By Nithila Talgaswatte and Pravin Jayasinghe
The headlines in economic and business sections of the media over the last few months warn of the arrival of that harbinger of economic frustration, inflation — Sri Lanka’s national inflation is the highest it’s been in over four years, while the National Consumer Price Index (NCPI) is the highest in over seven years, the situation is volatile and the future is made more uncertain, exacerbated by the dollar shortage crisis, global supply chain shortages and, of course, the pandemic.
But what’s the real story? Why should you be concerned about inflation and how can you protect yourself against its negative effects?
What is inflation?
Inflation is defined as the “general progressive increase in prices of goods and services in an economy”.
Another way to look at it is: Inflation is the decline of purchasing power in currency over time; simply put, you can do less with your money.
To quote a great insight from Sham Gad off Investopedia.com, “Inflation is often referred to as the ‘worst tax’ because its effects go unnoticed by most people. Hypothetically, earning 4% in a savings account while inflation grows at 7% makes many feel 4% richer. In fact, they are 3% poorer.”
So what can you do to protect yourself from inflation?
While the international experts are often divided on what constitutes “the best way” to protect your hard-earned savings from the spectre of inflation, there are many options that are widely accepted such as stocks, gold, select commodities, and certain financial instruments that are unfortunately unavailable to the Sri Lankan citizen. Real estate too is widely regarded as being a weapon in this arsenal.
Why is investing in real estate considered a hedge against inflation?
Simply put, real estate is a “real asset” which has an “intrinsic value,” other than as a means of exchange. Most real assets have an industrial or practical value. And unlike fiat currencies, real assets have a track record of retaining much of their value despite any manipulation of the money supply that might come from the central banks. Therefore they are considered attractive during inflationary times.
Real estate can also be incredibly versatile; while as a first-time real estate investor purchasing your first home outright or via a mortgage means that you won’t spend money on rent going forward, you can also acquire real estate as an investment property apart from your home, which can generate a rental/lease yield. As a landlord, you would generally have the ability to raise rents under better (or inflationary) economic conditions, which in turn increases property value.
Secondly, many real estate rental agreements or leases have contractual rent increases worked into them to account for annual inflation. This directly protects your rental income from devaluing over time.
Thirdly, and somewhat indirectly, higher inflation also results in higher costs for building materials and higher replacement costs during renovations, this includes materials and labour. These factors in turn make new development projects more expensive, thereby limiting new supply and giving more room for existing assets to gradually increase rents and appreciate in value.
Finally, another facet of real estate when acquired via a mortgage or property loan is that as an investor you will benefit from “depreciating debt,” whereby the value of the real estate owner’s mortgage payments depreciates over time.
For example, a Rs. 100,000 mortgage payment during the first year of a mortgage will remain the same nominally but may well only be worth Rs. 80,000 in the 10th year once you account for inflation.
So to summarise a good real estate inflation hedge will often work in four ways during inflationary times:
1) Additional Income from rents
2) Income from rents grows with CPI
3) Capital appreciation of property
4) ‘Depreciating debt’ for investors who have acquired property via a mortgage or a property loan.
What types of real estate will protect you from inflation?
Residential real estate, specifically houses, apartments and even apartment blocks (called multifamily buildings internationally), is the easiest way for a real estate investor to make their first foray into real estate.
As inflation rises, you as a landlord have the ability to ‘pass on’ that inflation to your tenants and thus protect your income from being devalued.
For commercial real estate too this can be fairly straightforward; everything from bare land to retail space, warehouses, office buildings and leisure properties can potentially cushion the blow of inflation insofar as you as the landlord have left appropriate provisions to adjust rents and leases during the contract period.
Obviously, there are caveats that must be considered. The late Lord Harold Samuel, a real estate tycoon in Britain, famously coined the expression: “There are three things that matter in property: location, location, location” – certain commercial real estate localities, as well as residential areas, will always command a premium due to specific advantages accruing to the tenants of the property, therefore it gives the property owner more leeway to raise rents/leases given the likelihood of other potential tenants being interested in that specific location. The reverse of this may also be true, where a somewhat unattractive location may not be able to price aggressively or keep pace with inflation.
Another aspect that affects both residential and commercial real estate is tourism. With the advent of platforms such as Airbnb, monetising your property has never been easier. As Sri Lankan tourism slowly recovers from the impact of Covid-19, short-term tourist rentals offer a hedge not only in terms of inflation, but also more directly, protection against rupee depreciation if property owners can accept payments directly in foreign currency.
