This space isn't dedicated to economic forecasting, but inflation sure has the look of being more persistent than transitory.
Perhaps it will ebb early next year as some experts are wagering it will. The Federal Reserve believes much, but the Fed's recent comments on the matter indicate the central bank believes inflation, though likely to fall next year – so the they say – will remain above the desired 2% target for several years to come.
In other words, it's not surprising that with about three months left in 2021, clients are likely tiring of hearing about the Fed, missed inflation forecast and the persistent vs. transitory debate. That's a cue for advisors because helping clients survive and thrive during inflationary climates isn't as difficult as many experts make it out to be.
In fact, there's considerable opportunity on this front for advisors because data confirm plenty of clients are likely flocking to Treasury inflation-protected securities (TIPS) on their own. That's fine – TIPS are the classic inflation hedge – but as interest rates rise, as is increasingly likely to happen next year, TIPS' yields usually pale in comparison to those of other bonds. Translation: It's time to consider other inflation-fighting asset classes and real estate investment trusts (REITs) are an ideal place to start.
Curing Inflation Blues with REITs
As has been widely noted, REITs are having some moments this year and inflation is part of that equation. The MSCI US Investable Market Real Estate 25/50 Index is up 21.56% year-to-date and its dividend yield of 2.34% qualifies as attractive in this environment. There's more to the REIT inflation-fighting story and many clients aren't aware of what “more” is in this case.
“Because most leases are tied to inflation, income from leases and property values tend to increase when overall price levels rise. This supports REITs’ dividend growth and helps investors to pursue real income during inflationary periods,” says Matthew Bartolini, head of SPDR Americas research.
In layman's terms, commercial landlords build into lease agreements gradual increases in rent that typically match or exceed inflation, making REITs the ideal asset equity-based asset class with which to protect against rising consumer prices. With those higher rents come the chance for increasing funds from operations (FFO) and with that, REITs are better positioned to grow dividends. Consistent dividend growth historically is an inflation topper in its own right.
“In all but three of the past 20 years, REITs' dividend increases have outpaced inflation as measured by the Consumer Price Index,” notes Bartolini. “Although the dividend yield of the US REITs industry has declined to around 3% as some REIT share prices increase, this income level is still much higher than inflation expectations and yields of investment-grade bonds.”
Returns Work, Too
When discussing inflation with clients, advisors often frame the specter of a rising Consumer Price Index (CPI) in terms of diminished returns and portfolio erosion and rightfully so.
To that point, REITs typically perform well when inflation is elevated, confirming that total returns come along with the above-average yields and inflation protection. In fact, REITs often beat other inflation buffers when the CPI runs hot.
“And when 12-month average CPI inflation has been in the top two quintiles, REITs have outperformed broad equities, US Treasury Inflation-Protected Securities (TIPS) and high yield bonds and been on par or slightly exceeded broad commodities,” according to Bartolini. “This underscores REITs’ total return advantage over other assets in a high inflationary environment.”
Bottom line: REITs may not be exotic, but they give advisors something to think about and the thought process could lead to unearthing better inflation-fighting tools for clients.