Among the more harmful effects of the COVID-19 pandemic has been the unprecedented inflation that has accompanied the recovery. The confluence of supply-chain issues and acute demand catalyzed by incessant monetary easing and fiscal spending has exacerbated rising prices, exhibited by the string of sharp increases in the Consumer Price Index. The unrelenting inflation coupled with the velocity at which interest rates have risen have wreaked havoc on markets this year.



Many asset classes that have historically exhibited lower correlations have fallen in unison, leaving investors with few places to hide. A prime example of this has been the disappointing performance of a traditional 60/40 portfolio. The prices of stocks and bonds, which have largely been inversely correlated for the past two decades, have abandoned their historical relationship, sending a traditional portfolio of 60% stocks/40% bonds down 20% year to date through September 30.

With the Federal Reserve on a tightening spree, it’s unclear how long it will take to curtail inflation or if a new regime of higher-for-longer prices is here to stay. Even less certain is how significant the financial contraction’s impact on economic growth will be. The landing, hard or soft, is yet to be determined. However, we believe it’s reasonable to assume that volatility is here to stay for the foreseeable future and that the need for assets that produce durable and sustainable cash flows is paramount.

With this in mind, investors may want to consider real estate investment trusts (REITs): income-generating assets that over long periods have been less correlated with traditional stocks and bonds and generally resilient in times of high inflation.

What are REITs?

REITs are companies that own, operate, and finance income-producing real estate. They generate total return through current income (via dividends) and share-price appreciation. These securities trade like stocks, and they’re listed on public stock exchanges. REITs enable investors to quickly deploy substantial capital into scaled, geographically diverse property portfolios, and they potentially offer a host of advantages, such as dividend-based income; competitive market performance; transparency; liquidity; and, importantly, inflation protection and portfolio diversification.

A key benefit of owning a REIT is that its shareholders earn a portion of the income it produces without having to purchase, manage, or finance a property. Also, a REIT isn’t taxed at the corporate level, which means it avoids the dreaded “double taxation” of being subject to both corporate and personal income taxes.

Inflation protection

REITs can provide some protection against inflation as real estate rents and property values tend to increase in response to rising replacement costs. Because REITs can pass price increases through to tenants, their dividend growth may provide a reliable stream of income that can offset inflationary pressures.

Also, higher costs for labor and capital can reduce incentives to build new supply, thus limiting competitive pressures. In addition, should economic conditions weaken, several real estate categories may provide more resilient cash flows, including sectors that provide shelter (multifamily, single-family rental, and manufactured housing) and sectors with strong secular tailwinds (data centers, cell towers, and industrials).

REIT dividends have tended to outpace inflation over long periods. Additionally, REITs have outperformed broad-based equities during long periods of moderate to high inflation since 1972.

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Diversification

Like most asset classes, REITs are not impervious to systematic risks. In the short run, shocks to the market—for example, acute increases in interest rates—can cause REITs to move in tandem with traditional common stocks. As the 10-year yield moved from 1.51% to 3.80% in 2022 through September 30, the FTSE NAREIT All Equity REITs Index fell 28%. In comparison, the S&P 500 Index was down 24% over the same period.

Nevertheless, over longer periods, REITs have behaved more like private real estate and have exhibited lower correlations relative to bonds, commodities, and equities. Their diversification benefits may help reduce a portfolio’s volatility and improve returns for a given level of risk. REITs are able to provide this diversification because their collective tenants are spread across a panoply of subsectors and localized geographies with their own distinct characteristics and end markets.

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Attractive yields

Over the past several decades, REITs have earned their stripes as liquid and transparent diversifiers that tended to generate strong cash flows. Because they pay out at least 90% of their pretax income in the form of dividends, REITs typically have generated competitive dividend yields compared with fixed income and equities. Historically, over the long term, roughly 50% of listed REITs’ total returns have come from dividends, compared with less than 25% of equities’ total returns (as represented, respectively, by the FTSE NAREIT All Equity REIT Index and the S&P 500 Index). This can be an attractive feature for investors seeking steady income in today’s environment.

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For investors looking to own real assets, REITs may be one viable solution. Income-oriented investors in particular could find them attractive due to their historically high and reliable dividend payouts that have tended to increase over time at a rate in excess of inflation.

In our view, the best REITs have the potential to generate sustainable cash flow and deliver compounding growth by owning quality real estate in various types and geographies. Some of the key attributes we look for include barriers to supply, low capital expenditure burdens, secular demand, experienced management teams, and durable balance sheets.

Similar to other assets, REITs are influenced by market conditions that may cause their prices to vacillate up and down. Also, while over the long term REITs have been less correlated with other asset classes, they possess a strong cyclical component and are sensitive to changes in interest rates. Nevertheless, they may serve as an integral part of an asset allocation strategy. We believe there are ample opportunities with the potential to generate alpha in the space and that the current backdrop is very favorable given the sharp valuation reset this year.

 

Disclosures

Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.

Copyright 2022. ICE Data Indices, LLC. All rights reserved.

The ratings indicated are from Standard & Poor’s, Moody’s Investors Service, and/or Fitch Ratings Ltd. Credit-quality ratings: Credit-quality ratings apply to underlying holdings of the fund and not the fund itself. Standard & Poor’s rates the creditworthiness of bonds from AAA (highest) to D (lowest). Standard & Poor’s rates the creditworthiness of short-term notes from SP-1 (highest) to SP-3 (lowest). Ratings from A to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the rating categories. Moody’s rates the creditworthiness of bonds from Aaa (highest) to C (lowest). Ratings Aa to B may be modified by the addition of a number 1 (highest) to 3 (lowest) to show relative standing within the ratings categories. Moody’s rates the creditworthiness of short-term U.S. tax-exempt municipal securities from MIG 1/VMIG 1 (highest) to SG (lowest). Moody’s rates the creditworthiness of short-term securities from P-1 (highest) to P-3 (lowest). Fitch rates the creditworthiness of bonds from AAA (highest) to D (lowest).

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