The impact of rising inflation
Inflation is a key global topic for both investors and consumers as prices surge to their highest rates in decades. What could lie ahead for economic growth, interest rates and real estate?
Global real estate outlook
Regional trends
United Kingdom
Continental Europe
Asia Pacific
Strategic calls
Source: M&G Real Estate, May 2022.
The war in Ukraine has heightened uncertainty and led to a sharp increase in prices, particularly for energy. This, in turn, has exacerbated the cost of living crisis. Navigating the economic risks, including recession or stagflation – continuing high inflation with economic stagnation or weakness – is no easy task. How this plays out through central bank policy is under close scrutiny by investors, and much depends on the path of the war. Rising inflation and interest rates could pose multiple challenges for real estate investors, from rising debt and construction costs to potential asset repricing. Yet property yields still have the potential to offer a wide spread over government bonds. As a real asset, property could also protect against inflation, particularly through investments positioned to see cashflow growth. This mid-year outlook takes a closer look at positioning portfolios for inflationary resilience and shares our views on global real estate trends by region.
Following a period of robust global economic growth, 2022 has been beset by inflation.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Where past performance is shown, please note that this is not a guide to future performance. Information is subject to change and is not a guarantee of future results.
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Explore M&G's outlook for regional markets
Positioning global portfolios for resilience
Hotels
Grocery-anchored retail parks
Prime offices in key cities
Tech and innovation hubs
Short leases
Logistics
Green assets
Food stores
Index-linked leases to strong covenants
Living sector
Unless a property has explicit index-linking in the lease, its contracted rental income could lag behind in times of high inflation. A frequent ‘reset’ of the lease to market rents can help cashflows to keep pace with inflation in markets and sectors that are seeing rental growth.
Whether in the UK, Europe or Asia Pacific, ongoing structural demand for logistics space is set to fuel further strong rental growth in low-supply markets. However, keen yields with insufficient risk premium priced in could be vulnerable if downside risks materialise.
With tight supply in many major city centres, high quality office space that reflects modern hybrid-working requirements in cities such as London, Berlin or Seoul is likely to benefit from strong competition from tenants and inflationary rental growth.
The sector is due a strong post-pandemic recovery as travel and tourism returns, fuelling solid income growth potential. Resilience and inflation protection is heightened for hotels with index-linked leases.
These economic hotspots continually attract new capital and talent, providing strong growth potential for various property types including life sciences, office space for tech firms, and housing for both students and workers.
Within the retail sector, these conveniently located assets are better positioned to weather the e-commerce storm, and offer more ability for inflation to be passed through to retailer revenue and rents.
With the drive to reach net-zero carbon intensifying, assets which already provide the best ESG credentials are likely to see the greatest demand from both tenants and investors, and the highest premiums on rents and values.
A defensive sector with a defensive lease structure, where inflation flows through to rental cashflows.
Properties with contracted rents explicitly linked to an inflation index are well positioned to benefit from high inflation, even during times of economic weakness, provided the tenant is sufficiently robust to maintain rental payments.
The residential Private Rented Sector, student housing, senior living and affordable homes all offer defensive characteristics, with rents closely related to inflation.
Living sectors
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Seeds of growth weather the climate
Real estate has witnessed the hottest UK logistics market in decades, as the pandemic further drove online consumption and logistics operators scrambled to bulk up their supply chain networks, already distorted by Brexit. But as UK consumers start to feel the pinch of rising living costs, the purse strings could tighten for discretionary retail spending. Experiences may also win out over goods, with the easing of lockdowns. This is the first time e-commerce has faced a significant consumer squeeze. Could this take the heat out of the logistics market? Especially as profits are squeezed and occupiers reassess their growth plans. Shopping and leisure destinations should continue to benefit from the tailwinds of reopening, particularly those with a strong experiential element or a bias towards discount retailers. The retail property sector has already seen a shake up; repurposed assets with stronger operators are better positioned to weather the storm. That said, occupiers may seek turnover leases to hedge their bets on consumer spending.
Record high job vacancies are putting upwards pressure on wages
GDP returned to pre-COVID levels in 2021, supported by a consumer-driven recovery. However, with the focus now shifting from the pandemic to prices, the UK faces economic headwinds. While current inflation trends are global, the UK story is nuanced. The country is less dependent on Russia for energy than European economies, yet the impact of Brexit has exacerbated supply-side constraints, boosting domestic inflation. ‘The Great Resignation’, triggered by employees reassessing their lives, has also resulted in labour and skills shortages, pushing up wages and adding to inflationary pressures. At the same time, rising interest rates could mean higher mortgage costs, adding to the near-term consumer squeeze. Despite the current scenario, tailwinds remain: buoyant employment and earnings growth should support households’ finances, helping to mitigate the rising cost of living. British consumers also have the potential to release significant savings into the economy¹, stored up during multiple lockdowns. These seeds of growth are still there and should help to support continued growth as the economy navigates current challenges, suggesting stagflation remains a tail risk for the UK.
