Real Estate in a Low Inflation Economy

Copyright: David Lawson - Property Week 1999

Home Page

Inflation is running at levels unseen since the post-War era. The leading economist Roger Bootle has sent shivers through the property sector by predicting it could even slip into negative figures, something unseen since the Thirties. Professionals who have never known such conditions are growing worried that property could lose out against rival investments like gilts and equities. Bootle is upbeat about medium-term returns but has predicted the demise of upwards-only rent reviews - a mainstay of income growth for more years than most can remember.

One major fear is that inflation has acted like an ageing star's makeup, hiding flaws in the apparent beauty of buoyant returns. Mistakes were washed away as debt was eroded and capital values floated upwards. Without this gloss, property will become even less attractive. But there a remarkable degree of optimism among insiders. Bootle appears isolated in believing we are heading for deflation. The consensus is an inflation rate of around 2.5%. Set against average yields of around 7%, this offers a low-risk, quality asset, say the sector's supporters.

Low inflation also means low interest rates. A developer borrowing at 6% can achieve an 8 or 9% return from day one plus a top-up, however small, from rising capital values. Even the sector's strongest backers warn about complacency, however. Competition from risk-free gilts and booming stock markets, doubts over the potential impact of depreciation and the move to shorter leases all cast shadows over the future. 

Len Eppel is shy about revealing his age. 'It's not the sort of thing a gentleman does,' he jokes. Suffice to say that the founder-chairman of Arrowcroft Estates joined the industry when TV was black-and-white, Elvis was still chopping cotton and the current prime minister was in nappies. After seeing more cycles than a Tour de France fan, he finds himself almost back to square one. But Eppel is unstirred by warnings of doom.

'It is a fallacy to believe inflation was a boon for property,' he says. It may have covered up mistakes but it also meant low yields for property companies. 'We faced negative cashflow for years until rent reviews came through.'

The crucial factor today is that cashflow is positive from the outset because low inflation means low interest rates, and borrowing costs less than potential returns. This does not mean a complete return to Eppel's early years, however. Some of the leases he would have negotiated then are only now coming to an end. 'It was a let-and-forget era,' he says. Today, leases are heading towards single figures. But that emphasises the need to be good at development, so buildings easily relet.

Low inflation will be a benefit rather than a curse. 'It means stability, which is what we all want,' he says. It will reward good management and expose incompetence. It may also make the industry less flighty. 'Medium to long-term investors have nothing to worry about - which is as it should be,' says Eppel. Fast-buck traders face the biggest squeeze.

Property companies will be forced to finally grow up as inflation is squeezed out of the world economy. 'The future will not be about manipulating bricks and mortar and massaging assets. It will be about understanding the business of your customers,' says veteran developer Martin Barber. Despite almost 40 years in property, he has never had to deal with sustained low inflation. But he saw the warning signs several years ago and restructured his company, Capital & Regional.

He saw that producing the performance demanded by investors would be hard without general market uplift, so he moved heavily into a sector where extra value could be added - shopping centres. 'When you have done everything you can to improve the bricks and mortar, you have to cross the line to raise the customer flow and help improve the performance of your tenants,' he says.

Marketing, merchandising and a host of other skills come in and C&R has already brought experts with a retailing background onto its staff. Other sectors can also benefit from this hands-on approach. It is no surprise that Barber recommended the giant US investor PRICOA to take over Arlington. Its chief executive, Patrick Deigman, was pioneering the switching of tenants around his massive business parks and offering all-in service packages. 'This is another method of adding value above the traditional massaging of assets,' says Barber.

John Andersen has seen inflation, deflation, boom, bust, gluts and shortages in his years of developing around the world. It has taught one lesson: 'There is no single magic answer to making profits.'

After gaining his international experience with Ladbroke, he is now facing a future of low inflation with equanimity as Burford's chief executive. 'It will be hard work,' he says. 'But that is no surprise. You need a good management team which can see angles and do its homework.' Andersen rejects concentration on particular sectors. With a portfolio ranging from Mayfair offices to provincial sheds, he says he would have missed two out of three opportunities if he had narrowed down.

