Is commercial property a good hedge against inflation?

Commercial real estate has the advantage of providing landlords with a high income return, generally a higher yield than residential property, that’s providing your tenants remain, rents can be increased regularly to keep pace with inflation, and where finances are involved, interest rates don’t get too high.

One commercial landlord, the Alternative Income Reit (AIRE), just published its third-quarter results which highlight a resilient and well managed commercial portfolio of 19 freehold and long leasehold properties. According to The Investors’ Chronicle, their portfolio is continuing to increase in value with its growing and contracted rents.

This is due to the company’s 93 per cent of rents being reviewed periodically, based on upward only rent reviews drawn into all the leases, easily keeping them in-line with inflation.

In the last quarter, contracted rents were increased by almost 5 per cent on a like-for-like basis to £7.22mn.

And 58 per cent of the group’s landlord’s income is due to be reviewed in the next 12 months, something the group is no doubt appreciative of, given that the RPI and CPI measures will probably reach double-digits in the autumn. That’s an inflation background the UK has not experienced for over 40 years.

Furthermore, the group is fortunate in having a diversified portfolio of tenants weighted across some of the hot sectors of the economy, particularly retail warehousing and industrial property.

New investment

Investors purchased a record amount of commercial property over the last 12 months, bargain hunting after the pandemic carnage. They’ve been encouraged by increasing tenant demand, and a shortage of space in some key sectors because building and development work stalled during the recession.

Some big bets were placed in commercial real estate as investors viewed the asset class as a good hedge against inflation. The strategy offers scope for higher valuations, that’s providing the group can retain good tenants and continue to increase rents in-line with inflation.

The alternative argument

With inflation running its hottest in four decades some industry experts are questioning the wisdom of relying on the strength of commercial real estate’s ability to fully protect against the ravages of inflation.

The traditional view that commercial properties are a good inflation hedge has been a sound one in the past, that’s because owners were protected when they could regularly raise rents to stay ahead of price increases.

The investor case has been helped by some of those same forces that are driving inflation: increasing labour costs and supply-chain shortages that are limiting the amount of supply, a lack of new building and developments that would otherwise provide competition for existing property owners.

But, with the recent signs of a slow-down in the economy, large company profits and therefore demand for industrial units, Amazon being a prime example, with its pull-back on its warehousing expansion, some investors are beginning to shift money out of real estate as they see less value in it as an inflation hedge.

They see more potential damage to the commercial property sector if there is a big downturn in the economy and persistent inflation, which will drive up long-term interest rates. Rising rates will lead inexorably to higher financing costs. It will then be more expensive for building owners to refinance and values will go down.

Commercial property’s appeal as an inflation hedge could suffer if the emphasis switched to interest rates. Interest rates look certain to keep moving higher as the Bank of England starts to unwind its bond-buying support and looks to cool inflation.

The bank will likely keep on hiking rates in the face of a slowing economy – a stereotypical stagflation bind.

Some argue that even if rates do rise because of inflation, a well diversified commercial real estate portfolio, with good paying tenants, is still a good bet. But the pandemic has introduced forces that are quite unique: supply-chain shortages and chronic labour shortages through people leaving the workforce early, it could mean that inflation might be with us for a prolonged period.

Landlords may not be able to keep increasing rents if tenants simply can’t afford to pay more.

Whatever happens in the future though, putting money to work is far better than keeping it under the mattress, where inflation will eat it away.

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