Spectre of inflation will test those chestnuts about the protective value of real estate

For a brief moment last November, it looked as if Germany's housing shortage and its related problems of rent freezes and expropriation of large private housing holdings were about to be tackled responsibly by the incoming "traffic light" coalition government that replaced the Angela Merkel era. We now seem further away from those potentially sunny uplands than ever before.

Not least because Olaf Scholz and his merry band of coalition partners have now been jolted out of their reverie and - within months - are now facing an entirely new set of budgetary and societal issues. The issue of housing for existing inhabitants - while still pressing - is jostling with a host of other priorities on the government agenda, including finding emergency accomodation for the raft of new arrivals from Ukraine.

Supply chain problems from Germany's eastern flanks are already causing severe damage to Germany's revered manufacturing and exporting sector, with managers scrambling frantically to source alternative suppliers or enacting emergency near-shoring measures to ensure continuity of production. Many German companies have critical operations in the Ukraine, and the effects of the current disruption have yet to fully flow through the system.

In the construction industry, a lot of key materials originate in Russia or Ukraine, and their absence is beginning to be felt heavily, reflected most notably in sharp price increases for key building materials. With the German construction industry operating at full capacity, these supply bottlenecks and radical price increases are making planning at the building site operational level almost impossible. Price guarantees on services and materials are down in many cases to a day's - or even an hour's - validity.

As we report in this issue of REFIRE, there has been a surge in demand from individual investors to lock in their financing for their project by means of forward funding. For many private investors in housing, scared of being locked out permanently from home ownership by soaring house prices, the situation is now taking on a fully new dimension.

Borrowing at 1% is one thing. But borrowing at what might soon be 3% is another, and requires an entire new calculation of the costs of the project, and not only for the initial fixed term period of the loan. Price inflation of building materials on top of the rise in the cost of financing offers an almost built-in guarantee that the overall price of housing must continue to move upwards. And with it the social tensions that arise when half the population is shut out from building wealth through property price appreciation.

This problem will prove more acute in Germany than elsewhere, given Germany's low level of home ownership, the lowest in the EU. Real poverty in old age is an understated problem in Germany, and is only getting worse as the country's heavily aging population put increasing demands on inadequate social welfare and the state's old age pension provision.

If inflation proves to be a permanent feature of our immediate future - and there are good grounds for believing it will be around for a while - there will be plenty of opportunity to test the old theories about the inflation-hedging properties of real estate. The traditional argument is that inflation eats up the value of debt, so the borrower ends up paying back less. True. And new leases on commercial property and even on new-build residential are now generally index-linked, so the landlord is largely protected from asset price erosion. But it's by no means universal, and many landlords are exposed to falling real revenues.

The other unknown factor is the role that soaring energy prices will play over the coming years. This too will throw the cat among the pigeons, with older properties which guzzle much more energy rapidly losing out in attraction to more modernised buildings, which are also more likely to have their rents index-linked. Both in offices and in residential, this issue will be the defining investment question of the coming years. For every well-capitalised new investor, there will be hefty losses for existing investors in closed or open-ended funds whose holdings contain too many assets of the unfortunate sort.

We saw this after the 2008 financial crisis when a number of German funds, having sailed along for years paying out their 4% to passive investors, suddenly had to write off 60% of their holdings' value. It's likely this phenomenon will repeat itself, given the whole new world of EU-taxonomy and ESG-compliance now required before anybody will touch anything. And all this just at a time when energy prices are literally going through the roof.

Germany, in particular, has tied itself up in knots over energy, and so far has no plan to legitimately loosen those knots. It's now so compromised over its freely-chosen dependency on Russian energy, particularly gas, that it has no attractive options, and will surely try to just muddle on. Meeting its ambitious climate change targets on energy conservation, boosting its housebuilding - particularly affordable housebuilding - targets of an extra 100,000 units a year above earlier completion levels, and defusing protests from a population unable to find, let alone afford, appropriate housing - this is a Herculanean task.

No matter how low yields currently are in real estate, they still represent a positive spread over bond yields, so there's no danger of business grinding to a halt just yet. Christine Lagarde at the ECB has shown she's desperate to keep interest rates low, but not so the Fed, which has programmed in steady rate rises over the immediate future. If investors are drawn to US bonds, as an alternative to German real estate where under 3% is becoming the norm, this could lead to a tipping point, where fund flow direction is reversed. For North American investors, or those prepared to live with exchange rate risk, this could prove significant. They might well be prepared to lower their European exposure for the next few years. All the more risk to enjoy for us Europeans, then.