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Higher inflation and real estate impact

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MEDIA RELEASE: Investors in Australian Real Estate Investment Trusts (AREITs) may want to consider what impact the prospect of higher inflation will have on company valuations and specific property sub-sectors, says Grant Berry, AREIT Portfolio Manager at SG Hiscock & Company.

“While we don’t have a crystal ball, we believe we are more likely to see higher inflation in a post-COVID world than prior to the pandemic, for a number of reasons, and investors may want to adjust their portfolios, particularly as inflation has not been a consideration for them in recent years,” Mr Berry says.

He points to a number of reasons for likely higher inflation, including:

  • Supply chains impact – while much of the disruption will be temporary, there will be a greater desire to diversify supply chains moving forward. Geopolitical forces are another factor to this but equally as significant
  • The multi-decade deflation from globalisation is not the tailwind that it has been in the past
  • The significant support of monetary policy has its limitations, with the rise of fiscal policy as a consequence of the COVID-19 pandemic, which is more inflationary
  • The advancement of technology having deflationary forces has merit; however, technological advancement is not new and we have had strong inflation before in periods of rapid technological advancement
  • The demographic drivers of an ageing population and its impact on consumption should also be considered in the context of an ageing and retiring workforce and what this means for wages
  • The political ramifications of wealth inequality primarily in the US
  • The “stickiness” of short-term inflationary pressures.  Will prices rapidly retreat should supply chains improve?

Mr Berry says for investors, the best way to position a portfolio for rising inflation is to hold properties that: offer higher yield (less repricing pressure should bond yields rise); are inflation linked (ideally inflation plus rental increases imbedded in lease agreements); have shorter lease terms where rents are at or below market levels (enabling positive resetting of rents in an inflationary environment); and tenants whose businesses are less impacted by rising inflation.

“As part of this, we are focused on investment opportunities in REITs that have quality underlying property assets, attractive valuations, rent-sourced income and diversification, while avoiding those with equity characteristics and high multiples,” Mr Berry says.

At the same time as the prospect of rising inflation, investors also need to review whether they are genuinely exposed to real estate assets, particularly as Sydney and Melbourne re-open.

“Not all AREITs are equal, with some having significantly less exposure to real estate than the name suggests.

“Increasingly, a number of companies that are classified as REITs are generating the majority of their earnings from activities such as funds management (through management and performance fees) along with development, rather than from owning real assets.

“This means investors may be taking on a very different type of risk profile than they realise while paying a higher multiple for it.

“There is no doubt that REITs with yield based on rental income suffered most during the  lockdowns. However, those who bought them last year have been rewarded with recovering distributions and, importantly, security prices.

“As economies reopen, the retail sector in particular is poised to experience a major shift, and investors in REITs would be wise to check whether they are in a position to be take advantage of the opportunities in this sector.

“In the office sector, while flexible working will be more pronounced than prior to COVID, business conditions will be the key driver of tenant demand.  For example in Perth, office “people occupancy” has declined around 20 percent  during the pandemic due to increasing flexible working.  However, interestingly the official PCA Vacancy Rate in the Perth CBD has declined by 3.6 per cent to 16.8 per cent – the lowest level in six years, supported by strong economic conditions.

“This highlights that changing “people occupancy” levels do not automatically correlate to corresponding building vacancy levels as the office may have peak and off-peak demand days.

“For the past 5 years we have observed a “flight to quality” in the office space and we expect this trend to become more pronounced. Softer leasing conditions in Sydney and Melbourne put tenants in a stronger position to strike favourable deals with landlords and the demand for higher quality space as we emerge from lockdown will accelerate this trend. Investors will therefore need to be selective to deliver the optimal outcome.

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