One of the biggest headaches that investors face in this climate is finding a steady income that has some protection against inflation. This isn’t a new thought: we’ve been wrestling with declining yields on most investments for more than a decade. But for much of that time, the big risk from inflation was what might happen in future rather than the immediate trend.
That risk no longer seems so far away. Prices are rebounding strongly as we emerge from the pandemic. UK consumer price inflation hit 2.5% in June, the highest for three years; in the US the inflation rate is 5.4%, a level it hasn’t reached since 2008. Yet central banks are saying they see this as transitory and so monetary policy is likely to remain loose.
This may yet be true – and it’s certainly hard to see how policymakers could justify tightening policy at this stage anyway, regardless of what they actually believe. But the risk that higher inflation expectations will take hold and bring us into a new era of steadily rising prices is evident in a way that it wasn’t for most of the 2010s. That means we are going to need to worry more urgently than before about which investments are going to respond best to inflation.
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This brings us to real-estate investment trusts (Reits): companies that own income-producing real-estate assets and receive preferential tax treatment in exchange for passing most of their rental income onto shareholders each year. Reits differ from real-estate development companies in that, even if they carry out some development work as part of their activities, their main focus is supposed to be on owning and operating a portfolio for long-term income. Other listed real-estate companies often focus more on making capital gains from developing and selling properties, and won’t necessarily pay steady dividends.
Real estate is an asset class with distinctively different properties to other major asset classes such as cash, bonds, shares or precious metals. Listed Reits provide a simple, liquid way for any investor to build a diversified portfolio in an asset class where direct investments require high minimum investments and are quite illiquid. Thus they occupy a very useful niche in the investment world between bond-type investments that pay a fixed income and equities with dividends that are often less steady.
What inflation means for real estate
Investors often say that real estate should offer good protection against inflation. As with many things in investment, this statement is probably broadly true, but is also a sweeping generalisation that disguises a lot of variation in returns and a good deal of uncertainty about what the future holds.
Returns on real estate come from two things: the rental income you receive and any change in the market value of the property. So when we think about whether real estate will beat inflation, we could be talking about either of these. Taking rental income first, if the economy is solid and the real-estate market is tight enough to allow inflation to be passed on through higher rent, a property that is let on a short lease (or allows for regular rent reviews) will see its rental income keep pace with inflation more consistently than one that is on a long lease with limits to how much rent can be increased before the end of the agreement.
The market value of the property on the other hand depends on a combination of the rent it will pay and the rate of return that a buyer requires on a property of that type (known as the capitalisation rate or cap rate). Cap rates will depend on a number of factors including the rate at which rents might grow and the risks associated with the property, but will be related to some kind of interest rate or bond benchmark (typically the yield on a ten-year government bond is used as the risk-free rate in calculations like these).
So if inflation takes off and growth remains fairly strong, but central banks hold down interest rates and so bond yields remain negative in real (after inflation) terms, then a good quality property with short leases will probably see rental income keep pace with inflation (because rents can be increased steadily) and capital values rise (because the low real bond yields will keep cap rates low). A property with longer leases may not pass on inflation into rents so steadily (there may be lumpy increases as leases expire), but capital values may still rise because cap rates remain low.
Conversely, an economy with high inflation and sluggish growth, where the central banks begin raising rates aggressively to try to squash inflation, might be very bad for real estate in the short term, because landlords may struggle to push through rent increases while rising bond yields mean higher cap rates and so lower capital values (all else being equal).
In short, there are a lot of moving parts, so it’s no surprise that studies that try to determine whether real estate is a good inflation hedge seem to produce quite inconsistent results. It also doesn’t help that many of them try to measure how closely real-estate returns move with inflation in the shorter term – eg, over a year – rather than whether they will keep pace with inflation over three years or five years. The first is the strict definition of a true hedge, but the latter probably matters more to most investors.
Broadly speaking, historical data seems to suggest that real-estate returns are not a perfect hedge in the strictest sense, but that they should outpace inflation over time. For example, UK commercial real estate substantially outstripped inflation over the period from 1947 to 2009, according to analysis done for the Investment Property Forum. However, during the 1947-1967 period of low inflation and the 1981-2009 period of declining inflation, the majority of this return came from rental income. In contrast, during the inflationary 1967-1981 era, capital growth became by far the more important part of returns.
