What do higher inflation expectations mean for AREITs?
Since the pandemic shock of early last year, investors have more recently focused on the after-effects. Record government stimulus, monetary policy easing and the roll-out of vaccination programs are now intersecting with the gradual lifting of lockdown restrictions.
These forces are feeding rising inflation expectations, expressed through a sharp increase in nominal bond yields. Last November, the Australian 10-year nominal government bond yield moved through 0.80%. Since then, it has taken just four short months to pierce a high of 1.90%, settling at around 1.70% more recently.
This is important because the government bond yield, or risk-free rate as it’s sometimes known, is a reference for the theoretical valuation of all manner of financial assets but especially ‘bond proxies’ like AREITs.
The theory is that as the risk-free rate rises, returns from assets like AREITs falls. That’s certainly been the case in Australia of late. With investors moving out of cash and listed bond proxies into more cyclical opportunities, AREITs underperformed the broader market by about 4% over the initial period of calendar year 2021 (they have since recovered some ground returning 6.30% in March).
Oddly, this hasn’t been the case in the United States, which experienced a similar rise in the risk-free rate. As the chart below shows, although nominal bond yields in the US increased by a comparable 0.70% so far this year, REITs outperformed by almost 5% in local currency terms.
There are a number of possible explanations for the difference, including the composition of Australia’s equities market and our relative success in combating the pandemic. It’s also possible that increasing nominal bond yields in the US was more than offset by expectations of a strong US recovery, driven by massive fiscal stimulus.
But there’s another possible explanation. Recent bond yield movements might be no more than the correction of extreme risk aversion when the pandemic was at its height.
According to CLSA, for most of the post-GFC period 10-year US government bonds typically yielded 2-3%. In Australia, especially over the last five years, a period characterised by weak growth and low inflation, a government bond yield of 2-4% was not uncommon. The recent rise in bond yields might therefore be seen as a return to normality.
If this is the case, there is less reason for income investors to worry about the return of inflation, especially as the ingredients for pronounced long-term inflation – labour capacity constraints and wage inflation – are yet to emerge. The fact that the Reserve Bank doesn’t expect inflation to reach its target band of 2-3% per annum for at least the next few years (with similar implications for bond yields) is another reassuring factor.
It’s easy to consider rises in bond yields and deduce that “bond proxies” like AREITs will underperform as inflation expectations rise but it’s not that simple. Even if higher inflationary expectations become a reality, in our view the prospects for future AREIT returns remain positive.
There are two reasons for this. First, a sustainable rise in general pricing levels and economic growth should be welcomed. Governments and central banks the world over have been working to engineer this for over a decade. It is odd that this imminent prospect is now a source of concern. Weak wages and economic growth have bedevilled the world for years. If the return of inflation heralds the end of these two things, income investors should be relieved rather than worried.
Second, the best protection against actual inflation (not just the expectation of it) is to invest in real assets. Commercial property leases typically include annual rent escalations equivalent to or above the consumer price index, or a fixed percentage of annual rent, often above the prevailing rate of inflation. Commercial property rents have in-built inflation protection.
A similar argument applies to capital values. Because asset revaluations incorporate consideration of replacement costs, rising inputs costs through higher material and labour charges are ultimately incorporated into asset revaluations.
Given these qualities, real bond rates (those adjusted for inflation expectations) are a better guide for commercial real estate investors than nominal rates. So, what might they reveal?
The graph below shows that while nominal bond yields may have increased sharply, inflation expectations look to have accelerated by a relatively greater amount. This has resulted in the real bond yield increasing by a smaller amount and remaining below zero.
This suggests that the relative AREIT underperformance which characterised the beginning of 2021 appears to have been in response to sharp nominal bond yield movements rather than the market’s conviction positioning for a higher real bond yield.
Where does this leave income investors? Relative to real yields, research by JP Morgan suggests that both prime commercial property cap rates and AREIT dividend yields are at levels above the historical average. This implies the AREIT sell-off has been overdone (March returns reiterate this) and is most likely a knee-jerk response to rising nominal bond yields.
Recent research by Morgan Stanley also suggests this is nothing new. During eight periods when bond yields increased over the last 20 years, AREITs underperformed. However, when bond yields ultimately settle after a period of increases, AREITs have historically outperformed. In six of the last eight cycles, AREITs outperformed by an average of 8% against broader equities. Presumably, this fact is not well known by investors currently reducing their exposure to AREITs.
This analysis leads to one unmistakable conclusion. AREIT investors focused on relatively high, sustainable levels of income while maintaining the purchasing power of their underlying investment should not be too concerned by short-term market reactions to increasing nominal bond yields.
As long-term investors in listed property, we welcome sustainable increases in general price levels and economic growth and see the current period as one of opportunity rather an indicator of future trouble.
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Mark is part of the Investment Team tasked with analysing and investing in global real estate-sector equities. He is an Associate of the Australian Property Institute, a Certified Practicing Valuer and a CFA charterholder.