Atop advisors' to do lists in 2021 are finding inflation-fighting and income-generating instruments for client portfolios. Sometimes, that task involves mutually exclusive asset classes, but there are examples of accomplishing those objectives in one group.
The real estate sector and real estate investment trusts (REITs), favored destinations for income and equity-based inflation protection, are springing to life at just the right time. The widely followed Dow Jones U.S. Real Estate Capped Index, which yields 2.08% on a trailing 12-month basis, is higher by 15.53% year-to-date. That after the sector was drubbed at the hands of the coronavirus bear market.
These days, REITs' encouraging performance is met with the group's utility in combating inflation, something that's often overlooked because some advisors have long leaned on other asset classes to fight rising consumer prices.
However, real assets, including real estate, have history on their side when it comes to trumping inflation.
Winning the Inflation Correlation Game
When the Consumer Price Index (CPI) jets higher, money managers frequently allocate to asset classes they think are correlated to inflation. However, what is believed to be correlated to inflation and what actually is are different things.
“Our observations show that just 7% of the capital in all Morningstar investment categories is allocated to asset classes with demonstrably positive correlations to inflation,” according to Invesco research. “These positively correlated pockets include asset classes like real estate, infrastructure, midstream energy, natural resources, and commodities (i.e., real assets), as well as bank loans and high yield bonds. One thing is clear: Investors who are concerned about the potential risk of rising inflation may want to consider a strategic allocation to real assets.”
Proving that REITs have the right inflation correlations, the group historically beats baskets of global stocks and bonds during periods of rising consumer prices. However, that's just one point in favor RETs in inflationary environments. There are several reasons why advisors should consider leaning into real estate today.
“In inflationary environment, the rising cost of land, labor, materials, and borrowed capital can cause developers to increase the price of new properties,” adds Invesco. “In addition, these rising costs can raise the economic threshold for new development, which in turn can limit the amount of new supply coming to market.”
Another benefit of REITs as inflation takes hold is pricing power. In most industries, commercial landlords and tenants engage in long-term leases that feature built-in escalators. Some of those increases are modest, but since they occur with regularity, REITs can drive more revenue and perhaps acquired funds from operations (AFFO) regardless of inflationary climates.
Right Now for REITs
Although the set up is favorable for REITs in a broad sense, advisors should be selective and consider limiting client exposure to mall and commercial office REITs because those are two corners of the sector where shifts caused by the coronavirus pandemic could prove permanent.
Conversely, growth for healthcare, industrial and technology REITs is likely to prove durable while gaming and hotel REITs offer leverage to the much-ballyhooed pent up demand story. Putting it all together, inflation has been subdued in the U.S. for awhile, perhaps too long. Changes to the that landscape could pave the way for REIT upside.
“Inflation in the US has been subdued since the global financial crisis. Yet the Federal Reserve has recently adopted a more dovish approach that could allow inflation to run above target in the aftermath of persistent inflation shortfalls,” concludes Invesco. “Investors who are concerned that the fiscal and monetary stimulus employed in response to the pandemic could result in higher inflation may want to consider a strategic allocation to REITs.”
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