In this interview, Stephen Hayes, Head of Global Property Securities at First Sentier Investors, gives us an overview of Real Estate Investment Trusts (REITs) as an asset class. He explains how they behave in a stagflationary environment and reveals where he is finding the best opportunities and which areas he is avoiding. He finishes by describing how they can help the move towards decarbonisation.
REITs are generally considered to be a natural hedge to inflation as they are usually able to pass through higher costs in the form of rental increases.
In periods of stagflation, where growth slows, we would expect REITs that display greater levels of pricing power in the form of advantageous lease structures and a resilient demand profile to perform well.
Although REITs are generally safer, stagflationary environments can pose risks for certain types of REITs that may experience lapses in demand or have lease structures that don’t bode well in periods with higher inflation.
We expect that current macroeconomic conditions, comprising of higher energy costs, the start of the monetary tightening cycle and the potential for a slowing of economic growth will favour landlords that are able to maintain pricing power. More specifically, we are looking for assets that are supported by structural property themes, demonstrate resilient tenant demand, and maintain healthy balance sheets.
The Americas, although affected by macro headwinds, has shown to be comparatively resilient to other major markets. At present, we are pleased with the outlook for the apartments for rent, detached housing for rent and independent living retirement assets. The outlook for these property types continues to be supported by recent operational updates and have evidenced pricing power in rental contract renewals.
Current economic conditions are also seeming to create a unique investment opportunity in Japan. Japan provides access to comparatively modern and green “new-build” logistics assets that have a balanced demand & supply outlook as well as currently reporting historical low vacancy numbers. We are also positive on the large cap diversified property companies as they have shown significant improvement in ESG focus and are now attractively priced.
In the last few years, the world has gone through rapid change, particularly in the way we work, live and play, which we believe has had a lasting effect on the underlying value of certain property types.
The rise of E-commerce has had a lasting effect on the purpose of shopping malls and a variety of retail type tenants as they are slowly replaced by online alternatives or no longer need the space that they once occupied. This theme has been evident for larger department stores which typically occupied “big-box” space in shopping malls.
Similarly, increases in flexible working arrangements have led to a lower dependency on CBD (central business district) office space for corporates. Offices with larger floor plates in sub-prime CBD locations may experience decreases in tenant demand in the future. Current data, suggests that the same theme is not present in prime locations, with assets offering modern and sustainable spaces for flexible work.
The tenant mix of these assets are dominated by large E-commerce companies which have been impacted by supply constraints and cost inflation, as well as being impacted by a greater sell-off of growth equities. In a similar vein, interest rate hikes and the fears of a potential recession has detracted from market sentiment globally in recent months. Which brought the sector lower as investors looked to crystallise gains from last year.
Notably, a profit warning from Amazon earlier in the year sent the sector downwards as they announced that the growth seen throughout the pandemic period would not be able to be sustained. This directly affected logistics REITs globally, however some regions were less affected than others, for example Japan only has 20 Amazon facilities compared to the 250 in the US.
Although the sector has been impacted briefly by a market correction and sub-optimal news, we maintain that property fundamentals for the sector are still intact, with healthy competition for space and sustained rental growth for logistics and warehousing landlords.
Decarbonisation is the most urgent and important challenge we have as investors. By understanding how our portfolio impacts the climate, and engaging with REIT owners to drive positive change, we believe we can make a difference.
As the global population approaches 10 billion, the world’s building stock will likely need to double in size*. Given that the global real estate sector already creates one-third of global greenhouse gas emissions**, we have a significant responsibility for reducing those emissions.
Our net zero analysis covers five areas. The first is operational carbon, which comes from completed buildings, and is generated from activities such as lighting, cooling, heating, and running appliances. In order to reduce operational carbon emissions, modernisation is key.
The second is embodied carbon. This relates primarily to the start and end of life of the assets, from demolition to construction. This is a critical part of the carbon puzzle: it’s estimated that 74% of total emissions from new buildings between 2020 and 2030 will be from embodied carbon***.
Then there is on-site energy generation. Buildings are conducive to on-site energy generation, particularly solar. Photovoltaic cells costs have fallen in recent years, and where a building’s surface area has the appropriate orientation, installing solar panel systems can deliver compelling economic returns while also reducing emissions.
The fourth area is procuring renewable energy. Retail electricity providers are becoming more sophisticated in offering negotiated renewable energy procurement contracts with large energy users such as REIT owners. As a result, relative costs have fallen in many countries and renewable energy uptake has increased among building owners.
The final area is carbon offset. It’s not realistic for buildings to eliminate their emissions altogether – in the short-term at least. So, at the moment, carbon offsets play an important role in reaching net zero, for example land and forest regeneration projects, which have significant long-term benefits for the environment.
Investors can access REITs through a number of different vehicles. As well as the First Sentier Global Property Securities fund run by Stephen Hayes, Chelsea investors can access REITs through the likes of Cohen & Steers Global Real Estate Securities and CT European Real Estate Securities.
*Source; World GBC – Bringing Embodied Carbon Upfront, Sept 2020
**Source: World GBC - Advancing Net Zero – Asia Pacific Embodied Carbon Primer, Sept 2020
***Source: World GBC - Advancing Net Zero – Asia Pacific Embodied Carbon Primer, Sept 2020
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the manager and do not constitute financial advice.