Supply Chain Real Estate
Hard assets like real estate are distinct from soft assets, such as stock and bonds, because they hold intrinsic value. Assets with intrinsic value are supply constrained (scarce) and serve a basic human need by providing food or shelter. As a result, hard assets are able to hold their value during periods of inflation. Real estate is one of the best hedges to inflation because it’s impossible to make more land and shelter is essential even during times of economic hardship.
NOYACK’s fundamental conviction is that supply chain real estate assets are now essential to the U.S. economy because they enable the storage or delivery of goods and services. Consequently, supply chain real estateis undervalued relative to the market maturity of e-commerce.
In the past 5 years, digital commerce has grown 140% to a $2.4 trillion market opportunity, yet the supply of real estate infrastructure to meet this demand has increased only 25%. This enormous supply–demand imbalance will drive increasing revenue in these assets classes for the next decade.
Inflation is here; What Next?
The Consumer Price Index (CPI) and Producer Price Index (PPI), two important indicators of inflation, rose to 9.1% and 11.3% in June 2022, some of the most dramatic yearly increases since the 1980s. In the wake of the pandemic, inflation is back with a vengeance due to intractable supply chain disruptions and dramatic growth of the money supply as the government printed several trillion dollars in fiscal stimulus. The knock-on effect from this has been a sharp increase in prices and wages, sparking fears that we are entering a new period that will be characterized by higher inflation and interest rates. Naturally, investors are seeking to protect their wealth by re-assessing their portfolio’s ratio of stocks, bonds, and private real estate. NOYACK Logistics Income REIT (NLI) believes a greater exposure to commercial real estate will provide an effective hedge to inflation for investors, individual and institutional alike. This has propelled real estate specifically logistics properties – cold storage, dry warehouses, mobility hubs™, medical office buildings and life sciences labs into the spotlight as it is often argued that “property is a good hedge against inflation”. A 2011 study by Wharton concluded that real estate is “ a perfect hedge against inflation, under the strong assumption that future rent growth and discount rates move in line with expected and actual inflation rates.”
Triple-net leases shift the operating costs of a property to the tenants, including real estate taxes, building insurance, utilities, and maintenance costs. So as the price of these inputs rises with inflation, property owners are able to protect their cash flow by passing along the increased costs. Triple-net leases have the potential to significantly increase the net operating income (NOI) of a property over the duration of its lease.
Real estate leases may include negotiated annual rent escalations to keep up with inflation by contractually tying rent increases to upward movements in the CPI. This was standard practice in the 70s and 80s during periods of high inflation, and it remains an excellent way to protect investor returns.
Shorter leases allow property owners to increase rents more frequently to keep pace with rising inflation. Shorter leases protect the real value of cash flows and shareholder returns.
Particularly important for longer-term leases or when only one tenant occupies the property, periodic rent reviews create preset opportunities to adjust rents over the course of a lease.
For properties with loans negotiated during periods of low interest rates, when rents go up, net cash flows increase, all else equal.
All portfolio assets owned or considered have pricing power either in built-in lease increases or in real time with ultra-short duration. NLI ONLY considers for acquisition properties with rental increase codified into the existing leases.
NLI has a barbell approach to lease duration. While the majority of acquired tenancy will be long term (> 7 years), a significant lever to long term rental growth is the opposite end of the barbell, short duration leases in markets where the existing rent is lower than the market rent determined by recent comparables.
Our existing debt was purposefully sourced during recent periods of deflation and only at a long term fixed nature. Thus this attractive debt never exceeds a prudent 65% leverage ratio is now an additive value when the time come to sell the portfolios as all loan agreements are transferable.
Another target characteristic of our underwriting is placing a greater value on triple net lease with lowers any risk attributable to rising costs mismatched to rental income growth because the tenant is responsible for ALL expenses. A critical component of inflation protection.
So far, industrial rents have kept pace with inflation, according to the most recent data from CBRE, with rents advancing 11.8% year-over-year during Q1.
CBRE’s data is confirmation of a long-term trend: real estate income has exceeded inflation since at least 1996, according to data from the Bureau of Labor Statistics and Green Street Advisors.
This data has led many market watchers to believe that real estate could outperform the broader market in the near term. “Inflation and Real Estate Investments,” a 2017 study published by NAREIT and Wharton, substantiates this claim. Without veering too far into academia, the study indicates that a portfolio with a 39% allocation to real estate investment trusts (REITs) has a 78% chance of exceeding inflation.
This recommendation is validated by the relative performance of real estate in comparison to other asset classes during periods of high inflation. In fact, with economic growth appearing to slow in the near term, private real estate may be poised to outperform public equities by 4.2x during the upcoming period of low growth and high inflation, a.k.a. “stagflation.”
In comparison, most publicly traded stocks and bonds have a much harder time keeping pace with general inflation. These investment types — especially bonds and similar fixed-income debt instruments — typically lose value as the Consumer Price Index increases. Because hard assets have low correlation with many stocks and bonds, they are capable of adding strong diversification power to a portfolio.
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