Inflation up, interest rates up, REITs... Up ? Not the other way around ?!
Welcome to the 4th edition of our Global REITs newsletter. This week, we'll dive deep into the complex relationship between REITs, inflation, and interest rates, offering valuable insights for investors in these turbulent times.
Contrary to conventional wisdom, REITs often thrive in periods of moderate to high inflation. A key contributor to this behavior is the fact that it is usually during these periods that market rents also increase (we explain further ahead some of these dynamics). Summed to that, rents are allowed to be adjusted by inflation in most countries. These positively affects dividends which in turn directly impacts REITs prices. We can clearly see this in the graph below which compares annualized inflation vs. income growth.
These characteristics make REITs a compelling addition to a traditional portfolio of stocks and bonds. They offer a blend of both asset types with low correlation, on average, enhancing the portfolio with a positive contribution to the Sharpe ratio.
A study by Cohen & Steers, represented here by the graphs below, found that REITs have outperformed the S&P 500 in 87% of periods when inflation was 3% or higher since 1978. Besides that, in the graph below, the higher the inflation the higher REITs performance among the three levels of inflation environment.
An interesting way to get a sense of the relation between Inflation and asset class return is seeing this in terms of Beta as shown in the graph below.
Although real estate is considered to be a strong hedge against inflation, it's crucial to note that not all REITs are created equal in this regard.
Different REIT sectors respond differently to inflationary pressures:
1. Multifamily and Self-Storage: Often perform well due to short-term leases allowing for quick rent adjustments.
2. Industrial and Logistics: Benefit from increased e-commerce demand and supply chain reconfiguration.
3. Office and Retail: Face challenges but may offer value opportunities in prime locations.
Key Findings on Inflation and REITs:
The Interest Rate Conundrum
Rising interest rates have been a significant worry for REIT investors. However, the relationship between REITs and interest rates is more complex than it might appear at first glance.
REITs and Monetary Tightening Cycles
Monetary tightening cycles, often implemented to combat inflation, can initially raise concerns for REIT investors. However, historical data paints a more optimistic picture:
During monetary tightening cycles, real estate developers often face significant challenges that can impact the supply of new properties in the market. One of the primary concerns for developers is the uncertainty surrounding future construction costs. As interest rates rise and inflationary pressures mount, the cost of materials, labor, and other construction inputs can become more volatile and difficult to predict. This uncertainty makes it challenging for developers to accurately budget for their projects and to predict if future rent growth will be sufficient to offset the inflation and financing costs effect on property transacted prices and on valuations.
Furthermore, developers also contend with the reduced availability of capital to finance their projects. When central banks raise interest rates to combat inflation, borrowing costs for developers increase as banks and other lenders adjust their rates accordingly. Higher borrowing costs can make it more difficult for developers to secure the necessary financing for their projects, as lenders become more cautious and selective in their lending practices. This tightening of credit conditions can create a significant barrier for developers looking to initiate or complete new real estate developments.
Below is a chart illustrating the performance of REITs during and after the last three monetary tightening cycles by the Federal Reserve, highlighting the periods of tightening and the subsequent two years.
As a result of these dynamics, the delivery of new real estate supply to the market often slows down during monetary tightening cycles. The combination of uncertain construction costs and reduced access to capital can lead developers to postpone or cancel planned projects, limiting the amount of new space being added to the market. This reduction in new supply can, in turn, help to support or even increase market rents, as the existing stock of properties faces less competition from newly constructed buildings. In such an environment, REITs that own prime properties in the best submarket locations may be able to capitalize on the constrained supply and potentially achieve higher rental income growth.
Conclusion
While the current economic environment presents challenges for REITs, it also offers significant opportunities for discerning investors. By understanding the complex interplay between REITs, inflation, and interest rates, and focusing on quality and diversification, investors can position themselves for long-term success in the global REIT market.
REITs' ability to potentially outperform other asset classes during moderate to high inflation periods, combined with their resilience during and after monetary tightening cycles, makes them a compelling addition to diversified investment portfolios. As always, investors should consider their individual financial goals and risk tolerance when making investment decisions.