Lazard: Investors pause to assess impact of inflation

Institutional investor levels of activity in committing capital to private equity real estate funds declined in May after sentiment shifted.

There is increased caution among institutional investors as they digest the changes in the macroeconomic environment, such as higher inflation, rising rates and greater volatility. Nonetheless, real estate can provide an effective hedge against inflation and can remain competitive relative to other asset classes.

Inflation hit 9 percent in the UK in April, the highest level in 30 years, and is expected to rise above 10 percent. Pre-existing supply-chain disruptions caused by the pandemic have been amplified by the war in Ukraine, exacerbating inflationary pressures caused by rising energy, commodity and agricultural prices. This is a major area of concern for real estate investors as they grapple with rising costs of construction, operations and financing as well as the potential valuation impact of higher rates.

Recent interest rate increases reflect this unease about inflation. Currently, UK interest rates stand at their highest level since 2009 and that is likely to have an impact on both the financing and valuation of real estate assets. In response, some institutions are pausing new commitments as they try to assess future rate rises and the impact that will have on property yields.

Volatility has increased in the equity markets more broadly as they have reacted to higher inflation and rate rises. Stock market indices globally are down between 10 to 30 percent. A number of institutional investors are thus likely to find themselves overallocated to private real estate due to the denominator effect of falling listed markets.

Inflation does not, however, necessarily always lead to widespread disruption for real estate. In many ways, real estate can provide an effective hedge. Further, the impact of inflation upon the asset class is unlikely to be felt uniformly.

Certain sectors with strong demand and supply imbalances are likely to perform better: those with demographic or structural tailwinds, or where lease structures are either shorter or indexed are in a stronger position.

The pause in activity levels is a result of institutions evaluating the uncertain economic situation. However, activity levels could well pick up over the coming months as institutional investors reorganize their portfolios in light of current economic conditions.