Does real estate investing offer protection from inflation?

Real estate has been traditionally known as a strong inflation hedge because it protects an investment from losing its value due to decline in purchasing power.

Increases in prices of goods and services have enabled real estate prices to keep pace with inflation and maintain its value over time, as property prices increase as a result of higher construction cost and other expenses.

If we look at the residential real estate price index from 2016 to 2021, we will find that property prices have been rising by an average of 4.2 percent every year, faster than the 3.5-percent average rise per year of the consumer price index.

Based on this data, we will also find that investing in townhouse and condominium units appears to be a better strategy than investing in single detached units, because the increase in average prices over the past five years has been higher than inflation.

For instance, prices of townhouses have appreciated by an average of 11.4 percent per year, while prices of condominium units have risen by 6.2 percent per year.

If inflation drives up property prices, then it must also be good for property developers because this will increase their total revenues and earnings growth prospects.

But market history shows that property stocks, in general, tend to fall when inflation increases, especially when it is combined with other macroeconomic risks.

For example, if we combine inflation and unemployment rate, we will find that the property index is negatively correlated with the “misery index” over the past 22 years 51 percent of the time.

Traditionally, inflation and unemployment tend to move in opposite directions.

Inflation increases when unemployment decreases, because higher employment means higher demand for workers, which can add upward pressure on wages.

Conversely, when unemployment increases, a fall in employment means lower future income, which can result in lower aggregate spending, hence lower inflation.

Over the years, because of inflation targeting by the central bank, which helped anchor market expectations, the link between inflation and unemployment has considerably weakened.

In fact, if we look at the data for the past 20 years, inflation and unemployment are positively correlated, which means that unemployment tends to move in the same direction as inflation.

Although inflation can increase property prices, an increase in unemployment can mean lower demand for properties.

A rise in both inflation and unemployment will raise the “misery index” which could pressure property stock prices to fall.

The other effect of rising inflation, as we have previously discussed in this column, is the rise in interest rates.

Higher interest rates make borrowings become more expensive, which may decrease demand for home loan financing, resulting in lower property sales.

If we look at how property stocks are related to interest rates, we will find that the property index is significantly negatively correlated with the movements of the 10-year Philippine bond yield 63 percent of the time since year 2000.

During this time of uncertainty, a further rise in inflation and interest rates may not be completely avoided, as these are risks inherent in the market.

One way to minimize such risks is by identifying the historical volatility of a stock, which we call the beta that tells us how sensitive a stock is to the movement of the index.

For example, among the property stocks in the sector, Ayala Land has the highest beta of 1.16, which means that the stock is 16 percent more volatile than the property index.

A decrease in property index by 1 percent due to rise in interest rate or inflation means that the stock can fall by 1.16 percent, and vice versa.

If we want to have a more stable property stock, we can choose SM Prime Holdings, which has the same volatility as the market with beta of 1.0.

Alternatively, we can also choose relatively less risky property stocks that have beta lower than 1.0, such as Robinsons Land, which has beta of 0.89 or Megaworld at 0.78.

While investing in hard asset, real estate ownership can offer protection from inflation, investing in property stocks may not necessarily afford the same protection because of differences in risks and volatility. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools were provided by First Metro Securities. To learn more about investment planning, attend the 95th batch of RFP program this May 2022. To register, email [email protected] or text at 0917-6248110.