Inflation fears have gripped markets in recent weeks, dampening investor optimism surrounding the global economic recovery from Covid-19. In the UK, inflation more than doubled last month, while US inflation rose 4.2% year-on-year in April – the highest level recorded since 2008.
While equities and other risk assets have displayed heightened volatility recently due to renewed inflation concerns, one segment of the stock market has proven to be more resilient during periods of price pressures – real estate investment trusts (REITs). Below, five investors examine the prospects for REITs should we witness a sustained inflationary environment.
Jon Cheigh, CIO and head of global real estate at Cohen & Steers
As investors adjust asset allocations for the shifting market environment, we believe REITs today are especially appealing. Just as Covid-19 upended the REIT market in 2020, we believe real estate could directly benefit from vaccine distribution and the massive fiscal stimulus introduced in the past year – even as rates rise. In particular, property types that were disproportionally affected by social distancing measures, including hotels, retail and offices, stand to benefit directly from the economic reopening.
Real estate sectors tend to have varying sensitivity to economic growth based on lease durations. Property types with shorter lease durations – such as hotels, self-storage, apartments, senior housing operating assets and billboards – may benefit more from economic expansion, as landlords can quickly adjust rents to capture rising demand. Other sectors with longer lease durations, such as net lease companies, often have explicit rent escalators tied to a published inflation rate.
Consequently, REITs have historically responded favourably to inflation surprises, compared with the negative impact on stocks and bonds. Active REIT managers who understand these differences can position portfolios to potentially take advantage of changes in interest rates and inflation expectations.
Gillian Tiltman, portfolio manager on the Neuberger Berman Global Real Estate Securities Fund
As economies around the world recover from the coronavirus crisis and vaccination programmes begin to show a way out of the pandemic, signs of inflation have reappeared – and with them, rising bond yields. With bonds and equities both potentially at risk from this dynamic, we consider the performance of REITs across different inflation and interest rate regimes of the past.
The heightened volatility in equity markets we have seen this year has been around doubts about the commitment of central banks to accommodative policy – or worse, fear that they might lose control of inflation and be forced to raise rates quickly and substantially in order to rein it back in.
Our findings on the relationship between REITs returns and the two-year US treasury yield suggest this scenario may not be especially harmful for REITs – indeed, it could even be a tailwind. We think that is likely due to the inherent inflation sensitivity of the REITs asset class. In our view, it is yet another reason to consider an allocation to REITs now inflation and interest rates are generally expected to rise.
Ben Fry, manager of Residential Secure Income Plc (ReSI) and head of housing investment at Gresham House
Investments into the UK housing market are a good hedge for inflation, as the costs of housing are a significant constituent of the baskets of goods used to calculate inflation. The UK gilt market prices in inflation forwards each year, and that gives the most heavily bet-on view of inflation. At the moment, RPI is predicted to be 3% this September – a big increase from last year.
However, as investors in the affordable end of the residential space, rising inflation is less a concern, more an opportunity. Our leases with residents all have RPI or CPI-linked rents, which means the income from our retirement homes, shared ownership, and local authority housing increases in an inflationary environment.
There is more demand from investors for inflation-linked income than there is supply of it. In commercial real estate, caps and collars are increasingly being put on inflation-linked leases. This means a lease that increases with inflation is subject to a minimum of 1% and maximum 3% exposure, which limits an investment’s increase in a heavily inflationary environment. From our side, however, we are in the very good position of having assets without capped inflation exposure, something investors will increasingly seek out.
Rick Romano, portfolio manager of PGIM Global Select Real Estate Securities Fund
Strong yields and attractive valuations make REITs a compelling asset class for investors searching for income. Recovery from the pandemic, rising inflation expectations and a long future with accommodative monetary policy could all contribute to price appreciation in real estate securities.
Investors with concerns about inflation should note commercial real estate often has CPI-based increases embedded in leases, protecting investors from the impact of rising inflation. As a result, REIT dividend growth has consistently outpaced the rate of inflation growth over time.
We continue to find opportunities for rent and cash flow growth across the world. Real estate trends in place prior to Covid-19 are accelerating. The penetration of e-commerce and grocery e-commerce – at the expense of bricks and mortar real estate – is accelerating. Also, mandated work from home in most parts of the developed world may lead to less demand for offices globally as firms realise portions of business can work remotely without a loss in productivity. While these trends may be a negative for retail and office space, they are a positive for last mile industrial, cold storage, data centres and cell tower REITs.
Calum Bruce, manager of the Ediston Property Investment Company (EPIC)
It looks likely the UK is going to enter a period of increased inflation, which could be good for the real estate market as historically real estate has done well during inflationary periods. As the economy expands and the demand for goods and services increases, rents tend to grow, making property investments a good hedge against inflation.
In addition, the benefits of REITs versus open-ended physical property funds have always been compelling. Free from the necessity to hold large sums of cash for the purposes of liquidity, closed-ended funds can remain fully exposed to the asset class, thus avoiding cash drag on performance and yield.
The closed-ended structure means redemptions cannot snowball, forcing managers to quickly sell assets at a sharp discount. Managers are therefore better positioned to take advantage of distressed sales, can maintain their best assets, take advantage of investment opportunities as they arise, and focus purely on accretive asset management initiatives. Investors, meanwhile, can access their investments without restriction. Even if shares fall below net asset value in the short term, REITs have the advantage of being able to hold onto assets until they reach potential.