REITs, investors' response to inflation and slow growth.

Stagflation fears are growing among investors as inflation has accelerated since 3Q21. After a decade long of low inflation from 2011 to 2020, inflation has emerged as a critical area of focus. Tightening monetary policies, the war in Ukraine, and covid restrictions in China have exacerbated macroeconomic uncertainties since the start of the year. In April 2022, IMF reduced the global growth rate this year by 0.8%, from 4.4% to 3.6%. If the stagflation scenario materializes, markets will likely see further pressure on equities. The equity risk premium, despite being elevated, is still lower than comparable periods of market peaks (i.e., 2008, the first quarter of 2020, and the late 1970s), indicating room for further upside. Historically, REITs have performed relatively well against the traditional equities in times of high inflation, hence the recent focus among institutional investors. 

Is inflation transitory or persistent?

Until mid-2021, the prevailing narrative among asset managers and policymakers was that inflation would be transitory. While some managers still firmly believe that inflation is transitory, the start of the Russian-Ukrainian war and the implementation of China's zero-Covid policy have anchored the view of persistent inflation.

Franklin Templeton (1.5trn AUM), AB (780bn AUM), Alliance GI (700bn AUM), and Lord Abbett (250bn AUM), only to mention a few, are among the managers that see inflation to be persistent. Covid supply chain disruptions have driven MNCs to prioritize supply security over cost; alternative supply locations diversify supply risk, but they usually lack the economy of scale of traditional supply locations. The globalization that accelerated 20 years ago may have peaked due to geopolitical tensions. Finally, "sticky" components of inflation have also ticked higher. For example, housing expenses in the US have been climbing steadily above historical ranges since 4Q21. Healthcare costs would likely follow the same pattern, given the industry's pricing practices and the shortage of nurses and doctors in many countries.

On the other hand, asset managers, such as Western Asset (480bn AUM), Jupiter Asset Management (70bn AUM), continue to view inflation as transitory as they see the supply bottleneck to ease. More importantly, they insist that the long-term structural deflationary pressures have not changed. Aging demographics will reduce spending over time. Technological progress will maintain productivity improvements. Zombie credit to corporates will keep excess production capacity in the economy. 

How do inflation expectations impact the equity market?

Several central banks have an explicit mandate to maintain price stability. While transitory inflationary shocks are more benign as their impacts on inflation are usually temporary, persistent shocks are problematic. They can push inflation well above 2% and require the Central Bank's policy actions. But as inflation shows signs of peaking, debates emerged again over the nature of the inflation and the risks that a too hawkish Fed will raise the funding cost for companies, dampen valuations and push the economy into recession. Discussions are even more exacerbated given that the markets have not experienced inflation well above 3% for over 20 years. The lack of near-term references and the complex backdrop of the current inflationary environment creates more uncertainty, thus leading to higher market volatility.

Are REITs a good hedge against inflation?

With more investors seeking to protect themselves against inflation, REITs have attracted some attention - historical studies have supported their inflation hedge qualities. Just referencing a few:

"Indeed, based on both empirical results and theoretical arguments, real estate, accessed through publicly traded equity REITs, provides attractive return characteristics and deserves consideration in diversified inflation-protected portfolios." from Inflation and Real Estate Investments, 2017, by Brad Case, Susan M. Wachter, Richard B. Worley.

"Over the long run, developed real estate stocks provide a positive inflation hedge against expected inflation, while no similar evidence is found in the emerging markets. The findings suggest that the inflation-hedging properties of real estate stocks are related to the institutional involvement in the real estate stock markets." Do European real estate stocks hedge inflation? Evidence from developed and emerging markets, 2012, by Chyi Lin Lee and Ming‐Long Lee.

More recently, a study conducted by Man Group (150bn AUM) and Duke University found that residential real estate in the US and UK tend to hold significantly better than traditional equity and bonds during times of high inflation. The same study found that Japanese residential real estate produced a slightly positive total return during high inflation periods. An even more recent study conducted by PGIM Quantitative Solutions (100bn AUM) found that REITs show a positive 1.5% real return in periods of high inflation, largely outperforming equity (-1.9%) and bonds (-0.1%).

Recently, many asset managers also expressed their positive views on REITs in inflationary contexts. Early April 2022, Brian Jones, Portfolio Manager at Neuberger Bergman (400bn AUM), expressed that REITs should be an effective hedge against inflation when the latter is persistently above-average while the economic growth remains solid. In Apr, John Corcoran, Senior Director, Client Portfolio Manager at Invesco (1.5trn AUM), wrote that a strategic allocation to real estate should be considered in the face of rising inflation risk. In early May, Mark Callender, Head of Real Estate at Schroders (770bn AUM), pointed out that some investors have taken shelter in UK real estate as 1) commercial real estate rent tends to follow inflation and 2) the correlation has been quite strong in the UK since the 1970s. The lower LTV of REITs post-GFC has made the asset class less risky. In mid-May, Fidelity (4.5trn AUM) stated that REITs might benefit from a higher inflation environment. 

To summarize, the pro-REIT arguments are:

• Commercial leases have rent escalators that are explicitly tied to inflation, while shorter tenors of residential leases provide opportunities for rental reversion
• Rising construction costs can cause some developers to increase the price of new supply, supporting the valuation of existing properties. 
• In the meantime, other developers may choose to put new projects on hold, limiting new supply, which in turn preserves the valuation of existing properties and gives landlords the bargaining power to raise rents.

Is it full-on risk on REITs, though?

A closer look into asset managers' views reveals that they remain selective when allocating to REITs / real estate assets. Fundamental criteria still need to align. 

• Location exposure of the REIT remains critical. For example, Matt Werner, managing director of REIT strategy at Chilton Capital Management (2bn AUM), is negative on US gateway cities (e.g. New York, Boston or Chicago) for office REITs as growth is slow and prefers Sunbelt cities such as Atlanta, Tempe, Charlotte.
• Pricing power. J.P. Morgan Asset Management's (3.1trn AUM) Real Estate team expressed that they prefer fast-growing sectors such as distribution warehouses, data centers, life science facilities, and single-family rentals vs. office and retail. Morgan Stanley Investment Management (1.6trn AUM) highlights segments with secular tailwinds, such as industrial and residential.
• "Greenness": Nora Creedon from Goldman Sachs Asset Management (1.5trn AUM) emphasizes that green buildings protect long-term investors from downside risks related to changing tenant preferences, higher operating costs, and potential regulatory penalties. A study published by Knight Frank in late 2021 found that green office buildings commanded rental premiums of 3.7-12.3% in the UK.
• Lease maturity profile: REITs with shorter WALE (unless rents are inflation-linked) are preferred to capture higher rental reversion potential in the short term
• Leverage: REITs with lower gearing, fixed financing rates, and back-end refinancing schedules will be less impacted by higher refinancing costs in a time of high inflation.

If persistent inflation remains the base case, REITs are likely to gain momentum with institutional investors, given their inflation hedge qualities. However, considering the growth uncertainties, investors are likely to base their selection criteria on asset quality, lease maturity profile, and financial leverage to maximize protection.

We hope you enjoyed this article and that it will help fuel your conversations with prospective investors. IRs and CFOs of REITs can reach many real-estate analysts and portfolio managers referenced in this article through Irostors. If you are interested, feel free to get in touch with us.