Protect Your Portfolio From Inflation With REITs (2024)

Co-produced with Beyond Saving

We have previously discussed our outlook on inflation, stating:

Ignoring the shorter-term supply and demand factors which generally resolve soon, we have seen the setup for inflation via a very high growth of money supply (free or very cheap money by governments and central banks). On the positive side, consumers don't want to borrow and financial institutions are reluctant to lend. Until that fact changes, the potential inflationary cycle will remain in hibernation. However, there's definitely a storm brewing under the surface and the potential for serious inflation is very high.

In other words, we don't see inflation tomorrow, but we do see the potential for significant inflation down the road. The reason for high inflation is simple. All this quantitative easing and money printing by central bankers across the globe (in responsive to COVID-19) will come at a high cost. Someone will have to pay! It will most likely be paid in part through inflation which is indirect taxation that will impact every one of us.

Therefore, It's important to remain proactive with our retirement portfolios. While it's impossible to envision, let alone protect yourself from every possible risk, when we can predict a risk we can position our portfolio methodically to reduce the impact or even turn it to our advantage.

We want:

1. Investments that will experience cash flow growth related to inflation.
2. Investments that will have valuations increase with inflation. Or investments that go up in price as inflation kicks in.
3. Investments that are relatively cheap right now on a cash flow basis.

One investment of the best inflation hedges available for investors is real estate. When inflation takes off, the price of real estate goes up. What happens to rent? It also increases. And that leaves us with No. 3, is real estate relatively cheap right now? The answer to that question is "maybe." Some real estate is cheap, some is still trading at pre COVID-19 levels. Having said that, even higher-priced properties are likely to go even higher once inflation kicks in.

For many retail investors, it's not practical to invest directly into rental properties, or it's just to much of a headache. Fortunately, the markets offers investors the possibility to buy real estate through "property REIT stocks." Investing in property REITs in a retirement portfolio allows you to have flexibility to adjust to changing conditions because REIT stocks are generally very liquid and can be bought and sold instantly on the markets. On the other hand, physical real estate is very illiquid and requires a relatively large capital commitment into a single property. Furthermore, managing physical real estate is a big headache and can result in losses if you have a bad tenant.

As an income investor, I'm interested in owning real estate through listed property REITs that invest in properties. By doing so, an investor gains exposure to real estate in a vehicle that's extremely liquid and can be bought or sold quickly. When you are buying these REITs, you also are buying the management, so you don't have the headache of renting these properties yourself. You get the benefit of the cash flow growth and valuation increases of the underlying property. Best of all, REITs are cheap right now relative to other stocks and relative to their own history, even as the properties they own might not be.

Cash Flow Growth

At their essence, property REITs buy property with the intent to lease it out over a long period of time – providing a large amount of capital upfront in order to collect rent over a period of time. While the details can vary substantially among different sectors, with REITs, they generally have substantial real estate holdings and rent will be their largest source of revenue.

Rental contracts are going to vary by sector and from REIT to REIT. Rent is raised two ways – at expiration of the original lease it's renegotiated at current market rates and most leases contain some kind of provision for rent escalators. Those escalators might be fixed at a certain percentage, but are frequently tied to an inflation index.

For example, Realty Income (O) is a very strong blue-chip REIT that we are recommending to our investors as part of our high-yield ModelPortfolio. Their leases are frequently 15-plus years long. Nobody can predict what inflation will do over 15 years, so the leases have provisions that will increase rent based on an inflation index.

The result is that their same-store properties will see consistent rent growth that will be more or less in-line with inflation.

Source: Realty Income

Investing in REITs with longer average lease terms will result in a more consistent same-store growth, but a slower reaction to inflation. REITs with short lease terms will react quickly to changes in inflation. Apartment REITs for example typically raise rent annually for most of their tenants.

Real Property Assets

One of the most underrated features of REITs is their massive real estate holdings. Due to the durability and long-term growth potential, real estate is the preferred collateral for lenders. It's something tangible, potentially revenue producing and over the long term real estate prices trend upwards, often beating inflation. This is why individuals can routinely get mortgages on their homes at 80% loan-to-value (LTV) or even higher at very low interest rates.

