- Expected returns for traditional assets remain under pressure; 60/40 portfolio valuations are the richest they have been in 35 years.
- Inflation should pick up over the course of the coming year, moving long-term interest rates higher.
- Fixed income investors are increasingly being forced to trade protection for yield, a trade-off complicated by a backdrop of rising rates.
- U.S. core real estate provides a return premium to corporate credit while simultaneously being uncorrelated to equities.
Investors relying largely on traditional stocks and bonds to meet their return and risk objectives face challenges: Returns are expected to be modest, interest rates are low, and bonds are unlikely to provide the level of portfolio protection they have in the past. Higher yielding bonds may help meet the need for income but are more highly correlated to equities. U.S. core real estate can offer opportunities to address each of these concerns with its potential to enhance income, return and diversification.
The same old song—a low interest rate, low return environment
The return challenge facing investors has been well documented: The reality is that returns on a 60/40 portfolio of stocks and bonds are generally expected to fall short of most return targets. In fact, a 60/40 portfolio is more expensive than it has been at any point in the past 35 years (Exhibit 1). High valuations, which can foreshadow poor performance, reinforce the idea that investors will likely need to embrace a larger, more diverse universe of investment opportunities going forward.
Traditional 60/40 portfolios look expensive—more than at any point in the past 35 years
EXHIBIT 1: BLENDED S&P 500 FORWARD E/P RATIO AND BLOOMBERG BARCLAYS US AGGREGATE YIELD-TO-WORST
This environment of meager expected returns and historically low interest rates has created another problem—investors are starved for income. Unfortunately, the parts of the bond market that provide yield tend to be correlated to equity markets. But in the more defensive parts of the fixed income universe (e.g., long-duration investment grade bonds), the lack of yield and potential for rates to rise create an asymmetric risk-return profile.
The Federal Reserve (Fed) and other central banks have committed to keeping policy rates low for the foreseeable future, but there is only so much they can do to control the long end of the curve. The past 12 months have seen an unprecedented amount of fiscal stimulus deployed around the world, and with an economic recovery on the horizon, the risk of inflation, and therefore rising rates, feels tilted to the upside. The Fed’s measure of expected inflation five years forward indicates that those expectations have been on the rise since the depth of the pandemic crisis (Exhibit 2).
Actual inflation should begin to show signs of life in the coming months as base effects boost year-over-year readings in April and May and the combination of stimulus and vaccine distribution allows pent-up demand to be realized in the second half of 2021. One of the unique things about the pandemic-induced downturn is that incomes, which usually dry up when the labor market softens, were replaced by stimulus checks and enhanced unemployment benefits. This means that the consumer is in a very different position today than is usually the case coming out of a recession. According to data from Chase, consumers entered 2021 with the highest total savings balances on record. Furthermore, an elevated savings rate and significant pent-up demand should lead to a strong rebound in consumption and potentially drive inflation higher as the U.S. economy reopens later this year.
Long-term inflation expectations have risen to levels not seen since 2018
EXHIBIT 2: FIVE-YEAR, FIVE-YEAR FORWARD INFLATION EXPECTATION RATE
Finding a “real” solution
Given the risk of higher inflation, and therefore higher rates, and the impact this would have on the value of fixed income allocations, investors are increasingly turning to core real assets—specifically, real estate—as a solution. As seen in Exhibit 3, valuations in core real estate are not nearly as stretched as those prevailing in credit markets. Core real estate also comes with far less interest rate risk.
Core real estate looks cheap relative to credit
EXHIBIT 3: SPREAD BETWEEN JPMAM UNLEVERED UNDERWRITTEN IRRS AND MOODY’S BBB YIELD
While a clear valuation advantage is seen for real estate when looking at trailing metrics, given the variety of dislocations that exist across asset markets in the aftermath of the pandemic, what does a more forward-looking analysis suggest? Drawing on our Long-Term Capital Market Assumptions, expected returns from U.S. core real estate are well above what we believe will be available in both the high yield and investment grade corporate bond markets over the next 10 to 15 years (Exhibit 4).
Relative to high yield bonds, U.S. core real estate is expected to provide higher returns and a wider premium to investment grade bonds
EXHIBIT 4: U.S. CORE REAL ESTATE VS. HIGH YIELD BONDS: LONG-TERM EXPECTED RETURNS AND PREMIA
Core real estate assets and bonds have different types of risk. The Federal Reserve’s response to the pandemic effectively papered over cracks that had begun to form in credit markets during the latter stages of the prior expansion—when many seemingly troubled companies experienced difficulty in servicing and/or repaying debt. By providing broad-based support through a variety of liquidity facilities, the Fed may have merely delayed the inevitable. While we do not imagine a seismic shift in the next 12 months, there is a substantial risk that cracks will begin to reemerge as policy supports are gradually withdrawn. Investors should not forget that corporate debt levels are higher today than was the case coming into the pandemic.
While there is a clear fundamental argument for substituting core real estate for corporate credit, there is a portfolio construction argument as well. Adding core real estate to a diversified portfolio of stocks and bonds can help reduce volatility and enhance returns, particularly when it is used as a substitute for equity-correlated high yield (Exhibit 5). Although some investors may prefer to swap their investment grade exposure for core real estate, we think replacing high yield is a more natural transition. Investment grade corporates, despite low yields, are increasingly being used for equity diversification. Core real estate can provide an uncorrelated source of income.
U.S. core real estate can increase portfolio efficiency more than high yield
EXHIBIT 5: ESTIMATED PORTFOLIO RISK AND RETURN IMPLICATIONS OF REPLACING HIGH YIELD WITH U.S. CORE REAL ESTATE
Significant portfolio and strategy investment implications
This year should bring more clarity around the outlook for growth, and as that occurs, investors will begin to focus on the risk stemming from inflation and what that might mean for Fed policy. Structural forces like technology adoption and the remediation of income inequity look set to weigh on inflation in the long run, but rising prices do represent a medium-term risk. As such, investors will need to be cautious as they allocate to fixed income, and incorporate assets that can provide attractive yields without adding to the overall level of equity risk in a portfolio.
With that in mind, core real estate assets present a unique opportunity: Not only should their cash flows adjust if inflation picks up, but these productive assets can provide a direct benefit to the end user. Plus, the majority of the return that these core assets generate comes from income rather than capital appreciation; that can help address the income conundrum created by a low interest rate environment.
At the portfolio strategy level, we believe COVID-19 has accelerated changes already underway in the U.S. economy, and we think real estate portfolios should reflect these changes. The path of goods from factory to consumer has been irrevocably fragmented; distribution now ends not at 1 million stores but at 150 million doorsteps. The pandemic-induced medical crisis and vaccine search showed the need to restructure a medical and life sciences system that is the world’s most innovative but also needs to do a better job of delivering the best cost-effective care to millions of Americans. New medical and lab properties have an important role to play.
Our grand experiment in remote work has, perhaps forever, increased the share of U.S. economic activity that happens in the home—meaning many people need more residential space at a lower cost. Most importantly, COVID-19 has taught us to invest as though evolutionary changes can turn into revolutionary disruptions.
Investors are always trying to protect themselves from a variety of risks. Core real estate may be an interesting way to protect your portfolio from today’s low interest rate environment, as well as the risk that inflation picks up tomorrow, while tapping into some of society’s strongest secular trends.