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Larry Antonatos, managing director and portfolio manager with Brookfield Asset Management.
2022 has been a difficult year for investors with both equities and bonds declining dramatically. With inflation running higher for longer, global central banks, including the U.S. and Canada, are fighting inflation with an aggressive tightening cycle, reducing monetary stimulus by raising benchmark interest rates and tapering asset purchases. The good news is that high inflation is a tailwind for infrastructure and real estate cash flows. The bad news is that rising interest rates are a headwind for infrastructure and real estate valuations.
The high inflation tailwind is stronger for infrastructure than it is for real estate. This is because the contractual cash flow linkage with inflation is tighter for infrastructure than for real estate. Pricing for infrastructure services is generally based on long-term regulation or long-term contracts, both generally allowing price increases tied to inflation. In contrast, pricing for real estate rent is based on lease contracts with terms generally ranging from one year to 10 years, and with rental rates determined by negotiations between landlords and tenants, and heavily influenced by supply and demand conditions at the time of negotiation.
Real estate leases also frequently include annual rent increases of either a specified amount or amount tied to inflation. The inflation linkage is looser for real estate than for infrastructure because expiring real estate leases will roll over to new market rents, which may be higher than expiring rents in a high-growth economic environment or lower than expiring rent in a slow-growth economic environment. Accordingly, we would expect infrastructure to outperform real estate in a high inflation but slowing growth environment such as we have had in 2022.
Let’s now review the actual results. All quoted returns are for year to date through September 30th, 2022 in U.S. dollars.
2022, Q3 marked the third consecutive quarter of declines for global equities, bringing the MSCI World Index down to minus 25% year to date. Infrastructure equity benchmark outperformed, down 15% year to date, while real estate equity benchmark underperformed, down 29% year to date.
Within infrastructure equities, there was a wide range of performance by sector. The strongest performing sector was the oil and gas storage and transportation sector, down 2% year to date. The sector benefited from strong supply-demand fundamentals and high commodity prices in the underlying oil and gas sectors. Strong performance has been accompanied by strong earnings growth. Accordingly, valuations remain reasonable and we expect sector outperformance will continue.
The weakest performing sector was communications, down 29% year to date. Although this sector benefited from strong supply-demand fundamentals, and strong revenue and cash flow growth, the sector began the year at very high valuations. Following this year-to-date decline valuations are now reasonable and provide an attractive entry point for this high-growth infrastructure sector.
Within real estate equities, there was meaningful divergence in performance by both geography and property type year to date. By geography, Europe, which faces the greatest risk of recession, was the worst-performing region, down 48% year to date. While Asia was the best-performing region, down 18% year to date, and North America was in line with the global average, down 29% year to date.
By property type, within North America, hotels were the best performing sector, down 20%, as leisure travel demand remains strong and business and group travel demand continued to recover. There was a close race for worst performing property type, with industrial down 36%, office down 36%, and data centers down 35%. All very weak. Industrial and data centers benefited from strong supply-demand fundamentals and strong revenue and cash flow growth, but these sectors began the year at very high valuations. Following the year-to-date declines, valuations are now reasonable and provide an attractive entry point for these high-growth sectors. In contrast, office suffered from a lack of demand and continued uncertainty surrounding work from home.
In summary, 2022 has been a very difficult year for investors. However, year-to-date price corrections have created attractive entry points for equities in select infrastructure and real estate sectors with strong fundamentals, strong growth potential, and pricing power. This includes communications, infrastructure, data, and industrial real estate.