- Record-low and slowly increasing interest rates may continue in the coming years.
- Combined with rising inflation, this is making it difficult to generate critical inflation-adjusted returns needed for income-oriented investors.
- Real estate as an investment has a history of delivering strong returns through various rate and inflationary environments.
- We believe investment managers who build an all-weather strategy that can deliver real income in low rate/rising inflation environments are positioned to succeed.
“How long can the low-rate environment last?”
We suspect that question is top-of-mind for investors across the globe. While no one can definitively answer it, rates are anticipated to increase at least twice in 2022 and the amount of debt with a negative yield across the world is on the rise. Adding insult to injury, inflation and inflation expectations are also increasing, further eroding the already-low real yields sought by these investors.
Negative yielding debt is once again on the rise
Value and percent of negative yielding debt globally
This reality begets a similar but even more important question: “How long can I last through the low-rate environment?”
Central bankers have all but promised to keep rates low and easy money flowing in the coming years. This doesn’t bode well for those seeking income and safety, particularly when adjusting for inflation. Considering this, we at the multi asset solutions team believe that investors who are seeking income would be wise to prepare their portfolios for the so called “lower for longer” rate environment, in which some asset classes have the potential to deliver this critical income much better than others.
Enter real estate.
Real estate’s real income
Real estate is generally considered to be an asset class that can deliver consistent, real (i.e., inflation-adjusted) income in many different rate environments. Since the peak of interest rates in the United States in 1981, quarterly real income returns on U.S. real estate investments have averaged about 3.84% on an annualized basis.1 Notably, they’ve also demonstrated significant stability over time and have almost never been negative. Admittedly, in Q2 2021, we saw a negative real income return for the first time since 1981 due to an inflation print that was the highest since that time, but with inflation likely to moderate, we expect that to reverse course. Still, this is in stark contrast to benchmark government bonds, which generated respectable inflation-adjusted income when rates were high, but which, in the last decade, have often been negative—particularly over the last year.
Real estate has historically delivered stable, real income
Quarterly nominal 10-year U.S. yield vs real estate real income returns (%)
U.S. benchmark real yields are creating new lows
U.S. 10- and 30-year real yields
Real estate’s propensity to deliver consistent inflation-adjusted returns is in no small part thanks to its ability to help protect against the detrimental effects of inflation. Real estate, however, is a deep asset class, and not all of its sub-sectors are necessarily created equal in terms of their ability to deliver the necessary real returns. Building a real estate portfolio that can deliver consistent inflation-adjusted income over the long term—despite a decreasing rate environment that shows no signs of ending in the near future—necessitates a careful and methodical approach.
Finding opportunities in a diverse asset class
Real estate as an investment comes in many forms, and to fully understand its ability to deliver real returns thanks to its embedded inflation hedge, we must consider each property sub-sector—generally divided into apartment, retail, office and industrial. The real estate equity team’s view is that lease terms, whether property expenses can be passed on to tenants or not, and construction costs and lead times are the biggest factors affecting real estate investments’ ability to protect against inflation.
- Lease length—We view the length of a lease as the element listed here with the greatest impact on the inflation hedge and therefore the ability to drive long-term real income through rent growth. In general, the shorter the lease, the better the hedge, as managers can best capture inflation through rent increases when contracts expire and are renewed. In this regard, apartments are the most attractive, as their leases are usually signed for one year.
|Average remaining lease terms||6.4||10.3||0.5*||5.5|
Source: Altus valuation benchmark, as of Q1 2020. *We assume typical apartment leases are signed for one year and the signing date is equally spread over time.
- Expenses passed to tenants—While property income generally increases during inflationary periods, rising maintenance and material costs for the building in question can be highly detrimental to overall returns—something that became all too real in 2021. Clauses can be added in contracts to help asset owners pass on these costs to tenants—this is critical to net operating income, margins, and therefore the inflation hedge. Such clauses are common in the real estate industry across all sectors, except for apartments.
- Construction costs and lead times—To be clear, real estate isn’t just about income, nor is its inflation-hedging ability; the value of the properties also plays an important role. An important driver of value is supply, and the more expensive and the longer it is to build real estate, the less supply usually comes on board. As prices of materials such as lumber, steel and copper are subject to global inflationary pressures, higher inflation will result in new projects being more expensive for property developers, limiting the supply and thereby increasing valuations of existing buildings. This dynamic benefits real estate sectors composed of assets with long construction lead times, since new buildings will take more time to hit the market once the cost environment becomes attractive, creating a demand/supply imbalance that can driving prices higher. In short, the value side of real estate can also provide an inflation hedge, but it’s important to factor in the construction process.
All of the sectors have some elements that add to or that detract from the ability to hedge inflation and therefore have the potential to deliver real income. For example, while office properties have long lead times, high construction costs that are tied to global inflationary pressures, and expenses that are generally passed through to tenants—factors that improve the inflation hedge—the fact that leases are usually long limits their ability to hedge against inflation. It’s also important to note that even the criteria aren’t etched in stone; for example, construction costs and lead times can vary significantly in urban versus suburban areas, and therefore our table below should serve as a general summary rather than a definite list.
