Real estate feels impact of interest rates and inflation

Listed real estate funds have been hammered by rising rates although property is attracting attention as a hedge against inflation

The year so far has been very different for the two halves of the real estate market – listed and direct. Real estate investment trusts, or Reits, always sensitive to interest rates, have been hit hard by the rising numbers (see View from Morningstar). The direct part of the market however, has thus far proved more resilient, despite the gloomy economic outlook.

“In a pretty short space of time, really in the second quarter of this year, global Reits went from being a beneficiary of the inflation narrative to pricing in a negative scenario for the outlook for commercial real estate across pretty much every property type,” says Guy Barnard, co-head of global property equities at Janus Henderson Investors.

There have been some quite price dramatic moves and sentiment is low, he says, pointing to a recent Merrill Lynch fund manager survey for Europe which shows real estate stocks are the least favourite sector of the equity market

While the listed market is looking at the troubles that lie ahead, and have repriced accordingly, the direct market continues to look backwards and is seeing property values continue to rise, says Mr Barnard. “So, the million dollar question is: what is the right answer? And the truth is likely to lie somewhere between the two extremes.”

With the global economy entering “a very tricky period”, Mr Barnard is trying to identify companies with strong balance sheets and believes the Reit sector is in much better shape in this regard than it once was, with much lower leverage. The resilience of earnings streams is also key, he says, where landlords have pricing power or which have historically generated decent earnings growth even when economies have slowed.

With global Reits now trading at a substantial discount, this could provide an interesting entry point for investors, with the potential of some decent returns going forward. “These are long-term resilient cash flow streams, and earnings and dividends can continue to grow even as the economy softens if it is backed by some really high-quality real estate, strong balance sheets, good management teams and some really interesting assets across a wide array of different sectors,” adds Mr Barnard.

Inflation proof

European real estate securities do indeed offer attractive upside potential, believes Leonard Geiger, portfolio manager, European real estate at Choen & Steers, claiming that property fundamentals in Europe remain healthy. Furthermore, listed real estate has continued to offer attractive levels of secure and long-dated inflation-linked income relative to traditional asset classes, he says.

“Traditional asset categories may have less ability to defend against a prolonged environment of higher inflation than real estate companies, which generally have high operating margins, low commodity and labour price sensitivity, and – in many cases – inflation-linked rents,” adds Mr Geiger.

While all real estate has a tendency to be quite inflation-proof, some of it is “unbelievably good”, says Roger Clarke, CEO of IPSX, a regulated real estate stock exchange. “One type which is an outstanding hedge against inflation are very long-term indexed rentals, particularly if you have a tenant like the government. If you were able to get hold of property with tenants like that for 20 years indexed, it is almost like an index-linked bond and those are the most expensive investments in the world.”

Perhaps counter intuitively, at the other end of the spectrum, very short-term agreements can provide excellent inflation protection as well. “A good example is self-storage, which reprices all the time so you can actually pass on price increases regularly. So very long or very short are both good hedges,” adds Mr Clarke.

No guarantees

People do generally think of real estate as an inflation hedge, but investors would be wise to  caution against accepting that notion without critical thought, says Vincent Nobel, head of asset based lending, Federated Hermes Limited. “In an environment of high inflation and high growth, investors should be able to expect rental growth across the board. However, in the current environment of high inflation and low growth that doesn’t necessarily hold.”

For a start, it is “not entirely accurate” to say that rents are usually linked to inflation, he says. Some rents are, but many leases have no such indexing and usually rely on an “upward only rent review” which looks at “current rent” and “current market rent” and then picks the higher of the two.

These sorts of rent reviews would commonly be applied once every five years, while even inflation-linked leases might not actually be updated more than once every five years. Whereas some leases may only be three or five years in duration and may have no indexing of any kind included in the contract.

“Therefore there may be a limit on how much inflation hedging real estate provides, particularly in an environment of low growth where there is a limit to how much rental growth tenants can actually afford,” says Mr Nobel.

