The threat of stagflation worries many investors. Our base case does not anticipate an extended period of stagflation, as we expect the eventual resolution of the war in Ukraine and the easing of supply-chain bottlenecks. However, in a scenario where inflationary pressure remains elevated and economic growth stalls, real estate investment trusts (REITs) include a number of sectors with the potential to perform well over the coming year.
In our base case of persistently above-average inflation coupled with solid economic growth, we believe REITs should act as an effective hedge against inflation for investors. One straightforward way to think about REITs and inflation is that landlords have the potential to capture higher rents when inflation is higher. Sectors with sustainable cash flows mitigated by long-term leases with embedded rent escalators, such as the health care, grocery-anchored retail centers and investment grade net-lease properties, offer cash-flow resilience in tougher economic times. For REIT sectors with longer-term lease structures, the leases typically have annual escalators that can either consist of fixed-rate annual bumps (typically 2 – 4%), or escalators calculated based on the change in the consumer price index (CPI). REIT sectors with shorter lease terms, often one year or less, provide landlords at least an annual opportunity to reset the rents they charge.
Certain REIT sectors are benefiting from additional secular drivers. Growth in residential sectors is supported by housing inflation and the “underbuilding” of residential housing since the Global Financial Crisis. The self-storage sector has experienced a surge in demand during the pandemic as individuals have decluttered to create viable home offices that should remain even as the pandemic fades. Retail REIT sectors have also benefited as retailers have reimagined their physical stores, leading to increased focus on the fulfilment of e-commerce orders from stores. Both trends appear to have improved store profitability and reinforced the importance of the store fleet.
We expect cash flow growth potential to be roughly 12% from the REIT sector in 2022, which should be comfortably above inflation expectations for the year and more than twice the average over the past 20 years. The REIT structure is designed for investors to share in this potential growth as REITs are required to pay out at least 90% of their earnings in the form of dividends.
All of these inflation-driven and secular trends support our view that REITs are well positioned to benefit from the inflationary trends coursing through the U.S. and global markets.
