“IS PROPERTY A GOOD HEDGE AGAINST INFLATION?

Sing Tien FooCentre for Real Estate StudiesNational University of Singapore3 August 2002

CPF Multiplier Seminar

Outline of Presentation

Investing in Property Market Why invest in Property? Historical performance of property vs. financial assets Is Property a good hedge against inflation?

Evidence in overseas markets Research Methodology

Types of inflation Empirical Results Implications for investors – Diversification Strategies Conclusion

Investing in Property Market

Direct Investment Residential Property, Office, Shop, Industrial Property,

Hotels Lands with development potential (institutional

investors/ collective sale sites) Indirect Investment

Property stocks, eg. CDL, CapitaLand, etc. Asset backed bonds, eg. Raffles City, Robinson Point, 6

Battery Road, Century Square, NOL, etc. Real Estate Investment Trusts, eg. CapitaMall Property

Trusts

Asset-Backed Securitization Deals

Issue

Date

Property Owner Market Value

Mar 99 Neptune Orient Line HQ

NOL $185 mil.

Jun 99 Century Square Shopping Mall

First Capital Corporation

$200 mil.

Jul 99 Robinson Point DBS Land $193 mil.

Sep 99 268 Orchard Road DBS Land $184 mil.

Nov 99 Tampines Centre DBS Land $180 mil.

Nov 99 Six Battery Road DBS Land $878 mil.

Mar 01 Raffles City Raffles Holding/ CapitaLand

$984.5 mil

Other Secondary Property Market Instruments

Hedging instrument Single Property Future

New mortgage instruments (Potential) Mortgage REITs Mortgage Backed Securities Commercial Mortgage Backed Obligations

Operation of Secondary Mortgage Markets

Direct Sale ProgramsMortgage Pools

Originators sell to FNMA.FNMA creates large pools of mortgagesFNMA sells securities from pool.

MortgageOriginator

CreatePool

Issue Securities

Investors

Why invest in Property?

For a wealth maximizing investor:Pride of ownership Desired rate of returnCapital appreciation Risk diversification Hedge against inflation

Historical Performance of Property Market (Q278 – Q498)

Expected Return Risk Correlation

SES-All Share 0.068% 17.908% 0.176

SES All-Property 0.225% 22.421% 0.217

URA All-Property 2.240% 6.761% 0.486

Residential 2.477% 6.538% 0.444

Industry 1.940% 8.859% 0.453

Shop 0.870% 9.721% 0.222

Office 2.081% 10.326% 0.406

Actual Inflation 0.618% 0.863% 1

Expected Inflation 9.185% 4.798%

Unexpected Inflation -8.556% 4.407%

Stock Vs. Property Returns

-160%-140%-120%-100%-80%-60%-40%-20%

0%20%40%60%

SES-All ShareSES-PropertyURA-Property

Property Returns – by sector

-60%

-40%

-20%

0%

20%

40%

60%

ResidentialIndustrialShopOffice

Historical Correlation Coefficients (3Q78 to 4Q98)

SESA SESP URAP RES IND SHP OFF

SESA 1

SESP 0.958 1

URAP 0.528 0.576 1

RES 0.547 0.582 0.980 1

IND 0.357 0.438 0.708 0.632 1

SHP 0.355 0.398 0.603 0.541 0.349 1

OFF 0.376 0.431 0.795 0.722 0.752 0.515 1

Overview of Historical Inflation Rates

Inflation is defined as an increase in general price level in the economy

Measured by CPI, GDP deflator, RPI Inflation rate in Singapore has been relatively

stable, especially over the last 10 years Average 0.62% per quarter (or 2.48%

annualized) 1978-1998

Inflation Rate (1978 – 1998)

-2%

-1%

0%

1%

2%

3%

4%

5%

Year-Qtr

Infl

atio

n R

ate(

%)

Second oil price shock

Mid-80s Recession

Asian Crisis

Is real estate a good hedge against inflation?

Real estate has been widely regarded as a good hedge against inflation vis-à-vis other financial assets

The study aims to empirically test the inflation hedging characteristics of the returns of real estate and other financial assets

Related research questions: Real Estate by sectors: residential, shop, industry, and

office Type of inflation: actual, expected and unexpected Over different sample periods Different inflation regimes Compared with different financial assets

Country-studies on Inflation Hedging

Mainly in US and other countries Comparing real estate and other assets In the US, REITs is used as proxy of real estate Using the classical Fama and Schwert (1977)

framework Serial-correlation is taken care of in the model In general, findings show that real estate is good

inflation hedge

Overseas Evidence (1) – Real Estate

In the US, real estate has positive hedge against expected inflation, but office and industrial property offer no significant hedge against unexpected inflation

In the UK, real estate offer good protection against inflation, and office and shop did not hedge against unexpected inflation

Capital returns hedge against unexpected inflation

Results of studies in Switzerland, Canada, New Zealand an dHong Kong are consistent

Overseas Evidence (2) - Stocks

In the US & UK, studies showed that stocks offer no significant hedge against inflation

In the UK, when returns were decomposed into capital and income returns, income did significantly hedge against inflation

Swiss stock market also offers no hedge against inflation

In New Zealand and Hong Kong, stocks offer negative hedge against inflation

REITs in the US, UK and Australia show no hedge against inflation

Overseas Evidence (3) – Bonds

Bonds offer no hedge against inflation in the US, UK, New Zealand and Australia

In summary, real estate offer good hedge against expected inflation, but not against unexpected inflation

Stock, real estate stocks (REITs), and bonds offer poor hedge against inflation in most of the countries under studies

Inflation & Inflation Hedging

CPI is compiled by the Dept of Statistics (DOS) Laspeye Index – a fixed basket of goods and

services in CPI 7 broad categories of goods & services in CPI basket: food,

housing, transport & communications, clothing, health, education and miscellaneous

