As concerns around global inflation grow, there is a common belief that property investments will suffer in this environment, especially if there is added interest rate pressure. However, Andrew Parsons, Fund Manager of the Nedgroup Investments Property Fund, strongly disagrees and says that not only can global REITs produce competitive risk-adjusted returns, but they can also act as an effective inflation-hedge. 

It’s important to look beyond the noise and focus on the fundamentals. There is long-term evidence that real estate is capable of being an inflation hedge. Inflation tends to occur in a strong economic environment, which tends to lead to rising property prices and steep rental increases, providing growing distributions from REITs. 

Parsons says the argument that a higher-inflation environment will cause REITs to suffer doesn’t hold true due to some fundamental characteristics of REITs. Firstly, over the past 25 years, operating income (rent) for REITs outpaces inflation over the medium/long term. The reason for this is that inflation-related income streams from property, such as rent reviews, tend to be CPI-linked and there are fixed rent escalators greater than inflation built into agreements. Furthermore, increased building costs mean that developers typically require higher rents to justify new supply. So new buildings coming online are more expensive than existing building. Prologis expects replacements costs in the US to increase 20%-25% over the two-year period through 2021 – this will be the fastest rate ever. 

Crucially, for real-estate to be a good investment, we need to have solid underlying supply and demand conditions. And for REITs we need the added feature of appropriate and disciplined capital management. If either of these features are not present, then the argument around inflation becomes superfluous. Global REITs are well-placed post-Covid to deliver returns – both from a capital management and a supply/demand point of view. 

Global REIT management teams have been improving balance sheets as they were forced to adopt responsible through-cycle capital management and have de-leveraged during the low rate environment. Furthermore, real-estate fundamentals are encouraging. Vacancy rates are moderate, if not low, and new building supply is far from excessive and continues to be constrained. Meanwhile conditions for strong tenant demand are manifested in global economic growth tracking at circa 5%. The key is to look for real estate attuned to the nature of today’s economy. Economically relevant real estate will continue to have pricing power. These are businesses intertwined with trends such as digitisation, e-commerce, health, omni-channel retail and shelter. 

In the US, residential REITs are actually enjoying robust pricing power, increasing rents at an unprecedented level. This is significant as a signal for inflation as residential rents are a constituent of US CPI calculations. The market does seem to be taking the view that broader inflation pressures are temporary. However, understanding this dynamic and the broader impacts of Covid and QE is beyond the scope of mere mortals, so it’s important to separate the narrative from the fundamentals. If real estate is heading for a period of excessive supply and falling rates, or if the sector is lacking capital discipline, then any talk of an inflation hedge is academic.