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Studying Inflation Hedging in Direct Real Estate Investment

This research provides a methodology to analyze the long-term inflation hedging properties of direct real estate investment, considering lease structure and indexation. It focuses on five countries and explores the impact of market conditions on inflation hedging.

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Studying Inflation Hedging in Direct Real Estate Investment

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  1. Long-Term Inflation Hedging Properties of Direct Real Estate Investment A methodology to study protection against inflation given the lease structure and the use of indexation Charles-Olivier Amédée-Manesme , BNP Paribas Real Estate Investment Services Michel Baroni , Essec Business School Fabrice Barthélémy , THEMA, University of Cergy-Pontoise Etienne Dupuy , BNP Paribas Real Estate Investment Services

  2. Research summary • Objective: To elaborate a selection method of pan-European real estate portfolios according to an inflation hedge criteria • Methodology: Construction of portfolios for each country taking into account the standard country-specific lease structure, indexation and the possible break-options during the holding period. • Conclusions: A flat market for Market Rental Value (MRV) combined with low indexation may lead to more volatile cash flows and a poorer inflation hedge than a booming market.

  3. What is inflation • Inflation can be defined as a general rise in the level of prices  For the same product, the price is higher  Erosion in the purchasing power of money • Generally measured by a price index that represents the overall level of price. For example : • Consumer Price Index (CPI) • Cost of Living Index • Producer Price Index • Commodity Price Index • GDP Deflator (measure of all the prices and products in the GDP) • Measuring inflation is a contentious issue and there is no consensus (the selection of the best weighted basket is often discussed) • Inflation hedging is often one of the main motivations for investors in real estate

  4. Literature • Hoesli, MacGregor, Matysiak, Nanthakumaran, 1997 • Hartzell, Hekman, Miles, 1997 • Tien-Foo Sing, Swee-Hiang Yvonne Low, 2000 • Hoesli, Lizieri, MacGregor, 2008 • Solnik, 2009 • Francis , Ibbotson, 2009

  5. The continental Europe lease structure • The leases in continental Europe are known for: • significant differences among countries • break-options possibilities (asymmetric or not) • various indexation methods • In this research, we focus on five countries: • Germany • France • Italy • Spain • Belgium

  6. The continental Europe specificities: the break-options • In continental Europe, the tenant has the right but not the obligation to terminate the lease contract before the end of the lease. • This option to leave can be dealt as a financial option where the tenant leaves the premises as soon as his/her option is in the money (ie the market rental value plus the transaction costs are below the rent paid). • This optional part has already been described in a parent paper by COAM, MB, FB, ED.

  7. Risk of European Lease contract Usually, in continental Europe, tenants cannot renegotiate the rent during the course of the contract whatever the level of the MRV.

  8. The Model • Monte-Carlo simulations are used to simulate over time the evolution of the price of the portfolio and the MRV: • The rent paid is compared to the MRV available on the market.

  9. Simulating the evolution of the portfolios: the dataset • Property Market Analysis (PMA) database is used for two periods : • 1998-2008 (excluding the financial crisis) • 1998-2010 (including the financial crisis) and for the following variables of each country: • Yearly inflation • Yearly office capital growth (Prices) • Yearly office market rental growth (MRV) • For the rent’s indexation, the following indices are used • France : Construction Cost Index (INSEE) • Belgium :Health Index (Belgian Federal Government Service Economy website) • Germany, Italy and Spain : Inflation rate (PMA) • The correlation factor between the capital growth and the MRV growth is taken into account for each country. • For each country, trends and volatilities of the capital growths and of the MRV are also estimated.

  10. The assumptions (I) • Initially five identical portfolios are supposed to be respectively invested in Belgium, France, Germany, Italy and Spain. • All considered portfolios have the same initial value fixed to 100. Only the lease structure and the indexation are different. • The portfolios are assumed to be sold at the end of the period and no arbitrage can be done during the holding period of the portfolio. • All the cash-flows occur each year on 1st January. The discount rate of the investor is fixed to 6.5%. • For each country, only one lease structure is considered and is supposed to be the most relevant for the country. The table below shows the retained lease structure for each country In Germany the lease lasts 10 years with an option to terminate the lease at the fifth year. The rent is indexed when cumulated inflation reaches 10%.

