Real Estate Credit in Times of Inflation
The February rise in 10-year Treasury rates, a barometer for inflation expectations, indicated that investors are fearful of inflation again. Alex Popov, Head of Illiquid Credit Strategies at The Carlyle Group, joined us in our recent webinar to discuss Real Estate opportunities in a low-interest rate climate. Watch the replay here, with summary notes on key topics covered: - Asset classes to watch in the current environment - Debt vs equity in real estate - Long-term shifts in consumer attitudes towards real estate
A Sharp Rise in Treasury Yields
Alex explained that markets have expressed serious concerns over inflation on multiple occasions during the last decade when prices of oil and other commodities surged in 2010 and 2011, during the Taper Tantrum in 2013, and again in 2018 when the Federal Reserve raised rates and oil reached US$70 per barrel.
The 10-year Treasury rate is attractive to foreign capital, particularly after the elections. The 10-year bond, on a currency-hedged basis, is at a five-year high for Japanese Yen and Euro investors. It has attracted foreign investors, moderating the Treasury sell-off over the last few weeks. The market is re-adjusting to a fairer compensation after the meaningful sell-off in credit over the last few months.
The rise of 10-year Treasury yields to a record 2.35% since 2013 was driven by inflationary expectations in industries that have seen serious supply constraints following the pandemic. Demand has risen faster than supply, while the rising cost of shipping, transportation, logistics, and plastics indicated runaway inflation.
But inflation has strong mitigants: GDP is not higher than last year, unemployment is high, payroll remains low, and the industrials sector has ample idle capacity. Digitization has especially fuelled changes in the economy with the pandemic, although this may not be a cause for major alarm. Competing dynamics are moderating and compensating for inflation.
Asset Classes that Tend to Fare Well in Such an Environment
Investors need to ask whether real estate, as an asset class, is undergoing a transitional or structural change after 2020. Changes for real estate investors during this pandemic are more pronounced than ever. A key characteristic of real estate has always been that supply adjusts slowly and is sensitive to capital, and capital increases supply in anticipation of demand. However, demand may adjust overnight which can create massive supply-demand imbalances as those created during the 2020 pandemic.
Residential and logistics asset classes, the biggest beneficiaries of the decade-long demographic and technological changes, accelerated massively by the events of the last 12 months. Capital has favored such assets and flowed towards them more willingly. On the other hand, office space and hotels are in an uncertain phase. Are they undergoing a transitional change or a fundamental one? The future of hotels will be known before that of office space as vaccinations progress and the pent-up demand for vacations and leisure is released. Change in the office market will be slower, relying on longer term commitments and contracts from tenants.
The important question is whether the real estate subsector is undergoing a transitional change versus a structural one. For example, Alex cited asset-heavy companies, including residential home builders and niche assets, such as infrastructure for marinas, leisure or entertainment venues. Real assets that were affected by the pandemic in a transitional way are expected to rebound.
Lessons Learned in Real Estate Investment
Alex stressed that real estate is not a monolithic asset class. It is affected by downturns and other crises. Capitalization rates (operating income over value) depend on the 10-year Treasury yield, the risk premium, and the economy.
Secondly, there must be distress opportunities in properties clearly affected by the events of last year and the reluctant supply of capital.
Asset classes that have changed structurally cannot weather this crisis. Real estate and credit in different corporate businesses will undergo structural changes. Most asset classes will rebound, but not all. Consequently, investors must consider the long-term changes in each sub-sector.
Notes from the Q&A
Europe vs the US. Alex mentioned that Western Europe and North America are not directly correlated. At the beginning of 2020, the capital need was recognized in North America while during the last few months, the investment pipeline has shifted to Europe. The two markets have different value propositions at different times.
Best Regions for Real Estate Investment. Alex stated that Carlyle has worked historically in real estate credit in North American and Europe. During market dislocations, capital tends to flow towards clean businesses with a clear future. By default, better value can be found outside those markets. Look for areas of geographic dislocations. European markets have more dislocation and better opportunities today.
Market Trends. Investors should seek supportive trends. Today, market trends support residential, industrial, and logistics. As the economy recovers and the COVID-19 crisis subsides, supportive trends may arise in hospitality and leisure travel. Investors should avoid the pitfalls of certain offices and retail.
Remote Office Work. Alex detects worldwide fatigue from remote work, which does not separate work and personal life clearly. Although the last 12 months have proven the efficiency of working remotely, the ultimate resolution is a hybrid of remote and in-office work.
The webinar was held on April 7, 2021 in collaboration with The Family Office Bsc (C).
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