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Savills benchmarks global real estate assets on resilience to inflation

by LLP Editor
24th Dec 21 11:00 am

With inflation rising in many markets around the world, and interest rates likely to rise throughout 2022, Savills has analysed how inflation-proof various commercial real estate assets and geographies are around the world, finding that (in general) Europe provides the best inflation hedge in comparison with North America or Asia Pacific. The European industrial sector stands out given the strength of underlying demand, while Amsterdam is an especially attractive destination.

Oliver Salmon, capital markets research director, Savills World Research, comments: “There are key idiosyncrasies across geographies and sectors that affect the inflation hedging properties of various assets classes; most importantly the underlying strength of demand, as well the flexibility of leases – including the typical lease term and the use of regular index-linked adjustments to rent.

“A perfect inflation-proof lease would include regular index-linked rent increases based on the prevailing inflation rate and clauses allowing the pass through of any costs to the tenant. In the absence of these, shorter lease lengths provide more flexibility to renegotiate rents, although landlords need pricing power, which is underpinned by demand. The least attractive proposition is a long-term, fixed rent agreement. Our relatively simple analysis shows that there are large differences in the typical lease conventions at both sectoral and geographical levels that can have a major impact on the degree to which future returns can be insulated from inflation.”

In the analysis, which is part of the latest update to its Impacts research programme, Savills says that from a regional perspective, European real estate broadly provides the best inflation hedge in comparison with the Middle East, North America or Asia Pacific. This is underpinned by the widespread use of indexation, meaning that the average lease term is less important given automatic rental adjustments. Within mainland Europe, the industrial sector stands out given the strength of underlying demand, while favourable supply and demand dynamics make Amsterdam a particularly attractive proposition.

The London office market does not use indexation by convention, but rather periodic rent reviews, typically every five years. In turn, higher levels of vacancy will reduce landlords’ pricing power, and long lease terms also make for a poor comparison with major European cities. The industrial sector is not too dissimilar, however strong demand is encouraging landlords to opt for open market rent reviews in the expectation that rental growth in the market will exceed inflation.

The US markets are not too different to London: rental escalation is typically fixed, and therefore income is at risk to a sustained period of unexpected inflation, and agreements also tend to be long term – particularly for offices. In Toronto, while lease conventions are similar to the US, lower vacancy rates suggest demand conditions are more favourable.

In Asia Pacific, indexation is also infrequent but lease lengths are typically short at around three-to-five years with frequent rent reviews, although the degree to which landlords can increase the rent will be determined by pricing power. In turn, demand conditions differ across major cities and across sectors – vacancy rates tend to be higher in office and retail compared with industrial (similar to the global trend), and are much lower in Tokyo compared with other markets such as Shanghai and Singapore. Shanghai retail leases, much like many other cities globally, often include a turnover linked component.

The international real estate advisor says that in Dubai lease agreements typically include fixed rent escalation clauses rather than indexation, suggesting its real estate is more vulnerable to a surge in unexpected inflation, especially considering high and rising vacancy rates (with the exception of the major shopping centres) and shorter lease lengths.

According to Savills, beyond the prime commercial sectors, the residential sector can provide a good inflation-hedge. Indexation is again more common in Europe, and the combination of short lease lengths (often one or two years) and multiple tenants provide frequent opportunities to adjust rents. Leased hotels can also typically provide a strong inflation hedge through very long lease terms (up to 25 years) which are traditionally index linked to inflation (although cap and collar conditions can limit protection).

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