  11. The assumptions (II) • Each portfolio is composed of 10 assets (leases). • The initial rents and MRV of the premises are supposed to be the same for all the portfolios. The transaction costs are taken into account and are the same for all the portfolios. The transaction costs are linearly depreciated. Thereby they do not affect the tenant’s decision with the same weight during the stay in the premises. All the considered portfolios are composed of 10 leases of which: - 4 properties are leased over the market price - 4 are leased under the market price - 2 leases are rented at their market rent

  12. The assumptions (III) A country-specific lease structure is considered for each portfolio. The portfolio is bought in 1998. For example the lease structure for the first four leases of the portfolio is the following : For all countries, the first lease starts in 1998, the second in 1997, the third one in 1996 and the fourth one in 1995.

  13. MARKET RENTAL VALUE GROWTH 1998-2007 1998-2009 Mean Trend Volatility Mean Trend Volatility 1,3% 1,4% 3,6% 0,7% 0,8% 3,7% Belgium (Brussels) 6,0% 7,1% 14,8% 3,6% 4,7% 14,5% France (Central Paris) 1,8% 2,1% 8,3% 1,1% 1,4% 8,1% Germany (Munich city) 8,4% 9,2% 12,0% 6,6% 7,4% 12,6% Italy (Milan) 9,7% 11,6% 19,3% 5,7% 7,8% 20,4% Spain (Madrid) CAPITAL GROWTH 1998-2007 1998-2009 Mean Trend Volatility Mean Trend Volatility 1,9% 1,9% 3,3% -0,1% 0,0% 5,6% Belgium (Brussels) 8,9% 10,0% 14,6% 3,9% 5,5% 18,2% France (Central Paris) 2,7% 3,6% 13,2% 0,4% 1,2% 13,1% Germany (Munich city) 9,8% 10,5% 12,0% 6,2% 7,1% 13,8% Italy (Milan) 11,1% 13,1% 19,9% 4,3% 7,1% 23,8% Spain (Madrid) Correlation factor (Market Rental Value / Price) 1998-2007 1998-2009 Belgium (Brussels) 80,2% 60,2% France (Central Paris) 87,7% 83,3% Germany (Munich city) 89,5% 83,0% Italy (Milan) 96,2% 91,3% Spain (Madrid) 81,6% 82,9% Computing MRV and Capital Growth Belgian market is quite flat. As expected, trends decrease when the last financial crisis is taken into account. Slight increase of the volatility on the period 1998-2009. Spanish, Italian and French markets are the most risky one. Sources: PMA

  14. Using Indexation Sources: PMA, insee, Belgian Federal Government Service Economy website Note:In Germany, the rents are indexed by breakthrough. The rents does not change until the accrued inflation has reached a predefined amount (10%). French and Spanish indexation are sometimes a little “violent” in comparison with the other countries.

  15. Results and conclusions (I) – The discounted price of the portfolio* Belgian and German markets do not hedge against inflation over the period * The discounted price of the portfolio is the sum of the discounted cash flows including the void period in case of vacancy and the terminal value of the portfolio. In column 2004, it is a Portfolio hold from 1998 and sold in 2004.

  16. Results and conclusions (II) – Rents The rents produced over the periods are globally below the initial rents indexed on the inflation rate except for France. This is probably due to the Cost of Construction Index (ICC) which traditionally performs better than the inflation rate. Therefore investors in French market are hedged against inflation exposure for their cash flows but are at risk in a bear market if MRV decreases when the passing rent is positively indexed.

  17. Results and conclusions (III) – Volatility and risk measurements • The volatility of the real rents flows is higher for the Belgian and German markets. • This result can be explained by two reasons: • 1. The model considers numerous exercises of the break-options possibilities when the rents and the MRV are very close (as it is the case for the German and the Belgian markets by opposition to the Spanish market where the MRV are higher than the rents). • 2. The low level of MRV trend observed in these two markets over the period. On the contrary, over the last few years the Spanish and the Italian markets have grown at around 10% per year and the tenants have been tempted to stay in the premises in order to maintain their rents (even if they were indexed).

  18. Overall conclusions • Simulating cash-flows throughout continental Europe may help to determine which allocation provides the best protection against inflation. • Flat markets prices and rents may induce a higher level of volatility in the cash flows and less effective hedging against inflation.

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