As the US economy expands, the global interest rate environment is now clearly on an upcycle, with both short- and long-term interest rates expected to increase over the next one or two years.
In this environment, REITs and other commercial real estate options can outperform fixed income asset classes, because income of a commercial property is tied to its rents, which can go up during an upcycle.
Within commercial real estate, asset classes that have more rental upsides may outperform other, more stable asset classes.
Commercial real estate is an interest-rate-sensitive asset class, as every increase in the interest rate will prompt investors to think whether the prevailing cap rate still makes sense.
Specifically, investors would ask if the total return of real estate, driven by both rental income and capital value movements, compares favorably against the higher income from long-term government bonds. If investors collectively demand more return over real estate, cap rates will expand.
However, cap rate expansion does not always mean a fall in capital value. Real estate prices are typically derived from its net operating income divided by cap rate.
During an economic expansion, rents are increasing alongside interest rates, and thus as long as income increases are fast enough, capital value can continue to go up.
In fact, this is supported by empirical evidence. In the last 45 years since the first major US REIT index was published, there were 24 years of interest rate increases. US REITs had a positive performance in 20 of them.
The positive performance is always invariably tied to the REITs’ ability to increase rental income during economic expansion.
The ability to increase rent varies by asset class and the lease structure. For example, a hotel asset, having daily or close-to-daily leases, will respond to economic changes faster than a single-tenant office campus.
Oftentimes, income of a hotel operator or a hotel REIT will see its inflection point before noticeable shifts are seen in the overall market sentiment.
Since this interest rate upcycle is driven by an expected acceleration of the global economy, hotel assets should do well in the short to medium term.
This is especially true as Asia-Pacific as a region is maturing and the number of intra-regional tourists is expected to grow.
According to the United Nations’ World Tourist Organization, the number of inbound tourists to the Asia-Pacific grew from 60 million in 1995 to 210 million in 2014. The organization also expects the number to grow to 300 million by 2020 and 500 million by 2050. This growth should support a continued expansion of the hotel sector in the region.
Even with the same asset class, however, buildings can respond to rental upcycles in different ways. For example, rental increases of an office building leased to a single tenant will be limited to either what is written into the lease or renewals with the tenant.
But an office building with multiple tenants will probably have some lease expiry every year. Thus, during a rental upcycle, multi-tenanted office buildings will see a more consistent and likely higher income increases.
A building’s lease structure refers to information such as the number of leases a building has, their average lease expiry, and the gap between the contracted rent and market prevailing rents. This set of information helps investors to understand the likely amount of rental increases of each REIT, or if enough details are given, the likely rental increases of each building.
In short, the defining characteristic of commercial properties as an income-producing asset class is that its income can grow during an economic upcycle. Thus, as the global economy accelerates, investors are well advised to focus on assets that can produce an income growth.
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