The Building That Has to Earn Its Hedge

The case for property as an inflation hedge rests on income. If rents rise with prices, the real value of the income holds. That depends on the lease. Fixed annual reviews below inflation, long terms without market reviews and incentives that eat into effective rent can all leave income trailing prices for years.

Even where the lease works, income is only half the picture. The other half is what the building will ask of its owner over the same period, and that half is rarely modelled with the same care.

Every planned replacement in a building is, in effect, a commitment to buy construction at some future price. Roofing, lifts, chillers, switchboards, fire systems: all of these are priced in the construction and services markets, and those markets have their own inflation. In the years after 2020, building costs in Australia, Britain and the United States rose faster than consumer prices, driven by materials, labour shortages and long equipment lead times. The pressure eased from 2024, but the episode showed how quickly the gap can open, and the energy-price shock of 2026 has brought input costs back into view.

An owner with a large deferred programme is therefore short construction inflation. Each year of deferral is a year in which the eventual cost can rise faster than the income meant to pay for it. The hedge leaks through the plant room.

A building with a light capital programme and well-indexed leases is a strong hedge. A building with a heavy programme and soft leases can be a weak one, whatever the asset class says.

The gap between construction prices and general inflation is no longer a theoretical risk. It has been measured in all three markets, and in the United States it is large.

Put simply: works priced at $1 million in February 2020 would have cost about $1.43 million by the end of 2025, while rent indexed to consumer prices rose about 26 per cent. A building whose income tracked inflation and whose capital plan tracked construction lost about a sixth of its real capacity to fund its own renewal in under six years.

The gap did not open evenly. Most of it arrived between 2021 and 2023, when US construction prices rose 5.2, 19.9 and 7.9 per cent in successive years. In 2024 and 2025 they rose only 0.1 and 1.6 per cent. The lesson is not that construction inflation always runs hot. It is that it moves in surges that income rarely matches, and a capital plan that assumes general inflation will be caught out by the next surge.

A practical test needs three inputs. First, the income path: how the leases index, when they review to market and when they expire. Second, the capital path: the register’s ten-year programme, by horizon. Third, an assumption about construction cost escalation relative to general inflation, which can be varied. With those, an owner can see whether net income after capital holds its real value under a warmer inflation regime, or leaks.

Two buildings with identical leases can give opposite answers. One has a light programme spread across the decade and keeps most of its hedge. The other has a heavy mid-decade programme in roofing, plant and facade, priced in a construction market that has run ahead of CPI, and gives a large part of its hedge back. The difference is invisible in a valuation and obvious in a register.

Who actually bears that capital inflation depends on the lease. Under fully net structures common in the United States, many outgoings and some capital items pass to tenants, though structural and major replacement items often stay with the owner. In Australian and British leases, the line between recoverable outgoings, tenant repair obligations and landlord capital varies widely by lease and by asset. We explore the mechanics in Who Pays; the point here is that the same building can be a good hedge for one owner and a poor one for another, depending on what the leases say.

Earning the hedge is mostly a matter of knowing the capital position early. If the major replacements over the next decade are visible, with a sensible range and timing for each, an owner can decide which to bring forward before costs rise, which to defer with confidence, and which to stage. That is a different posture from discovering the chiller is failing in a hot summer and buying a replacement at whatever price the market sets that month.

It also changes how an acquisition should be read. A building bought as an inflation hedge should be tested against its own capital programme, priced in the same inflationary world the hedge is meant to protect against. If the programme is heavy and early, part of the hedge has already been spent.