Whichever way things are going, they’ll go a long way.

Inflation was rediscovered in September. Up to that date the quoted REIT sector had risen 25%, rebounding as the economy re-opened against a rise in the All Share Index of less than half that. I’ve been pretty bullish on the sector all year, believing it offered ‘something for everyone’ in terms of long-income inflation-linked income from what we call new generation REITs, a booming logistics sector, potential recovery in the London office market, maybe a nadir in retail and corporate activity which has seen five companies exit the sector this year.

Then inflation loomed on the horizon and the sector has given up just a little of its easy-won gains. Share price reaction though, has been rather curious. One would have thought that the new generation REITs would have benefitted most from rising inflationary prospects, but that hasn’t been the case, far from it. The best performers have been sheds, both in the shape of logistics-owning companies and above all the self-storage businesses, both of which categories were already on pretty demanding ratings. Growth out performing value yet again.

Along with the doubtless sacking of more Premier League football managers, by the time you read this, it’s highly likely that interest rates will have been raised for the first time since the GFC and the market is discounting an eventual rise to 1% next year compared to inflation on the CPI index, peaking at over 4% imminently before returning to the B of E’s remit range of c 2% by the end of next year. I’m not so sure. I have one mantra when it comes to interest rates: namely that they always move further in whichever direction they are travelling than anyone forecasts at the outset.

Doubtless the short-term inflationary pressures primarily pandemic related will start to ease Y-on-Y, transient inflation, but a more endemic inflation is possible and I don’t think the Government would worry about that, very much preferring the economy ‘running hot’ rather than the post GFC austerity.

QE did its job after the GFC in terms of basically stabilising banks’ balance sheets, but austerity followed under Brown and spreadsheet Phil. QE this time around leaves banks with a lot of liquidity and eager to lend, and the monetary stimulus is matched by the fiscal stimulus evidenced in the recent budget. Throw in rising real wages and rising real prices, and an estimated personal savings accumulation through the pandemic of up to £200bn, which could be unleashed if consumer confidence increases and one can envision a right old bout of inflation. As someone once said, controlling inflation once it starts is rather like trying to get toothpaste back into the tube.

So, back to the subject matter and what to do with REITs. Real estate is often described, wrongly, as an inflation hedge. It isn’t – certainly not commercial real estate – in the long run. Rental values in every commercial sector have under-performed CPI both over the life of the IPD index back to 1988 and since the GFC just over a decade ago. There’s also a complex relationship between bond yields, interest rates, inflation and property yields made more confusing by the supply/demand balance or imbalance in specific asset classes at any moment in time.

REITs with inflation-linked income will see earnings and dividends grow at a quicker rate, but in years ahead it is likely that the portfolio will become (more) over-rented should the assets be held until lease expiry, which in most cases for REITS, owning such leases is many years away.

On t’other hand, were the economy to really run hot, then risk-on is probably the call because it should imply rising tenant demand in response to rising GDP. This would mean a likelihood of increased development, especially as ‘green buildings’ will be very much where demand will focus and there’s a dearth of those available in the office sector. Construction costs are already rising and does the tenant pay a higher rent or does the developer take a slimmer margin? At the moment it appears it would be the latter, with Great Portland recently advising that it expects a decline in yields on cost of 1% for development deliveries from next year onwards.

Similarly, transportation costs are rising significantly, which in theory means that 3PLs will experience lower profits and have less to offer in rent unless those costs are passed right the way through to the end user, namely the consumer. And so the debate goes on. 

If bond yields, especially corporate bond yields, rise meaningfully and erode some of the risk premium on which real estate trades, does that lead to yield ‘de-compression’, as we say these days?

I’m at the crossroads and still moving in a northerly direction for choice, but were interest rates to rise meaningfully to restrain inflationary pressures then life could get rather tricky for the asset class. On balance I still prefer to stick with those ‘pure’ REITs with inflation-linked income on the basis that you know what you’re going to get, and what you’re going to get in the way of earnings and dividends has now got more upside. Elsewhere, those companies that have short occupier leases, such as in self-storage, where increased costs can be passed on to increased rents almost immediately, it explains some of the on-going share price strength in these companies. But within the office sector workspace, providers would appear to be well placed, notably the aptly named Workspace PLC.

I started with an interest rate mantra. I’ve a few! Here’s one: no one can take your dividend away, but a valuer can always take your NAV away! I’ll stick to income-oriented REITs, even though a basket of such companies as LondonMetric, Supermarket Income REIT, Assura, Target Healthcare, and Secure Income REIT has already generated a total return 52% greater than the old generation REITs of, for example, Landsec, British Land, DerwentLondon, and Great Portland – and that was when inflation was benign!