Inflation concerns have now begun to grow after trade liberalization helped industrialized countries import deflation, which has contributed to a low, and tame, inflation environment since the early 1990s. Despite local and global economic slowdown, the Bank of Canada chose to stop lowering interest rates in the spring of 2008 in order to ensure that inflation does not get out of control due to pressure from commodities and energy prices, and thus joining many other central banks which find themselves in the same bind. Inflationary pressures might also persist as a result of demographic pressures brought by baby boomers starting to retire, the rapid middle class growth in developing and emerging economies, and ever- rising salaries in developing countries, where the supply of manufactured goods and services has been transferred.
Private real estate has been perceived as the best inflation hedge after real return bonds. Indeed, most pension funds benefit from such hedging ability because of their long-term inflation-linked liabilities, as this hedge protects the purchasing power of plan participants. Future benefits are frequently linked to the salaries of current participants, or in the case of current retirees, to inflation, in order to keep up with the cost of living. At the end of 2007, Canadian pension funds held 9.0% of their investments in real estate assets.
This article attempts to provide a clearer picture of the relation between Canadian real estate and inflation based on Le Moigne and Viveiros (2008-a,b). Le Moigne and Viveiros (2008-b) examines whether the inflation hedging ability of Canadian direct real estate varies by property type (apartment, industrial, office, retail, and mixed-use) and by province (British Columbia, Alberta, Saskatchewan, Manitoba, Ontario, Quebec, and the Atlantic Provinces), as correlations between these sub-indices vary from 81% down to 11% (not shown in paper), and sub- index weightings differ significantly. The relation between inflation and real estate returns may vary among provinces because of their specific economic activities and local regulations, and also by property type, due to differing lease characteristics (typical lease term, recovery calculations, renewal options, percentage rent, etc.). Although much of Canada is dominated by a natural resource-based economy, it is more so in certain regions, such as the western provinces (Alberta and Saskatchewan), than in Ontario and Quebec, which have a greater dependence on manufacturing.
Newly created derivative products based on private real estate indices such as swap, forward and futures increase the relevance of these tests. They are now commonly traded in the UK, volume is ramping up in the U.S. and a first transaction occurred in June 2008 in Canada. A better understanding of the inflation hedging characteristics of geographical and property type sub-indices might allow the optimization of the hedge by overweighting specific property types or provinces because of their superior hedging abilities. Read the full article here.