This Sector Can Wall Off Inflation

The stock market this year is off to its worst start in decades. Through the first week of May, the S&P 500 (proxy for the U.S. market) has essentially given back all of its gains over the past 12 months.

Amid the carnage, the energy sector in the S&P has bucked the trend, returning about 60% over the last 12 months. That’s not really a surprise given surging oil prices.

Another group that has held its own may surprise you: real estate investment trusts (REITs).

REITs vs. the S&P 500

The two charts below show the comparative performances of the Vanguard Real Estate Index Fund ETF (VNQ) and the SPDR S&P 500 ETF (SPY).

The first chart shows the relative performance from May 5, 2020 to May 5, 2021. Oof, not good.

But the second chart tells a different story. REITs have clearly been better than the market over the past year.

This third chart, which shows how inflation has progressed, explains why.

The Impact of Inflation

Throughout most of the period covered by the first VNQ vs. SPY chart, inflation was low. Stock investors favored higher-growth stocks like tech stocks. As a result, slower-growth, more income-oriented stocks like REITs lagged.

However, over the past year, inflation has risen steeply. In this environment, high price-to-earnings (P/E) growth stocks become less attractive. High inflation, which typically leads to higher interest rates, reduces the valuation of growth companies’ shares.

Expected future cash flows are discounted back to the present using a discount rate. When interest rates are higher, the discount rate used also goes up, which reduces the estimated present value of the company. Higher interest rates also increase the cost of borrowing so it becomes more expensive for growth companies to access capital. Also, when the economic outlook is less certain, investors are less willing to pay up for future earnings and cash flow.

The highest inflation since the 1980s, with no end in sight, coupled with the Fed’s hawkish stance, is stoking fears of stagflation, which is defined as inflation plus recession. Against this backdrop, investors have a higher preference for companies with stable cash flows and some protection against inflation.

Created With Regular Joes in Mind

REITs were created by law in 1960 to give retail investors a chance to invest in real estate without breaking the bank. After all, just buying one house is usually the most expensive thing an American will buy in his/her lifetime. Unfortunately, not everyone can afford a house.

REITs, however, allow regular Joes to buy shares in a real estate portfolio, thus owning small ownership in multiple properties, including commercial buildings, for literally as little as under $100 per share. And there’s no hassle of directly paying for renovation, maintenance, property taxes, or mortgages. The REIT does all of this and passes through the profit or loss down to its unitholders. There’s no taxation at the entity level as long as they qualify as a REIT.

By law, to qualify as a REIT, a company must distribute at least 90% of taxable income to unitholders. As an investor (unitholder), you do have to pay taxes on the dividend you receive, but unlike a corporation, you avoid double taxation.

Defense Against Inflation and Recession

Property values and rent tend to rise with inflation. Thus, REITs offer a degree of protection against inflation. Especially in the case of non-residential buildings, tenants typically sign long-term leases, sometimes for 10 years or more, which provide stable cash flows regardless of economic conditions. In other words, REITs can offer stability during inflation and recession, and that ability becomes more attractive when investors’ risk aversion increases.

Moreover, REITs offer an additional benefit that may not be obvious. REITs often specialize in certain types of properties. For example, you can invest in residential REITs, industrial REITs, commercial REITs, medical REITs, data center REITs, and the list goes on.

If you are bullish on a certain type of industry or business, but you don’t want to bet on a specific company, you could bet on a REIT that serves that industry instead. For example, investors who invested early in REITs specializing in data centers and cell towers did really well on their investments. These REITs benefit from the acceleration of digitalization and connectivity.

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