INSIGHTS | Relationship Between Rents and Inflation

Inflation has jumped of late and to eye watering levels in the UK for example. This has led to any number of comments that property can be an inflation hedge compared to other asset classes. I wanted to have a look at why that might be.

What is Rent?

Let's go back to the beginning and revisit the theory of rent. Essentially, rent can be considered a surplus.

"The rent of land, therefore, considered as the price paid for the use of the land, is naturally a monopoly price. It is not at all proportioned to what the landlord may have laid out upon the improvement of the land, or to what he can afford to take; but to what the farmer can afford to give." — Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Book I, Chapter XI "Of the Rent of Land"

That last part on “what the farmer can afford to give”, is intriguing for commercial property in Australia. Looking at the Australian company profit trend over just about any period, profits have been growing which is one reason the unions are fired up about wage stagflation.

Using a simple theoretical model, we can look at the relationship between rents and inflation.

Gross Income – Expenses = Net Income

Gross Income ($100) – Expenses ($25) = Net Income ($75)

Net Income if all prices doubled due to Inflation

Gross Income ($200) – Expenses ($50) = Net Income ($150)

So, if the basic model holds true and Australian company profits are strong, then in theory the prospect for Australian commercial rents to track moderate levels of inflation looks promising.