And, of course, higher interest rates will mean higher financing costs, something which those invested in leveraged strategies will have to consider. “This could mean that the real estate owner gets squeezed both on the income and the cost side,” he adds.

With public equity markets seeing relatively significant drawdowns, historically private real estate has been one of the few assets classes with a negative correlations to public markets, says Zsolt Kohalmi, global head of real estate and co-CEO of Pictet Alternative Advisors.

“With all the talk of recession, and people worried about significant drawdowns, real assets like bricks and mortar tend to be very popular for the simple reason that people are looking for things that will not lose their value in the way that any type of paper may.”

We are now in a very different rate environment, he says, though the US and Europe are in different cycles in a world which is becoming increasingly desynchronised.

“I think a very interesting question is: will rate rises really materialise in Europe? Because there are a lot of recessionary clouds on the horizon already. Europe is in a bad economic state given its proximity and dependency on Ukraine and Russia for energy and food. And, and so a lot of people would feel that, by the time we would have any meaningful rate rises in Europe, the cycle will likely turn because the fear will be recession. Unlike in the US and UK where rates have been raised much faster.”

European outlook

Although the European economy is likely to be harder hit than the US, Mr Kohalmi believes its property market may fare better. One reason for his assertion is the possibility of lower interest rates, as mentioned above, while the second is down to supply and demand. The US has been much quicker in permitting and building new real estate, he says, while Europe, despite the need, has been much slower out of the box.

“Banks have been concerned about lending against development, and the numbers of houses built, for example, have been way off government targets. So, while there are undoubted headwinds, the reality is that supply is still very, very low versus demand.”

But the headwinds remain very real, he cautions, not least the higher costs of construction and refurbishment, which are likely to slow future developments even further.

In addition, with sustainability high on the agenda, and the real estate industry being a significant carbon emitter, the sector is coming under the ESG microscope.

“If a company is looking to decrease its own carbon emissions, by far the biggest thing it can do is move into an environmentally sustainable building,” says Mr Kohalmi. There is therefore considerable demand for these types of buildings, yet with most of the carbon emissions occurring at the point of construction, the industry should be focused on refurbishment rather than building in an environmentally sustainable way.

“It is already the case that many pension plans can only buy environmentally sustainable buildings. So the price differential between climate resilient and non-climate resilient buildings is only going to increase going forward,” he adds.

Many real estate occupiers such as businesses, governments and NGOs have set ambitious targets to reduce greenhouse gas emissions, says Guy Sheppard, global market analyst, indirect real estate investment, HSBC Asset Management.

“Improving the quality of their office space, though less so retail and industrial space, is often a key component in achieving these goals,” he says, and there has been a notable shift in recent years for office tenants to focus on new or refurbished space with a leading green building accreditation.

“Evidence suggests such space achieves higher rents, more robust rental growth, and leases faster than space without a green building certificate,” adds Mr Sheppard. New buildings do tend to achieve higher green ratings, but refurbishment of older buildings is often the greener option as new steel and concrete production is kept to a minimum. However, not all buildings lend themselves to refurbishment due to their layout and original build quality, he cautions.

Greener path

The sector has made significant progress in tackling its carbon contribution, says Jessica Pilz, global head of ESG at Fiera Real Estate. But while green building certifications are a great badge to have, they do not always equate to strong environmental performance.

“A green building certification is only fully effective when the tenant is operating that building the way it was designed to be used from an environmental perspective,” she explains. “I think the primary objective of any business should be to decarbonise their operations and supply chains.”

Pressure from both regulators and investors is forcing many real estate companies to embark upon a decarbonisation trajectory, says Lucas Vuurmans, senior portfolio manager, listed real estate at Kempen Capital Management. “This is further accompanied by growing pressure from tenants themselves as they recognise that renting greener office space represents an effective way to reduce their own CO2 footprint. This is particularly true for the financial and law sectors.”

Consequently, modern green spaces are increasingly being rented at premium rates when compared to similarly located spaces that do not have green features, he adds.

