The previous two years were eventful, to say the least, for real estate markets. They were turned upside down in 2020 by COVID-19 and then resurrected last year. Most economies have now reopened and are actively employing strategies of “living with COVID”. Private core real estate witnessed an exceptional year of performance in 2021, largely driven by the logistics and residential sectors.
For example, in the US, the NFI-ODCE (NCREIF Fund Index – Open End Diversified Core Equity), which comprises open-ended, core, unlisted, diversified equity real estate funds in the US, delivered a record year of performance. The coming years are expected to deliver attractive, albeit lower rates of return. The biggest risks for the sector exist in the form of further escalation in geopolitical conditions, prolonged high inflation, rising interest rates, and potential subsequent COVID-19 variants.
Real Estate Sectoral Trends
E-commerce growth and a reconfiguration of supply chains continue to drive logistics performance. In the US, the sector delivered the best annual performance in 2021, achieving the highest yearly total net return for a traditional sector on record. The residential sector also prospered last year. Strong demand outmatched supply, further constricting vacancy levels and engendering rental growth. In the office sector, work-from-home policies induced by the pandemic have led to lower absorption rates. This has hampered valuations since the onset of COVID-19. However, absorption picked up towards the backend of 2021. A desire for office space in high-quality, well-located properties with ESG credentials is evident. Owners of buildings that fit the aforementioned criteria are best positioned for a reshuffling of space. Retail suffered from the proliferation of e-commerce throughout the pandemic and for most of last year. Some stability and comfort formed around yields towards the end of 2021. Encouragingly, investment activity has picked up, and vacancy rates are lower than the peak witnessed during the pandemic. A focus on well-located stores, experiential elements, and food-anchored assets remains paramount.
Real Estate as an Inflation Hedge
Prolonged, soaring inflation presents a potential headwind for real estate. It may lead to subsequent, notable interest rate hikes, which could have an impact that reverberates throughout most asset classes. Real estate is, however, well-insulated against inflation. The developed world last dealt with prolonged periods of high inflation in the 1970s and 1980s. Real estate demonstrated its inflation hedging characteristics over these phases. It has historically outperformed other traditional asset classes in inflationary environments for the following reasons:
- Property values tend to rise with the overall price environment. Higher prices for labor, land, and materials used in construction can raise the economic threshold for new development.
- New supply can easily become constrained as a result, supporting higher occupancy rates, and providing landlords with greater power to raise rents.
- Real estate sectors with shorter lease durations – such as residential, self-storage, senior housing, and logistics – can take advantage of inflationary rents relatively quickly.
- Commercial leases commonly have explicit inflation links, particularly in Europe, with rent escalators tied to an inflation rate. In the US and Asia-Pacific region, several sectors that have longer average lease lengths have built-in annual rent escalators, which provide a partial inflation hedge.
- Shorter-term rental contracts (typically used for residential and self-storage) can be regularly adjusted to match market rents, and thereby act as an inflation hedge.
Higher inflation and automatic rent increases should lead to a continuation in rental growth, improving on the last two years’ growth rates, which were impeded by the pandemic. This bodes well for returns going forward. Please see the table below for our historical and expected income returns and rental growth for SFP AST Global Core Property:
In the recent past, total net returns for real estate have been elevated as a consequence of strong capital appreciation, which was reinforced by low interest rates and high demand. Further increases in interest rates appear imminent due to higher inflation. We do not expect to see similar levels of yield compression in the near future. Therefore, rental income will represent a greater proportion of total returns over the coming years. This promotes the case for a core real estate investment strategy emphasizing on income returns.
Conservative Financing & ESG
Further interest rate rises are expected in the US and Europe. They will have a blanket impact on investment markets. Core real estate and investments with lower debt to equity ratios will be less susceptible to this effect, however. Moreover, funds with a focus on ESG can raise debt through green bonds at notably lower costs than for comparable standard bonds. We have a strong focus on core funds with low leverage levels and ESG-oriented approaches. Our ability to analyze the sustainability efforts of underlying funds has been enhanced since becoming a GRESB Investor Member. We continuously evaluate the long-term environmental targets of our underlying funds and host ongoing discussions with them to gauge their progress regarding net zero carbon targets. The risks of stranded assets, which will face leasing difficulties without extensive capex injections, will increase for owners that are not active in the sustainability space. The table below conveys our portfolio’s ESG targets and progress for the 2021 GRESB assessment.
Conclusion
Our outlook for the global real estate markets remains positive, supported by solid rental growth and attractive income returns. Central banks are forecasted to continue increasing their interest rates in small increments, in response to high inflation. We have witnessed substantial increases in developed nations’ 10-year government bond rates since the start of the year. However, further rises are expected to remain limited. Real estate yields, which are typically measured against these rates have not followed suit. We do not expect them to drastically move outwards as the asset class remains attractive due to its inflation hedging properties, amongst other factors. Moreover, in most developed nations, spreads between real estate yields and 10-year government bond rates nations are still sizeable. Employing a core strategy in the global real estate space will enable investors to best-navigate the coming circumstances due to inflation hedging through in-place contracts with fixed annual increases and inflation links, and defense against interest rate rises owing to low leverage levels. A focus on ESG is imperative. Lastly, due to an increased perception of risk and volatility, a well-balanced portfolio with minimal concentration risk regarding diversification offers security.