When institutional investors look to any asset class – especially real estate – for investment there are three things are they should be concerned about: enhancing returns, reducing risk and hedging inflation.
Over the past few years, it’s fair to say investor focus – for both LPs and GPs investing in real estate funds – | |
| Real estate:
As good as
gold? |
was geared primarily at boosting returns, often at the expense of judging the risks associated with many deals and vehicles. Inflation, though, also got lost in the mix in discussions about portfolios, not least because we’ve lived through a decade of ever-decreasing inflation. But inflation has now become a major worry for investors.
As governments globally drench their economies with cash and run up huge deficits via generous spending programmes, fears of out-of-control inflation are being ignited. From the US, to the UK, Europe and Asia, governments are increasingly being urged to start slowing things down. Indeed, in the US Republican Senator Chuck Grassley went even further in December warning that unless the “printing presses” were cranked down the country would face price jumps that qualified as “hyper-inflation”.
Doug Herzbrun, global head of research at Los Angeles-based CBRE Investors, notes that inflation could increase substantially in the medium-term, although the outlook is still clouded with uncertainty. “For the |  In the medium-term, in three to four years, there is significant risk of inflation, particularly in the US and UK where government debt levels and default spending are particularly high.
Doug Herzbrun, global head of research at Los Angeles-based CBRE Investors |
next year or so, the chance of high inflation is extremely low, given the amount of excess capacity throughout the world,” he says. “However, in the medium-term, in three to four years, there is significant risk of inflation, particularly in the US and UK where government debt levels and default spending are particularly high.”
It’s something that all public and private pensions, endowments, foundations and institutional investors are eyeing cautiously in relation to their portfolio allocation policies. “Economists are debating the problems associated with deflation, but for pensions schemes we are switching our concerns to the spectre of looming high inflation,” Manchester, UK-based Sarah Abraham, a consultant and actuary at Aon Consulting, recently told the Press Association.
A focus on inflation should mean good news for real estate, right? Real estate, like gold, has always been judged a good hedge against inflation, holding its value and purchasing power during inflationary periods when compared with many other asset classes.
But with vacancy rates for real estate sectors in most developed countries set to peak over the next two years, (Jones Lang LaSalle predicts the US office sector will peak in the first quarter of 2011) just how accurate is that belief? What happens if developed countries start to experience a period of high inflation coupled with little growth, a real risk with high government budget deficits. Just how easily will landlords be able to pass on rising prices to their tenants?
All things being equal
As in life, not all real estate is created equal. Different food groups offer different hedging capabilities owing to their leasing structures.
Traditionally hotels, which reprice every day, were deemed a good hedge as they allowed landlords to pass rising (and falling) costs immediately onto customers. Multifamily apartments, generally leased on six-month or one-year leases, were thought to be second-best while retail and office, which have usually had inflation-kickers, escalators or percentage rent clauses in their leases allowing rents to raise according to rising prices or sales, followed.
Susan Hudson-Wilson, however, argues that real estate’s ability to hedge against inflation is more limited than traditionally believed. A 2007 paper co-written by Hudson-Wilson, retired founder of property research and portfolio strategy firm PPR and a member of the University of Vermont’s board of trustees, and Haibo Huang, PPR’s head of US forecasting, found real estate’s ability to hedge against inflation came | I don’t want some little suburban motel or rental apartment, but prime assets. I want affordable high-rise housing for young people in central locations. I want real estate that is expensive to replicate. Susan Hudson-Wilson, retired founder of property research and portfolio strategy firm PPR and a member of the University of Vermont’s board of trustees |
predominantly from capital appreciation rather than income return. That is, real estate’s inflation hedging power was a product more of the capital markets, rather than the net income generating processes of real estate’s leasing and expense structures.
The theory strikes at the heart of real estate as a natural hedge against inflation. However, that’s not to say real estate isn’t a hedge against inflation at all – it is, especially when compared to some other asset classes. You just have to understand real estate's limitations.
The key to dealing with those limitations therefore is to understand the leases and properties within your portfolio. In the 2007 paper, Hudson-Wilson found that office was the strong sector for inflation-hedging followed by apartment and warehouse. Contrary to conventional wisdom, retail was shown to have no significant hedging capability against inflation.
