The REIT Way To Think About Inflation

Summary

• There are already signs of inflation bubbling up based on rising commodity prices, bond yields, and the housing boom.
• However, Fed Chairman Jerome Powell is wagering it won’t get out of control.
• REITs overall are positioned to benefit from an inflationary environment while providing attractive current income streams – which should grow over time.
• This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Learn More »

Photo by lemono/iStock via Getty Images

One of the most frequent questions I get from readers these days is this:

“Is inflation about to get out of hand?

And it’s almost always followed up by this one:

“What will be the impact to real estate investment trusts (REITs)?”

Both are certainly valid questions since the ingredients for inflation are present. By that, I of course mean lots and lots of fiscal and monetary stimulus. Between the extra money lawmakers have spent and will soon spend, the extra stimulus amounts to around $5 trillion…

Roughly a quarter of GDP.

There already are signs of inflation bubbling up based on rising commodity prices, bond yields, and the housing boom. However, Fed Chairman Jerome Powell is wagering it won’t get out of control.

He says that reviving the economy is more important right now. He seems to have doubled down on keeping rates low, indicating that hikes won’t happen before late 2023.

There are reasons to think the central bank is right.

For one, the labor market remains weak if you consider everyone who lost jobs during the pandemic and gave up on finding new ones. And wages aren’t likely to start soaring either.

In addition, while consumers appear to be flush with cash from the stimulus checks, many are using it to save or pay off their credit cards.

In the next few months, the headline rate could top 3% – largely because it will be based on comparisons with depressed prices from 12 months earlier. However, by year end, it should settle around 2.5% as price pressures ease.

None of that data is calming some investors down though. So let’s see what else I can add...

REITs and Inflation

Again, the potential for higher inflation primarily comes down to government spending. That traps central banks into keeping interest rates low to finance the resulting debt.

According to research from global fund manager Cohen & Steers:

“The fiscal response to the pandemic has been massive to date. And more help is likely on the way, as policymakers seek to support employment and spending until a vaccine allows for a broader economic recovery.”

It added that “plans for unprecedented levels of fiscal spending over the next five years would, if implemented, add to already significant debt burdens.” In which case, “debt could reach its highest level in the nation’s history, including World War II.”

Naturally, that kind of activity does set up at least a decent chance of “inflationary surprises toward the upside – perhaps sooner than investors expect.” In fact, it cautions:

“The risks of inflation may be as high as they have ever been from a portfolio perspective, with bond yields at historic lows and equity markets highly concentrated in high-duration large-cap growth stocks.”

Now here’s some commercial real estate-specific good news, no matter how it sounds at first. If it does happen, higher inflation will make new construction that much more expensive.

There will be higher costs for labor, higher costs for land, and higher costs for materials. Which will mean fewer buildings built. Which will enhance the attractiveness of existing buildings, giving them more pricing power.

To quote Cohen & Steers again, “At different points in a market cycle, pricing power can vary materially depending on the property sector and overall economic conditions.” This can lead to wide differences in cash-flow protection.

Specifically, “data center, cell tower, and self-storage companies have generally maintained or increased rents.” Retail and hotel operators, however, have suffered.

More About REITs and Inflation

One great advantage for most REITs is that they provide natural protection against inflation. Real estate rents and values tend to increase when other prices do.

That’s partially because many leases are tied to inflation. This supports REIT dividend growth and provides a reliable stream of income regardless, helping to support the following fact…

That, in all but two of the last 20 years, REIT dividend increases have outpaced inflation as measured by the Consumer Price Index. The chart below illustrates dividend growth per share compared to the annual inflation rate.

In 2002, dividend growth failed to edge out inflation by just half a percentage point. But the only other time in recent history that happened was just after the financial crash in 2009.

Over the 20-year period though, average annual growth for dividends per share was 9.6% (or 8.9% compounded) – compared to only 2.1% (2.2% compounded) for consumer prices.