For REITs, this means that they have a plethora of options for borrowing money. With a strong credit rating they can get unsecured debt, but even REITs with weak balance sheets frequently find lenders that are willing to work with them on collateral. Hotel REITs are a good example as they have seen their revenues virtually vanish and they are operating at losses due to COVID-19.

For example, RLJ Lodging Trust (RLJ), recently announced a deal with their revolving lender that not only waives all covenants that would be violated by their hotels not being open, the deal also allows for the acquisition of $200 million in new properties. This will allow RLJ to take advantage of any sellers who are forced to sell at a discount. RLJ's strong financial position is why RLJ Lodging Trust, $1.95 Series A Cumulative Convertible Preferred Shares (RLJ.PA) is our favorite hotel investment right now. RLJ-A currently offers a yield of 8.1%.

Some sectors of the real estate market, like hotels, are likely to see a flood of forced sellers. Quality REITs are well positioned to take advantage of such discounts and we expect that the overall pricing of real estate will recover quickly.

REITs Are Cheap

There are several methods to compare the value of REITs and their cash flow. One is to compare the spread between REIT dividend yields and 10-year Treasuries:

Source: REITWatch

By that measure, REITs are the cheapest they have been in 30 years with the exception of 2009.

The natural question to ask is "why?" Nobody should be surprised that the answer is COVID-19. COVID-19 has impacted every company and those with a large physical presence – those that pay a lot of rent – more than others. Many tenants didn't pay rent in April through June as they sought to hoard cash and faced their own difficulties with many industries seeing virtually no revenue during the shut downs.

For the most part, renters found their REIT landlords very cooperative. As Q2 earnings continue to come out, we are seeing deferral agreements where rent for Q2 or even longer is being deferred and will be payable in installments in the future. In a few cases, landlords have even granted abatements. These are agreements that will forgive all of or a portion of the missed rent if the tenant upholds certain conditions such as paying current rent in a timely manner. If the tenant fails to meet the terms, then the abated rent becomes due and payable.

REITs understand that ongoing revenue is a priority. They want their tenants to be financially secure and able to pay rent for the next decade. It helps that REITs had historically strong balance sheets entering the crisis.

REITs have the ability to cooperate with their tenants, and they have. However, that willingness only goes so far. The Gap (GPS) is facing several lawsuits from landlords for unpaid rent.

The Opportunity

The market is still punishing REITs, and they have broadly under-performed the market year to date.

Data by YCharts

This is a buying opportunity. Low treasury rates means that the cost of borrowing has declined for healthy REITs. It also means that once the noise has died down and tenants resume paying rents as normal, REITs will recover in force. Not only will many REITs recover to pre COVID-19 highs, we expect that the new reality of much lower Treasury rates will be very bullish for REITs.

Yield-hungry investors are going to increasingly be forced to turn to dividend paying stocks, as the yields from Treasuries and high-rated corporate bonds are inadequate. REITs, by tax laws that require minimum distributions and tradition, pay above average dividends and those dividends increase with inflation.

REITs will not only close the gap, when they recover they will roar through it and trade at much higher premiums than they did before the treasury rate cut. This is why we are increasing our exposure to REITs.

Conclusion

REITs are well positioned to thrive from current prices given our outlook on inflation. They are designed to grow cash flow inline with inflation, their underlying assets tend to grow with inflation and provide strong collateral for cheap borrowing, and today REITs are relatively inexpensive.

We recognize that the market is fearful of tenants not paying rent. The actual impact is going to vary from sector to sector and REIT to REIT. The likelihood of tenants paying back rent and the impact if they do not is a new factor that has to be considered on a case by case basis. As a class, we are very confident that REITs will thrive.

When inflation strikes, you want to be the one collecting rent, not the one paying it. You also want to be owning assets that go up in price as the inflation monsters knocks on your door. One of the best way to do it is by buying real estate.

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