Although it may seem necessary to review everything Coronavirus related over the past few months, we feel it appropriate to look ahead and discuss a growing concern amongst investors globally: the prospect of rising inflation coupled with a potential environment of rising interest rates.
The most recently published inflation rate is over 5 percent in the US, while the Federal Reserve expects inflation to narrow to 3.4 percent this year, up from the 2.4 percent rate anticipated in March. In the UK and Eurozone, these rates are now around the 2 percent levels. Asian figures also continue to grow, many of which began the year in negative territory.
Policymakers imply that this phenomenon is likely temporary. The question for many is whether this is indeed short term in nature, or whether we are beginning to live in a time of sustained rising prices. And if the latter is so, what is the impact on the various asset classes and are there ways to hedge against prolonged and elevated inflation?
A common perception is that real estate acts as an inflation hedge (as opposed to other asset classes, particularly bonds), but what does history tell us and what are the reasons for this? Unfortunately, the data is not as immediately revealing as one would hope due to the lack of inflation globally over the last few decades. One is therefore required to look a bit further back in time for insight. For example, in the US, the last period of heightened inflation was over the decade ending in the early 80s. During this time, home prices held their value in real terms and equity REITS delivered returns exceeding inflation. Over the same period, general equities and bonds failed to do so and posted negative real returns. This evidence supports the belief that real estate acts as a hedge to inflation, producing positive real returns over time.
Real estate also screens attractively in an environment of rising prices from a theoretical perspective. To begin with, many leases globally have rents indexed to some measure of inflation or are contracted to escalate rents annually. Property values also generally increase as higher prices for labour, materials and land make construction less economically viable without a commensurate rise in rental levels. This may result in a limit to new supply, which creates a barrier to new entry and allows existing property owners to raise occupancy levels and corresponding rents.
In theory, property sub-sectors with shorter leases should outperform during inflationary periods relative to longer, fixed leases. Shorter lease durations, being more economically sensitive, enable landlords to benefit from economic expansion and realise inflationary prices and rents quicker upon lease expiration. However, longer leases still offer protection upon lease expiry as rents are rebased to higher levels during periods of increasing market rental growth. Property sub-sectors enjoying superior demand growth should also fare better versus those sectors experiencing muted demand, all things being equal and if supply is contained. Collectively, this supports the notion that REIT dividend growth should increase above inflation over the longer term, as has been the case in the US over the last two and half decades.
An environment of higher interest rates is generally perceived to be negative for listed real estate. Indeed, sharp and unexpected increases in rates may negatively impact returns over the short term. The historical evidence points to REITs performing strongly during periods of increasing rates when combined with positive economic growth. While costs of capital and the capitalisation rates used to value cash flows and property values may be negatively impacted by higher interest rates, the state of the economy to drive increased demand and elevated rent levels appears to have a larger impact on long term value. Furthermore, many real estate companies have taken advantage of lower interest rates over recent years and have extended debt maturity schedules. This should make these companies less sensitive to an increase in their cost of capital over the medium term. Conversely, it is anticipated that fixed income should underperform relatively in an environment of rising rates.
Although the real estate sector overall is anticipated to perform well within an environment of increasing inflation and interest rates (and particularly versus bonds), if coupled with economic growth, we believe that ultimately the underlying fundamentals impacting the various property sub-sectors will drive long term performance to a greater extent over time. More specifically, such sub-sectors facing demand tailwinds combined with healthy levels of supply should outperform those sub-sectors experiencing lacklustre demand and/or elevated supply levels. We have positioned our portfolios accordingly. In addition to this, recent meetings with the majority of our universe’s management teams over this past quarter, particularly via virtual conferences held covering the US and Europe, have resulted in adjustments to our expectations together with an affirmation of certain house views.
We continue to favour residential real estate, our largest overweight position. Not only should the sub-sector benefit from short annual leases in an inflationary environment, but is also expected to outperform on the back of robust fundamentals.