(Source: Nareit)

One of the difficulties in assessing REITs’ performance during periods of high inflation is that there haven’t been any such periods since the 1980s, before the modern REIT era. The U.S. had periods of high inflation in the 1970s and 1980s when it was as high as 13% annually, but since 1990, the inflation rate has rarely gone much over 3%.

Looking at the historical inflation rate since REITs’ inception in 1972, as illustrated below, the U.S. has had two periods of high inflation, and several periods of moderate or low inflation.

(Source: Nareit)

For the record, high inflation is defined as greater than one standard deviation from the time period’s average of 4%, greater than 7.1%. So moderate inflation is between 7.1% and 2.5%, based on the Federal Reserve target. And low inflation is below 2.5%.

The chart below compares the performance of equity REITs and the S&P 500 accordingly, as demonstrated in the above chart. In the high-inflation periods, falling REIT prices were made up for by strong income return.

In periods of low and moderate inflation, meanwhile – although the S&P had stronger price returns – REIT dividends allowed them to outperform anyway.

(Source: Nareit)

So What Should I Buy?

As I said above, not all REITs have the same level of pricing power in an inflationary environment.

For example, hotel REITs like Apple Hospitality (APLE) and Hersha Hospitality (HT) can adjust their room rates. But I’m not quite ready to jump into that frying pan since business travel isn’t back to normal.

Other sectors like apartments, single family housing, and self-storage can adjust their rent annually, however. That’s why, over the last few months, we’ve been purchasing shares in REITs like:

• Essex Property (ESS)
• AvalonBay (AVB)
• Mid-America (MAA)
• Equity Residential (EQR)

(Source: Yahoo Finance)

And hopefully investors have already jumped onto “red hot” manufactured housing REITs like:

• Equity LifeStyle (ELS)
• Sun Communities (SUI)
• UMH Properties (UMH)

Because that train has already left the station.

(Source: Yahoo Finance)

We also like the pure-play campus housing REIT, American Campus (ACC). We bought it last year when shares were very, very cheap.

(Source: Yahoo Finance)

Most retail REITs have tenants sign long-term leases, many with initial terms of 15 years or more. Those leases typically have annual rent increases built in, usually in the 1%-2% range.

So if inflation were to rise to around 4%, rent would rise more slowly.

When it comes to shopping center REITs, we’ve been cautiously buying them – with the keyword being “cautiously.” Our focus has been on beaten-down names like Federal Realty (FRT), Urstadt Biddle (UBA), and Regency Centers (REG).

(Source: Yahoo Finance)

We’ve been underweight malls for over four years now based on oversupply dynamics alone. And the shutdowns haven’t helped, to say the least.

We continue to hold Simon Property (SPG). But we’re extremely bearish with regard to CBL Properties (CBL), Washington Prime (WPG), and PREIT (PEI).

(Source: Yahoo Finance)

Net-Lease REITs, Gaming REITs, and More

One common misconception with net-lease REITs is that they can’t keep up with inflation. While most do have built-in rent escalators of 1.5%-2% per year, they also have longer-duration debt. And those essentially lock in their investment spreads.

Rising inflation is typically accompanied by rising interest rates, which is generally bad news. When the latter happens, it gets more expensive for REITs to borrow money – and virtually all major REITs rely on the debt markets to fund growth.

However, most REITs have been locking in low-cost debt, recognizing that rates are going to rise eventually. Its these so-called “low-cost leaders” that I like owning.

That includes a number of net-lease examples with their now very attractive investment spreads:

• Realty Income (O)
• Agree Realty (ADC)
• Essential Properties (EPRT)
• Four Corners Property (FCPT)
• W.P. Carey (WPC)

(Source: Yahoo Finance)

I’ve also been buying “new kids on the block” like Broadstone Net Lease (BNL), NetStreit (NTST), and Alpine (PINE).

