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October 04, 2021 | GSAM Connect

The Building Blocks of Real Estate

Commercial real estate (CRE) may be one of the few asset classes that offers a compelling solution in today’s environment where investors face a trifecta of issues: higher inflation, lower yields, and potentially greater taxes. Given strong growth potential, attractive capitalization rates, and unique distribution structures, we believe this may be an opportune time to consider owning CRE.

Inflation: CRE is a popular asset class to own during reflationary environments as it not only holds intrinsic value, but also provides a stream of income that is tied to inflation. As most asset class returns tend to be negatively correlated with US Consumer Price Index (CPI), and see their real returns eroded during periods of rising inflation, real estate may be attractive because its revenue streams have historically demonstrated resilience.

As Exhibit 1 shows, real estate revenues generally run above the rate of inflation because: 1) leases tend to reset over time and are often inflation-linked, 2) during periods of rising inflation, construction costs increase and developers have a harder time justifying new developments, which acts as a natural ceiling on supply, and 3) incumbent asset values tend to rise as input costs go up. CRE in areas that have high, reliable and growing demand may have greater pricing power and ability to raise rents as inflation increases. Therefore, we think a discriminate approach to opportunities is important.

EXHIBIT 1: Real estate revenue streams adjust to inflation

Chart Source: US Bureau of Labor Statistics, Green Street Advisors, and Goldman Sachs Asset Management. As of 1Q 2021. Net operating income (NOI) growth represents the average NOI growth by year across the equal-weighted average of private commercial real estate in the apartment, industrial, mall, office, and strip retail sectors. NOI may not be correlated to or continue to keep pace with inflation. Past performance does not guarantee future results, which may vary.

 

Income: The search for income opportunities remains challenging as global rates stay at record low levels. We believe CRE may be an attractive alternative source of income as capitalization rates are attractive relative to yields in fixed income. Currently, private CRE trades at a premium of 368bps to US Investment Grade bonds. Historically, such premiums have preceded periods of strong returns, averaging 12.6% in subsequent 3-year periods, as shown in Exhibit 2. On top of providing a steady stream of income – which is often indexed to inflation – CRE may also offer the potential for appreciation at lease maturity or at the time of sale, as opposed to a bondholder who receives a fixed principal repayment at the maturity date. We believe CRE necessitates a selective approach in both geography and sector, as properties that are in high demand can generate differentiated income and capital growth. When appropriately sized for the right investor, CRE may generate steady cash flow alongside potential capital preservation in a portfolio.

Exhibit 2: Attractively priced with return potential

Top and bottom chart source: Green Street Advisors and Goldman Sachs Asset Management. As of June 30, 2021. Investment Grade (IG) Bonds refers to the Bloomberg US Aggregate Bond Index. Commercial Real Estate (CRE) refers to Private CRE and is represented by the NCREIF Fund Index Open End Diversified Core (ODCE) Total Returns Index. Spread on the top chart refers to the difference between the yield for IG bonds and the ODCE equity-weighted capitalization rate. Capitalization rate is a common profitability metric for CRE and is calculated by dividing a property’s Net Operating Income (NOI) by its market value. Bps refers to basis points of 1/100th of 1 percent. Past performance does not guarantee future results, which may vary.

 

Tax: When considering the potential benefits of real estate, we think that Real Estate Investment Trusts (REITs) are particularly interesting as they are publicly traded companies that own CRE, and they benefit from favorable US federal income tax treatment. As a pass-through vehicle, REITs do not face double taxation concerns as they do not incur corporate tax on their profits. The Biden administration’s proposed tax reform includes a corporate tax rate hike to 28%, which is expected to create negative earnings drag across most S&P 500 sectors, and real estate remains one of the few sectors that is insulated.

In essence, we believe real estate is a dynamic asset class with opportunities that span the private and public markets, can be traded or non-traded, and can be equity or credit investments. We believe that a selective approach to this asset class may help capture benefits such as inflation-hedging, yield generation, and tax insulation. Furthermore, we see many secular growth opportunities that have been amplified during the COVID-19 pandemic, such as the acceleration of ecommerce logistic centers from brick-and-mortar retail, and believe that disruptors and secular growth winners are especially positioned to enjoy tailwinds from these trends. 

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About the Author

Maria Li

Maria Li

Vice President, Senior Market Strategist, Strategic Advisory Solutions, Goldman Sachs Asset Management

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