“So, how are real estate fundamentals looking?” That is a question we haven’t been asked by investors in quite a while. And understandably so – over the past 2+ years there have been significant macro events which have been material drivers of share prices, far more than any underlying real estate fundamentals. From global Covid-induced shutdowns, subsequent vaccine-led re-openings, and now rising rates and inflation, further exacerbated by the Ukraine invasion. It has indeed been an interesting time to be an investment professional.
Even before the Ukraine invasion, rising rates and inflation were becoming front of mind for most investors. Putin’s actions to resurrect the former glory of the USSR have only exacerbated these concerns even further. We therefore believe it appropriate to unpack these two items insofar as they relate to global listed real estate.
Firstly, if we consider the impact that higher inflation has on global listed real estate, it is worth noting that global listed real estate has historically performed well during periods of high inflation. Taking the US as a proxy, and as our single largest geographic exposure, we note that over the preceding 50 years, there have been 8 instances of inflationary spikes (>100bps). During 5 of those 8 instances, US REITS outperformed both the S&P500 and CPI.
During a period of high inflation, it is crucial for a company to have pricing power, which is ultimately determined by supply and demand. In the global listed real estate space, we are fortunate to have exposure to multiple sectors, many of which have strong secular demand drivers behind them. These include demographic tailwinds, i.e. an ageing millennial population driving demand for Single Family Rentals; increased data consumption and rollout of 5G networks driving demand for Towers; and increased e-commerce penetration driving demand for well-located Industrial assets, to name but a few.
It is important to point out that these secular demand drivers are largely independent of general economic growth, and we believe that they would hold up even if GDP growth were to temporarily stall. If we consider the supply side of the equation, it is worth noting that we generally have good visibility on new real estate supply coming online. It is usually a multi-year process to obtain planning permission, commence construction, and ultimately complete a new development. Save for a few pockets of oversupply, supply of product in the global listed real estate space is generally in check. When we combine this with the robust demand mentioned above, it affords landlords strong pricing power, as market rents push higher even if general economic growth temporarily slows. Landlords are then able to push these increases on to their tenants through contractual escalations each year, as well as upon expiry of the lease agreements, when new lease agreements will be reset at prevailing market rental levels.
A key consideration in an inflationary environment is the wide range of lease lengths that lie within the various sectors of the global listed real estate opportunity set. These range from daily leases (hotels), monthly leases (self-storage), annual leases (residential), all the way through to 20+ year leases (triple net lease). We are therefore able to apply a tactical overlay to our portfolio construction, during a period of high inflation, towards sectors with shorter lease lengths, which are therefore able to reprice to market levels a lot quicker. It is crucial to note that this is only relevant if the underlying sector has strong pricing power (as discussed above), i.e., pricing power and lease duration must be considered together. There is no benefit to be in a short-dated lease sector which does not have pricing power.
While the above explains the pricing power that certain listed real estate companies will have during an inflationary environment, it is also worth considering what impact rising inflation will have on the expense lines of these companies. While global listed real estate stocks are by no means immune to rising costs, it is worth noting that the composition of operating expenses (opex) for a typical REIT is very different to the constituents of a CPI basket. It would therefore be incorrect to expect stocks’ opex costs to increase on a 1:1 basis with rising CPI.
- For example, on average (it will differ largely across various sectors) the single biggest component of opex for a REIT will be real estate taxes, comprising c. 40% of total opex (see chart below). These taxes are driven by rising real estate values, with a lag of c. 2-3 years. Therefore, real estate taxes will be driven by rising real estate values which have increased over the preceding years, likely due to strong fundamentals, rather than being driven by the latest CPI print.
- The next biggest component of opex would generally be labour costs, which would on average constitute c. 20% of total opex.
- Again, this varies significantly by sector (as can be seen in the 2nd chart below). Certain sectors are heavily reliant on labour (e.g., cold storage, where labour costs comprise c. 66% of total opex), while other sectors are “labour light” (e.g., industrial and retail where labour costs comprise <10% of total opex).
- It is also worth noting that certain sectors will have some element of variable labour cost, which can be flexed during times of tight labour markets. As an example, as at 31 December 2021, hotel operator Marriot had reduced their total employee headcount by 31% vs 2019 levels, on the back of reduced hotel occupancy. While this headcount reduction will likely diminish as occupancies return to pre-Covid levels, it illustrates how easily companies can flex their staff headcount in markets that do not have overly protective labour policies.
If we turn to rising interest rates, there is generally a misconception that rising interest rates will have an immediate and material negative impact on REITS’ earnings. While rising rates will ultimately translate to a higher cost of debt, the actual impact is a lot more gradual and muted than commonly thought. As a starting point, it is worth noting that, on the whole, global listed real estate companies’ balance sheets are well capitalised, and much improved since the Global Financial Crisis (GFC). Again, using the US as a proxy, being our single largest geography, the below chart shows that average levels of debt across US REITS are at the lowest they’ve been in over two decades, as depicted by loan-to-value (LTV) at c.30% vs c. 45% going into the GFC.
In addition, debt maturity profiles have been extended to levels not seen in the last two decades, with average debt maturity being c. 7.5 years vs c. 5 years going into the GFC. Furthermore, the majority of this debt is then swapped out for fixed rate debt. The low levels of debt, combined with long duration debt, which is generally swapped out to a fixed rate, results in a very small impact to earnings when interest rates rise. It is only when these debt instruments expire and need to be refinanced at higher rates in later years, that it will impact cost of borrowing, and even then, the impact will be gradual and spread over time.
While global listed real estate is by no means detached from the economic realities and geopolitical risks the world is currently grappling with, we are still comfortable with the depth and breadth of the opportunity set that the asset class has to offer. Sectors with strong fundamentals, being driven by secular tailwinds and not general economic growth; opex and interest expense that will likely tick up with time, but at a much slower run rate than the cadence of interest rate increases and CPI prints; and a historic record of performing well during periods of high inflation give us comfort to invest in the sector at this time. On a valuation basis, we currently see value in the sector for long term buy and hold investors.