Does listed real estate provide a shelter from an inflation storm? Matthew Mowell investigates
There has been plenty of research into the inflation-hedging benefits of direct real estate, but what about real estate investment trusts (REITs)? Can US REITs, in particular, protect against purchasing power? And under which inflation scenarios would they respond positively?
Part of the answer lies in understanding the REIT structure. To operate under the REIT ‘wrapper’, a firm must distribute 90% of its annual taxable income to shareholders. This framework delivers an income return that is unique to real estate while also offering an investor exposure to the wider equity market.
The long-term performance of any REIT is ultimately tied to the underlying assets and investors’ confidence in the company’s management. The result is greater liquidity and price transparency. REITs also enjoy access to public capital markets, which can provide a material advantage over private buyers.
REITs outperform direct real estate during equity bull markets. US REITs outperformed the National Council of Real Estate Investment Fiduciaries (NCREIF) Property index (direct property) on a one, five and 10-year basis through 2012. But where ‘bricks and mortar’ real estate shines is on a risk-adjusted basis; during 1980-2012, the NCREIF index yielded a risk-adjusted return 30 basis points higher than REITs. Different investment styles also generate varying performance.
REIT and direct fund performance is ultimately derived from the same income and investment multiples of the underlying property market. On the surface, this may not be immediately obvious. A straight comparison between the National Association of Real Estate Investment Trusts (NAREIT) and NCREIF suggests a poor relationship. Returns for listed real estate returns mirror more closely those of the S&P 500 index. Since the year 2000, the correlation coefficient between NAREIT and the equity market has been a robust 0.74.
However, there is an empirical link between the NCREIF and NAREIT indices over the long-term, which deepens when lagging NAREIT performance by one year. And further, when looking at rolling two- to three-year average annual returns, the influence of ‘bricks and mortar’ on real estate securities generates a correlation coefficient over 0.70.
Arguably, this relationship will only improve as the listed market grows and plays a greater role in the real estate sector.
As investors grow more concerned about inflation, the relationship between indirect and direct real estate should become increasingly important. Such fears are not completely unwarranted. The US government has effectively embarked on a programme of monetising its liabilities, which could ultimately erode the US dollar’s purchasing power. In an inflationary environment, hard assets such as real estate have traditionally been viewed as an inflation hedge relative to fixed income and equities.
Inflation can have a marked impact on the performance of the direct property market. It is especially significant in the US, where many commercial leases are linked to CPI by a periodic ‘step up’ mechanism. In addition, heightened inflation can lead to higher construction costs, constraining development and driving rental growth of existing properties. Some research also suggests that inflation expectations cause capital to shift towards real estate, thus supporting outperformance.
So, if direct property performance and inflation are positively correlated, and direct property and REITs are correlated over the long term, do REITs also provide an inflation hedge? The answer is not straightforward. While there is a correlation between US CPI and NCREIF over the long term, it is not significant between NAREIT and US CPI. This divergence can be explained by the equity component of REIT performance, which is highly susceptible to the vagaries of the stock market.
Inflation can occur for a myriad of reasons and some of them can be beneficial for REITs. There is evidence that REITs exhibit outperformance during periods of demand-pull inflation, or when inflation is rising due to upticks in capacity utilisation and economic growth. Indeed, REITs outperformed a range of other asset classes when inflation peaked in 1996, 2005 and late-2009. This is sensible given that NAREIT has a higher beta value to GDP than other risky assets, such as high yield debt, industrial metals and direct real estate. Arguably, it is not inflation that drives this outperformance but REIT pricing trending higher on expectations that improving economic conditions will drive leasing and support earnings growth.
The less positive causes of inflation, such as a spike in commodity prices, result in different outcomes. In 1990, the 50% rise in oil prices when Iraq invaded Kuwait pushed CPI above 6%. Risk-based assets fell and businesses delayed investment, such as leasing space.
REIT valuations improve as investors anticipate greater income from the underlying assets. Therefore, when we ask if REITs can provide an inflation hedge, what is most relevant is REIT net operating income (NOI), which is directly tied to the underlying real estate, and CPI, which is highly correlated. The relationship between CPI and same-store REIT NOI growth is considerable, coming in at 0.75 during the past 12 years.
These inflation-linked cash flows may prove attractive in future years should recent central bank policy result in a period of higher inflation.
The impact that quantitative easing will have on future CPI is far from certain, however. The key concern is that if lender and business sentiment improves – initially positive for REITs – the dormant supply of money from the US Federal Reserve could be unleashed into the economy, which would be difficult to absorb.
In such a case, underlying real estate leases may catch some of the inflationary effects but the securities market may begin to demand greater premiums on stocks. Ultimately, the income component of REITs, which is linked to inflation, would be attractive relative to fixed income instruments, but the capital component of REITs would weigh on overall performance. However, any negative implications of rising interest rates on the capital component of REITs could be mitigated through portfolio diversification.
Matthew Mowell is a real estate investment analyst for the Americas at Standard Life Investments