“EMERGING FROM AN ULTRA-LOW INTEREST RATE ENVIRONMENT AND THE RISK OF RISING INFLATION.”
“The UK has been living in a low interest rate / low inflation bubble for a while now, but what happens to real estate investment when this bubble bursts?”
Conventional economics looks at inflation as either a monetary phenomenon linked to theories about money supply or unemployment rates ala “the Phillips curve”. Post GFC Quantitative Easing (QE) by the Bank of England has swelled its balance sheets and boosted broad money supply (M4). Meanwhile in the real economy, UK unemployment has steadily fallen from a peak of over 8% in 2011, to its’ lowest since 1975 at 4.3%! Adding to the mix a post Brexit Sterling depreciation, which is still steadily filtering through to UK import prices, then it is understandable that some investors are nervous that rampant inflation could be lurking around the corner.
The implication for all asset prices, not just real estate values, should be fairly self-evident. If the inflationary climate is about to ratchet upwards, then so too will risk-free rates, which is the theoretical yard stick by which all assets are judged. The cost of property debt financing will also rise, more directly impacting those looking at things from a more practical property perspective. Either way, higher inflation will push up minimum acceptable nominal hurdle returns and consequentially property yields and capitalisation rates will need to rise, thus resulting in falling prices.
However, this view completely ignores some fundamental facts:
Firstly, falling unemployment and a grossly expanded monetary base have characterised the UK economy throughout the post-GFC recovery, yet UK CPI has averaged just 2.2% per annum over this period. So much for economic theory! Perhaps the answer to this conundrum resides with a much more prosaic realisation that QE wasn’t ever ‘helicopter money’ and that despite near full employment in the UK, wage growth and thus demand-pull inflationary pressures remain very weak. Some now link this to the combination of globalisation (off-shoring and immigration), reduced unionisation of the UK workforce (zero hour contracts etc) and demographics (an older UK workforce are less likely to shift jobs and/or make aggressive wage demands). While Brexit may now alter the UK’s demographic profile via a reduction in immigration levels, these are longer term drivers and it is difficult to imagine a sudden volte-face here, given labour shortages particularly in many UK public services.
Secondly, while property’s higher yields remain a key attraction, it is ultimately not a fixed income investment. Rental growth prospects are just as important to investors, making them a vital determinant of property market price expectations. While rents might not be a hedge in the very purest academic sense, there is no doubt property is a real asset capable of offering inflation protection over the longer term, if not the 1-2-1 correlation that a technical hedge implies. This opens up an entire debate about rental growth prospects for the UK CRE sector. On the one hand Brexit uncertainty might mean a sluggish economy and therefore slower momentum in our occupier markets, yet on the other, structural tailwinds such as technology and demographics are building. One such example is the IPD UK All-Industrial rents which are currently growing by in excess of 4% per annum, powered by e-commerce impacts, at a time when the UK GDP growth rate has effectively halved following last June’s EU referendum.
Come and listen to Paul and a panel of other influential speakers discussing this topic on Thursday 19 October at MIPIM UK.
Photo credits: © Getty Images / malamus-UK
This article originally appeared in Estates Gazette