22 March 2018
If inflation starts to rise around the world, as is currently predicted, it will be an overwhelmingly positive outcome for long-term real estate investors, according to a recent paper by global listed real estate investor Quay Global Investors, “Going up: what high inflation means for listed real estate”.
“A common reaction to higher bond yields and higher inflation is to ‘sell yield’ – which invariably includes REITs. This is particularly true for inexperienced investors and equity managers,” says Chris Bedingfield, co-founder of Quay and author of the paper.
“However, our research shows this reaction would be a mistake.
“Certainly 2018 may be the year that accelerating inflation finally returns, and the US Federal Reserve may hasten a rise in interest rates. In the short term, this could have negative consequences for listed real estate as unsophisticated investors may sell REITs in a knee-jerk reaction to abandon ‘interest rate sensitive sectors’. We have seen some of this play out already this year.
“For longer-term investors, however, rising inflation is unequivocally good for real estate. It drives higher levels of replacement cost, which underwrites current values and ensures new supply (when needed) will occur at a progressively higher price.
“This is why real estate has a reputation as one of the best asset classes to protect against any erosion of purchasing power.”
Chris says history shows that during periods of high inflation, such as the 1970s and early ‘80s, REITs delivered an attractive real return compared to equities.
“During periods of high inflation, listed real estate did an outstanding job in protecting the real purchasing power of investor capital. For instance, between 1970 and 1985, US REITs delivered a real return of 7.1 percent per annum, compared to 1.9 percent per annum from the S&P 500.”
Chris points out that higher bond yields, if sustained, can only be due to higher inflation expectations or higher real return expectations.
“If it turns out to be the former, listed real estate is likely to preserve and grow capital in real terms as higher construction costs underwrite higher values over time.”
Chris acknowledges the view that higher discount rates reduce the net present value of future cashflows and therefore current share prices, but says this isn’t necessarily the case.
“While it sounds counter-intuitive, for real estate valuation it doesn’t matter where bond yields are in 10 years. If it costs $20,000 per square metre to build an office tower in Manhattan by the year 2028, then prices will be at or around this level. If higher inflation means it is closer to $30,000 per square metre, then prices are sure to follow, or supply is forever constrained.
“In this way, real estate ensures the protection of purchasing power. If purchased well (below replacement cost) and sensibly financed, it can deliver outstanding long-term real returns.
“Meanwhile, in this scenario, corporates will fight among themselves in a tight labour pool and battle against rising wages and rents to maintain earnings. Across the three ‘factors of production’ of land, capital and labour, capital is the likely loser – a stark reversal of the past 30 years,” Chris says.
Since inception in July 2014, the Quay Global Real Estate Fund has returned a net 12 percent per annum, beating its index by 4.5 percent per annum (as at 28 February 2018). Quay has been nominated in the 2018 Lonsec “Fund Manager of the Year” awards in the Emerging Manager category, and the Fund is also nominated in the Global Property Securities category.