The fear of inflation coupled with all time low interest rates globally has prompted investors to find ways to protect their wealth against inflation. The fact that gold prices are at an all time high doesn’t make things any better.
Real estate is one of the traditional asset classes recommended to protect an investor’s wealth against inflation. However, it would be foolish to believe that any real estate investment would make a good hedge against inflation.
Real estate investments tend to have a number of key attributes that provide inflation-hedging benefits. The key to determining if a real estate investment is a good hedge against inflation depends on the presence of these attributes and how they relate to the overall economic environment:
- Global vs Domestic Inflation
- REITS or Direct Real Estate Investment
Going Global, Thinking Local
The US QE (Quantitative Easing) initiatives following the 2008 global financial crisis have led to excessive liquidity in the markets. In fact, QE III will be printing US$40 billion a month indefinitely until the outlook for the labour market improves substantially. As a result, the excess reserve held by central banks globally have also gone up considerably, potentially leading to significant global inflation issues down the road. Thus, it will be wise to consider the currency which a real estate investment is traded in as well as the currency of the rental income. With the USD not expected to regain its strength in the short term and potential global inflation in the future, a real estate investment traded in an appreciating currency such as SGD and AUD would be a better hedge than one priced in a depreciating currency like USD, ceteris paribus.
Unlike global inflation, domestic inflation is a simpler function of domestic supply and demand. However, domestic inflation is also dependent on the local economy and the strength of the domestic currency. An economy that is a net importer will have more exposure to global inflation than an export-based economy.
As such, an investor looking to hedge domestic inflation with real estate should be concerned about the intrinsic value of his real estate investment and its ability to generate capital gains and rental adjustments that are in line with inflation.
Location, Location, Location!
The old adage, “Location, Location, Location” remains as true today as it was a hundred years ago. The intrinsic value of a real estate investment is a key determinant of its ability to hedge against inflation. Strong capital appreciation and rental demand for highly desirable real estate contribute to the effectiveness of an inflation hedge.
The capital appreciation of a real estate is a function of many factors but it largely depends on supply and demand. Real estate investments in good locations with strong intrinsic values tend to be highly desirable and will always be in demand. Rental demand for such investments in good locations will always be strong as well. The investor will therefore be able to negotiate with tenants for inflation-adjusted rental which provides a natural hedge against inflation.
Does Timing Matter?
The timing of a real estate investment purchase plays a very important role as well.
The peak of the real estate cycle usually coincides with periods of strong inflation. Hence, entering a real estate investment at the peak of the cycle can lead to significant capital loss and a bad hedge against inflation.
Acquisition of a property at a good time provides a good hedge against a rise in value as such investments usually outperform inflation when they are acquired at the right time.
A good time to enter a real estate investment is at the trough of the cycle where inflation is weakest at the beginning of an economic recovery. Real estate investments held over extended period of time also provides a better hedge as it would have gone through a number of economic cycles.
How Much Debt?
A good financing structure also contributes to the ability of the real estate to hedge against inflation.
Long-term mortgages with fixed interest rates offer a better hedge than short term mortgages with floating interest rates.
Long-term mortgages with fixed interest rates allow the investor to pay off debt that is worth lesser with inflation while realising real returns on their real estate investments.
Short-term mortgages with floating interest rates will result in the value of the mortgage increasing with inflation. So,if the interest rate goes up and the value of the debt increases more than the gain in the value of the real estate investment, the investor may experience negative real return, which doesn’t offer the investor any hedge against inflation at all.
However, real estate investments that are fully paid in cash will still offer a better hedge against inflation than leveraged investments as there will not be any exposure to the cost of mortgage.
How good is your investment?
In general, newer properties tend to stand up better against inflation than older by virtue of the lower embedded rate of depreciation associated with newer properties.
As such, over a similar period of time, newer properties will tend to be able to retain their value better than aged properties.