A squeeze on e-commerce?
¹ Bloomberg, UK Consumers Add £27 Billion More to Bank Saving Accounts at End of 2021, March 2022.
Housing affordability is coming under increasing pressure
The housing crisis looks set to see renewed focus as a rising cost of living bites. The rise in house prices has stormed ahead of earnings growth, benefiting those that already own property but pushing home ownership further out of reach for people seeking to get on the ladder. Affordability constraints face the perfect storm: higher house prices and mortgage costs make buying difficult, while rising construction costs mean supply is likely to remain tight. Young and lower income households are likely to be impacted the most, reinforcing the need to rent for longer. Tenant demand for Private Rented Sector housing is unprecedented and rents look set to rise significantly, supported by earnings growth. In this context, the sector looks well positioned in the higher inflation environment. But what about those households whose finances would be stretched by both home ownership and private renting? As essentials like food and fuel demand a growing proportion of incomes, the need for affordable housing becomes ever more pressing. The attractive, defensive characteristics of the sector should encourage investors to step in and bridge this supply gap, offering the potential for good returns and, importantly, much needed affordable homes.
Housing affordability faces the perfect storm
Spending on experiences may outweigh goods as lockdowns fade into the distant past
ONS, April 2022.
Source +
Nationwide March Spending Report, May 2022.
Nationwide, Q1 2022.
Source: Nationwide March Spending Report, May 2022.
Real estate has witnessed the hottest UK logistics market in decades, as the pandemic further drove online consumption and logistics operators scrambled to bulk up their supply chain networks, already distorted by Brexit. But as UK consumers start to feel the pinch of rising living costs, the purse strings could tighten for discretionary retail spending. Experiences may also win out over goods, with the shackle of lockdowns behind us. This is the first time e-commerce has faced a significant consumer squeeze. Could this take the heat out of the logistics market? Especially as profits are squeezed and occupiers reassess their growth plans. Shopping and leisure destinations should continue to benefit from the tailwinds of reopening, particularly those with a strong experiential element or a bias towards discount retailers. The retail property sector has already seen a shake up; repurposed assets with stronger operators are better positioned to weather the storm. That said, occupiers may seek turnover leases to hedge their bets on consumer spending.
Source: ONS, April 2022.
Source: Nationwide, Q1 2022.
Time for Europe to regain energy security
With higher inflation here to stay, at least in the next few years, the increasing cost of land, construction and labour is likely to be a double-edged sword for investors. Higher costs can mean new supply is less financially feasible; good news for rental growth prospects in Europe. Markets such as Germany and the Netherlands, where supply is already constrained, may see particular upside. But rising costs can also mean higher values for investors seeking development opportunities. 88% of real estate firms were concerned by construction costs according to a recent survey¹. Many are facing both delays to building projects and price increases for steel and lumber, ranging from 30% to 100%. These pressures will not continue indefinitely, however. As COVID-related supply chain issues smooth out over the coming 12-18 months and global commodity price rises begin to soften, upwards pressure on costs should start to subside.
Some countries are further invested in renewable and nuclear energy than others
The war in Ukraine has exacerbated the energy price shock in Europe. With inflation the highest in decades, governments and the ECB must now make difficult decisions, both to stave off longer term inflation and regain energy security. There is increasing pressure to move Europe out of negative interest rates. Policymakers also plan to cut Russian gas imports by two thirds this year, and eliminate fossil fuel imports by 2027. Weaning off these energy sources is no easy challenge given Europe consumes 2.5x more gas than it produces. Plus, some countries are much more reliant than others. The European Commission has already outlined a far-reaching plan to triple electricity capacity from 2030 targets, investing in domestic and renewable energy sources like green hydrogen, wind and solar. This should ultimately provide better insurance against future energy-driven price shocks. The transition to greener, more stable energy is made more pressing by the current inflation crisis. Some economic upheaval may result, but the ripple effect is likely to drive progress across European markets, including the decarbonisation of real estate portfolios.