Don’t chase real income—build it
While inflation and inflation expectations can change rapidly, it’s important to note that real estate’s ability to deliver consistent real returns in the long run can’t be built overnight; it can take months or years to buy or sell a property for the right price, and by the time the portfolio has been revamped to position itself for a low rate/high inflation environment, the environment in which it was meant to thrive may be gone.
Considering this, the multi-asset solutions team believes that chasing inflation expectations isn’t a prudent strategy; instead, we prefer investment managers build an all-weather strategy that can help deliver real income even with a low-rate and rising inflation environment, while also ensuring our portfolios—both our multi-asset strategies and the underlying strategies—thrive in all environments. In other words, if they expect to enjoy respectable inflation-adjusted income, we believe that real estate owners must keep a long-term view, even during slower inflationary periods.
In the experience of the real estate equity team, there are three key elements that can help a real estate portfolio capture inflation and then have the potential to deliver the necessary real income: sector and geographic diversification, sound lease maturity management, and prudent and proactive capital expenditure programs.
Sector and geographic diversification
To be able to properly capture inflation with higher rent increases, real estate managers need a supportive underlying economic landscape, or at least one that’s not too detrimental to tenants within a given sector or region. In a weaker economy, tenants’ financial positions may be compromised, leading to rising vacancy rates and/or an inability for owners to raise rents; this may result in a weaker local real estate market and can reduce properties’ income generation, even if inflation is elevated. As a result, it’s critical to be diversified by both region and sector to stave off any detrimental impacts of a weak environment in any given sector or locale.
Structural shifts in the economy also affect different sectors in different ways. For example, as it stands, we view industrial and multi-residential as better positioned to capture rent growth, given increasing e-commerce and a perpetually under supplied housing market in the United States. Retail, on the other hand, faces headwinds because of the rise of e-commerce, while office might see less demand due to hybrid and at-home work models post-COVID-19 that reduce demand and limit owners’ abilities to grow rents in certain buildings and markets.
In short, dislocations between global or national inflation and local economic health can be detrimental to real estate managers’ ability to capture inflation. In the United States, for example, we’ve seen a bifurcation in employment and population growth between growth markets in the Southeast, Southwest, and Mountain West compared to coastal, gateway markets. In Canada, we see similar differences across provinces or regions and gateway cities. Being overexposed to any one of these regions is a dangerous game, and we believe that the only way to counter these is through investment managers that apply strong diversification across real estate sectors and regions.
Lease maturity management
While higher inflation and inflation expectations can help property owners negotiate more appealing rent increases for new contracts and contract extensions, real estate leases—with the exception of apartments—are long, and those negotiations for a given asset may only happen once a decade. It’s important, therefore, at the strategy level, to have a laddered lease approach rather than having similar lease maturity dates across the portfolio. This diversifies contract termination dates, with contracts expiring on a regular basis rather than at the same time.
In other words, having more frequent contract renewals during higher inflation periods is crucial to capture the upside and hedge against inflation. Of note, if we think inflation is running too low at the time of a contract renewal, we usually try to sign a shorter lease to avoid locking in lower inflation expectations for too long—and vice versa when inflation is high—while keeping a healthy lease term distribution at all times.
Real estate is a highly competitive market, and existing and potential tenants can usually choose among a wide variety of properties with similar characteristics. It’s key that properties within the strategy remain well positioned in their respective market and attractive to tenants through tailored, long-term captal expenditures programs. Otherwise, all the efforts to manage leases to best capture higher inflation and deliver real income to investors would be damaged by tenants tempted to leave upon contract renewal, reducing occupancy rate.
Examples of capital expenditures that are likely to see returns to the asset owner include:
- Multifamily: unit renovation projects that result in higher rents after modernizing finishes and upgrading appliances
- Healthy buildings: Post-COVID-19, there is likely to be more emphasis and demand for healthier indoor spaces including air quality through improved filtration and ventilation. Given this, buildings with healthier qualities could be in a position to charge higher rents.
- ESG: We believe buildings that are more resilient and adaptable to potential impacts from climate change will be more desirable since occupiers want to be seen as engaging in best environmental practices. This means that owners of environmentally friendly buildings could demand higher rents than comparable buildings.
Keep an eye on the long term
It’s easy to get caught up in the hype surrounding inflation and its erosion of returns, especially in our ultra-low-rate environment. Certainly, short-term market realities aren’t something that a prudent manager can ignore, but it’s also critical to keep an eye on the long-run management of your portfolio. We believe low rates are likely to be the norm in the foreseeable future, and portfolios need to be built to deliver real income that can continually satisfy investors’ needs years down the road.
Real estate has a demonstrated history of delivering consistent, inflation-adjusted income, but not all real estate strategies are created equal. We believe managers who are truly focused on the future build all-weather portfolios that deliver income no matter what market realities exist. In our view, these are the strategies that are more likely to thrive over time.
1 Based on the income returns component of the NCREIF Property Index and U.S. quarter-over-quarter change in core CPI, as of Q2 2021.