Written by Robert Nystad, head of research. This article appeared in Norwegian business journal Kapital on 24 June 2021.

An old issue has reared its head again. For the first time in many years, the threat of high inflation is a hot topic in the financial world. But we in the property market are not normally afraid of inflation. On the contrary, investment in commercial property can be viewed as a safeguard against rising prices because leases are normally adjusted in line with the consumer price index (CPI). So surely, then, we have nothing to fear?

Even if you are well positioned, the sky is not cloudless. At least two scenarios could play out negatively. First, we might find prices rising faster than today’s interest rates can justify. That would force the central banks to raise rates more than expected, which would almost certainly increase required returns and contribute to falling value in the financial markets. Should the downturn be steep enough, it could infect the property market.

The second scenario is less dramatic but perhaps more realistic. Assume US inflation reaches a high level at the same time as Norwegian price rises are low or moderate. In that case, interest rates globally will probably be driven up – including in Norway. Ten-year rates, in particular, have a tendency to keep pace with their “age group” out in the big wide world.

In other words, we risk seeing a higher level of interest rates externally without a corresponding change in inflation or growth prospects for the Norwegian economy. That would, in the event, reverse the trend we have seen during recent decades, where Norway’s economic development has periodically been solid while it could import low interest rates from abroad.

This brings us to an important point, namely that what drives the inflation is not insignificant. Although it is difficult to isolate such drivers, the consensus at the moment appears to be that three important factors are putting increased pressure on prices. First, governments in many countries have very expansive financial policies. Second, a large surplus of savings has accumulated in households. And, third, an extensive increase has occurred in global raw material and freight prices.

Even in a globalised world, the first two of these factors can be expected to have disparate impacts in different countries. However, the third will contribute to inflationary pressure “across the board” if it persists. Higher raw material and freight prices are moreover interesting because they have a big effect on construction costs. As a rough rule of thumb, materials typically account for half the cost of a new building. And, given the price trends we now see for metals, timber and other raw materials, it is easy to envisage construction costs far outstripping the CPI.

Increased construction costs have several wider consequences. On the one hand, they help make it more expensive to put up new buildings, rehabilitate existing premises and customise for new tenants. That could put pressure on the profitability of such projects. On the other, the marginal cost of providing new space rises. That could boost rent levels and increase the value of existing buildings with a high standard.

Over the past decade, we have seen how declining yields in many cases have made new buildings very competitive in terms of rents, and thereby inhibited rent growth in other parts of the property market. Examples include office buildings in Oslo East and logistics premises outside the city limits. Should construction costs now rise faster, replacement costs would increase. Rents would probably move higher.

In other words, faster inflation could affect the market in many ways – partly depending on where it occurs, what drives it and how the central banks respond. Property is not immune to inflationary trends, but offers greater protection than most other sectors.