Here’s a secret hedge against rising inflation

Is it gold? Is it cryptocurrency? You might be surprised at what one fundie is spruiking as the perfect counter to rising interest rates.

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A fund manager has claimed, contrary to conventional belief, that real estate investment trusts (REITs) are a practical hedge against inflation.

With the world transitioning to a post-COVID recovery, inflation is expected to pick up.

Traditional wisdom dictates that as inflation rises, interest rates will rise. And higher interest rates dampen enthusiasm for real estate.

However, Resolution Capital chief investment officer Andrew Parsons told an investor briefing that this is a false correlation.

“It’s a simple catch-phrase that the market focuses on without actually looking at the history of returns,” he said.

“There’s plenty of evidence to demonstrate that REITs are not highly correlated to rising interest rates and bond yields.”

Resolution Capital is a specialist manager of international listed real estate assets.

The proof was just last year

Parsons said investors needed to “look deeper” into the dynamics between the economy and real estate “fundamentals” to gauge how rising interest rates could influence REIT values.

One only had to look at last year to see the conventional relationship between property and inflation turned on its head.

“We had falling bonds and falling interest rates and yet REIT prices actually fell,” said Parsons.

“So, to us it’s a common error for people to focus on the simple thought that rising interest rates are bad for REITs. The historic evidence does not show that clearly, whatsoever.”

Where REITs are headed this year

In the current post-pandemic recovery, rising construction costs would act as a “strong tailwind” for real estate funds, according to Parsons.

“What we’re seeing is a very significant increase in building costs. Important ingredients in building properties have been going up at a very dramatic rate in the last 12-18 months,” he said.

“That’s been as a consequence of a number of factors, including the likes of the COVID disruptions, the problems with Vale mines in Brazil, a recovery in new housing starts in the US, plus the extraordinary [Australian] government infrastructure plans that have been announced.”

Real estate is a hedge against inflation

All that points to REITs rising in values along with inflation.

“Ultimately we believe that real estate is a hedge against inflation,” said Parsons.

“Developers are facing the prospect of higher building costs and as a consequence they will need higher rents to justify making that investment in new buildings.”

As higher rents are charged for new buildings, that helps existing landlords.

“You’ve got a cost advantage and therefore it should in fact moderate the supply picture and underpin existing property values.”

Parsons said this is why it’s important investors not get caught up in time-worn cliches.

“Actually look at the real returns that the sector can produce and the drivers that are so important in determining that. 

“For us it’s about pricing power and capital management.”

Australian REITs have done pretty well in the last 12 months. The S&P/ASX 200 A-REIT index (ASX: XPJ) has risen 31.74% over that time.

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Motley Fool contributor Tony Yoo has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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