In more developed markets instruments such as Real Estate Investment Trusts or REITs have offered investors the opportunity to benefit from real estate while not having to make significant investments or get involved in the administration or property management side of things.
With the adoption of blockchain technology, we’ve seen new instruments such as tokenised real estate also gaining traction in countries such as the US, UK and Canada.
While unfortunately neither option is currently available for Sri Lankan investors to avail themselves of, we’re hoping to see the first REIT being launched in Sri Lanka in the not-too-distant future.
What the future holds for Sri Lankan real estate
We at FlatList believe that the real estate market in Sri Lanka is in an incredibly nascent state; for a country of 21 million people, the numbers are hardly what you can call even modest compared to more developed real estate markets across the globe. While we concede that Sri Lanka is both small in terms of geographical size and population size, an $ 80 billion economy isn’t necessarily something we should discount either.
While we must be very careful in making comparisons with significantly larger and more developed markets, the Australian property for residential property alone is an eye-watering $ 9 trillion or about 112 times Sri Lanka’s current GDP. Australia also benefits from massive foreign investment coupled with approximately 200,000 new immigrants during an average year contributing to demand for both rentals and outright purchases. Australia also gets a significant number of tourists, recording 9.4 million prior to the pandemic in 2019.
Sri Lanka, in turn, has all the ingredients to make a robust real estate market; urbanisation continues to pick up pace, tourism, long viewed as the panacea for all that ails the economy, has truly massive potential.
Rising incomes of employees from industries such as IT and outsourcing companies locally will only exacerbate the number of Millennials and Gen Zs wanting to move out of suburban ancestral homes to get ‘closer to the action’ in Colombo, potentially driving up rents and more importantly rental yields in the process.
In our opinion, however, the single largest game-changer for Sri Lanka is its location, particularly when considering the impact of Covid-19 in changing holiday habits with a preference of travellers to holiday closer to home. With 1.8 billion people within the subcontinent and a further approximately 700 million in the ASEAN region, Sri Lanka is well-positioned to reap the benefits provided the right strategies and structures are put in place.
Sri Lanka, and Colombo in particular, if positioned correctly can be an economic and social hub for the subcontinent much in the way Singapore was to ASEAN or Hong Kong was to China. The regional politics alone make Colombo and by extension Sri Lanka the most neutral venue within the region. With the Port City development gaining more traction and the need for reforms now widely accepted in the various strata of Government and private sectors alike, the Sri Lankan real estate market could be on the cusp of a slow but steady growth trajectory that could see a linear growth running into decades.
(Nithila Talgaswatte and Pravin Jayasinghe are Co-Founders and Executive Directors of FlatList (Pvt) Ltd., a commercial real estate broking company based in Colombo)
Why is investing in real estate considered a hedge against inflation?
Simply put, real estate is a “real asset” which has an “intrinsic value,” other than as a means of exchange. Most real assets have an industrial or practical value. And unlike fiat currencies, real assets have a track record of retaining much of their value despite any manipulation of the money supply that might come from the central banks. Therefore they are considered attractive during inflationary times.
Real estate can also be incredibly versatile; while as a first-time real estate investor purchasing your first home outright or via a mortgage means that you won’t spend money on rent going forward, you can also acquire real estate as an investment property apart from your home, which can generate a rental/lease yield. As a landlord, you would generally have the ability to raise rents under better (or inflationary) economic conditions, which in turn increases property value.
Secondly, many real estate rental agreements or leases have contractual rent increases worked into them to account for annual inflation. This directly protects your rental income from devaluing over time.
Thirdly, and somewhat indirectly, higher inflation also results in higher costs for building materials and higher replacement costs during renovations, this includes materials and labour. These factors in turn make new development projects more expensive, thereby limiting new supply and giving more room for existing assets to gradually increase rents and appreciate in value.
Finally, another facet of real estate when acquired via a mortgage or property loan is that as an investor you will benefit from “depreciating debt,” whereby the value of the real estate owner’s mortgage payments depreciates over time.
For example, a Rs. 100,000 mortgage payment during the first year of a mortgage will remain the same nominally but may well only be worth Rs. 80,000 in the 10th year once you account for inflation.