(Source: Yahoo Finance)

The same goes for VICI Properties (VICI), a gaming REIT that also has master leases with built-in CPI clauses. As illustrated below, it’s been a definitive Strong Buy for iREIT on Alpha:

(Source: Yahoo Finance)

Another “specialty” REIT that should perform well during inflation is Iron Mountain (IRM). Most forget that the boxes it stores are its primary competitive advantage. It can simply pass through any increases to its customers, making it less impacted by rising interest rates.

Plus, IRM has only 2% customer turnover in a given year. As such, 50% of the boxes it agreed to store 15 years ago still remain today.

(Source: Yahoo Finance)

In Closing…

Keep in mind that, when interest rates rise, dividend yields generally do too.

Investors expect a certain risk premium over what they could get from Treasury securities. So when Treasury yields rise, so do REIT yields.

As Cohen & Steers explains, real assets’ history of equity-like returns shows their ability to deliver attractive returns over longer market cycles, inflation or not. Notably, the past three decades have been characterized by low inflation – indicating that high inflation hasn’t been necessary for real assets to deliver attractive long-term returns.

(Source: Cohen & Steers)

During inflationary periods, REITs have historically tended to appreciate and rental/lease payments have tended to increase. Private U.S. real estate’s performance in such times can be seen below:

REITs have a long history of helping investors hedge against inflation. Again, property values tend to rise with the overall price environment. Plus there’s the potential for growing cash flows as landlords raise rents.

Yes, the current level of inflation remains subdued. But a case for higher inflation expectations can certainly be made given 1) global central bank policies and 2) a rebound of the world economy from the COVID-19 pandemic.

The timing and catalyst of a spike in inflation expectations and subsequent inflation can be argued. Obviously. But for investors concerned about their portfolio income…

REITs overall are positioned to benefit from an inflationary environment while providing attractive current income streams – which should grow over time.

Analyst’s Disclosure: I am/we are long ACC, ADC, AVB, BNL, EPRT, EQR, ESS, FCPT, FRT, PINE, REG, SPG, UBA, UMH, VICI, WPC, NTST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.

Comments

[Retire2020]

Thanks Brad for another great article.

[Brad Thomas]

@Retire2020 You bet!

[P3Limited]

Hey Brad, thank you for coming through with your long-anticipated (well, since yesterday, in my case) article. I'd been looking forward to your assessment on office REITs' ability to thrive in a higher-rates and/or higher-inflation environment, but I found no mention of the sub-sector (maybe that's not a good omen!). Do office REITs generally sign leases with inflation-based step-up clauses? Might the 2020/2021 demand crunch be leaving them more poorly positioned to negotiate favorable lease terms that include such protections? I ask because I am long SLG, BXP, CIO, and HIW. Thanks in advance for your thoughts!

[Keep it Country]

Net lease REITS "low costs leaders" also have the advantage of very low expenses. They are not impacted as much from the rising maintenance, property management costs but they do benefit from the rent escalators.

[Brad Thomas]

@Jackson Falls NH Correct. Thanks for reading and commenting...

Come and visit us at iREIT on Alpha ;)

[Nunthia]

Sure are long a lot of good dividend stocks. Brad must be very wealthy by now and lots of income off those dividends

[Brad Thomas]

@johnny corsaro if wealth is defined by family, I am rich beyond your wildest imagination... 5 kids + wife = BLESSSED

All the best - B

[cristobal cardona]

@johnny corsaro if you read him he is, he was up in 2008 then took a dive in his finances. But he is back. Read his last articles is in there!

[Nunthia]

@Brad Thomas looks like it

[nkaln31]

I love this article. I have thought for years that Reits are the better bond alternative. I think it is crazy that people run from Reits when interest rates are rising. I remember in 2017-2018 when Reits sank for months. . . until March 2018 when people did a collective forehead slap and reits rose 20% until the market top in July. Reits are inflation protected, because rents rise with inflation, albeit with a lag. Long CTO.

[Brad Thomas]

@nkaln31 Thanks for reading and all the best - Brad

[kmi]

"the potential for higher inflation primarily comes down to government spending."

Um, let me disagree and just say that doesn't create monetary velocity, and thus inflation, it just shifts money around, and in many ways can't lead to inflation for the dollar because of other things going on internationally and domestically economically.

Certainly, the government can drive inflation, and may well do so based on the moves the current administration is making:

One is proposed higher taxes on corps, which will mean higher prices for the products corps produce. Another one is massive re-regulation, which will drive prices higher by increasing operating costs (e.g. the meat industry www.foxbusiness.com/... (Both are government fueled inflation, but not via spending.)

That said, there's a lot of things that are fighting inflation (concurrent printing by trading partners around the world, low yield on foreign bonds, technological innovation) and a lot of people have missed the inflation that has *already* happened in commodities.

I'm not worried about inflation but about stagflation a la the Obama gig economy era where working and middle class people had to work harder and harder just to stand still. Most Real Estate will perform fine in most scenarios including that one, but more so in the lower income manufactured housing $SUI areas and net leases $O in my opinion.

[2bears]

The labor market is not weak. Where I live in Indiana every factory, store and service business is looking for help and can't get it. Could this be because the government is paying people not to work? Everyone has plenty of money to spend by how busy the stores are.

[user 11202791]

they want people without criminal records who can pass a drug test, but they are already employed

[Robert in Vancouver]

REITs own multiple buildings, each building has a mortgage and lease that come up for renewal at different dates.

So when mortgage rates rise there is very little impact on most REITs since they have time to increase rents on many buildings before mortgages have to be renewed.

And when mortgage rates are increasing it generally means the economy and inflation are increasing, which boosts the market value of land and buildings.

So I can't understand why some well known market pundits are so much against REITs when mortgage rates rise. Am I missing something, or are they missing something?

[pelican11]

@Robert in Vancouver I understand your point/question, but one thing to note is that most REITs do not put a mortgage on every building. Many properties are held unencumbered by a property level mortgage, and rather the REIT finances their overall obligations with cross collaterized loans, lines of credit, etc. Many REITs prefer long term fixed rate debt where they can lock that in.
Additionally, depending on the asset type, there can be multiple tenants in a given building and therefore multiple leases with expiration dates independent of each other. Having said that, I don't think that changes your point, that many REITs should be able to survive or thrive in a rising interest rate environment.

[Catskills1]

@Brad Thomas Tremendous article Brad. Most interesting was Chart 3, showing REIT returns vs. S&P returns in low, moderate and high inflation. I stared at that for a good while. If correct, a move from low to moderate inflation (which we may face soon) 1) gives REITs an advantage in total return over the S&P 500, from a similar return for both in low inflation, and 2) increases REITs' price return greatly over their low inflation price return, while maintaining or even slightly increase REITs' income returns. This is very counterintuitive to the argument that inflation pushes up interest rates, and the coupons on bonds, which make bonds more attractive and reduce the demand for REITs, causing them to stagnate or depreciate in value. The chart suggests that REITs do not lose income as rates rise, i.e., perhaps by offsetting increased interest costs with rent increases? A puzzle for me is that the chart suggests price return for REIT investors RISES as prices go up--so demand for REIT shares is increasing as this happens? Do I understand this right? How confident are you in the data? Any additional understanding would be much appreciated. Thank you.

[Brad Thomas]

@Catskills1 Thanks for reading and commenting... I am writing a follow up article and I will address these points... Are you a member at iREIT on Alpha.... What can we do to earn your business?

All the best. Brad

[dwillinlvill]

Brad, You mentioned nothing about mReits here. Your thoughts!

[Brad Thomas]

@dwillinlvill mREITs are "trading" vehicles IMO and when you combine that with leverage you get a speculative alternative. Overtime, equity REITs will most always outperform mREITs. - Thank you, Brad

[nkaln31]

@dwillinlvill Inflation hurts lenders and helps borrowers, but it really helps the owners of real assets. mReits borrow at low rates to buy higher yielding debt and mortgage backed securities, so mReits are both a lender and a borrower. eReits own actual properties.

I've heard gold bugs talk about gold as an inflation hedge because an equal amount of gold in the past would buy the same size house today, while many more dollars would be required to buy that same house over time. It seems to me that the gold bugs miss the point that the measure of value in that example is the house, not the dollar or the gold. So, real estate, or eReits should be an effective inflation hedge.

[Just One Lab Nerd]

Good article. I have had and held some FPI for years, and recently have been slowly adding in UMH and STAG. Any thoughts on HASI? Could see a surge if that stimulus package with all the green energy infrastructure support comes through.

[Just One Lab Nerd]

Never mind,... Just noticed your other recent article that included HASI. Cheers!

[Brad Thomas]

@Just One Lab Nerd We recently interviewed FOI's CEO at iREIT on Alpha (video)..... UMH and STAG and pricey....

I just posted this:

3 Strong Buys Poised To Profit seekingalpha.com/...

[Brad Thomas]

@Just One Lab Nerd Thanks!

[bearcub1936]

Good Article
Just what I have been worried about!
Am bookmarking
Thank You

[Brad Thomas]

@bearcub1936 Thank you!

[careful investor 1]

Iron mountain has a declining business. We used to store files also. Now we store them digitally and frees up a lot of space

[Brad Thomas]

@careful investor 1 Declining business?

We're not talking about Blockbuster Video here...

Where else can you store your loan documents, precious art, medical files etc...

Before you say, the cloud....

IRM is investing heavily in digitization and data storage...

The perfect storm.... and AFFO is growing... not declining....

Long IRM

[careful investor 1]

@Brad Thomas
Sorry but I respectfully have to disagree. FFO last 3 QTRS are .53,.61,.60.
They don't cover the dividend Their storage business is in decline and there are bigger and better players in digital storage. This is why I sold my position. I'd rather invest in a growing business and this is not it.

[Brad Thomas]

@careful investor 1 You're using the wrong metrics... you should use AFFO instead to get a more accurate picture of cash flow before dividends.

[boog3]

You don’t own O? Thanks for the article. Well written easy to understand.

[Brad Thomas]

@boog3 Thanks- Yes I own O.... must have missed that by mistake... All the best. Brad

[Hungry for Knowledge]

Ah yes, the perpetual Catch-22:
Too late to invest in mobile home parks, they're performing great!
Don't invest in $HT, too early!

I, for one, find that I have to be "too early" or else I miss it all.
I've been in $HT for months, up 100% (and my understanding is that it's a vacation-focused hotel REITs, in NYC / Orlando / Miami, etc.)

Love your work. Thank you as always.

[Brad Thomas]

@Hungry for Knowledge Thank you.... We plan to launch a REIT option service soon (at wide moat research dot com) and we will likely including lodging... Thanks for reading and commenting.. All the best - Brad

[Anthonyhai2003]

But with Biden’s desire to raise taxes, I don’t know if economic growth that Powell wants to see, will be nullified in the next few years....

[Brad Thomas]

@Anthonyhai2003 Working on a tax article this week for iREIT on Alpha... come check out our marketplace service (2 week FREE trial)... All the best

[rsmab01]

Good Morning Brad,

Excellent discussion of an important topic that is on most REIT investors’ minds.

Have also been “nibbling” on triple net newbies like NTST. Maybe even a bigger nibble today with an expected price drop with the announcement of a secondary. Sounds like an opportune time to lower your cost basis. Hope it gives a better return than if you put your money on Gonzaga!

Warm regards,
Rob

[Brad Thomas]

@rsmab01 Wow. What a game... BAYLOR came out swinging! Thanks for reading, and yes, a good time to pounce on NTST! All the best. Brad

[Rydercup2020]

@Brad Thomas you obviously meant Baylor.........must have had Butler on your mind. :)

[eric2620]

@Brad Thomas Rydercup2020 beat me to it.

[Jcraig304]

I see you do not list NTST as a long? Yesterday’s dilution have something to do with this?

[Brad Thomas]

@Jcraig304 I am long NTST.... I will edit that now... Thank you. Brad