Manufactured housing’s long-term fundamentals remain appealing, despite some rebound in performance over the quarter, due to a landscape of virtually no new supply; a heightened demand for affordable housing; and low capital expenditure needs on the part of landlords. Furthermore, in the seasonal/transient business component, expectations have been exceeded as RV (Recreational Vehicle) operating fundamentals surpass that which is assumed in full year guidance numbers. Discussions with management teams also suggest continued cap rate compression from persistent investor demand for this sub-sector, which should further benefit property values and returns going forward.
Single family housing fundamentals continue to profit from strong demographic tailwinds combined with a decade of undersupply. An aging millennial population, now the largest generational cohort exceeding that of the boomers, will positively drive this space over time as certain life events transpire, such as coupling; starting families; and moving to the suburbs. Strong demand and occupancy levels near all-time highs has resulted in accelerated rental growth throughout the pandemic and management teams are anticipated to further raise year-end guidance levels this year.
We largely break down apartment counters in the US based on their portfolio exposures to predominantly coastal markets or to the Sun Belt and have overweight positions in both. Coastal markets, such as New York and San Francisco, suffered last year as vacancies rose and high rental levels tumbled from a population exodus as these cities shut down, offices remained closed, and work-from-home/anywhere became mainstream. Coastal markets remain a recovery play as economies re-open, people return to work and rental growth returns. Sun Belt markets, such as Phoenix; Raleigh; and Houston, continue to screen as attractive despite strong performance on the back of structural tailwinds. A mounting increase in the attractiveness of these markets based on their relative affordability, lower taxes and even better weather is resulting in migration, corporate relocations, and job growth that are fuelling rental growth and cap rate compression. We also continue to favour apartment landlords elsewhere in the globe exhibiting good long-term fundamentals, largely in Canada, Ireland, and certain parts of Germany.
We remain cautious of the office and retail sub-sectors due to structural headwinds, particularly since the current global pandemic has accelerated certain concerns for these sectors. For offices, we anticipate a bifurcation in rents and cap rates within the sector. The right markets and type of office product should fare better relatively; however, it will take some time to fully understand the longer-term role of the office in a new reality of increased working from home and hybrid working models. We forecast reduced demand for the sub-sector as a whole when compared to pre-pandemic levels. We remain underweight offices overall with our exposure largely limited to landlords with high quality portfolios, the right tenant mix, and the ability to add value through development.
The retail sub-sector has enjoyed an incredible run on the back of vaccine news last November. We probably underestimated the strong bounce back in returns over the last few months, particularly in malls, although most retail stocks still trade below pre-COVID levels. As long-term investors we focus on sustainable trends. In the retail sphere, we continue to prefer well-located and essential, necessity-based retail over discretionary, and often enclosed, retail properties. This is largely due to the former type of retail real estate being less exposed to the impacts of e-commerce and the growth in online spending that has accelerated globally out of necessity during the pandemic.
The world remains uncertain over the short to medium term on the back of Delta variant spread and varying degrees of lockdown measures being experienced globally. We remain focused on long term fundamentals that have driven our process for over 20 years. Based on global real estate’s solid rebound in performance this year, we currently consider the market to be fairly priced on an expected total return basis. However, we stress the view that within the sector exists a large divergence in potential returns. This bifurcation of opportunities should allow for the ability to pick stocks that will deliver superior performance versus the market. We also consider the low correlation of real estate to other asset classes over the longer term and the diversification within the property sector, both from a geographic and sub-sector basis, as appealing for investors.
Relative to bonds, real estate screens attractive with Catalyst currently pricing the global listed property market at a 265bps spread relative to BAA bonds, versus the historic spread that is just shy of 200bps. This implies that some buffer exists to absorb interest rate move-outs or alternatively, that room for continued cap rate compression exists (assuming interest rates remain as they are) to boost property values. High return premiums versus BAA bonds have historically resulted in real estate relative outperformance. It should be noted that if we priced the real estate market off the historic spread to BAA bonds, we would see significantly more value in the overall market. We remain conservative in our assumptions.
The estimated forward FAD (Funds Available for Distribution) yield for the sector is 3.98%. Based on our earnings estimates and market break-even inflation expectations, we expect the listed real estate sector to deliver at 4.54% real return for buy and hold investors over the medium term. As mentioned, within the listed real estate universe, more attractively priced opportunities exist in specific sectors and stocks, providing opportunities for astute active managers.