Q: What are the biggest trends driving the real estate market today?
A: There are four key trends driving opportunity within real estate that either grew out of the pandemic or were accelerated by it – namely reflation, rising rates, reopening, and recalibration. Shorter term, real estate around the world is recovering in a reflationary environment that is forcing central banks to raise interest rates. Also, the reopening play still exists in certain parts of the world, such as the reopening of borders in Asia. Longer term, real estate is recalibrating to how the world is changing, with technology pulling forward trends that have been gaining traction for some time. These include the digital transformation of our personal and work lives, the need for affordable housing, an aging population across much of the world, and sustainability concerns.
Q: On the first theme, how does real estate perform during inflationary periods?
A: Historically, real estate investment trusts (Reits) have outperformed stocks significantly during periods of elevated inflation. Lease structures allow landlords to directly pass along CPI-type increases to tenants. At the same time, inflation increases construction costs, which deters new projects by making them less profitable. This keeps supply low, driving up the value of existing properties.
Q: But with inflation comes rate hikes. How will that impact Reits?
A: A rising rate environment can benefit real estate markets, as the focus on risk premium for these assets shifts toward their higher income potential. Managers learned important lessons from the global financial crisis, so Reits today have stronger balance sheets and should be minimally impacted by rising rates. Reit managers took advantage of the lower rate environment in recent years by refinancing into longer-term, fixed-rate debt. The combination of sharply higher net operating income and dramatically lower interest expenses now reduces leverage ratios and enables decent dividend growth. The long-term dividend growth rate for Reits has averaged about 8%. It currently stands at roughly 21%, which is well above the inflation rate and S&P 500 earnings growth expectations.
Q: What is your view on the valuation dislocation between public and private markets? Where should investors allocate capital now?
A: Allocating to both public and private real estate can help create a well-diversified real estate portfolio. Public Reits offer exposure to property types that benefit from secular growth tailwinds, compared with the harder-to-access private markets, which tend to be more cyclical. We currently see public Reits trading at a substantial discount to private funds, because Reits have already taken their medicine and probably overshot to the downside, offering investors a compelling opportunity to buy at wholesale prices. Private real estate has not yet corrected as much in terms of valuation write-downs. Public markets tend to lead private markets by about six to nine months, on average.
Q: How are you positioning portfolios given high inflation and rising recession fears?
A: We believe properties with the following characteristics are attractive in this challenging macro environment. Firstly, defensive tenant demand. Shelter, which everyone needs, is an example of defensive tenant demand. Mortgages become more expensive with rising rates, making renting more attractive than buying. Self-storage is also historically defensive. Healthcare, such as assisted living, medical premises, and hospitals, is another example. We look for long-lease durations, high-credit-quality tenants, and a diversified tenant base.
Next, pricing power. We want companies that can pass through rent increases above and beyond inflation. For example, urban apartments in the US have seen double-digit rent increases, with areas like New York City seeing 30% increases. Industrial leases signed five years ago are now renewing with 40% to 50% rent increases. These leases are being signed with annual CPI protection or fixed rent bumps of 4%-6% for five years.
Finally, attractive valuations. The ‘best buy’ candidates are companies that trade at large discounts to their real estate value. And the big disconnect between private and public real estate valuations creates a compelling arbitrage opportunity.
Q: Which areas do you see as the best prospects in the current environment?
A: Given the defensive tenant characteristics, we like apartments, manufactured housing, self-storage, assisted living, and healthcare. Geographically, we selectively favour Europe, where the market has been particularly hard-hit with war in Ukraine. Japan is also interesting, because it is one of the few developed economies with accommodative interest rate policy now. A weaker yen has historically been constructive for Japanese developers, Japanese Reits currently have high dividend yield spreads compared with sovereign bonds, and Japanese hotels should be aided by reopening and some consumer spending programmes.
