History has shown that over the past 50 years in US markets, during the five periods where inflation was greater than 3% (i.e. ‘high’) and rising, REITs have delivered inflation-beating returns more than two thirds of the time. The reliability of this outperformance is second only to energy and mining stocks during the relevant periods. The historical evidence thus appears clear: buy property stocks when inflation is high and rising. However, the case for listed property might not be quite so straightforward in the current environment.
TWO OPPOSING FORCES
Global listed property has two opposing forces at play at the moment: its historical ability to pass on to shareholders the income from increased rents in a high-inflation environment, and the negative impact of rising bond yields.
Inflation and rising interest rates are currently front of mind for investors. Although it has taken a few months longer than anticipated, the sharp move higher in global bond yields (which drives bond prices down) is in line with our expectations and our multi-asset portfolios have been positioned accordingly. The US 10-year bond yield is now 2.5%, up from 1.5% at the start of the year and a low of 0.5% only 18 months ago. This comes on the back of higher inflation. We expect US bond yields to climb a bit further over the remainder of 2022.
Since we last wrote about listed property in July 2021, global property has delivered a flat total return, in line with global equities, but well ahead of the negative 9% return from global bonds.
WHAT HAS CHANGED?
What makes the current environment different from the three most prominent and longest-lasting high-inflation periods in the 50-year sample set? First, these periods were in the early 1970s, the late 1970s, and the late 1980s and early 1990s. Much has changed in the world since then, the rise of the internet being the most obvious development.
Second, inflationary pressures today have emerged from a highly unbalanced post-Covid-19 economy, with excess spending on goods and underspend on services. While we expect this to reverse in the coming year or so, it has been in place for long enough now to lift the price of labour in developed markets. This creates a self-reinforcing cycle that central bankers will have to work hard to arrest through multiple interest rate hikes.
Over the past 25 years, global listed real estate has correlated more closely to global equities (0.71 correlation) than to global bonds (0.31 correlation). Our concern is that in an environment of higher bond yields, the correlation may increase, thus reducing the extent of diversification that property offers global investors.
Simple financial logic suggests that as interest rates rise, so must property yields, which of course means REIT prices should fall. But unlike bonds, REITs can and do pass on inflation to shareholders.
Global listed property has historically done well in inflationary periods for the simple reason that the lead times to create additional commercial property space (both office and industrial) are quite long, and most cities have limited new land available. The inflationary periods of the 1970s were also characterised by the entrance into the workforce of a large cohort of baby boomers, which increased demand for space.
LOWER DEMOGRAPHIC PRESSURE
Nowadays, demographic pressure is far lower, while technological advances have resulted in fewer people needing to work from offices. Also, around 15-20% of US retail sales are now online, reducing the requirement for retail space.
Global property is more diversified these days. Property stocks now offer exposure to much more than traditional office, industrial and retail space – there are also apartment rentals, free-standing houses, cell towers, laboratory space, data centres, hotels, storage, student housing, healthcare and more in the mix.
NEED FOR DISCERNMENT
In our view, investors currently need to be quite picky about their property exposure. The acceleration of online shopping through the Covid-19 period means that industrial warehousing to support this is in high demand, while traditional retail space may well continue to struggle.
Equally, while much of the world is now back at the office, attitudes have changed and companies are more willing to allow full-time remote work. We remain unconvinced about the impact of hybrid work arrangements as most office workers, given the choice, will work from home on Mondays and Fridays, leaving offices requiring just as much space on Wednesdays as they did pre-Covid-19.
On the positive side, global REIT balance sheets are in their best shape ever, with the ratio of debt to the market value of assets now below 30%, compared to an average of more than 35% over the past 20 years. Weighted average lease terms are also at record highs at around seven years, but given the spike in inflation, this is a two-edged sword that improves predictability while limiting inflation pass-through.
Over the past two months, while bond prices have fallen, global property has remained flat, protecting investors’ capital. Our concern is that the yield spread of property over bonds has narrowed from about two percentage points to one percentage point. This means that, all else being equal, the market is pricing in higher growth for property stocks – hence the need for discernment when selecting these stocks. We favour those areas of superior supply-demand balance such as housing, industrial warehousing, storage (outside the US) and laboratory space, while we remain wary of traditional retail and office space.
