In this Q&A, portfolio managers Guy Barnard and Greg Kuhl discuss REITs’ performance to-date, stagflation concerns, and the impact of rising costs on the sector.
- Despite concerns that slowing growth will weaken earnings, the recent quarterly reporting season showed strength among those REITs exposed to areas of structural growth.
- Stagflation and rising energy costs remain a risk. Landlords with pricing power are increasingly differentiating themselves and should see more resilient demand and growth.
- Should bond yields and interest rates move significantly higher, this will impact property capital values. However, most REITs have been very proactive in recent years improving their debt position, which should reduce the exposure to short-term rate rises.
- There is an increasing focus on the sustainability of buildings, where there is a huge polarisation in tenant demand and asset value between more sustainable buildings and those that lack these characteristics.
Q: How has listed global real estate performed year-to-date?
A: The year to-date has proven to be a challenging period for markets broadly. With geopolitical, inflation and growth concerns causing investor expectations to rapidly adjust, most notably around the path of monetary policy, very few asset classes have been left unscathed. Amid a more uncertain backdrop, global property stocks have also seen a decline in recent weeks, triggered by rising real (inflation-adjusted) yields and investors underwriting the impact of slowing economic growth or recessions on real estate income streams.
Despite concerns that slowing growth will pressure earnings growth in broader equity markets, the recent earnings season for REITs proved to be strong for companies especially those exposed to areas of structural growth. Positive company outlooks re-emphasised how well-placed sector fundamentals are, with strong tenant demand and limited new supply driven by an increasingly challenging backdrop for new construction. Additionally, the theme of mergers and acquisitions in the sector has continued, with large private aggregators of real estate seeking to take advantage of listed real estate stocks trading at wide discounts to private market valuations.
Q: Are investors' current concerns around stagflation justified?
A: While real estate will not be immune to the changing macro-economic landscape, its ability to provide more dependable income streams, diversification benefits, and inflation protection over time, should provide some protection. Within the sector, fundamentals are likely to reflect a wide divergence across different property types in the years ahead, driven by the themes of changing demographics, digitisation, sustainability, and the convenience lifestyle. These secular themes are benefiting property types such as residential, industrial, technology-related properties, and hotel/lodging. It therefore remains important, in our view, to remain selective.
The importance of management, asset and balance sheet quality (financial strength) are also likely to come to the fore again. In markets like today, when credit markets are weakening, exposure to businesses with stronger balance sheets are more likely to be rewarded.
We have yet to see signs of a slowdown in demand across most commercial real estate property types. For the most part of last year and to-date, we've had strength across the board in just about every property type from retail through to industrial. For example, in US apartments we have seen double-digit rental growth on a year-over-year basis, depending on the market and specific asset. We're seeing similar rental growth in industrial properties, as well as healthy growth in hotels, driven by strong demand and an element of limited supply across these property types. A question that we’re often asked is, “is that rent growth sustainable?” It's pretty tough to sustain something like 20% year-on-year rent growth in US apartments. But it doesn't necessarily mean that growth will slow dramatically based on the high occupancies that we're seeing and the continued willingness of customers to accept higher rents.
On the lower side of the growth spectrum are office and retail, parts of the property market that we believe are facing structural headwinds to growth. Office rents have been flat and haven’t really recovered to pre-pandemic levels. In retail we're seeing low single-digit growth in rents as well.
Q: Can you comment on the impact of rising inflation on REITs?
A: We have seen a positive long-term correlation between inflation and real estate. Real estate companies are the landlords to the global economy. Typically, as economies grow, so does property demand and so do rents over time. While not being a guide to future performance, historically, REITs have typically generated their strongest returns in periods where inflation is at medium to high levels versus the 2% inflation targets in recent years.
What we’re experiencing now is cost-push rather than demand-pull inflation. In this environment, pricing power is a big advantage, but only when underlying tenants are experiencing strong business levels and confidence is high. Within some areas of real estate inflation costs can be passed through to tenants via higher rents, meaning a positive level of real (inflation-adjusted) income can be achieved with current levels of inflation. But there are also parts of the market where inflation is going to put pressure on tenants, as wells as business and consumer confidence. This creates risk either in over-renting (too high rents) or when leases expire, vacancy levels could be higher and are rising. So, I think there are some areas that we do have to be mindful of, and with current inflation around 7%, 8% in some economies, these levels of inflation are not going to correspond to the same level of rental growth on average.
Q: How are landlords and developers affected by higher input costs and supply constraints?
