This article was publish in BDO M&A Horizons magazine 2022 - Issue 2
Now that 2022 is in full swing and everyone seems eager to leave Covid-19 in the past, there is a new global fear popping up, Inflation. Following the supply chain disruption and consumption shift associated with COVID-19, western countries have seen an uptick in inflation throughout 2021, mainly driven by slowing growth due to Covid and the massive amount of liquidity pumped into the market. We saw US inflation jumping to 7.9 percent as of February 2022 from 1.6 percent a year before. Such inflation has not been seen in more than a generation.
Globally this has pushed central banks to review and adjust their monetary policy to find ways to curb the inflation that is eroding the purchasing power of consumers. The FED announced, after considering inflation not to be transitory anymore, that they would raise interest rates up to 7 times throughout 2022. They have already shifted it up a 25 basis point in March 2022. On the European side, the ECB may raise their deposit facility interest rate from -0.50 percent back to 0.00 percent, which was last seen in 2013. There are further uncertainties to come with the situation in Ukraine and the full-scale disruptions resulting from it yet to be unraveled.
Investors through all asset classes are thus looking for a hedge on inflation.
From a property value standpoint, there has been an historical inverse relationship in between prices and interest rates which is mostly due to purchasing power capacity. When money is drying up, the pool of buyers is reduced, resulting in a lack of demand. In appraisals, this typically would be reflected in an increase in capitalization rates and discount rates.
On the other hand, as long as grown revenue remains affordable by demand, a high inflation rate would not necessarily erode property valuation, as cash-flow generating properties would exhibit superior cash-flow growth, compared to historically low-inflation periods. In addition, fast growing cash-flows are beneficial for homeowners, given that debt outstanding remains flat. Consequently, in the long run, higher-than-average inflation may result in better unlevered and levered returns for an overall similar level of risks.
Counterintuitively, such an environment may actually benefit real estate values. Investors may thus start using real estate as a hedge against inflation by capitalizing on still cheap mortgage interest rates, passing through rising costs to tenants with higher rent prices, and benefiting from rising home values over the long term. Such a trend would further drive up values of real estate and keep it one of the most attractive asset classes available. This trend is likely to continue especially for residential properties but also for multi-functional assets in the industrial and logistics sector.
While inflation will likely have an impact on all asset classes of real estate, asset classes are expected to bear differently. With supply chain disruption continuing, BDO REC expects industrial and logistic properties to further consolidate their advantage. On the other side of the spectrum, the retail and hospitality sector may weaken further and will be extremely dependent on the shift in consumers’ habits i.e. where and how consumers shop and where consumers go. Office properties appear at risk in core Central Business District (CBD) markets.
An inherent risk to the real estate sector caused by inflation relates to the increased cost of building material, which will slow down construction in various areas. Therefore, property owners with good assets might even see an added benefit from reduced new supplies coming to the market, which will allow for an increase in rental rates.
While historically it was to be expected that increases in global interest rates, as a result of the effort to curb global inflation, may trigger an overall decrease in property values, there are factors which may send the real estate market into overtime. Current owners may be able to benefit from the inflationary environment with higher cash-flows in prospect. Real estate operators, investors and managers will need to closely monitor this broad dynamic in the coming months and property values may not necessarily be found to be negatively impacted.
The BDO Real Estate and Construction group has set up a global Real Estate Valuation network to address the valuation challenges associated with these complex problems, allowing us to work on several different markets maintaining an overall market view of real estate.