This is important: it tells us that, in an inflationary world, we can’t necessarily expect a steady real increase in Reit income, but our total return including capital gains is likely to help us keep inflation at bay. So given the likely scenarios for the world over the next few years, I see Reits as an important part of my portfolio. That said, picking Reits that will either be able to pass on inflation, have solid underlying growth prospects or are starting at attractive valuations will be important. We are starting from a position where yields in general are comparatively low by historical standards and where the impact of the pandemic has had a serious impact on rental prospects.
Much more than offices and shops
The global Reit market covers a wide range of different sectors and is more diverse than a lot of investors realise. The traditional sectors are offices, retail, industrial and residential. Several of these sectors then span a number of sub-sectors. Some include variations on a similar theme: retail could be major out-of-town retail parks, local shopping centres or individual high-street properties – which are all ultimately about consumption and leisure, but are driven by different forces. Others are quite different: the industrial sector includes warehouses and distribution logistics, but also science parks occupied by technology and pharmaceutical companies.
Other slightly smaller but well-established sectors include healthcare (another broad category that includes facilities as disparate as hospitals, retirement homes and laboratories) and hospitality (ie, hotels and similar). More recent years have seen rapid growth in new niches such as self-storage facilities, infrastructure (often telecoms towers and networks) and data centres, but there are also longer-standing speciality Reits such as timberland. You’ll also occasionally find quite esoteric Reits (or business trusts that work in a similar way) that own less obvious real-estate-based assets such as golf courses – since these tend to have few listed peers, analysing them and knowing what to expect can be unusually tricky.
Many Reits today are diversified across more than one sector. A Reit that owns offices will often naturally end up owning some retail space as well. Established industrial Reits or office Reits have been expanding into growth areas such as data centres for some time, while some retail Reits are looking at converting some of their space into logistics to adapt to the threats of e-commerce.
Returns from all of these will be driven by the specific markets where the Reit invests rather than the sector alone, but we can look at long-term returns for US Reits (by far the biggest market and with the best data) to get some idea of trends. Between 1994 and 2019, residential Reits (ie, apartment buildings – not single private houses) returned an annual average of 12.1%, industrial returned 10.9%, offices 10.6% and retail 9.8% (diversified did worse at 8% – maybe it pays to focus on a single sector). If you break down the return between capital and income, the income return is similar between sectors at 5%-6%, suggesting that investors did a good job of spotting which sectors had the best income prospects and bidding up share prices accordingly. Among smaller sectors, healthcare did well (11.8%) while hospitality did notably badly (5.1% – all of which came from income). Self-storage (which has a longer history in the US than in the UK) had an exceptional return of 15.2%, driven by capital growth (the income component was similar to other sectors).
This data is interesting in setting expectations (anybody buying a hospitality Reit should ask themselves why the sector has such a poor record and why their choice might do better), but when it comes to what to expect now, we’re concerned about two main factors: how lease lengths interact with inflation and how the pandemic has affected long-term trends.
Flexibility to respond to inflation
Lease lengths determine how rapidly rents can rise to reflect market conditions. For example, hospitality, self-storage and residential tend to have short lease terms (ranging from almost day-by-day to around a year), industrial and some retail operators tend to have middling terms (a few years), and office and healthcare tend to have longer lease terms (a decade or so in some cases). Some longer leases will have provision for inflation-busting rent increases built in, some won’t. You’ll also see some Reits own buildings built for and let to a client on a long lease that spans many decades, where the tenant is responsible for most operating expenses – these are known as net lease Reits. Their leases will often provide for inflation-linked rent increases and may offer a steady real income stream, which can be attractive. The trade-off is that the Reit doesn’t have the opportunity to shop the property around to potential tenants for bigger rent increases every few years if the real-estate market is booming.
Broadly, we’d expect Reits with short leases to be able to pass on inflation most easily and thus investors might favour them, especially if underlying demand for the kind of assets they hold is strong. Set against that, the past couple of years have been good for Reits that focus on logistics and data centres. The shift to online retail and the growth of digital services had already been benefitting them, but the coronavirus pandemic accelerated the trend. Thus Prologis, the largest US logistics Reit, and Equinix, which runs data centres, are both up by about 120% since the start of 2019. This isn’t confined to the US market: UK-listed Segro, which owns logistics space across Europe, has done similarly well, as has Singapore’s Keppel DC Reit, Asian’s first data-centre trust.
