Inflation and property equities – time to get ‘real’
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.
Key takeaways:
- 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?
Turning point
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, offering structural and secular growth and is capable of providing effective protection from inflation.
Footnotes:
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.
Glossary:
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.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
Marketing Communication.
Important information
Please read the following important information regarding funds related to this article.
- Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
- The Fund is focused towards particular industries or investment themes and may be heavily impacted by factors such as changes in government regulation, increased price competition, technological advancements and other adverse events.
- This Fund may have a particularly concentrated portfolio relative to its investment universe or other funds in its sector. An adverse event impacting even a small number of holdings could create significant volatility or losses for the Fund.
- The Fund invests in real estate investment trusts (REITs) and other companies or funds engaged in property investment, which involve risks above those associated with investing directly in property. In particular, REITs may be subject to less strict regulation than the Fund itself and may experience greater volatility than their underlying assets.
- The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.
Specific risks
- Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
- Shares of small and mid-size companies can be more volatile than shares of larger companies, and at times it may be difficult to value or to sell shares at desired times and prices, increasing the risk of losses.
- If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
- The Fund is focused towards particular industries or investment themes and may be heavily impacted by factors such as changes in government regulation, increased price competition, technological advancements and other adverse events.
- This Fund may have a particularly concentrated portfolio relative to its investment universe or other funds in its sector. An adverse event impacting even a small number of holdings could create significant volatility or losses for the Fund.
- The Fund invests in real estate investment trusts (REITs) and other companies or funds engaged in property investment, which involve risks above those associated with investing directly in property. In particular, REITs may be subject to less strict regulation than the Fund itself and may experience greater volatility than their underlying assets.
- The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
Specific risks
- Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
- Shares of small and mid-size companies can be more volatile than shares of larger companies, and at times it may be difficult to value or to sell shares at desired times and prices, increasing the risk of losses.
- If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
- The Fund is focused towards particular industries or investment themes and may be heavily impacted by factors such as changes in government regulation, increased price competition, technological advancements and other adverse events.
- This Fund may have a particularly concentrated portfolio relative to its investment universe or other funds in its sector. An adverse event impacting even a small number of holdings could create significant volatility or losses for the Fund.
- The Fund invests in real estate investment trusts (REITs) and other companies or funds engaged in property investment, which involve risks above those associated with investing directly in property. In particular, REITs may be subject to less strict regulation than the Fund itself and may experience greater volatility than their underlying assets.
- The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- The Fund may incur a higher level of transaction costs as a result of investing in less actively traded or less developed markets compared to a fund that invests in more active/developed markets. These transaction costs are in addition to the Fund's Ongoing Charges.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.