Property equities portfolio managers Guy Barnard, Tim Gibson and Greg Kuhl discuss the impact of rising expectations for inflation and interest rates on listed real estate.
- Market expectations for inflation and interest rates are rising as economies begin to recover post COVID.
- Historically, there has been a positive relationship between returns from property equities and rising inflation expectations over the longer term.
- Listed property currently has an attractive valuation, offers structural and secular growth and has also been shown to provide protection from inflation.
Inflation remains the topic du jour, and probably for good reason. Having been in a downward trend since 1980, falling from 15% to around 2% in the last decade based on OECD data, it is now on the rise.
What does this mean for property equities, and what are the implications from rising bond yields?
Bank of America (BofA) recently stated that they ‘believe a turning point for both inflation and interest rates has arrived and the 40-year bull market in bonds is over.’1 The investment bank’s view is based on the unprecedented supportive government policy measures worldwide, that will likely lead to inflationary pressures.
This is quite a headline-grabbing statement, and while only time will tell if it is correct, we have seen a recent pickup in inflation expectations and interest rates/10-year US Treasury (bond) yields.
How have real estate equities performed?
Intuitively we might expect that rising bond yields are as negative for real estate equities as they are for bonds: after all, rising yields result in falling prices, all other things being equal. In reality, however, it is much more nuanced. Equity markets (including listed real estate) by their nature are forward-looking and historically, there has been a low correlation between 10-year US Treasury yields and listed real estate returns over the long term.2 Recently we have seen global property equities perform well against broader equities even as 10-year US Treasury yields have risen.3
“Thankfully, the relationship between inflation expectations and real estate equities is a little clearer with, historically, a positive correlation existing, ie. as inflation expectations have risen, so too have real estate equities. This relationship has existed over the longer term, highlighting the potential for real estate equities to benefit from rising inflation expectations."
Figure 1: Property equities offer the potential for inflation protection
Source: FactSet, Janus Henderson Investors, as at 22 March 2021. Index year-on-year (YoY) percentage change from March 2004 to March 2021, weekly data, in USD terms. Breakeven inflation is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity and is taken as a more reliable measure of inflation expectations. Past performance is not a guide to future performance.
But why has property performed well when inflation rises, and will a rising tide lift all boats?
We often talk about real estate as being the ‘landlords of the economy’ whose income streams benefit from positive economic growth. A recovering economy typically leads to rising rental income and increases the value of underlying real estate assets. Rental contracts are often linked to inflation through annual uplifts or are reset when they expire, as can be seen from Figure 2.
Figure 2: Rental contracts often have fixed or inflation-linked annual uplifts
Source: National Council of Real Estate Investment Fiduciaries (NCREIF), US Department of Labor, CEIC, Refinitiv Datastream, UBS estimates as at Q1 2021. Net Operating Income/NOI measures an income-producing property's profitability before costs from financing or taxes. NOI growth calculated as the sum of four quarter-on-quarter NOI growth, CPI/Consumer Price Index (inflation) calculated is the sum of four quarter-on-quarter growth.
However, there is a distinction between property sectors. When it comes to rental negotiations, rising inflation tends to have a bigger positive effect on sectors that have pricing power.
The acceleration in real estate trends as a result of COVID-19 has seen certain sectors negatively impacted such as shopping centres, regional malls and hotels. However, others have been uplifted by strong secular tailwinds, such as e-commerce, cloud computing and changing demographics. Industrial, logistics and real estate tech (eg. cell towers, data centres) are among the sectors that are likely to benefit the most.
We do not know the exact direction or magnitude that inflation and yields will take, but believe it is becoming increasingly difficult to overlook an asset class that currently has an attractive valuation [see link to previous article], offers structural and secular growth and is capable of providing effective protection from inflation.
1BofA Global Research, The Case for Real Assets, 25 March 2021.
2Source: FactSet, Janus Henderson Investors, as at 22 March 2021. Based on rolling quarterly data since 1990 for listed property equities (FTSE EPRA NAREIT Developed Index) versus 10-year US Treasury yields. Correlation measures the strength of a relationship between two variables. A low correlation suggests a weak relationship, ie. both variables move in opposite directions while a high correlation suggest a strong relationship with both variables moving in the same direction.
3Source: Refinitiv Datastream, FTSE EPRA NAREIT Developed Index versus MSCI World Index in USD terms 31 December 2020 to 20 April 2021. Past performance is not a guide to future performance.
Bull market: a market condition when asset prices such as bonds or equities continue to rise.
Bond yields: the level of income on a security, typically expressed as a percentage rate. The return on a bond has an inverse relationship with its price. When yields rise, bond prices fall, and when yields fall, bond prices rise.
The FTSE EPRA NAREIT Developed Index is designed to track the performance of listed real estate companies and real estate investment trusts (REITs) worldwide.
OECD: Organisation for Economic Co-operation and Development.