In all these cases, while historical earnings growth has been decent, the share price has outstripped recent growth: for example, Segro was on a trailing yield of around 2.8% at the beginning of 2019, which has now fallen to 1.7%. Meanwhile, investors worry about the outlook for offices and retail Reits and shares have fallen to reflect this. Land Securities, the largest UK commercial property Reit (a mix of offices and retail), was on a yield of 4.6% at the beginning of 2020. It suspended dividends for much of 2020 as tenants ceased paying, but has resumed at around 60% of the previous level. It yields 3.9% and dividends should hopefully rise as the economy gets back on track.
These differences make Reits very interesting. Investors can buy a fund such as the iShares Developed Markets Property Yield ETF (LSE: IWDP), with a portfolio of around 300 stocks. But there is also plenty of opportunity to build a portfolio with a mix of growth and value that will hopefully offer protection against inflation. I’ve outlined my holdings below.
The 11 Reits in my portfolio
I take the view that fears about the future of offices and retail are overdone – people will work from home more and many weak retail companies will go bust, but good-quality space will still remain in demand. Rents may drop in some cases, but Reit share prices fell by enough during the panic to reflect that. So I was a keen buyer of Land Securities (LSE: LAND) and British Land (LSE: BLND) and I think they remain solid recovery plays even though I am not especially optimistic for the UK economy.
I also bought Boston Properties (NYSE: BXP), the largest US office Reit, which has rebounded more but remains below its highs. In Europe, I hold Aroundtown (Frankfurt: AT1), which predominantly owns offices in Germany. This is not a Reit and it puts more focus on procuring and improving distressed properties. I generally favour Reits that focus on prime properties, but this has a decent record of steadily growing dividends. I’ve been a long-term shareholder in Capital and Integrated Commercial Trust (Singapore: C38U), which is a mixed office and retail Reit. The dismantling of Hong Kong’s special status by China makes me bullish about the outlook for Singapore as the obvious alternative regional base for many firms.
Ascendas Reit (Singapore: A17U) holds industrial assets, including logistics, science parks and data centres. Around 60% of the portfolio is in Singapore, with the rest in Australia, the UK and the US. It offers a higher yield than Reits of similar quality in markets such as the US and UK, although it’s important to note that properties in Asian markets such as Singapore and Hong Kong are typically held on a fairly long leasehold from the government rather than freehold (hence any uplift in the value of properties that a Reit owns due to growth or inflation is partly offset by the steady reduction in the remaining term of the lease).
Notwithstanding my suspicion that hospitality is the long-term laggard of the Reit space, I also bought into Ascott Residence Trust (Singapore: HMN) last year. This has a global portfolio of short-and medium-term accommodation. As demand returns, it should offer a decent yield on the current price. I also hold Starhill Global Reit (Singapore: P40U), a smaller retail Reit with assets in Singapore, Malaysia and Australia. I’ve had this for a while because it’s controlled by a fairly competent Malaysian property group that I expect to source new properties for the portfolio over time. This hasn’t happened so far and my return on investment so far is modest, but the shares look cheap now.
Real-estate investment in emerging markets is somewhat different to buying solid assets in developed markets: you have to worry more about economic volatility, corporate governance and (in some places) the security of private-property rights. So I mostly don’t see it as part of a core Reit income portfolio. That said, I think Ascendas India Trust (Singapore: CY6U), which owns IT parks and logistics, is an interesting growth prospect. Also on the growth theme, it seems likely that healthcare research will be a huge investment focus after the pandemic and that should benefit firms that own offices and laboratories leased by science firms. I hold Alexandria Real Estate Equities (NYSE: ARE), the largest and most focused US Reit in this area. Finally, timber is potentially an interesting inflation hedge and a play on housing demand (both through the use of lumber in construction and the chance to sell land for development). I hold Rayonier (NYSE: RYN), one of four US-listed timber Reits.
Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.
Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.
He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.
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