Have you be watching the wrong kind of inflation, and missing the implication for real estate values?

Transitory inflation has grabbed the headlines. This kind is caused by sudden supply constraints and the price spikes they produce. Once the supply constraint eases, prices come down. This kind of inflation comes and goes; the danger is short and sharp.

Embedded inflation is more chronic than acute, and it is harder to escape. In this scenario consumer and business expectations about inflation begin to harden. The result is that spending patterns change, and wage claims go up, as economic players adjust to ever-increasing costs, in the process creating a self-sustaining spiral of rising prices.

Until the summer many central banks, and property market in-house economists, assumed inflation was the transitory kind, inspired by pandemic lockdown shortages. It would wash through the system by early next year. However, the balance is now tilting to the assumption that it could be embedded inflation.

There is already evidence that embedded inflation is a risk. UK households are raising their long-term expectations about price growth, with the latest data suggesting the expectation is above 4%, at least twice the expectation norm in recent years, according to a YouGov/Citi analysis.

Analysis by Oxford Economics has now revealed the substantial potential downside risks that embedded inflation poses to property returns up to 2024.

Its baseline analysis suggested total real estate returns averaging 5.2% in 2022-24, a figure already down from 7.4% since the energy price shock began to bite in June. But embedded inflation would scale returns of 5.2% back to 2.1%. If inflation remains high, and central banks can’t control it, then embedded inflation could damage all property sectors, even the highly favoured industrial sector, Oxford said.

Property values would be severely eroded, falling some 11% below the baseline forecast by year-end 2025. Low-yielding sectors like industrial and residential are hit the hardest, with U.S. industrial values falling nearly 25%, Canadian residential 20%, French residential 19% and UK industrial 16%.

Some economies would fall further, and harder. Returns could fall by 6.1 percentage points for the UK and 5.5 percentage points for the U.S. Gas rationing — now looking likely, according to Oxford Economics — would hit European economies even further.

"As headwinds mount, the global economy is teetering on the brink of a late 2022/early 2023 recession," Oxford Economics Associate Director Christopher Babatope said. "These downside risks pose a significant threat to the near-term outlook for real estate.

“Adjusting for the current round of associated risks, the weighted average of global real estate returns is 4.4% a year. While much weaker than returns over the past five years, we still believe that real estate will outperform other asset classes over the five-year forecast horizon."