A: In terms of input costs, there is some pressure on the construction market. Speaking to various companies across different markets, you might be looking at around 10% year-on-year increases, in some cases more in terms of construction costs. The availability of raw materials can be more challenged as well as the labour side of the equation. The good news is that construction is typically planned in areas with strong tenant demand. So while input costs might be on the rise, if rents are moving in the same direction as well as the property yield investors are willing to pay for, you could still make that margin. But I think we do need to be mindful of the risks around new construction.
Finance costs are clearly a very significant component too. Looking at the credit markets today, REIT balance sheets are generally in a good position. Leverage (debt levels) is not too high; companies have been very proactive in recent years extending and fixing their debt book, so that their actual exposure to short-term rises in rates and the impact of that can be limited. But I think the risk premium piece is something we have to be mindful of. If we do see bond yields and interest rates moving significantly higher from here, then clearly this will impact capital values. Expectations of capital value growth have clearly come down, having had a really strong run in recent years, which is something we have to monitor carefully from here.
Q: Given the situation in Russia and Ukraine, how big an impact are energy prices and energy cost inflation impacting the REIT sector?
A: Tenants will be reconsidering the total cost of occupation. Rising energy costs may limit landlords’ ability to move rents significantly higher. This is a scenario that needs monitoring, we need to see how it plays out over the next six to 12 months.
What is likely to come to the fore is a stronger focus on the sustainability of buildings, particularly in areas like the office market where there is a huge polarisation in tenant demand and asset value between more sustainable, environmentally efficient, energy efficient buildings and those with much lower levels of sustainability and energy efficiency.
We had a discussion with a very large US industrial landlord. The company is rolling out solar energy production across their massive industrial logistics assets and believes it could be a leading renewable energy provider. As battery storage technology is improving, instead of selling excess energy that's not used within the buildings back to the power grid, they can save that to energy on site and sell it to their tenants. Selling that back at retail prices rather than back into the grid at wholesale prices could be really meaningful to the company’s earnings. Given rising energy costs, there’s an attractive opportunity for companies with more sustainable buildings and in particular, those that can benefit from the ability to harness solar energy.
Those property companies that show a strong and ongoing commitment to Environmental, Social and Governance (ESG) considerations are more likely to be rewarded with premium valuations by the market. Active management enables company interaction and engagement, which are key to understanding, underwriting and improving ESG outcomes.
Q: Amid ongoing uncertainty, what REIT characteristics will be increasingly important moving into the second half of the year?
A: Pricing power and balance sheet strength, which we touched upon earlier will be key differentiators in a slowing growth dynamic. For those landlords with existing buildings where there's a continuing demand for space, they have fixed assets where costs might not increase as much as for some other businesses and within inflationary environments. But rentals do tend to increase with inflation and with current supply and demand fundamentals. We think what will be increasingly important is the quality of balance sheets and access to capital. There are many investment grade-rated companies in the listed REIT space, with an increasing advantage versus companies with weaker balance sheets in the public markets and also compared with private market participants in real estate who generally don't have a strong cost of debt capital in comparison. We think companies with low leverage and strong balance sheets will be increasingly appreciated by the market as the year unfolds.
REIT or Real Estate Investment Trusts invest in real estate, through direct ownership of property assets, property shares or mortgages. As they are listed on a stock exchange, REITs are usually highly liquid and trade like shares.
Monetary policy relates to the policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money.
Commercial real estate relates to property used only for business-related purposes (non-residential).
Demand-pull versus cost-push inflation. Demand-pull inflation occurs when prices increase due to increasing aggregate demand and is associated with a healthy economy. Cost-push inflation occurs when the supply of goods or services is limited (eg. because of rising energy prices) but demand remains the same, pushing up prices.
Stagflation is an economic condition that occurs when there is a combination of slow economic growth, high unemployment, and rising prices.
Bond yield is the level of income on a bond, typically expressed as a percentage rate. Note, lower bond yields correspond with higher bond prices and vice versa.
Property yield is a measure of annual return on a property investment. It is calculated by expressing annual rental income as a percentage of property cost.
Real estate securities, including Real Estate Investment Trusts (REITs) may be subject to additional risks, including interest rate, management, tax, economic, environmental and concentration risks.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.
Environmental, Social and Governance (ESG) or sustainable investing considers factors beyond traditional financial analysis. This may limit available investments and cause performance and exposures to differ from, and potentially be more concentrated in certain areas than, the broader market.