Rising interest rates have been felt across financial markets, but the impact has been particularly painful in areas such as commercial property and infrastructure. Investors have diverted capital towards fixed income, there have been idiosyncratic problems with the investment trust market, while commercial property has struggled with shifting tenant demand. Is a shift in the interest rate cycle likely to revive these asset classes or should investors proceed with caution?
Both areas have relatively predictable, inflation-linked cash flows, which makes them sensitive to interest rates. However, the nature of the cash flows for the two asset classes are different. Commercial property has more economic sensitivity and this will shape the likelihood of any reversal in its recent fortunes.
The cash flow from commercial property come from tenants. While landlords should be able to push through inflationary rental increases, this only happens where if there is sufficient demand to absorb supply. For infrastructure, on the other hand, the cash flows are governed by long-term contracts, with inflation-adjusted price rises built in, and – in many cases – may be back by government guarantees.
In our view, this means commercial property still warrants caution today in spite of the significant discounts in the market. Not only is the global economy likely to weaken next year, there are still structural pressures in certain parts of the commercial property market: high street retail remains weakened by the ongoing move to ecommerce, while the office market is also in the process of adjusting to new working patterns post-pandemic. The bankruptcy of WeWork, a major landlord in key areas such as the City of London, may also create a glut of supply on the market.
Another complexity for commercial property is the move to ‘green buildings’. The Net Zero Carbon Buildings Commitment was created in 2018 and enhanced in 2021 to recognise carbon-friendly buildings, while enhanced climate change disclosures for companies are also driving a transition to cleaner buildings. For all companies, the buildings they inhabit may be an important part of their overall carbon scores, and they are demanding more of their landlords. While low emission, high scoring commercial property assets may be in demand, it also creates the prospect of ‘stranded assets’. This is also distorting commercial property markets.
As such, the risks around commercial property still look significant. The discounts of many investment trusts and REITs to net asset value is worthy of note, but a change in direction on interest rates may not be enough to draw investors back to the sector. Equally, while supply and demand remain out of balance, it is difficult to see how landlords can push through inflation-linked rental increases.
Infrastructure has less economic sensitivity. In the absence of higher yields on fixed income, infrastructure had become the default asset class for inflation-linked income. Infrastructure investment trusts had moved to significant premiums to net asset value. This left them vulnerable to a reversal in flows.
This has happened over the past 18 months. Many investors reasoned that they no longer needed to own infrastructure assets when, for the first time in a decade, they could get a high yield on a bond. This was a sharp contrast to much of the preceding decade when zero interest rates left the yields on infrastructure assets looking uniquely attractive. Money has flowed out of the sector, creating significant discounts to net asset value.
This has been painful and, unless interest rates go back to zero, infrastructure assets are unlikely to resume their previous popularity. However, with interest rates rolling over, the selling pressure has ebbed. Investors are starting to look at infrastructure assets on their own merits again. This should narrow the discounts and create some momentum in the sector.
It is also worth noting that the fixed income and infrastructure are not a straight swap. Fixed income does not protect against rising inflation. While inflation is falling, a lot of the components of inflation are losing downward momentum. Our view is that inflation is likely to remain above the 2% level in the near term. Investors still need protection, and infrastructure assets generally provide that link to CPI.
Against this backdrop, there is argument for selectively revisiting infrastructure assets. Discounts may move quite quickly, and the opportunity is likely to be temporary. However, our view is that the risks inherent in commercial property are still too high, even as interest rates roll over. The sector remains in flux and needs to rediscover its equilibrium.
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