Impact of Covid

Covid-induced lockdowns and the resultant work-from-home practices continue to impact the real estate sector, even as economies reopen.

The sector where the lasting effect of the pandemic is least clear is offices as markets continue to debate just how much the work-from-home trend will impact long-term office demand, says Lucas Vuurmans, senior portfolio manager, listed real estate at Kempen Capital Management.

“Large companies still find it difficult to commit to plans and office space as the situation fails to stabilise; space is still needed on Tuesday-Wednesday-Thursdays but less so on Mondays and Fridays,” he says. Meanwhile, employers remain reticent to push for a return to the office due to tight labour markets around the world, as flexible working arrangements remain one of the top three motivators for finding a new job, according to research by McKinsey, adds Mr Vuurmans.

The work-from-home concept has quickly morphed into work-from-anywhere, says Leonard Geiger, portfolio manager, European real estate at Choen & Steers. People are thinking differently about where they work, live and travel and while these new habits may have grown out of the pandemic, they are likely to stick around.

“This shift in work preference could have a significant and lasting impact on office and housing demand, driving the de-densification trend from larger urban locations to medium- or lower-density locations,” he says.

It also has implications for retail, as people tend to shop where they live, and for other property types such as leisure, as increased flexibility allows people to spend more time in the places they like, adds Mr Geiger.

VIEW FROM MORNINGSTAR: A challenging environment for Reits managers

The spectre of stagflation has dragged down real estate investment trusts (Reits) thus far in 2022, highlighting that strong performance in inflationary environments is no sure thing for real estate investors.

Often thought of for their ability to pass through rising costs to tenants and thus weather inflationary pressures better than other businesses, instead many Reits, and thus Reits-focused strategies, have underperformed the market in this period of high inflation. The average fund in the Europe/Asia/Africa (EAA) Indirect Global Property Category (which consists of globally diversified Reit funds) has lost 16.2 per cent through July 2022, versus a 14.6 per cent decline in the MSCI All Country World Index.

This performance is disappointing for investors who may have correctly anticipated elevated inflation, but sought Reits as a hedge. It appears many investors did just that; these strategies saw more than $23bn in investor inflows in 2021 across the US and Europe, higher than any other calendar year in history. Many are second-guessing that allocation, with more than $7.5bn in outflows in 2022 through June.

The performance demonstrates the challenges facing investors right now. For one, developed market central banks around the world (save for Japan) are hiking their policy rates in an effort to combat inflation, which has made it more expensive to borrow and reined in property values. In the US, for example, 30-year fixed mortgage rates peaked at 5.8 per cent in mid-June, levels not seen since the  financial crisis. Higher risk-free rates also make the dividends that Reits pay out less attractive, which can impact the share price.

Besides rising rates, many sectors are still struggling to find a post-Covid equilibrium. The two worst-performing Reit sectors this year are offices (-21.9 per cent) and regional malls (-30.5 per cent), two parts of the market whose future state is still unknown to investors. Others, like healthcare (-4.6 per cent) and diversified (-2.5 per cent) have held up better.

All these factors make for a challenging environment for Reit managers. Indeed, Reit strategies are not merely struggling against broad indexes, they are lagging sector-specific benchmarks as well. More than 80 per cent of EAA Indirect Global Property strategies are lagging the FTSE EPRA Nareit Developed Index, with the average fund trailing by 220 basis points. The dispersion across the best and worst Reit subsectors has made sector positioning important, with tilts to the wrong sector having an outsized impact on returns this year.

It may be that the worst is already baked into Reit prices, with the index up 10.7 per cent off the lows reached in mid-June. Even if that were not the case, an investment in a Reit fund can still benefit long-term investors seeking to diversify their portfolio. With a correlation of 0.74 to broad equity markets, a healthy 2.4 per cent yield, and lower historical volatility, a strategic allocation to Reits can help buoy a risk-conscious investor’s portfolio.

Bobby Blue, senior manager research analyst, Morningstar