Newer properties also command higher rental income and gives the landlord stronger bargaining power to negotiate for rents that can be regularly adjusted to inflation.
REITs vs Direct Real Estate Investments
REITs are publicly traded real estate vehicles that manage real estate properties and pay out 90 per cent of their income to shareholders.
They smell like real estate, look like bonds, and yet walk like equity.
As a contemporary asset class for real estate investment, REITs are relatively more liquid than direct real estate investments and allow for more flexibility in an investor’s portfolio.
REITs also generally offer tax advantages on their dividend income which direct real estate investments are unable to offer. As a result, REITs generate a better stream of income that can be used to purchase more inflation hedging products in an environment of increasing inflation.
REITs can offer investors the ability to diversify their real estate portfolio for a relatively affordable investment principal. As a result, the investor will be able to reduce his systematic exposure to global inflation.
The dividends from REITS also tend to adjust faster to inflation than rental income from direct real estate investments due to the diversity of properties in a REIT portfolio and economies of scale.
However, REITs are unable to offer investors the same financial leverage that a direct real estate can.
Depending on the various exchange and broker regulations, REITs may at best allow an investor to trade on margin that is marked to market daily and subjected to daily interest rate adjustments. Such short-term financing may affect the investor’s hedge against inflation.
On the other hand, direct real estate allows an investor to structure longer-term fixed interest mortgages which offer better protection against inflation.
Different location offers different inflation benefits
2011 Headline CPI (Consumer Price Index) shows that the US CPI is rising at a rate of 3.4 per cent YOY, Singapore CPI is rising at per cent YOY, London CPI is rising at 4.8 per cent YOY and China is at 4.1 per cent YOY.
In contrast, we find that the change in house price for Real Estate in the US is -2.9 per cent, 5.9 per cent in Singapore, 2.3 per cent in London and 2.9 per cent in China.
All in all, only Singapore real estate investments in the last one year beat inflation with a real gain of only 0.4 per cent. In contrast, real estate investments in all other regions would have lost out to inflation as a result of the dynamic relationship between real estate fundamentals and the general economy.
In considering a five-year period, China real estate outperformed all other economies as the best hedge against inflation with a cumulative real gain of 50.0 per cent, followed by Singapore with a real gain of 34.2 per cent. London real estate made a marginal real loss of -4.5 per cent during this period while the US performed disastrously.
Over a period of eight years, London saw a marginal real gain of 4.6 per cent while the real gain on US real estate improved from -28.6 to -11.7 per cent. The best performer is China at 88.1 per cent, followed by Singapore with a real gain of 46.0 per cent.
However, a period of 10 years saw London generating a whopping real gain of 36.2 per cent over inflation with Singapore coming in second at 29.4 per cent and US real estate experiencing a small positive gain of 3.2 per cent.
Therefore, when we consider real estate growth over a longer period of time of 10 years, we find that real estate investments hold their value in the face of inflation across all regions. Unfortunately, over a shorter period of time, real estate may not be a good hedge against inflation.
We are also able to observe from the relative performance of the real estate in the five-year period that real estate traded in weakening currencies such as the USD and the pound tend not to be as good a hedge as real estate traded in appreciating currencies such as the Chinese Yuan.
All in, it would appear that real estate as a hedge against inflation only holds true over an extended period of time.
Does Real Estate really provide an Inflation Hedge?
In summary, real estate as an investment class is not an absolute and definite hedge against inflation.
Rather, an investor looking to hedge against inflation using real estate would be wise to consider the many characteristics of a real estate investment before concluding if his real estate investment is a good hedge.
The investment horizon of the real estate investment also plays a very important role in hedging against inflation. While the relationship between real estate and inflation may not be strong over short investment horizons, it does actually strengthen over significantly longer investment horizons.
Article is contributed by Dr Boaz Boon, Toh Shao Wei and Joel Lin, Market & Strategy Insight (China) Unit, CapitaLand Limited.