Inflation-Hedging Real Estate Opportunities
Hear Rick Romano discuss why today’s inflationary environment can be positive for real estate investors.
As the world recovers and reopens at varying speeds, the real estate industry is transforming and offering new opportunities. While the uncertainty caused by the war in Ukraine and increased rate-hike expectations remain wild cards, the worst of the COVID-19 pandemic has passed.
Higher interest rates are undoubtedly a concern, but there are good reasons that the tightening cycle now underway in the U.S. or the tightening cycles which are expected to commence soon in most major global economies will not last long. Inflation should recede from its four-decade high, although stay elevated for some time given the lingering impact of supply-chain disruptions. Real estate is well positioned to perform well against this challenging macro backdrop.
Real estate’s recent performance in a turbulent economy suggests the industry is well positioned to weather whatever comes next—recession or no recession. Data from the first half of 2022 are holding up well—even in Europe, which is absorbing a direct impact from the war. However, real estate data typically lag other economic data as a result of such factors as fixed-term lease contracts, index linking, and infrequent valuation cycles.
Rising Rates: After the global financial crisis, real estate investment trusts (REITs) restructured their debt to strengthen their balance sheets and operating efficiencies. Today, REITs tend to have long-term fixed rate debt, which have largely been locked in at low levels. Additionally, net operating income margins have risen sharply and are now back near pre-pandemic levels. This has reduced their leverage ratios, meaning REITs should be minimally impacted by rising interest rates.
Reflation: Historically, real estate has demonstrated strong correlation with inflation, particularly in assets with short-lease duration and strong operating leverage. Shorter-lease-duration assets tend to appreciate the most when reflation takes hold, particularly those seeing strong demand, which allows lease holders to pass expenses along to their tenants. Residential properties, which offer inflation protection, are poised to benefit from reflation as improving cost controls and supply/demand imbalances should lead to above-Consumer Price Index operating income growth. Other sectors, such as self-storage and data centers, have little exposure to wage inflation.
Reopening: As the U.S. has largely reopened from the pandemic, U.S. real estate markets have seen a robust recovery from pandemic lows. Using the U.S. as a proxy for international real estate markets, hard-hit sectors should recover as business operations return to normal as economies around the world fully reopen. While many regions are currently trading at significant discounts, we expect share prices to bounce back strongly in consumer industries and travel, particularly in lodging and urban real estate. Because COVID-19 vaccinations are progressing at varying speeds across the world, this trend will likely continue for months, if not years.
Recalibration: Technology has enabled some REITs to take advantage of their scale and operating history to incorporate vast volumes of data into various aspects of their business. What will follow is a period of consolidation as some REITs acquire small to midsized trusts to realize value through efficiency gains.
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