is to play defence and bond investors typically advocate adding index-linked exposure and adapting the duration and risk profile of a bond portfolio. Equally, as this Goldman Sachs chart amply illustrates, stock investors have playbook and any are already beginning to consider rotating equity portfolio allocations towards sectors and companies that are perceived to have ‘pricing power’.
Even so many allocators will also go the extra mile and begin to look to alternatives that add both inflation correlation and additional diversification to their allocations. Alternatives, real assets and real estate will almost inevitably be at the top of mind under such conditions.
Real Estate as a Hedge Against 'Bad' Inflation
As the chart below suggests, real estate has historically done a fairly good job of hedging inflation surprises.
There are two primary drivers for this performance effect. The first driver is leases that almost always include some form of annual CPI indexation. The second is a glacially slow-moving and highly restrictive planning system, which when combined with a long and complex supply chain creates capacity constraints that lifts market rents. When combined, these factors come together to give landlords pricing power and hence nominal growth (that includes CPI) passes through into net operating income. Some of this earnings effect should theoretically be offset by a rise in cap rates, reflecting an increase in the discount rate that is applied to the cashflow, associated with rising interest rates. However, as this chart shows this cap rate effect has not been that significant in prior inflation 'outbreaks'.
This is largely explained by capital flows. Broadly speaking, the capital that rotates out of other asset classes into the real estate sector in search of the NOI hedge has held down cap rates and worked to offset interest rate shift (creating a so-called ‘reverse-yield gap’ in the 1970's or 1980's). Given the inflation dynamics we are currently presented with, it seems unlikely that we will see the return of a 'reverse yield gap', but even so, the capital flow effects on cap rates should not be under-estimated. As the chart below shows, investors in fixed income assets are currently earning a negative real return, thus the appeal of a relatively high yielding (lower convexity) real asset that offers some level inflation hedge will be strong. Equally it is far from clear that European rates will rise significantly, particularly given the concept of 'curve control' and the scale of the public sector debt burden. The markets ability to reconcile the theory and the practice of pricing risk may well get tested in the next few years.
Where then is the reality of the inflation risk for real estate investors? With capital flowing into the sector and inflation driving nominal growth and tenant demand and as supply is inelastic in the short term, a real estate cycle becomes more probable. The chart below illustrates this nicely. When an inflation cycle builds, investors crowd into the sector in anticipation, pushing up values ahead of rising NOI. This both diminishes any risk premium on offer in the sector and increases the risk of speculation. In the 1970s the flows into the sector in the face of surging inflation risk fed a cycle that culminated in a speculative development boom. History tells us that building booms (particularly when the involve reflexive capital flows that involve bank financing) almost always undermine themselves, values and rents. The risk for investors is that the wider response to inflation may fuel a cycle and that cycles have the potential to undermine the hedge.
How to Position for Inflation Risk?
The current debate about inflation risk appears to be occurring early in the cycle, in an environment where supply is constrained and with limited evidence of 1970s style spikes in inflation volatility. This affords an inflation sensitive investor some cyclical comfort and also some time to think about what they can do now to prepare for any future risk. In our view there are a range of options to consider across varying 'risk styles. These are illustrated in this stylised inflation model below:
Ultimately, the adjustments required to allocation and strategy really depend on the underlying economics, cyclical dynamics and the levels of inflation that you are seeking to protect against. Right now the cyclical and economic dynamics are supportive, so most of the focus will likely be on your view of inflation risk.
On this basis, if you are in the ‘persistent’ CPI camp then you would up allocation and most likely rotate your equity and debt strategies to accommodate more operating and financial leverage. Some would also tweak the balance between the debt and equity buckets, particularly if the inflation persists and trends beyond our 'magic' 4% threshold. Conversely, if you are in the ‘transitory’ camp but felt you needed some insurance against the remote risk of a bad inflation surprise, you might add to your allocation and keep an open mind about financial and operating leverage across all strategies. If you are in the ‘70’s stagflation’ camp, then you should rotate to equity, lever up and then keep a very watchful eye on the cycle and its effects on the supply of credit and the number of cranes.
IMHO the key to making real estate work for you as an inflation hedge right now is as follows:
1 - Decide type of inflation you think is most likely and think about the risk of being wrong.
2 - If you decide to change allocations/style, then be an early bird.
3 - Never forget that real estate is inherently pro-cyclical.