Q1 2022 Commentary
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In our 2022 Outlook Report we detailed:
- how we see REITs as well positioned to serve as an inflation hedging role while benefiting from a continued recovery in operating fundamentals;
- how we believe the key to creating value will be identifying companies with pricing power that are able to raise rents on new leases and pass-through higher rental rates on existing leases to offset the impact of higher inflation, rising labor costs, higher utility expenses and property taxes; and
- how raising interest rates won’t alleviate supply chains disruptions, help with COVID-related factory closures, or overcome energy shortages.
The events that transpired in the first quarter do not change this view. What changed (and was unforeseen) was the Russian invasion of Ukraine and the pace at which monetary policy was likely to normalize.
The sanctions on Russia’s actions are changing the flow of commodities, exacerbating supply chain issues, and causing commodity prices to accelerate higher, creating a negative feedback loop for the economy by hurting consumer wallets and sending producer input costs soaring. Russia is the world’s second largest exporter of oil, making up about 12% of the global market and supplies Europe with 45% of its natural gas, 45% of its coal and 25% of its oil.
Hitting an all-time high, inflation in Europe rose 7.5% in March. Inflation in the U.S. increased by 8.5% in March, the highest rate in 40+ years and first quarter inflation in Canada reached its highest mark in 30-years. Concurrently, job creation is robust, and wages and rents continue to push upwards.
Similar to the thought process in the 1980s, the only way to halt inflation is to raise interest rates high enough to choke off demand and stall its growth. As it relates to the path of monetary policy, fundamentals for global economic expansion are robust and the retreat of Omicron has unleashed another round of pent-up demand across North America, Europe, and parts of Asia.
Going into 2022, we believed that the expectations were for moderate interest rate increases.
Today, according to our models, the market is pricing in over a 200-basis point increase in interest rates from the U.S. Federal Reserve, Bank of Canada and the Reserve Bank of Australia; 125 basis points from the Bank of England; and nearly 50 basis points from the European Central Bank.
Central banks around the world are decidedly hawkish in their quest to fight inflation, which is why yields have risen by so much so quickly and why yield curves are flattening with some markets like the U.S. inverting at points along the curve.
So where does that leave us?
We do not believe a recession is likely in the near-term, but economic growth is likely to slow in subsequent quarters, pressured by rising gas prices, higher interest rates and cost inflation. At the same time, labour markets are tight, unemployment is low, corporate profits and dividends are poised to continue to grow and demand for goods and services in Asia should improve over the next 12 months, as those markets have fully re-open.
From a real estate point of view, fundamentals are healthy. Occupancy rates are high, rent collection rates are back to pre-pandemic levels and balance sheets are in good shape.
- Demand for rental housing and demand for commercial space across most property types around the world is strong.
- Supply is limited across most geographies and property types, with landlords regaining the upper hand in rent negotiations.
- Transaction volumes are rising and so are property prices, driven by above average NOI growth and there is a record amount of dry powder (USD $365 billion) sitting on the sidelines ready to be deployed to take advantage of improving real estate fundamentals.
- In our 2022 Outlook Report, we wrote about the 1970s being the last time the developed world dealt with a prolonged bout of high inflation. During that period, REITs delivered a 10%+ annualized total return - the third highest of any asset or equity sector.
While our crystal ball is not perfect at predicting how high and how long inflation persists, we do believe inflation is likely to get stickier if global supply chains remain disrupted, labour remains scarce and countries limit mobility, of which all three remain in-place today.
The events in Ukraine and the acceleration of monetary policy normalization have created more uncertainty today than when we penned our 2022 Outlook Report in December; historically, however, equity markets appreciate after the first interest rate hike, not collapse.
Today, we believe valuations are attractive and our models, which capture the current interest rate environment, suggest global REITs remain poised to deliver 15%+ upside in price and a double digit annualized total return. Earnings growth is still attractive and forecasted to rise by 10%+ in 2022. We believe property types with short lease durations such as hotels, apartments, single family rentals, manufactured housing, senior housing, and self-storage that can reset lease rates more frequently are in a more advantageous position to grow cash flow and offset rising inflation. Similarly, property types with strong pricing power, like industrial and life science, will benefit from the step-up in market rent. Areas to avoid are REITs trading at high multiples relative to underlying growth and deep value property types with minimal internal growth.
There is a light at the end of the tunnel: a tightening monetary policy is typically coupled with strong economic and job growth and fundamentals that lead to demand outstripping supply and demand, driving rental growth in real estate.
All figures USD. All sources Bloomberg LP unless otherwise noted.
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