Stock-picking skills are the key to success under low-inflation, says Ed Luker, investment partner at Richard Ellis St Quintin. 'You need to be very sure that if you are buying a low-yield investment that you can squeeze out extra value. It will not be harder to make property perform: but it will be more obvious when it does not,' he says.

Assets will also need to be sweated to get the extra value demanded by investors. That may require lateral thinking, such as funds linking with specialist managers such as the Hermes-Pillar association in retail warehousing. Limited partnerships are already being formed by major funds to pool assets and gain the added value of liquidity and specialised management.

Property can still make a reasonable return under low-inflation conditions. 'You can get a low risk, good quality asset with a total return of up to 10%,' says Luker. The problem is that investors are comparing with equity returns that have boomed as much as 20% a year. 'It is true that they cannot compare on this short-term past record, but will that continue? Now is the time to be getting out of stocks and into property,' he says.

Low inflation can be good for property. This flip side of current fears about the sector is why the Prudential, one of the UK's biggest investors, remains a property bull. Firstly, there is a consensus that inflation will not disappear but run at around 2.5% in the medium term, says Paul Mitchell, an economist at PPM Property. Secondly, the economy will make a 'soft landing' and return to normal growth rates.

Property then shows attractive returns relative to gilts, the benchmark by which the sector is measured. Ironically, the advantage stems from the relative unpopularity of bricks and mortar over the last few years. Yields have remained high, whereas gilts and shares have been re-rated.. Gilt yields of around 4.7% look attractive in the Bootle scenario, where inflation is negligible. If running at 2.5%, however, they pall beside the 7% offered by property.

'Low inflation means low capital growth but not necessarily low real returns,' says Mitchell. In fact, low inflation can be good for property because real values grow continuously rather than the owner having to wait for a rent review to claw back the erosion under inflation.

Property has long been seen as a hedge against inflation. It could now be a hedge against deflation, according to an in-depth analysis by Richard Ellis St Quintin. The secret lies in strong income flow. This averaged 7% at the start of 1999 and is expected to run at around 7.5% from 2000-3, forming the bulk of the 10% expected total return. In contrast, 15-year bonds are running at less than 4.5% and equities under 3%.

The total return may look weak compared with the boom-affected Seventies and Eighties, when yields averaged 15.1% and 14.6% respectively. But the death of inflation means real rates are still very attractive. The sector will have to adjust to these new conditions. 'Property will become increasingly driven by income returns and the invention and ability to use finance efficiently and to add value,' says the study. 'There will be few, if any, of the free rides which existed in the days of high inflation.'

As we move into the 21st century, this picture is eerily similar to the economic conditions of the Thirties. The decade is still seen as a low point in the 20th century, although the key economic indicator, Gross Domestic Product, was growing by a comfortable 2.6% a year. It was also the last time cheap money and low inflation ran in tandem. Inflation was 0.4% and income rather than capital appreciation was king. In that decade equities returned an average 4.3% and gilts 5% compared with 7% from property. Investors must expect similarly low returns in future.

But there is a sting in the tail of the study. RESQ warns investors not to get locked into a low-inflation perspective. 'We are not hailing a return to high inflation but at some point there may be a return to a more inflationary environment,' says the report. That will ring bells with those old enough to remember the 1970s crash. This wiped out many who had prospered in the post-war years but could not handle inflation which peaked at 25%. In the meantime, however, 'Income is king', says RESQ.

Property has been a good investment over both the long and short term, according to analysis by REsQ of figures going back to the Twenties. It may underperform other assets at times but returns are less volatile, making a strong case for inclusion in mixed portfolios.

This could go some way to counter carping from the City that bricks and mortar have been a poor investment over the decades. The recent stock market boom has exacerbated this problem and is seen by many insiders as the reason why institutions have deserted the sector in droves. In the last five years, during low and stable inflation, returns have averaged 11.3%. This is more than the 9.5% benchmark set by gilts but less than the 13.9% averaged by shares. Returns have, however, been far less volatile (risky).

The yield gap opens slightly over the long term, with property averaging 9.7% and equities 14.4% between 1964-98. But volatility (defined by variations from the average) was even less than in the short-term. This confirms that the property market works in a different way to shares and gilts, which tend to move together. Buildings are linked to economic (GDP) growth. This strengthens the case for funds to invest in property to smooth the volatile returns from other investments.

Other findings by the study include: