‘Sweet Spot’ for Real Assets May Be Coming

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Larry Antonatos, managing director and portfolio manager, Brookfield Asset Management.

The low interest rate environment of the past 18 months has been a key support for global economic activity during Covid-19 disruption. Low rates have also been a key support for asset valuation. Most visibly, broad public equities, as measured by the MSCI World Index, have delivered phenomenal performance, and as of September 2021 are approximately 30% above pre-Covid highs. In contrast, benchmarks for public real estate and infrastructure equities are only approximately 5% above their pre-Covid highs. Because of this 25% return differential, public real estate and infrastructure appear very attractively valued relative to broad equities. This is an important investment opportunity. Very attractive valuations for real estate and infrastructure today.

As we consider investment opportunities in a future interest rate environment, we should focus on three important drivers of interest rates. First, central bank policy. As economic activity returns to pre-Covid levels, we expect central banks will prudently reduce monetary stimulus by tapering asset purchases and raising benchmark interest rates. Second, economic growth is a powerful macroeconomic force that will drive real interest rates. Higher growth drives higher real rates, and lower growth would drive lower real interest rates. Third, inflation. Inflation will play an important role in the level of interest rates. Higher inflation drives higher nominal rates, and lower inflation drives lower nominal interest rates.

Accordingly, we can consider future interest rate environments by constructing a four-quadrant map of economic growth versus inflation. To visualize this construct, in the upper right quadrant, growth and inflation are both rising. In the lower left quadrant, growth and inflation are both falling. In the remaining two quadrants, one of these factors is rising and the other is falling. The performance of real estate and infrastructure within these four quadrants will reflect different sensitivities to growth and inflation because real estate and infrastructure have very different business models. Real estate is generally free market business driven by the traditional interplay of supply, demand and pricing. Supply growth is cyclical, driven by optimism of property developers and the availability of construction financing. Demand for space is also cyclical, driven by economic activity. And pricing, or the rental rate, is determined by negotiations between landlords and tenants and is impacted by the levels of supply and demand at the time of lease negotiation. And frequently, leases include price escalation tied to inflation.

In contrast, infrastructure is generally a regulated business where government involvement can play a role in the drivers of supply, demand and pricing. Supply can be limited by government regulation, so many infrastructure assets benefit from limited competition. Demand is generally very steady because infrastructure provides essential services that generally have limited sensitivity to economic activity. And pricing for infrastructure services is frequently regulated or contracted with price escalations frequently tied to inflation. Due to these differing business models, real estate is generally more sensitive to economic growth and infrastructure is generally more sensitive to inflation.

So within our four quadrants of growth versus inflation, we would expect real estate and infrastructure to perform as follows. Rising growth, rising inflation: both real estate and infrastructure should deliver strong returns that may fail to keep pace with more cyclical sectors. If growth rises more than inflation, real estate with greater sensitivity to growth should outperform infrastructure. On the other hand, if inflation rises more than growth, infrastructure with greater sensitivity to inflation should outperform real estate.

In a rising growth and falling inflation quadrant, both real estate and infrastructure should deliver strong returns. Real estate with greater sensitivity to growth should outperform infrastructure. In a falling growth but rising inflation environment, both real estate and infrastructure should deliver a moderate return and should outperform more cyclical sectors due to the stability of cash flows and the benefit of inflation escalators. Infrastructure with greater sensitivity to inflation should outperform real estate. And in a falling growth, falling inflation environment, both real estate and infrastructure should deliver moderate returns and should outperform broad markets due to the defensive benefits of long duration cash flows. Within these four quadrants, the sweet spot for an investment performance of real estate and infrastructure is an environment with growth and inflation, both rising moderately, but not aggressively.

In this moderate but not aggressive environment, real estate and infrastructure should deliver strong returns, but should not be outpaced by more cyclical sectors. This is another important investment opportunity. We expect exactly this sweet spot, macroeconomic environment over the next few years.

Finally, I want to highlight that both real estate and infrastructure includes sub sectors with a range of sensitivities to economic growth and inflation. This creates more granular investment opportunities. For example, within real estate, growth sensitivity is higher for property types with short lease durations, such as hotels, which have nightly leases, self storage, which has monthly leases, and residential apartments, which have annual leases. Within infrastructure, place and sensitivity is higher for sectors where pricing is contractually tied to inflation, such as certain utilities and transport. Transport infrastructure offers the added opportunity of growth sensitivity due to volume increases.

So in summary, we see three important investment opportunities. First, as of September 2021, very attractive valuations for real estate and infrastructure. Second, we expect the sweet spot macroeconomic environment over the next few years with growth and inflation both rising moderately, but not aggressively. And third, there are specific growth and inflation sensitive sub-sectors within real estate and infrastructure that offer terrific opportunities.