So to summarise a good real estate inflation hedge will often work in four ways during inflationary times:
1) Additional Income from rents
2) Income from rents grows with CPI
3) Capital appreciation of property
4) ‘Depreciating debt’ for investors who have acquired property via a mortgage or a property loan.
What types of real estate will protect you from inflation?
Residential real estate, specifically houses, apartments and even apartment blocks (called multifamily buildings internationally), is the easiest way for a real estate investor to make their first foray into real estate.
As inflation rises, you as a landlord have the ability to ‘pass on’ that inflation to your tenants and thus protect your income from being devalued.
For commercial real estate too this can be fairly straightforward; everything from bare land to retail space, warehouses, office buildings and leisure properties can potentially cushion the blow of inflation insofar as you as the landlord have left appropriate provisions to adjust rents and leases during the contract period.
Obviously, there are caveats that must be considered. The late Lord Harold Samuel, a real estate tycoon in Britain, famously coined the expression: “There are three things that matter in property: location, location, location” – certain commercial real estate localities, as well as residential areas, will always command a premium due to specific advantages accruing to the tenants of the property, therefore it gives the property owner more leeway to raise rents/leases given the likelihood of other potential tenants being interested in that specific location. The reverse of this may also be true, where a somewhat unattractive location may not be able to price aggressively or keep pace with inflation.
Another aspect that affects both residential and commercial real estate is tourism. With the advent of platforms such as Airbnb, monetising your property has never been easier. As Sri Lankan tourism slowly recovers from the impact of Covid-19, short-term tourist rentals offer a hedge not only in terms of inflation, but also more directly, protection against rupee depreciation if property owners can accept payments directly in foreign currency.
In more developed markets instruments such as Real Estate Investment Trusts or REITs have offered investors the opportunity to benefit from real estate while not having to make significant investments or get involved in the administration or property management side of things.
With the adoption of blockchain technology, we’ve seen new instruments such as tokenised real estate also gaining traction in countries such as the US, UK and Canada.
While unfortunately neither option is currently available for Sri Lankan investors to avail themselves of, we’re hoping to see the first REIT being launched in Sri Lanka in the not-too-distant future.
What the future holds for Sri Lankan real estate
We at FlatList believe that the real estate market in Sri Lanka is in an incredibly nascent state; for a country of 21 million people, the numbers are hardly what you can call even modest compared to more developed real estate markets across the globe. While we concede that Sri Lanka is both small in terms of geographical size and population size, an $ 80 billion economy isn’t necessarily something we should discount either.
While we must be very careful in making comparisons with significantly larger and more developed markets, the Australian property for residential property alone is an eye-watering $ 9 trillion or about 112 times Sri Lanka’s current GDP. Australia also benefits from massive foreign investment coupled with approximately 200,000 new immigrants during an average year contributing to demand for both rentals and outright purchases. Australia also gets a significant number of tourists, recording 9.4 million prior to the pandemic in 2019.
Sri Lanka, in turn, has all the ingredients to make a robust real estate market; urbanisation continues to pick up pace, tourism, long viewed as the panacea for all that ails the economy, has truly massive potential.
Rising incomes of employees from industries such as IT and outsourcing companies locally will only exacerbate the number of Millennials and Gen Zs wanting to move out of suburban ancestral homes to get ‘closer to the action’ in Colombo, potentially driving up rents and more importantly rental yields in the process.
In our opinion, however, the single largest game-changer for Sri Lanka is its location, particularly when considering the impact of Covid-19 in changing holiday habits with a preference of travellers to holiday closer to home. With 1.8 billion people within the subcontinent and a further approximately 700 million in the ASEAN region, Sri Lanka is well-positioned to reap the benefits provided the right strategies and structures are put in place.
Sri Lanka, and Colombo in particular, if positioned correctly can be an economic and social hub for the subcontinent much in the way Singapore was to ASEAN or Hong Kong was to China. The regional politics alone make Colombo and by extension Sri Lanka the most neutral venue within the region. With the Port City development gaining more traction and the need for reforms now widely accepted in the various strata of Government and private sectors alike, the Sri Lankan real estate market could be on the cusp of a slow but steady growth trajectory that could see a linear growth running into decades.
(Nithila Talgaswatte and Pravin Jayasinghe are Co-Founders and Executive Directors of FlatList (Pvt) Ltd., a commercial real estate broking company based in Colombo)