Expanding the property horizon

Allocations to property can be very beneficial even during periods of high inflation and rising interest rates. Justin Blaess puts forward the case for SMSF members to look to global real estate to truly take advantage of this return characteristic associated with this asset class.

In recent months, something has happened many believed almost impossible – house prices in Australia, most notably in the hot property markets of Sydney and Melbourne have, on average, come down.

It’s been a very long time since we’ve seen this in Australia. Many homeowners will never have experienced or anticipated the value of their home going backwards.

While this downturn is still a long way off any kind of crash, such as that experienced in the United States during the global financial crisis (GFC), it’s a timely reminder residential property as an asset isn’t always guaranteed to deliver.

It’s also a reminder it can be worthwhile considering other types of property investment as part of a diversified portfolio. And while SMSF investors can access specific benefits by investing directly in property through their fund, investing via equity markets is worth considering.

Real estate is possibly the oldest form of investment around. Over decades, and indeed centuries, owning land has proven to be a spectacular way to build and preserve wealth.

One of the big advantages of real estate as an investment is that it’s based on real assets and as long as any leverage used is managed, real assets rarely lose all of their value. Even under a worstcase scenario, the rate of obsolescence for quality property is low.

As a result, real estate, encompassing a range of property sub-sectors, such as office, industrial, retail and technology, has been one of the better performers across asset classes and across time.

This may surprise some investors, especially in the current environment of rising interest rates when conventional wisdom says real estate should struggle.

Looking back to the years leading up to the GFC and the US housing crash, there are a number of striking similarities that may concern investors today, particularly regarding inflation and interest rates. For example, US house prices before the GFC were on a sustained upward trajectory, annualised US inflation had risen from a low of around 1 per cent in June 2002 to over 4 per cent by September 2005 and the US Federal Reserve, in response to this high inflation, was increasing rates. But by 2008, mortgage delinquencies had spiked and US house prices had crashed.

Today, we’re in a situation that seems to be mirroring many of these trends. House price growth post-pandemic has been historic in both magnitude and speed. Inflation is high and appears stubborn. Central banks are expected to continue lifting interest rates aggressively.

Reassuringly, however, these superficial similarities mask some significant differences, not least the change in the regulatory environment in the US. This has resulted in the disappearance of NINJA (no income, no job or assets) loans and other highrisk mortgage loans, a better-informed borrower and less risky lending for housing.

It’s also a mistake to think a higher interest rate environment is automatically a bad one for real estate.

Indeed, we believe inflation and high interest rates provide an environment for real estate to show its worth. From a valuation perspective, current high levels of inflation and high interest rates can be a positive for medium to long-term real estate investors.

This is because long-run pricing of real estate is anchored around replacement cost. Market sentiment moves asset prices above or below replacement cost over an economic cycle, but eventually prices gravitate back to replacement cost. When prices are below replacement cost, developing new property tends to become loss-making. Real estate supply will be constrained, with no incentive to develop new assets.

As time goes on, the constraint to supply in the face of growing demand will eventually drive up rents and ultimately values. At some point the development becomes profitable again where prices are above replacement cost.

It’s a relatively predictable cycle, but the one unknown is time, that is, how long until there is enough demand-supply imbalance to justify new construction or how long until supply will overwhelm demand.

In the current cycle, many sectors were and remain priced above replacement cost. Supply has been responding, whether it be industrial construction, residential or niche asset classes such as data centres. Rising construction costs as well as rate hikes from central banks will and are expected to have an impact. In the face of rising costs and potentially falling values, developers and builders will be discouraged from supplying markets that are arguably already undersupplied.

These factors should contribute to improved pricing power for existing owners of real estate in the medium to long term.

Another factor supporting the health of real estate is the fact good-quality, well-located land is a finite resource, thus minimising the risk of obsolescence. At the same time, building costs and hence replacement cost usually increase in line with inflation, meaning rental yields need to rise to recover such costs to justify supply. In this way, real estate, and by default listed real estate, can act as an inflation hedge for investors.

This is borne out by history. Looking back at returns from listed real estate over the past 50 years, it’s clear that relative to general equities, listed real estate is an excellent hedge for inflation and has historically delivered strong positive returns (both nominal and real) in higher inflationary environments as demonstrated in Table 1.

Table 1

CPI threshold (%) -- Number of sequences -- Months total -- Max month in any sequence -- Avg. monthly return REIT (Nominal) (%) -- Avg. monthly return S&P500 (Nominal) (%) -- Avg. monthly return REIT (Real) (%) -- Avg. monthly return S&P500 (Real) (%)

<3 -- 17 -- 282 -- 110 -- 0.8 -- 1.2 -- 0.6 -- 1.0

3-6 -- 22 -- 210 -- 41 -- 1.2 -- 0.7 -- 0.9 -- 0.4

>6 -- 4 -- 103 -- 66 -- 0.7 -- 0.4 -- 0.1 -- 0.4

Sources: Quay, Robert Shiller, NAREIT, US Bureau of Labour Statistics. http://www.econ.yale.edu/~shiller/data. https://www.reit.com/data-research/reit-indexes/monthly-index-values-return. https://data/bls.gov/cgi-bin/surveymost?cu.

It also offers a better relative return when compared to general equities.

Between 2000 and 2021, global real estate outperformed Australian equities, international equities, infrastructure, bonds and even gold. Even though during that period the world experienced the GFC and the COVID pandemic, which were bad for real estate, this asset class still outperformed.

Notably, during periods of moderate inflation, in the 3 per cent to 6 per cent range, listed real estate has historically generated more than double the real return relative to equities. And at times of very high inflation, over 6 per cent, listed real estate continues to outperform equities, albeit at a lower relative level than in a moderate inflation scenario.

One of the benefits of real estate is that it includes a range of sub-sectors, which means it’s a massively diverse asset class. Data storage facilities, self-storage facilities, life sciences and manufactured housing all fall under this asset class, none of which correlate with traditional residential real estate.

But in order to access and benefit from some of the most important and powerful demographic and economic themes in today’s world, investors must look beyond the Australian property market to the global environment.

While Australian listed real estate is significant in size, it provides very limited access to the sectors expected to benefit from some of the strongest real estate themes. For example, listed real estate entities investing in the health, aged-care, student housing and apartment (rental) sectors are limited or non-existent in Australia.

Finally, investors shouldn’t fear inflation. In fact, when investing in real estate, inflation can be your friend. Higher inflation will protect your investment from supply issues (and therefore competition for tenants) and will drive up the replacement cost and residual value of improvements. But it’s worthwhile looking beyond the local residential property market to unlock the true potential of real estate investments.