Inflation hedging – the real return of an asset is independent of the rate of inflation

An asset is a complete hedge against inflation, if and only if the nominal return of the asset changes in a one-to-one relationship with both expected & unexpected inflation

Definition of terms

Nominal return: Rjt = Log (Pjt/ Pjt-1)

Inflation rate t = [CPIt – CPIt-1]/CPIt-1

Expected Inflation E(t|t-1) = Quarterly lagged T-bill rate

Unexpected Inflation = actual inflation – Expected Inflation: Ujt = t - E(t|t-1)

Data Source

Sample period 1978 Q3– 1998 Q4 URA all property price index and related sub-

indices SES all-share index Consumer Price Index (CPI) Treasury bill rate Nominal return

Rjt = Log (Pjt/ Pjt-1)

Theoretical/ Conceptual Framework

Nominal return of asset = real rate of return + expected inflation + unexpected inflation

Regression model

Positive inflation hedge not rejected: If and only if the nominal return of the asset moves in a

one-to-one relationship with both expected and unexpected inflation

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([)|~

()|~(),|~

( 1111 tttjtttjtttjt EEERE

jttttjttjjjt EER )]|~

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Empirical Models

Test against expected & unexpected inflations

Test against actual inflation Rjt = j + jΔt + jt

Five-yearly sub-period analysis I: 1978 – 1982 II: 1983 -1988 III: 1989 - 1992 IV: 1993 -1998

High vs Low Inflation Periods Analysis

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Empirical Results (1)

    Expected Inflation

Asset Type Actual Inflation

Entire Sample Period

Sub-period+

Low Vs. High

Inflation#Real Estate IV

Residential IV

Office I

Shop

Industrial I High

Stocks IV

Real Estate Stocks

IV

Empirical Results (2)

  Unexpected Inflation

Asset Type Entire Sample Period

Sub-period+ Low Vs. High Inflation#

Real Estate IV

Residential IV Low

Office II

Shop

Industrial I High

Stocks IV Real Estate Stocks IV

Analysis of Results (1)

See tables Real estate assets (industrial & shop) are better

hedges against inflation compared to financial assets

Industry show significant hedges against expected and unexpected inflations & shop hedge effectively against expected inflation

Residential property offers good hedge against expected and unexpected inflations for sub-period IV (1993-1998)

Analysis of Results (2)

Stock and property stocks also provide good hedge against expected and unexpected inflation in sub-period IV

Office and industrial property perform better in sub-period I (1978-1982)

In high inflation period, industrial is good asset for inflation hedging, whereas residential is more suitable during inflation period.

Industrial Return and Inflation

-30%

-20%

-10%

0%

10%

20%

30%

40%Industrial Actual InfaltionExpected Inflation Unexpected Inflation

Shop and Inflation

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

ShopActual InfaltionExpected InflationUnexpected Inflation

Residential Return and Inflation

-25%-20%-15%-10%-5%0%5%

10%15%20%25%30%

Residential Actual Infaltion

Expected Inflation Unexpected Inflation

Implications for investors’ Strategies

It is strategic to improve hedging capability of institutional portfolio by increasing the asset weight of industrial and retail properties

However, in Singapore, investment in industrial property is limited and dominated by public agency like Ascendas and JTC

Strict restrictions on industrial land uses limit the upside potential

For retail properties, majority of prime shopping centers are developed and managed by institutional investors for long term investment purposes

Implications for Investors’ Strategies

Economies of scale for single ownership for shopping centers – resources could be optimized for implementing crowd-pulling tenant mix strategies

New investment vehicles, new launched retail REITs and the proposed industrial REITs

For residential property, good news for investors/owners of CPF financed private residential property, their property value will be preserved in low inflation period

Residential property has performed well in 1993-1998 period

Stock and property stocks have also performed well against expected and unexpected inflation

Diversification Strategy

How much investment should be allocated to property and non-property assets?

Diversification benefits – not putting all your eggs in one basket

Using empirical returns data from 4Q1993 to 4Q 2000

Using Markowitz’s risk-return optimization framework

Minimizing portfolio risks for a given portfolio return No short-selling and no borrowing in the portfolio

Historical Return (4Q93 – 4Q00)

Expected Return Risk

Residential 1.22% 1.24%

Office 1.42% 1.25%

Shop 0.10% 0.81%

Factory 1.44% 1.20%

Warehouse 1.31% 1.58%

All-Pro 1.17% 1.17%

SES-Prop 2.39% 4.71%

CDL Share 6.30% 5.58%

SES-All 1.88% 3.58%

Optimal Portfolio Composition

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0.1% 0.4% 0.7% 1.0% 1.3% 1.6%

SES-All Share

Warehouse

Factory

Shop

Office

Residential

Optimal Portfolio Composition

0%10%20%30%40%50%60%70%80%90%

100%

OPt

imal

Ass

et W

eigh

t

0.1% 0.3% 0.5% 0.7% 0.9% 1.1% 1.3% 1.5% 1.7%

Portfolio Quarterly Return

SES-All Share Cum Property Weight

Efficient Portfolio Frontier – Risk & Return tradeoff

0.0%

0.5%

1.0%

1.5%

2.0%

0.0% 0.5% 1.0% 1.5% 2.0% 2.5%Portfolio Risk

Portf

olio

Ret

urn

Conclusion

Do not reject the null hypothesis that real estate is a good hedge against inflation

Real estate assets are better hedges against inflation vis-à-vis financial assets

Industrial & shop are good assets for inflation hedging purposes

Industrial and retail REITs offer alternative channels for increasing asset weights in portfolio

Residential property value will be preserved in low inflation regime

Real Estate composition in institutional portfolio is important for risk diversification purposes

Thank you