Inflation throws lifeline to European property

LONDON (Reuters) - The clouds over European commercial property may be about to lift because falling prices have raised rental yields, while inflation pressures elsewhere are making the sector's index-linked rents a tempting hedge.

The vast majority of shops, warehouses and offices across the continent are let on rents that rise in line with inflation.

Fund managers and analysts say a surge in rents could help revive interest from income-hunting insurers and pension funds, who covet higher-yielding properties because they can more easily match investment returns against their liabilities.

"If we are in for a short sharp bout of inflation, rental indexation is one of the few ways investment managers can benefit," said Robert Gilchrist, chief executive of fund manager Rockspring LLP.

"As long as you avoid over-rented situations (where occupiers struggle to pay rents), you can get some significant, secure rises in income on a year-on-year basis," he said.

During the real estate boom-years of the recent years, institutions were forced to shell out large sums for European property providing meager annual rental income yields but the market is in the grip of a downturn, and yields are on the rise.

Research published last week by property services firm CB Richard Ellis showed double-digit increases in office rents across many European cities including London, Paris, Rome, Athens, Prague, Moscow and Stockholm in the year to March 31, despite concerns that a slew of banking sector lay-offs would dent rental growth.

"Office occupancy costs are continuing to defy sluggish economic conditions and the credit crunch as they rise faster than global inflation," said Dr. Raymond Torto, global chief economist at CB Richard Ellis.

Of course, inflation-linked rents are no cast iron inflation hedge, because rents could grow faster than occupiers can afford.

"Economic inflation and rental inflation are not the same," said Lehman Brothers analyst Mike Prew.

"Indexation increases the risk of over-renting...and trouble in credit markets has reduced ability of tenants to service higher rents, which is likely to lead to a rise in delinquencies."

INFLATION HEDGE ALTERNATIVE

Nevertheless, some institutions now see real estate as a cheaper inflation hedge than commodities.

According to data from Investment Property Databank, average UK commercial property values have slumped around 17 percent in the last year while oil, gold and copper have all hit record prices in the last six months.

By exiting traditional commodity investments at peak pricing and buying into high-income producing real estate at close to the bottom of the cycle, buyers can offset higher funding and property transaction costs, while rising rents make interest payments easier to service.

"There's a clear logic behind it," said Robert Matthews, head of International Property at Scottish Widows Investment Partnership (LLOY.L).

"If you look at commodity prices today you can see why some investors want to take a profit and deploy the capital in cheaper inflation hedges like real estate, which they regard to be more fairly priced now than 12 months ago," Matthews said.

Analysts at JPMorgan suggest inflation could also provide a tonic for listed European property companies which own assets let on index-linked rents, and whose shares are trading at substantial discounts to net asset value.

In a note ranking European property stocks on inflation-friendliness of rent contracts and average GDP growth forecast of domestic economies, JPMorgan said Babis Vovos (VOVr.AT), Corio (COR.AS), Hammerson (HMSO.L), ProLogis European Properties (PEPR.AS) and Europe's largest property company, Unibail (UNBP.PA), offered good inflation protection to investors.

The negative correlation of real estate prices to inflation could also help several European markets rediscover fair value for real estate faster.

This could help several markets avert the type of stalemate price correction seen in Britain and Spain where buyers are still stalling on purchases because they fear assets will priced more cheaply in the future.

JPMorgan said a rise in inflation would put upward pressure on the current UK property real yield spread of 4.4 percent and the current continental property 4.1 percent real yield spread, pushing them closer to their "worst case", and encouraging risk-averse buyers to re-enter the market.

A dose of rental income-boosting inflation could soothe European property owners still yet to see the value of their portfolios decline, said Brenna O'Roarty, director of European strategic research at Deutsche Bank's alternative investments arm, RREEF.

"Markets like Spain and Paris Central Business District have not re-priced sufficiently, while some Central and Eastern European markets like Warsaw and Budapest have hardly repriced at all," she said.

"Institutions recognize real estates' inflation hedging characteristics and have already indicated they are upping their allocations. Inflation will not spare these markets from repricing but it can help underlying investor demand" she said.

(Editing by Andrew Callus)