However, Hudson-Wilson tells not all offices offer the same inflation-hedging capabilities. As a board member at the University of Vermont (UVM), she recommends the endowment invest in prime stable offices with higher replacement costs, in central, urban locations. The same is true for hospitality and multifamily. Hudson-Wilson tells PERE: “I don’t want some little suburban motel or rental apartment, but prime assets. I want affordable high-rise housing for young people in central locations. I want real estate that is expensive to replicate.” Hudson-Wilson is also keen on urban China assets, owing to the migration to the cities from rural communities.
“As an institutional investor, you have to look at the kind of assets that managers will be targeting. I want a disproportionate share of the portfolio to be in urban areas and I would definitely pick differently had we | As an institutional investor, you have to look at the kind of assets that managers will be targeting. I want a disproportionate share of the portfolio to be in urban areas. Hudson-Wilson |
not conducted our 2007 study.” Hudson-Wilson adds: “I cannot buy into a manager unless they are specific about what they are targeting.”
Hudson-Wilson continues: “The job of real estate is about inflation hedging. I recently saw a document from one real estate investment firm which said they were going back to basics and operating real estate on the basis that it’s a slow way to get rich. That’s great, because that’s the way real estate is. The industry got carried away and thought real estate was a return enhancer. Well, that was amazing for a while but not so much anymore. We misused real estate. Real estate is an inflation-indexed bond. It’s a stable vehicle as long as you pick the right real estate. You have to be selective and work with knowledge about how inflation gets transmitted.”
It’s a sentiment Herzbrun, who advises CBRE Investors’ separate accounts and commingled funds, agrees with: “During the boom years there was a definite style drift away from what real estate should be, which is ultimately an income-producing product. People got infatuated with the appreciation aspect,” he said.
With uncertain prospect for appreciation over the coming years, income is now king for LPs and GPs. What both parties need to ask though is how they protect that cash flow from the ravages of high inflation.
Eggs in baskets
Just as in modern portfolio theory, diversification of leasing structures in real estate portfolios is key. Real estate is a local business, and when it comes to leases each market and sector acts differently. Take the | During the boom years there was a definite style drift away from what real estate should be, which is ultimately an income-producing product. People got infatuated with the appreciation aspect. Herzbrun |
office sector for example. In the UK leases typically range from between 15-years to 25-years compared to France’s average of nine years (with the right to break every three). In the US, leases typically involved five-year terms, while China’s average is two years. (See box on p. 33 for a further breakdown of the country-specific differences between European office and retail leases).
Lee Menifee, senior director of global strategy at CBRE Investors, says things are starting to change. In the UK, leases are becoming shorter as “landlords realise the benefits of short-term contracts”, and in some markets lease expirations of two to three years are “starting to appear”.
Meanwhile, in locations where short-term leases are traditional, landlords – uncertain of what tomorrow may bring – are currently trying to lock in tenants with longer-term leases. Menifree says, overall, there appears to be a convergence towards five to 10-year leases when it comes to office properties globally.
But, as he adds: “It’s critical to have a rolling schedule of expirations. In almost every market for the next two to three years there is virtually no construction which means that occupancy markets, when they come back, will be entirely demand side driven.”
Similar careful consideration also needs to be applied to escalator clauses, in which rents are explicitly linked to inflation. The decade-long bull run in real estate may have diminished the perceived need for such provisions, however faced with the prospect of rising | It’s critical to have a rolling schedule of expirations. In almost every market for the next two to three years there is virtually no construction which means that occupancy markets, when they come back, will be entirely demand side driven. Lee Menifee, senior director of global strategy at CBRE Investors |
inflation, all investors need to protect their ability – as much as the market allows – to pass-through costs.
Herzbrun interjects: “It all depends on your objectives as an investor. Real estate generally is about generating income and appreciation. The income component of real estate is now increasingly important. We have moved away from the time when a vacant property could be valued more highly than an occupied one because there was belief you could lease the property with higher paying tenants.”
Looking ahead, Herzbrun says he expects fears of inflation to prompt a small increase in allocations to the asset class.
It’s something Hudson-Wilson supports. “Allocations to real estate should definitely be moving up, not down, right now.
“We are looking forward to a global recovery and inflation, that’s the scene. If anyone agrees there will be a global recovery then they agree that inflation will be a natural outcome of that, they want to be increasing their position with respect to inflation hedging and real estate is still a great way to do that,” she said.
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