UK real estate: inflation hedges take centre stage

For investors, Russia’s invasion of Ukraine has sent inflation to new highs, increasing the risks of stagflation, particularly in Europe. While the property risk premium has been squeezed, we continue to believe real estate offers value, and it has outperformed both equities and bonds so far this year[1]. That said, we’ll be watching closely for any deterioration in expected rental growth for the asset class as a whole.

Despite the market volatility, many of the current drivers for the real estate sector remain the same today as at the start of the year. The need to get ahead on carbon-emissions reduction to meet net-zero targets is as important as ever as occupier demand pivots towards sustainable and high-quality assets. In the office sector, we still believe there will be positive implications for high-quality offices but growing risks elsewhere. For retail, while there is some variation, we continue to see pressure on rental values for the sector as a whole. We have been surprised by the resurgence in capital values for retail warehousing, where values increased by 7.2% in Q1 2022[2], given the risks still facing the sector.

Shining a light on alternatives

The strategic implications of rampant materials price inflation coinciding with wage inflation have shone a light on the alternatives sector, especially in the areas of Build to Rent (BtR) and purpose-built student accommodation (PBSA).

Such residential-based assets, we believe, are some of the strongest real estate sectors in terms of providing a hedge against inflation. There are clearly defined relationships between BtR rental growth and wage inflation, while the supply and demand fundamentals supporting high-quality PBSA in top university cities remain strong.

Sounding a note of caution in the industrial sector

The industrial sector also displays hedging characteristics, although low yields mean caution is necessary when assessing new investments. At these low yields decent rental growth needs to be maintained.

There is still evidence to support this. In multi-let estates, supply is limited with demand strong. Although we are cautious on rising occupier costs and the implications to affordability, the performance seen so far this year (total returns of 8.2% and rental growth of 3.4% in Q1[3]) is, we believe, illustrative of near-term momentum, which will be described in a subsequent blog.

By contrast, the challenges of high inflation and strong wage growth mean we are more cautious on the retail and office sectors, with construction inflation challenging the viability of capital-intensive repositioning strategies.

Sectors displaying resilience in the face of rising inflation

The graphic below plots analysis we have undertaken to capture the capacity of each sector to deliver income growth in the face of inflation – the strongest sectors are in the top right. The residential and industrial sectors, alongside more niche strategies such as life sciences, position well in this analysis, which partly explains the positive investor sentiment towards them.

Performance year-to-date has been strong but risks to subsequent returns have grown as economic fundamentals deteriorate, with the pace of performance likely to slow. We expect average returns over five years of around 5% p.a.[4] and sector, segment and style allocations will be increasingly key to determining the spread around this. Investor capital will most likely focus on parts of the market best able to offer a partial hedge against high inflation, but with that the risks of values overshooting, especially in industrial and parts of retail, increase. The need to be selective remains paramount.

[1] Source: MSCI Quarterly Digest, Q1 2022.

[2] Source: MSCI Quarterly Digest, Q1 2022.

[3] Source: MSCI Quarterly Digest, Q1 2022.

[4] Source: LGIM RA as at May 2022.