For the first time in over 20 years, Switzerland is experiencing a significant increase in inflation. Many savers are looking for security in the form of tangible assets such as shares, gold or real estate. We analyze to what extent apartment buildings are a good hedge against inflation.
Inflation is another word for rising prices. The inflation rate is expressed as a percentage and illustrates the extent to which the prices of goods and services have risen within a year. From an economic point of view, inflation is undesirable because it reduces the purchasing power of wages and pensions. If rising inflation cannot be compensated by rising interest rates, inflation is to the detriment of all savers. Account balances or other forms of nominal investments such as bonds lose value in real terms. In times of inflationary fears, investors usually turn to tangible assets such as gold, stocks and real estate. Apartment buildings and similar investments in the form of land are the ideal hedge, at least according to standard theory.
Supply bottlenecks due to the pandemic and the outbreak of the war in Ukraine have led to a noticeable rise in prices for the first time in a long while. According to official statistics, the inflation rate rose to 2.4 percent in March, its highest value in 14 years.
Employees of the UBS Chief Investment Office (CIO) have examined the causes of current inflation in greater detail: According to their study (“Ten questions on Swiss inflation”), the biggest contributing factor is energy, with fuel, heating oil, gas and electricity accounting for around 1 percent. Following the recovery of the global economy, the demand for fossil fuels in global markets has risen sharply, while supply has been limited due to low reserves. The outbreak of the Ukraine crisis further accelerated the price spiral. The price of a barrel of oil (Brent crude) has almost doubled since last year, reaching in some cases over USD 100 per barrel in April.
However, with an inflation rate of around 2.4 percent, Switzerland is still in a comparatively good position. Much higher inflation is already being observed in the USA and in the euro area. The main reason for the difference is the different structure of the basket of goods. In the eurozone, energy and food spending account for around 30 percent of the basket, but only for around 20 percent in Switzerland. By contrast, in Switzerland more money is spent on health and housing than in the eurozone. And the prices of these two items in the basket of goods usually prove to be more stable or may even fall. Overall, the strength of the Swiss franc is also likely to play a role as it dampens imported inflation compared to the euro.
Do apartment buildings offer protection against inflation? Inflation erodes the value of money, meaning that fewer goods can be purchased for the same sum. If, however, a higher return than inflation can be achieved with a certain investment strategy or type of investment, we can talk about protection against inflation.
Apartment buildings that generate regular rental income in principle satisfy many of the requirements for solid protection against inflation. This is also demonstrated by the long-term statistics: over the last 50 years, nominal real estate prices have increased about fivefold, while the general price level for consumer goods has risen by a factor of three. As a tangible asset, real estate therefore appears to be the ideal investment, although in terms of rental income, capital costs and interest rate changes, it is not protected against inflation under all circumstances. Below we discuss these factors in more detail.
Apartment buildings with rented apartments promise inflation protection by partially indexing apartment rents to inflation. The basic principle is that landlords can pass on 40 percent of general inflation to tenants. In the case of business rents and to some degree also in the case of long-term apartment contracts, rents can even be directly linked to inflation (national index of consumer prices).
If inflation leads to higher interest rates, the higher cost of capital can be passed on to tenants to some degree and with some delay. However, here too some formalities have to be observed. As is well known, rental law allows rents to be periodically adjusted to the official reference rate for mortgage financing. If, for example, this rate increases from 1.25 to 1.5 percent, a three percent increase is allowed. A gradual alignment with the official reference interest rate is only possible if the reductions in the reference interest rate were previously taken into account in the calculation. In addition, the official reference interest rate does not necessarily coincide with the actual financing and cost structure of a landlord who borrows.
In principle, the general economic picture, the location and specific circumstances of the property must always be taken into account; in the long term, rents can only be raised to the extent that wages and purchasing power also increase. In addition, the regional market must not be oversaturated. “Higher rents are not really possible in regions with relatively high vacancy rates and a challenging rental situation,” explains Katharina Hofer, economist and real estate expert at UBS.
In the case of apartment buildings with rented apartments, you should not underestimate the effort involved in passing on additional costs, even when objectively justified. The landlord cannot simply announce a rent increase or higher ancillary costs by letter or some other means, and leave it at that. Certain formal requirements must be observed for all adjustments. Let’s take as an example the item “heating costs” as part of the ancillary costs, which are most affected at the moment. Any increase in costs and in particular an increase in the agreed lump-sum amount or an increase in the advance payment for heating is deemed to be a unilateral amendment to the contract. The following conditions must be met for the passing on of costs to be formally correct:
Higher energy bills have long been a factor in property accounts. However, these costs can usually only be passed on somewhat later and subject to legal requirements.
Another essential aspect is that apartment buildings are usually financed with mortgages up to a maximum of 75 percent. In principle, this is a way of protecting against the consequences of inflation, because during periods of inflation, mortgage debt is effectively the counterpart to your account balance – like your account balance, the debt loses value. If, for example, the owner of the property has taken out a long-term mortgage at 1.5 percent, the calculation would look as follows: with inflation at 2 percent, the mortgage-holder gains half a percent every year. If the annual inflation rate rises to 3 percent, net assets increase by 1.5 percent. The mortgage is, as it were, “adjusted for inflation.” In other words, in times of inflation, falling debt means higher wealth in real terms.
However, this is only true if real estate values keep pace with inflation. Over the last few years, real estate prices have risen sharply in many places. But this is not a basis for a reliable forecast for the near future. If inflation continues to trend upwards, further interest rate increases can also be expected. Market interest rates for long-term fixed-rate mortgages have already risen significantly. And there are many indications that central banks in the US and the euro area will continue to raise key interest rates.
Following a small delay the Swiss National Bank SNB will also adjust its key interest rates. As Katharina Hofer of UBS explains: “Rising interest rates have an inverse effect on the value of real estate.” This undoubtedly applies to apartment buildings, but also to single-family homes. When evaluating the price of real estate, the discount rate plays a central role according to the earned value method or discounted cash flow (DCF) – the interest rate is an important means of adjustment in the valuation. Rising interest rates can have a considerable leveraging effect here. In purely mathematical terms, real estate values could fall by 20 to 30 percent if interest rates rise sharply.
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In such a scenario, the cost situation for the owners of investment properties would also change. The rental income would possibly still be just enough to cover the increased costs of the interest on the debt capital. And the price at which the investor bought the property will also always be of significance. Anyone who has bought real estate with prime yields in good locations in the last two or three years bears a higher risk in the event of rising interest rates than owners who invested in real estate in a different environment.
“Globally, high inflation rates are causing central banks to raise interest rates, which will also cause interest rates in Switzerland to rise,” predicts Katharina Hofer of UBS. In such a scenario, real estate prices are likely to rise more slowly than inflation in the medium term.
In the case of investment properties, the legal framework and regulations mean you can still pass on at least some of the additional costs associated with inflation. However, in operative business with apartment buildings, there are always some cost factors that do not justify increases in ancillary costs or rents. In addition, the market situation often does not allow higher rents. As a rule, the revenue side is thus not fully hedged against rising inflation rates. If the inflation trend continues, sooner or later interest rates will also rise. Investors in the real estate sector must also keep a close eye on inflation and interest rates. Experience has shown that the value of investment properties comes under pressure when interest rates rise.