- Commercial landlords can benefit from rising rents and asset values in an economic recovery
- However, sector selection has become more important following the pandemic as rental income is less reliable
The prospect of a post-pandemic bounceback in the economy and huge government stimulus has heightened expectations of rising inflation. As investors question whether central banks could intervene by raising interest rates faster than anticipated, and pulling back on asset purchasing, turmoil has ensued in some parts of the market.
Real estate investments could offer a port in the storm and benefit from a rising inflationary environment. However, the damage wrought by the pandemic on many businesses means that assets that may have previously risen faster in value than inflation are unlikely to offer the same protection.
The economic fallout from the pandemic and elevated levels of unemployment could keep a lid on inflation, but that has not stopped investors positioning for such a return. The yield on US 10-year Treasuries last week reached a 12-month high, after the largest daily sell-off since the pandemic-induced volatility last March. Inflation is anathema to bonds as it erodes the value of the fixed payments investors receive. Meanwhile, pricey tech stocks have also pulled back as the market questioned whether the low long-term interest rates underpinning their lofty valuations would disappear sooner.
“People are going to have to start thinking more about inflation in their portfolio regardless of when they think it’s going to come through,” says Ben Seager-Scott, head of multi-asset funds at investment specialist Tilney.
Analysis by Schroders (SDR) of US asset performance between 1973 and 2020 indicates that real estate investment trusts (Reits) have provided good protection against inflation. Reit returns exceeded inflation during 69 per cent of rolling 12-month periods when inflation was low – below 3 per cent – but rising, making it the third best performer after equities and Treasury Inflation Protected Securities. When inflation was high and rising, Reits beat inflation during 67 per cent of the respective 12-month periods, the second best performer after commodities.
Reits can provide inflation protection as a recovering economy should feed through to rising rental income and boost the value of the underlying assets in the portfolio. Some Reits have an implicit inflation linkage, particularly prevalent among health and care landlords that let properties on leases of around 20 years.
Care home specialist Target Healthcare (THRL), increases most rents annually in line with retail price index (RPI) inflation. Meanwhile, GP landlord Primary Health Properties (PHP) has a portion of its leases linked to RPI inflation, with rents increased in line with the index at review every three years. Reits in both sectors pay generous inflation-linked dividends.
The delay between inflation rising and rental income increasing can serve as a reminder that Reits often only protect your wealth if you hold them for the long run, says Phil Smeaton, chief investment officer at Sanlam Private Wealth. “There’ll be lags to it, it will take time for leases to be renegotiated, it will take time for clauses to kick-in and for inflation to move that higher,” says Smeaton.
In a rapidly rising inflationary environment, short income streams are more desirable, argues Tom Walker, co-head of global real estate securities at Schroders. Self-storage specialists are a good example, he says. "The landlords of [those assets] can adjust their prices very quickly to keep up with inflation," says Walker.
However, identifying where demand for space will endure and give landlords the ability to grow rents is the most crucial consideration in identifying Reits that might offer inflation protection. Within the commercial real estate market, that task has become tougher given rent collection rates have suffered as tenants have come under increasing financial pressure.
Logistics is the one area where consistent rental growth looks sure to continue, argues Rachel Winter, associate investment director at wealth management specialist Killik & Co. “There is the ability there for companies to raise rent,” she says. “For offices and retail we are still at a stage where we really don’t know what’s going to happen with that.”
Indeed, warehouse distribution landlords such as Segro (SGRO) and LondonMetric (LMP) have benefited from rising warehouse demand associated with e-commerce and efforts to strengthen supply chains, alongside barriers to constructing new sites that have restricted supply. Rising rental income has also backed steadily rising dividends.
For office assets, which typically have five-year leases, the chances that rents will continue to be raised at review are more uncertain. Rents attached to retail properties have continued to march downwards as structural challenges have exacerbated the structural oversupply of space and weakening covenants of potential tenants.
There is also the effect of the rising interest rates, which could greet rising inflation, on retail landlords who are already struggling to balance weakening income streams with their own debt obligations.
“If you’re in a sector that still has serious challenges and the companies that you’re looking at actually have high levels of debt, then your inflation issue isn't about the asset side of the balance sheet it’s about the liabilities side,” says Marcus Phayre-Mudge, manager at TR Property.
The anticipated end of lockdown restrictions could see a continuation of the rally in value shares that has emerged since the start of the year. Yet the fundamental challenges facing some commercial landlords seem likely to curtail any sustained re-rating.
Structural demand within the private rental, logistics and healthcare sectors helped Reits operating in those sectors generate the highest total returns in 2020. Those resilient rental income streams and dividends make them well placed to outperform against rising inflation.
