Can REITs thrive amid high inflation?
September 23, 2022 | Christopher Walker | IPE Real Assets
All markets are mired in uncertainty because of high inflation and interest rates. But it is in precisely this situation that real assets, including real estate investment trusts (REITs), will come into their own, according to director of real assets at WTW Thomas Symons – “thanks to their lower volatility, their higher income stream and their good diversification”.
Ken Weinberg, senior global portfolio manager at CBRE Investment Management, agrees. “The prospects remain bright with a sector that offers a combination of attractive current dividend income that should grow at a rate in excess of inflation as well as significant appreciation potential given the strong demand for property over a full economic cycle.”
He adds: “Despite the recent sell-off, the trailing returns of REITs over the past 20 years have been 9% per annum, besting the majority of alternative asset classes.”
Rick Romano, head of global real estate securities at PGIM Real Estate, is also “quite bullish for REITs at these levels – particularly in comparison to general equities”. He says: “Our analysis shows REITs perform very well historically in periods of high inflation. I could easily see global REIT returns in the low double-digits over the next 12 months – and if the economic situation turns out to be more positive it could be considerably more than that.”
Ji Zhang, global real estate portfolio manager at Cohen & Steers, concurs. “Overall, real estate is a high-margin business and less exposed to labour and cost inflation than other sectors – so we expect it to fare better in this high-inflation environment,” she says.
“There are certain sectors that have inflation-linked escalators and shorter lease duration that allow the landlords to pass through higher inflation. At the same time, other parts of real estate like healthcare and towers have defensive characteristics, such as long lease terms, less economic sensitivity, that should hold up better if we go into a recession.”
Crucially, REITs are in a generally better financial position than they were leading into the global financial crisis of 2008. “Most landlords learnt their lessons from that crisis and balance sheets are in a much better position,” Zhang says.
This is a factor Weinberg also cites. “Balance sheets have never been stronger, with low leverage, limited near-term debt maturities and significant dividend coverage,” he says.
John Worth, executive vice president of research and investor outreach at NAREIT, says the average leverage of US REITs is 27.6%. “This compares to a figure of 37% going into the financial recession of 2007-08,” he says. “In addition, REITs debt profile is favourable with very little coming due in the next few years.”
David Rosenberg, managing director and senior portfolio manager at Harbor Group International, agrees. “The listed sector is well prepared if we do go into a recession with…. what I would describe as fortress balance sheets. And portfolios that are much higher quality.”
However, Zhang admits that the global economy is looking distinctly “asynchronised”, with the “US opening up more quickly, while Asia has just started [and] in Europe hopes of recovery have now been clouded by war”.
She says: “We are also seeing a big divergence in monetary and fiscal policy. High inflation and the necessity to tighten monetary policy dominates consideration in European and US markets, whereas in Asia, particularly in Japan and China, monetary policy remains more supportive. In Asia, inflation is less of an issue. Inflation will pick up as economies reopen and pent-up demand comes through but, overall, it is less of a problem than in North America and Europe.”
There is also a question of the differing valuations between the three regions. “In Asia, we’ve seen falls of only 11%,” Zhang says. “But that is because listed real estate in Asia was only up 4% in 2021, whereas US REITs rose by 41% as the US economy reopened.”
In Asia, Zhang favours “the reopening stories” and Singapore offices which “benefit from significant tailwinds as corporates relocate there due to political challenges in China and Hong Kong”.
US outlook more favourable
In the US, Worth is more optimistic than Zhang. “It is noticeable at the moment the stock market returns are out of sync with operating performance,” he says.
During NAREIT’s REIT week conference in New York in June, “the majority of presenters consistently said that, while they under-stood economic forecasts were pessimistic, they were not seeing any signs of a slow down at present”, Worth says.
Romano adds: “There is an awful lot of capital sitting on the sidelines – we estimate something like $350bn (€353bn). In the US, many industrial REITs are in a strong position when five-year leases expire, and they are using that renegotiation to see significant rent bumps and to build-in potential growth in rents of, say, 4% to 6% over the next five years. This means they don’t just have built-in inflation protection, but if market forecasts that inflation will be tamed are correct, they may actually be inflation winners.”
Although less optimistic on the US, Zhang says: “Some sectors have secular stories which are less exposed to short-term economic considerations. Data centres will be a good example of this.”
When choosing sectors to favour, Rosenberg says the most important consideration is length of lease. “A fast-moving inflationary environment means it’s very advantageous for property owners to be able to raise rents and not be tied into long leases. This leads us towards the residential sector and single-family rentals in particular.”
The rise in the cost of purchasing your own home has been dramatic over the past six months in the US, with 30-year mortgage rates doubling from 3% to 6%. “With continuing strong demographics we expect this to lead to a dramatic rise in rental growth,” Rosenberg says.
European REITs, meanwhile, face the added uncertainty around energy security concerns. Both Romano and Zhang note their worry and caution for the region, particularly around energy security in Germany.
But Karim Rochdi, founder and managing partner of Aventos in Germany, says: “I think it’s fair to say US investors in general have long been much more concerned with the effect of energy security on real estate, and this perhaps the different perception of value in European real estate. In terms of the war in Ukraine, this certainly led us to make risk assessments of the European REITs which we invest in. But we still very much believe in the western European REITs and have not made a major switch out of Europe in general.
“In terms of the German energy situation, we believe it is most important in assessing REITs to concentrate on the inflationary impact on elements such as construction costs. Fortunately, we are seeing steel and wood prices falling substantially in the last two months. So the concerns we had two months ago are now abating.”
