Residential rents: holding the key to inflation protection?

Since the start of the year, rising bond yields have stoked the growing narrative around the return of the inflation genie. Exceptionally high levels of stimulus provided by the US and other developed governments, coupled with a potential surge in demand as economies reopen, should in theory mark the return of sustained inflationary pressures.

Our view is that there may be near-term inflation risks as economies reopen. Some prices might temporarily overshoot on surging demand as a result of impaired supply. Over the medium term, there is also a risk of a stronger-than-expected recovery eliminating the spare capacity that currently exists. Under this scenario, wage pressure could re-emerge relatively quickly and feed into higher inflation. However, we see central banks looking through the former and having sufficient tools to deal with the latter.

That said, we believe it is worth looking at how to protect assets against a period of rising inflation. One of these could be in the area of real estate. While the sector per se does not offer full inflation protection, a notable area where there is a record of relatively strong inflation linkage is in the residential sector. Institutionally held BtR (build to rent) homes can provide investors with access to the sector.

Positive correlation between residential rents and inflation

Residential rental data from the OECD show that UK rents have typically outpaced inflation over the long term. Since 1962, real rents (rents adjusted for inflation) are estimated to have grown by 1.4% per annum (p.a.). This relationship also holds across other developed economies, with rents growing faster than inflation at comparable rates.

UK housing demand is far outstripping supply

One of the reasons for the positive correlation between residential rents and inflation is, in our view, the fundamental imbalance between demand and supply in UK housing.

The UK housing market can be characterised as one where supply levels have failed to meet excess demand. Government estimates state that 300,000 new homes p.a. are required to meet the housing need but, over the past 10 years, only around 199,000 new homes on average have been built each year – far undershooting the requirement. The ensuing increase in house prices has acted as a barrier to becoming a houseowner for many, which has in turn led to stronger residential rental demand.

The quality of the accommodation, amenities and service provided in BtR has also proved to be a winner with residents. The existing private rented sector in the UK is one that has typically been associated with higher levels of – what are known in the industry as – ‘non-decent’ homes and lower satisfaction compared with other tenures.[1] BtR goes some way to changing this perception. The increasing proportion of people choosing to rent, because they prefer the flexibility it provides, and the greater focus on the quality of the living spaces, we believe, creates a backdrop to stimulate further demand for BtR homes.

Because of the basic need for housing, residential demand is far more stable than the more cyclical demand of other real asset classes, which typically fluctuate more with the fortunes of the economy. Tight housing supply and the inability to keep up with demand means that there is underpinning support for upward pressure on rents. This has resulted in residential rental growth levels being relatively more stable than those of commercial real estate assets.

All in all, the historical evidence suggests that the residential sector typically generates stable and long-term income streams that tend to outpace inflation. With the fundamental backdrop of continued pressures on UK housing, we expect this to continue. We believe this makes exposure to the residential sector a worthwhile complement for investors with liabilities linked to inflation.

[1] MHCLG English Housing Survey 2018/19