How will the inflation storm affect infrastructure and real estate?

9 May 2023
| By Rhea Nath |
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With initial signs that inflation might have passed its peak in Australia, portfolio managers have shared how they are positioning themselves for an interesting transition period in the coming months.

On 27 April, data from the Australian Bureau of Statistics (ABS) showed CPI inflation was down from 7.8 per cent in the December quarter, standing at 7 per cent in the year to the March quarter. Quarterly inflation witnessed an increase of 1.4 per cent, which was the smallest quarterly increase since December 2021.

This led Treasurer Jim Chalmers to state that inflation had passed its peak, although it remained far higher than the Reserve Bank of Australia’s (RBA) target range of 2 to 3 per cent.

Amid these developments, real estate investment trusts (REITs) and infrastructure saw dramatic shifts. As of 4 May, the benchmark S&P/ASX 200 A-REIT index’s year-to-date return stood at 3.9 per cent, marginally higher than the broader S&P/ASX 200 index, which was 3.06 per cent.

Meanwhile, according to the latest Australia Capital Trends report from MSCI Real Assets, Australia’s commercial property market recorded the slowest quarter in over a decade with transactions at just $5.3 billion, a year-on-year decline of 73 per cent.

The results confirmed that the market had entered a corrective phase as Q4 2022 volumes fell 51 per cent, the report said. The combined volume for those consecutive quarters was more than 25 per cent below the average of the past 10 years.

Historically, REITs and infrastructure have displayed defensiveness amid volatility in their ability to pass on rising costs. But it should not be forgotten that inflation remains disruptive even to these markets in the short term, explained Grant Berry, director and portfolio manager of A-REITs at SG Hiscock & Company.

“There is a close linkage to real bond yields (inflation linked bonds) and property income yields. This has been very apparent over the last year, whereby as real bond yields rose, REITs sold off,” he told Money Management.

Inflation-linked bonds moved from negative 60 basis points (bps) to positive 100 bps over that time frame, he said, and a higher real hurdle requirement meant prices needed to be lower to compensate.

“This happens in the listed space relatively quickly, potentially too dramatically, while the direct market has more recently responded,” Berry observed.

Delving into subsectors 

For Berry, the current appeal lay in exposures with the ability to pass on increased cost, such as the retail subsector. 

“In terms of our portfolio, we see securities or assets such as Scentre Group (i.e Australian Westfield Centres) well placed, as their rents are typically inflation plus 2 per cent, so you get the benefits of both. Also, having shorter leases can become more popular, [and] it provides you [with] the opportunity to reset the lease at a higher rent,” he added. 

According to MSCI’s Australia Capital Trends report, large format retail proved to be the strongest asset class in recent times, having seen yields compress from 7.1 per cent in mid-2018 to a low of 5.5 per cent in Q1 2022 to now sit at 5.8 per cent.

Amy Pham, fund manager at the Pengana High Conviction Property Securities Fund, also stressed that the inflation hedge in real estate and property was not straightforward and encouraged managers and investors to do their research before investing.

“For me, it’s not as simple as ‘inflation is beneficial for REITs and for property’. It affects the cost of capital, so therefore, you’ve got to look at each individual’s REIT’s hedging levels, gearing levels, and their balance sheet. The ones that are lowly geared and well-hedged are the ones that will do better in the right environment,” she explained.

Development continued to hold appeal as an investment, she agreed, with Stockland and Charter Hall Group among the fund’s top holdings as of the end of April. 

In Pengana’s March outlook, the fund outlined its preference for alternative assets such as data centres, childcare centres and hospitals though these sectors continued to be underrepresented in the REIT sector. 

Pham noted that in Australia, particularly in the REIT index, alternatives only made up some 8 per cent of the index, whereas in more mature markets like the US and UK, they were up to more than 50 per cent.

“I think this is because it’s just not institutionalised yet [in Australia]. The market is very fragmented and typically privately owned. But you see now more and more these assets being bought by institutions and then going into a vehicle like a REIT. The reason is that people have recognised alternative assets and their earnings are more stable compared to assets like office, retail, industrial which are more cyclical”.

Berry added that SG Hiscock also saw value in alternative assets, investing in offerings like service stations and storage.

“If the landlord [of the storage centre] wanted to increase the rent next month, they can. But if they push up the rents too much, the occupier may shift out of storage, so it’s got to be at a level where there’s a tight market from the demand perspective to do it,” he noted.

The growing popularity of infrastructure 

Trent Koch, a portfolio manager for the Global Listed Infrastructure team at First Sentier Investors, highlighted how global listed infrastructure as an asset class could deliver attractive risk-adjusted returns over the long term.

“Over the past 20 years (to 31 March 2023) global listed infrastructure has delivered a compound annual return of 11.0 per cent, with a standard deviation of returns of 11.2 per cent,” he said.

In comparison, over the same period, global equities returned 8.8 per cent per year, with a standard deviation of returns of 13.9 per cent.

Koch added: “Generally, during periods of high inflation, infrastructure has outperformed global equities as these essential and in-demand assets can address higher input costs and inflationary pressures by passing price increases to the end user. 

“Global listed infrastructure also offers defensive exposure, historically delivering most of the upside in rising equity markets but holding up relatively well during down markets. This pattern of performance has been underpinned by assets with high barriers to entry, strong pricing power, predictable cash flows and sustainable growth.”

The team held optimism for toll roads, whose concession agreements often included inflation-linked tolls, he said, along with towers and data centres, which benefited from the continued rollout of 5G mobile technology leasing. 

Consumers and businesses alike continued to move activities onto digital platforms, underpinning growing demand for communication infrastructure assets, Koch added.

Similarly, Magellan’s head of infrastructure, Gerald Stack, observed in its recent quarterly update that airports and water utilities, along with toll roads, were sectors that had performed particularly well. 

Stack offered that infrastructure and utilities held up as “resilient business models” that provided essential services even in recessions. 

“These are services that communities want to access, so we’ll continue to pay for them, so their underlying business models are very robust,” he said. 

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