With macroeconomic factors and market sentiment dragging down yields, investors are wondering what to do with their real estate investments. For one of the most capital-intensive asset classes, isn’t rising interest generally a bad sign? “Conventional wisdom saying that real estate would always be a good inflation hedge is nonsense.”
Over the past 30 years, real estate has been a popular asset class. This was due to a combination of falling interest rates, low inflation, cheap funding and, as a result, highly predictable cash flows and attractive returns on investment.
Now that central banks, led by the Federal Reserve, have positioned themselves around the prospect of rising interest rates in response to increasing monetary depreciation, the tide could be turning for real estate. The main question investors are asking now is: are the shrinking profit margins on property investments enough to hedge against inflation?
Real estate as an inflation hedge
Egbert Nijmeijer, co-head of real assets at Dutch investment bank Van Lanschot Kempen, said the idea that real estate would always be a good inflation hedge is simply “nonsense”. He still sees demand for real estate investments because his clients assume that the current level of inflation can always be passed on by increasing rents.
“An investor must be aware that only part of this asset class can compensate for inflation by raising rents,” said Nijmeijer, who manages €1.7 billion of investment property.
Certain rents, such as those of old, non-sustainable office buildings or homes in markets with regulated rents, do not move proportionally with inflation. Many institutional investors, such as Dutch pension funds, but also private individuals, have Dutch homes as an investment. But at the moment, according to Nijmeijer, the real returns on residential property in the Netherlands are negative because there is often a maximum permitted rent increase, as a result of which rent growth cannot keep up with inflation.
Nijmeijer said there is a risk that, in time, there will be no more capital available for new housing projects in the Netherlands. “The moment the government regulates rents too much, investors will no longer invest capital in Dutch homes, but rather, for example, in British or American homes where rents are not regulated and the property is inflation-proof. Then we are really far from home.
US Reit market seen as more professional
Boudewijn van Loen, who manages the Real Estate Investment Trusts, Reits, at Aegon Asset Management, said the US real estate market is more professional, and therefore more interesting for institutional investors.
Investors in the United States can choose very specifically what type of real estate they want to invest in. The trust that institutional investors have in Reits there is high, said van Loen.
“If you are listed as a real estate company in Europe, you don’t have to try to raise money; European real estate investors often want an entire office building right away. In the US, Reits can raise as much as 10 per cent in one day. That is enormously valuable for those companies,” he said.
Unlike Nijmeijer, Van Loen is positive about the Dutch housing market. “The possible pressure from politicians not to increase rents too much only depresses the profit margin a little. Housing remains a good investment for institutional investors, but not for ‘fast money cowboys’.”
Adding value in diversified portfolios
Olaf van den Heuvel, Aegon AM’s chief investment officer, is also positive about the added value of real estate in a diversified portfolio. He argues that inflation-linked rental income currently outweighs the negative implications of a rising interest rate environment. He also believes that the sector is interesting because falling prices have made valuations much more attractive.
For listed Reits, which posted a loss in euros of almost 5 per cent in the first quarter of 2022, there is an obligation to distribute most of their taxable income to shareholders.
According to van den Heuvel, the structure is such that a certain percentage of the profit is paid out as dividend, on which shareholders do not have to pay tax. “This is a relatively attractive investment in this inflationary climate,” van den Heuvel said.
Pricing power in logistics
Nijmeijer’s answer to the question of where the sweet spot is in the property market is clear: logistics property. Because of the enormous pricing power of this niche, Nijmeijer believes that any level of inflation can be passed on to the tenant. “Every rent increase will have to be swallowed by the tenant, because the development of these projects cannot keep up with demand at all. Rents in that sector are rising by as much as 10 per cent a year.”
Van Loen also acknowledges that distribution centres are very “hot” at the moment, but he said that this is only temporary. His argument is that the legislator will eventually intervene with stricter laws and regulations. “If you fill up the entire country with boxes while there is a shortage of housing, then that is no longer explainable. Besides, big buyers, like Amazon, are already indicating that they have sufficient capacity.”
This article originally was published in Dutch on InvestmentOfficer.nl.
Related articles on Investment Officer Luxembourg: