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As developments around the virus cease to be the main driver of country outlooks, markets now have to contend with aggressive monetary policy tightening amid elevated inflation and a commodity price boom. As a result, given its inherent qualities as an inflation hedge, the real estate sector stands to benefit compared to other asset classes from the inflationary environment, along with the recovery in mobility.
Vaccination rollouts and high community immunity allowed countries outside of China to manage the most recent outbreak of the less lethal Omicron variant without yielding to new restrictions, marking a change in the approach to the pandemic. As a result, the impact of virus developments on the outlook for real estate has diminished considerably over the past six months.
Instead, markets have been roiled by elevated inflation and the end to the decade-long era of easy money as central banks around the world embark on an aggressive tightening cycle. Inflationary pressures had started to build last year following supply chain pressures and have been exacerbated by the surge in commodity prices in the wake of Russia’s invasion of Ukraine. Bold monetary tightening from DM central banks will likely put pressure on those in EM to pick up the pace or start raising rates.
Therefore, at this juncture, given its inflation hedge qualities, we view real estate favourably relative to other asset classes. Admittedly, the tightening cycle spurred on by higher inflation is a headwind to real estate valuations as the rise in bond yields limits the re-rating of assets. But with the terminal rate priced in by financial markets in most countries still lower than the past and, importantly, below property yields, the real estate sector appears insulated. Moreover, with inflation-linked rental agreements commonplace in a number of DM and EM markets, real estate assets are relatively better placed in an inflationary environment. However, highly-leveraged companies, especially those with significant floating rate debt, are a risk.
Office and retail: Office values continue to recover in Europe, Australia and Singapore as mobility returns to its pre-pandemic level. But as remote working becomes entrenched and pandemic-related disruptions to pipelines ease, vacancy rates are expected to edge up, weighing on rental and capital values. With the risk of remote working not as great in EM, offices in those markets should hold up better than DM.
Meanwhile, the retail sector faces a number of challenges. Retail spending is likely to be dragged by the shift in spending back to services following the easing of restrictions and the drop in consumer confidence from elevated energy and food prices. In addition, the popularity of e-commerce will continue to be a structural headwind for the sector. However, given the sharp declines over the pandemic, it could be argued that the retail sector is well positioned for a recovery.
Residential: The surge in residential property prices since the onset of the pandemic is likely to come to an end as tighter monetary policy pushes up mortgage rates. Elsewhere, the growth of the middle-class and urbanisation are likely to continue to drive residential demand in EM.
Industrial: Demand for industrial properties will continue to be supported by the rise in e-commerce, while the sector should also benefit from the tentative easing in supply chain pressures. Rental growth shows no sign of slowing, as vacancy continues to tighten.
EM real estate (as measured by the FTSE EPRA/NAREIT Emerging Index) outperformed DM ex-US real estate (as measured by the FTSE EPRA/NAREIT Developed ex-US Index) by 9.6% points over the past six months. Valuations are more favourable for EM real estate. For a start, the gap between EM and DM dividend yields has continued to widen over the past six months. In addition while forward earnings for both indices have dropped back on a six-month basis, the decline has not been as sharp for EM.
Among DM, we move the Eurozone to neutral, as the real estate sector’s attractive valuations are offset by soft earnings momentum and a hawkish ECB. Elsewhere, we reduce our allocation to Australia to neutral given the real estate market’s stretched valuations and the expected slowdown in the housing market on the back of rising rates. We keep the UK, Japan and Hong Kong underweight, as disappointing forward earnings and the absence of a corresponding drop in trailing P/B and forward P/E ratios suggest that these markets are richly priced. Finally, we leave Singapore neutral given its position as the biggest beneficiary of the retreat from Hong Kong.
*The publication reflects asset performance up to 29 April, 2022, and macro events and data releases up to 20 May, 2022, unless indicated otherwise. Data about mobility and footfall are from Google, while data about real estate rents, net absorption and supply are from JLL.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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