Income With Growth In 2021: Got Real Estate?

Clarion Partners makes a case for real estate in the year ahead.

    Tim Wang, Ph.D.

    Tim Wang, Ph.D. Head of Investment Research, Clarion Partners

    Despite the recent second wave of COVID-19 cases globally, there are reasons to be optimistic about growth prospects in 2021. Several vaccines and treatments, including from Moderna and Pfizer/BioNTech, have shown highly effective trial results and are expected to be in mass production and distribution over the next few months. With these stunning medical breakthroughs, the end of the pandemic may be in sight. In addition, a closely contested U.S. election is over. A Biden White House and GOP Senate is arguably a more desirable outcome for the financial markets. A divided government may suggest relatively predictable policies going forward. Furthermore, another sizable fiscal stimulus package (CARES 2.0) in the range of $1 to $1.5 trillion will likely gain bipartisan support and receive approval by early 2021.

    Interest rates are near historic lows, but for how long?

    According to Moody’s Analytics, U.S. real GDP is forecast to grow by 4.0% in 2021 and 4.5% in 2022, driven by continued accommodative monetary and fiscal policies, pent-up consumer demand, and rising corporate investment. However, this strong projected growth over the next two years is clearly at odds with today’s low interest rates and low inflation – the 10-year Treasury yield remains under 1% and annual inflation is under 1.2% (as of October 2020). Indeed, major central banks have pumped approximately $8 trillion of liquidity into the global economic system since the beginning of the COVID-19 pandemic, raising concerns of potential future inflationary pressure. According to Bloomberg, 5-year inflation expectations have increased steadily from 0.9% in early April 2020 to near 1.9% in late November 2020. The key question to investors is: if the accommodative monetary policies successfully support a fast economic recovery, what adjustments should investors make to their portfolios amidst such economic growth?

    The current investment environment is particularly challenging. Aging populations and savings gluts globally have resulted in increasing desire for steady and high current income. Major stock market indexes have rallied significantly over the past several months to or near record highs, while, largely driven by central banks’ quantitative easing (QE) and interest rate reductions, global bond yields are at ultra-lows, with more than $17 trillion in negative yields. In addition, a large amount of cash is still on the sidelines ($4.5 trillion in the U.S. money markets alone), collecting almost 0% interest and waiting for potential investment opportunities.

    Real estate: the best of both worlds

    Many institutional investors have steadily increased their real estate target allocation over the past three decades to over 10% on average. Real estate is often viewed as a hybrid investment asset class between stocks and bonds. On one hand, it has similarities to bonds because landlords collect contractual rents as current income. On the other hand, it has similarities to stocks because landlords can increase rents under better economic conditions. In turn, real estate investments can be less volatile than stocks during recessions because of continued rent payments; conversely, it can outperform bonds under improving economic conditions because the ability to raise rents may serve as a hedge, at least partially, against rising inflation or interest rates.

    Income with growth is a key characteristic of real estate. Historically, average rent growth has equaled or exceeded inflation during the three most recent periods of economic expansion (1994-2000, 2003-2007, and 2010-2019), as illustrated in the chart below. The correlations between rent growth and inflation were over 96% in all three expansion periods. This makes intuitive sense: apartment operators can adjust annual rents at each renewal, while for longer-term leases for office, industrial, or retail properties there are typically built-in periodical rent bumps that are either linked to an inflation index or at a fixed annual rate, typically of 2-3%.


    Source: CBRE-EA, Bureau of Labor Statistics, Clarion Partners Investment Research, Q3 2020.

    Note: Average effective rent growth is calculated using simple average of the four main property sectors (apartment, industrial, office, and retail). Data are available going back to 1994. Effective rents are rents after any concessions. Past performance is not indicative of future results.

    A versatile investment vehicle for your investment objectives

    Over a complete market cycle, with moderate leverage, a core strategy – which typically focuses on stabilized, well-located, high-quality properties in major markets and certain high-growth secondary cities – may generate 7-9% in total returns, including approximately 4-5% in annual dividends. Investors willing to take on additional risk may prefer value-added or opportunistic strategies, which utilize lease-up, light renovations, re-development, or build-to-suit and can potentially generate 10-25% total returns, depending on the leverage levels and specific projects. In an economic expansion, it may be prudent to take on additional calculated risk to seek higher return potential.

    2020 may be remembered as a volatile but resilient year. While hotels and malls have been hit hard by the pandemic, other real estate sectors such as industrial/warehouse, life sciences, and rental housing have benefited or been minimally impacted. 2021 will likely mark the beginning of the next new real estate market cycle. Demand is expected to continue to recover across most markets and property sectors, as rising occupancy and higher effective rents should drive higher net operating income, supporting higher dividend and property appreciation. Thus, adding core real estate to a mixed-asset portfolio can be potentially beneficial because of relatively high current income, lower historic volatility, and portfolio diversification benefits (from low/negative correlations with stocks and bonds).

    While a dramatic rise in inflation is not a likely scenario, the risk of moderate inflation over the medium term has increased. As such, “income with growth” should be an important part of a portfolio allocation strategy given accelerating economic growth and a potential reflation environment. Real estate can be an effective vehicle to help achieve this investment objective.


    Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

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