You may have heard that commercial property is a ‘hedge against inflation’ but what does that really mean? Let’s look at the fundamentals and see why commercial property still works in an inflationary environment.
It’s important to remember that the valuation of all business is really based on the future stream of cashflow. That’s why share markets use a Forward Price Earnings Ratio as one of the main sources of price setting. In commercial property, the Net Income is used to establish the ongoing cash flow. Of course, there are risks with every investment class that need to be taken into account.
The Risk Premium
All asset classes apply a premium for risk. This is the amount of return above the ‘Risk Free Rate of Return’ that investors demand to take the risk of investing in that asset. The Risk Free Rate of Return is the return you get without taking any risk. Normally, in a developed country with a stable government, we would use the government cash rate as the risk free rate of return. i.e. it’s unlikely we will lose our money.
A couple of months ago the 90 day Bank Bill Swap Rate, was about 0.09%, very close to the RBA Cash Rate of 0.10%. Now, with some inflation worries, the Cash Rate has been increased to 0.35%, but the 90 day swap rate is around 0.90%, pricing in a significant likelihood that rates will rise further over the 3-month period.
Trying to get any return above the risk-free rate level means that you must accept some level of risk in your investment. The risk should only ever be proportionate to your expected return. For example, You could go to the casino and put your money on red, and double it for taking slightly more than 50% risk of losing it. You could invest in a start-up and hopefully get 10x on your money by taking the risk that the company may fail and you’ll lose everything, or you could invest in an ASX50 listed company and get a 4% dividend yield (which may vary), and also you’ll take some capital risk as the share price may go up or down.
If you don’t want any risk, you would put your money in the bank or buy government bonds and accept a much lower return. At the moment, the return is below inflation, which means you’re losing purchase power over time. This has forced many people to be more speculative and accept greater risk; perhaps even more than they are comfortable with or a higher risk than the expected return warrants.
The Risk Premium for investing in commercial property is around 6%, however, this will vary with location, quality of asset, weighted average lease expiry (i.e. term of expected cashflow), and age of building etc. When cash rates are near zero, as seen recently, then yields on commercial property were around 6%. If cash rates increase to 2%, then we would expect commercial property to yield around 8%.
People often get confused here, because 8% sounds better than 6%, however it’s important to remember that the yield has an inverse relationship to the value of the property, meaning that the lower the yield, the higher the price people are paying. This is simply because the rent is a fixed amount. If we are demanding a higher yield to buy the property and accept that risk, then we want a better return from the same Net Income. We turn the Net Income into a capital value based on the yield we want.
Here’s the Capitalisation Rate formula:
Net Income per annum
———————————– = Capital Value
Here’s an example: A property has Net Income of $100,000 per annum, and the market yield for that type of property, with that quality of tenant and that length of lease is say: 6.5%. We calculate the value as follows:
———————————– = $1,538,462 (round to $1.5m)
If the interest rate goes up, then the market yield (Cap.Rate) may go up too. Even though the rent doesn’t change, this will affect the value of your property. Let’s see what happens if yield increases to 8.0%:
———————————– = $1,250,000
We have just lost around $250,000 (or around 17%) of our value by going from $1.5m to $1.25m), and nothing has changed except interest rates, and peoples appetite for risk.
Inflation vs Commercial Property
That valuation change above sounds terrible, so why is commercial property considered a hedge against inflation? There are a number of offsets that commercial property has to protect against inflation, including the following considerations:
- A lot of commercial leases have annual rent reviews pegged to CPI. For example, the latest inflation figures showed annual CPI of 5.1%. If your rent goes up 5.1% from $100,000 to $105,100, then the new value of your asset in the example above at 8% Cap.Rate is: $1,313,750*. So, instead of dropping by $250,000, we have only dropped by $200k (approximately). i.e. inflation has offset some of your downside.
(* Maths: $105,100 / 0.08 = $1,313,750)
- What if your property has fixed annual increases? Well, the overall market rent will still change and when you get a new lease, or have a market review either mid-term or on option, then you may see your net rent go up, along with the associated valuation increase. Your valuer will always look at market rent as well as your passing rent, so you will still have a valuation uplift perhaps, even if you are stuck below market rent for a little while with an existing lease.
- Economic Growth. Inflation is normally the result of strong economic growth. If that is the case, then overall demand for commercial property increases, rents increase, and incentives reduce due to lower vacancy. All of these are good for the overall market and the actual cashflow that you will receive from your asset, and in return: valuation.
- Replacement cost. It’s important to remember that inflation flows through to construction costs. This affects replacement value, and can go directly to valuation.
- New development. With higher construction costs, gross rents must be higher for tenant pre-commitment and developers to ‘get out of the ground’. This often restricts supply (which helps reduce vacancy and keep demand up), and also resets new-build market rents to a higher level. In return, we see existing stock rents pushed up to reflect the overall market change.
So, how should we position in an inflationary environment? Here are some little hacks you may consider:
Firstly, when you’re negotiating a new lease, perhaps put in an annual review such as: a fixed annual review or CPI, whichever is higher.
Secondly, make sure you check the current market rent, so you know what to set on a market review or new lease. It may be higher than you expect. Consult your agent or the team at Pure.
Thirdly, make sure you keep your insurance replacement value up to date so that you are covered for any increased replacement cost.
Lastly, you may consider locking in your interest rate in full or part. This does not affect your valuation, but may assist with your cashflow planning. And if you’re in the mood, buying a new commercial property when rates are higher means that you may pick up some valuation through cap rate compression when rates drop again. The cash-rate cycle is normally a 4-5 year cycle.