Rising construction costs can be double-edged
Higher construction costs may starve markets of supply, keeping occupancy high
Lease events should hone focus on ‘working the asset’
With inflation surging, the adage that real estate provides inflation protection is set to be tested. Europe sits in a relatively strong position. Most commercial leases benefit from inflation kickers; annual or monthly reviews tied to CPI. But leases expire, and occupiers’ ability to fulfil rental obligations could be impacted by both COVID and cost pressure-related insolvencies. Landlords should not simply expect income growth to materialise – occupier demands are increasing across all sectors. According to a recent census, 67% of logistics operators saw on-site renewable energy as operationally desirable, while 50% wanted better warehouse insulation¹. This requires investment in assets, particularly if investors want to keep rents moving upwards. Working with tenants to help manage their cost pressures is also crucial. The drive to create truly affordable housing, for example, means maintaining rents at sustainable levels, at a time when the cost of living is being squeezed. Ultimately, landlords that put in the work now will reap the benefits further down the road: portfolios with long-term inflation protection and tenants who stick around for longer.
Achieving real asset growth through real work
¹ 2021 European Logistics Census, Tritax EuroBox, Savills.
¹ PWC Emerging Trends in Real Estate Europe, 2022.
Eurostat, Capital Economics, May 2022.
Note: Chart is illustrative. Source: M&G Real Estate, May 2022.
Source: Eurostat, Capital Economics, May 2022
M&G Real Estate, May 2022.
Forecasts are not guaranteed
Far away is not far enough
Like most markets globally, consumer price rises are evident in Japan. While higher than normal, inflation is still likely to remain much lower than in other economies. On the basis that supply chain disruptions ease and disinflationary trends return, the central bank’s dovish stance is expected to persist. We believe lower-for-longer interest rates in Japan mean property yield spreads against local 10-year government bonds are likely to continue offering attractive value compared to other markets, while the country’s relative stability and lower lending rates make it a continued magnet for cross-border investors. Combined with a weaker yen, this appeal may intensify. The country’s multifamily housing sector is likely to remain a chief focus for income-seeking investors, having shown resilience through various economic shocks. Capital growth potential could come from investments in sustainable and efficient urban logistics and fulfilment centres. Tenant-friendly leases in Japan could, however, present leasing hurdles in the current inflationary environment, with tenants taking a more cautious approach.
Healthy fundamentals are expected to support further economic growth across key Asia Pacific cities
Sustained employment and wage growth in Asia Pacific, coupled with the further relaxation of COVID restrictions in most countries, continue to underpin domestic appetite for goods and tourism. The scale of economic expansion could nonetheless be challenged by trade disruptions and inflation. Relative distance from the war in Ukraine – both in geography and direct trade – has not stopped commodities and food prices from rising, with consumers starting to feel the squeeze. Developed Asia is especially vulnerable as it relies on imports for fossil fuels consumption; Australia on the other hand is gaining from the boost in commodity exports. Higher inflation coincides with China’s increasing lockdowns of major cities to contain the spread of COVID, renewing bottleneck pressures. Policymakers are therefore expected to move faster and further to curb inflation – made more urgent by the strengthening US dollar, which could result in a rise in import costs.
Going against the global trend
Japan: expected disinflation should keep bond yields low
Japanese property yields look attractive against local bonds
Rising construction costs could further delay new completions in Asia Pacific’s historically undersupplied office markets
As general price levels rise, few markets are better positioned to ride the wave than expanding Asia Pacific office markets. Lease lengths here are relatively short – three years on average – meaning landlords are able to quickly capture upside potential through higher rents. Longer leases, for larger tenants, are typically subject to step-up rent reviews. Rental growth in office markets such as Seoul and Singapore is set to exceed inflation levels over the next three years¹, driven by long-term structural trends such as the economic shift towards digital industries. Tenant demand is expanding for prime office space - particularly that which promotes employees' wellbeing - owing to the relatively lower impact of hybrid working. Google Mobility data showed office use through the pandemic never fell below 75% in South Korea, and has since surpassed pre-pandemic levels². The prospect of income stability and tenant retention comes at a price, however, with investors competing for assets. The impact of rising debt costs could further challenge returns.
Riding the inflation wave
¹ PMA, as of May 2022. ² Compared to pre-pandemic levels. Google Mobility data, as of May 2022.
Source: Oxford Economics, as of May 2022.
Source: Oxford Economics as of May 2022.
Note: Data relates to office markets in developed APAC property markets including Australia, Hong Kong, Japan, Singapore, South Korea. Source: PMA as of April 2022, M&G Real Estate.
Source: PMA, ARES, M&G Real Estate as of May 2022.
