Real Estate: Aiming for Broad Diversification

Real estate offers generally stable income returns and provides low risk in portfolios due to low volatility and low correlations of returns with traditional asset classes. However, the challenging times we’re living in pose threats to all asset classes and require some words of caution. Taking a look at the past, and periods of higher inflation have been followed by typically higher real estate returns.

This was supported by an analysis we did in 2020 which compared nominal real estate returns and inflation across 26 countries globally. Our model showed that real estate offered a 78% inflation protection¹ and up to 80% when further conditions such as real interest rates and variable property risk premium were applied.

However, we are now seeing rising risk of stagflation (which occurs when inflation is above-average and GDP growth is below-average), due to rising interest rates from central banks as they attempt to curb inflation. These are our views for the US and Europe:

US real estate

Limited evidence from the US, dating back to the latest period of stagflation in the 1970s, shows that real estate outperformed equities and bonds, though performed below expectations compared to times of better economic growth (Chart 1). Since 1978, annual real – after inflation – total returns were of 6-7% during times of balanced economy, with a median of 6.9%. However, during periods of stagflation, real estate returned 5.5% in real terms while equities returned 2.5% and government bonds -7.3%.

In our view, the biggest threats to real estate markets are periods of recession combined with inflation at average or below average levels. To mitigate such risks, we believe broad diversification across countries is the most prudent strategy.

However, the US real estate market is in better condition than during the global financial crisis (2007+), with loan-to-value ratios being less stretched and spreads between real estate yields and bond yields less compressed.

Chart 1: US total returns by asset class during different economic environments (% YoY, 4Q78 – 1Q22)

European real estate

In Europe, the relationship between high inflation and strong real estate returns has historically been tenuous at best. In some instances, inflation has been propelled by strong demand which has been positive for rental growth.

However, when high inflation is a symptom of late cycle economic growth, additional risks are attached. Currently, inflation is cost-push rather than demand-driven, leading to a downgrade of economic growth forecasts. For example, the Bank of England expects the UK economy to stagnate in 2023/24. Also, interest rates are rising, with considerable hikes which have narrowed the spreads between real estate and fixed income. For real estate, this may translate into some upward pressure on yields, as the sector should price-in the new interest rate environment, and a downgrade in rental growth expectations as the economy weakens.

However, some segments of the European market still offer robust rental growth prospects and are showing a positive outlook in this challenging macroeconomic environment. This is especially the case for logistics assets located in strategic distribution hubs, where demand potential still significantly exceeds construction activity. Another sector continuing to benefit from structural trends is the European rental housing sector. In fact, the steady growth in household numbers and the rising attractiveness of the rental segment from a flexibility and affordability point of view continue to fuel a sizeable pent-up demand for the sector in most urban areas of the continent.

¹ Real Estate Outlook – Edition 1, February 2020