Real estate may not hedge effectively against inflation

Jun 13, 2022

Inflation is rising globally and in Singapore. Core inflation in Singapore – which excludes accommodation and private transport costs – jumped to 3.3 per cent in April, up from 2.9 per cent in March. This is its highest level since early 2012.

People are looking for assets to hedge against inflation. Physical property could be one such asset. In an inflationary environment, rental rates may rise. With higher construction costs, developers may pass cost increases in building homes to end-buyers.

The nominal value of money gets eroded faster when inflation is high, so putting money into physical assets such as homes, which have historically appreciated over the long term, can make sense.

Demand at recent new private home launches here is strong. Bukit Sembawang Estates’ condominium project Liv @ MB in the Mountbatten area sold over 75 per cent of its 298 units, at an average selling price of S$2,387 per square foot (psf), at its launch weekend. Piccadilly Grand, a joint residential project by City Developments Limited and MCL Land, which is linked to Farrer Park MRT station, sold 77 per cent of its 407 units at an average selling price of S$2,150 psf during its launch weekend.

Inflation effects

But, investing in property may not be effective in combating the inflation that we are facing today. While the inflation that the world is confronting started due to the rise in the supply of money and credit to fight the Covid-19 pandemic, it is now driven by cost increases, including that caused by supply chain disruptions due to events such as the war in Ukraine.

Retail landlords can gain from rising inflation. For selling the same quantity of goods, a retailer’s turnover rises if prices of goods rise. Should retailers enjoy higher turnover, they can in turn potentially afford to pay higher rent on their shop leases. Also, landlords may enjoy an immediate pickup in rent from retail leases that have a turnover component, due to higher sales of tenants.

But the picture for retail landlords is complicated when inflation is driven by higher costs of utilities and food. Where operating cost increases cannot be fully passed on to tenants, profit margins of mall owners may take a hit.

With inflation and a tight labour market, rising wages can support consumer spending power. But, consumers may be poorer in real terms if wage hikes cannot keep pace with inflation.

Also, those who are not in employment may not benefit from higher wages. Ultimately, many consumers may cut their spending on goods and services, which will affect turnover of retailers.

Furthermore, the propensity to save instead of consume could rise if consumers save more to cope with expectations of higher inflation.

In property segments such as offices, warehouses and factories, inflation may boost turnover of businesses, which can result in better ability to pay rent. Businesses that enjoy bonanzas from higher prices of commodities, may be happy to spend more on prime office spaces and other real estate needs.

But, higher borrowing costs due to central banks raising interest rates to fight inflation can hurt the cash flow and profitability of many businesses. Such businesses may look to cut real estate related costs.

Recession risk

Perhaps, the big risk to various property segments is that of an economic recession.

When speaking to media group Nikkei on May 20, 2022, Prime Minister Lee Hsien Loong said the global economy is currently facing high inflation, and there is a risk that measures taken to combat this problem may lead to a recession - but action must be taken nonetheless, lest inflation become a very serious problem for the world.

PM Lee noted that as inflation is now high, drastic measures are needed to bring it back down and prevent inflationary expectations from taking root.

“It is very difficult to do that and have a soft landing. There is a considerable risk of doing what you need to do, but as a result, provoking a recession,” said PM Lee.

Should the global economy tank, many businesses will be hurt, as falling demand crimps revenue and profitability. Demand for space from businesses will in turn be negatively impacted.

As it stands, many existing homeowners and potential home buyers here are facing rising cost of home loans. The 3-month compounded Singapore Overnight Rate Average has risen from around 0.2 per cent at the start of 2021 to around 0.6 per cent as at Jun 10, 2022. Monthly instalment of a S$1 million home loan is around S$190 higher for a 25-year home loan with annual interest rate of 1.6 per cent versus 1.2 per cent.

Floating rate borrowers face the risk that interest rates may continue rising going forward. On the other hand, getting a fixed rate loan can be costly, as fixed rate loans are generally much more expensive than floating rate ones.

And existing stretched affordability of private homes is worsened when inflation eats into household disposable income, thus making servicing of home loans more challenging.

What could really rattle the residential property market is the risk of recession, as this can lead to job losses and wage cuts. Uncertainties around jobs will invariably hurt home buying sentiment and the ability to service home loans.

Certainly, if inflation caused by supply shortages is then followed by a hard landing for the global economy, prices of many assets, including physical property, will be hurt

Overall, real estate is likely to be somewhat effective as an inflation hedge - commercial and industrial landlords may enjoy some up tick in rental revenue as some tenants see turnover rise amid higher inflation. There can also be resistance to home prices falling as the cost of building homes rises.

Yields that are in the low single digits across many property asset classes in Singapore trump what one gets by putting money in Singapore dollar fixed deposits. With real estate investment trusts (Reits), one may get distribution yield of 5 per cent or more.

In sum, it is worth considering putting money in physical property here or proxies such as Reits to hedge against inflation. However, it is a tall order for real estate to hedge effectively against the inflation that faces the global economy today.

https://www.businesstimes.com.sg/opi...inst-inflation