(Runtime: 5 min, 01 sec; size: 2.70 MB)
Larry Antonatos, managing director and portfolio manager with Brookfield Asset Management.
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. This will slow inflation, but will also slow economic growth. The risk is that economic growth will slow too much, resulting in a recession. With many investors anticipating recession, it is important to consider how different infrastructure and real estate sectors are likely to perform in a recession. Certain sectors are more vulnerable to a downturn, and certain sectors are safer places to invest as growth slows.
Broadly speaking, infrastructure is more defensive than real estate because infrastructure and real estate have very different business models. Real estate is a free market business driven by the traditional interplay of supply, demand, and pricing. Growth in supply is cyclical driven by the optimism of property developers and the availability of construction financing. Demand for space is also cyclical, driven by economic activity. Pricing, the rental rate, can be volatile because it is determined by negotiations between landlords and tenants, and is significantly impacted by the levels of supply and demand at the time of this negotiation.
In contrast to real estate, infrastructure is generally a regulated business where regulation can significantly impact supply and pricing. Supply growth can be limited by government regulation or by a first mover advantage. Accordingly, many infrastructure assets benefit from limited competition. Demand for infrastructure services is generally very steady because infrastructure provides essential services that generally have limited sensitivity to economic activity. Pricing for infrastructure services is generally predictable because it was frequently long-term regulated or long-term contracted with price increases tied to inflation.
Relative to many traditional investment sectors, infrastructure and real estate generally offer more predictable revenues and cash flows. For infrastructure, these predictable revenues derive from long-term regulated pricing or long-term contracted pricing. And for real estate, predictable revenues derive from long-term leases. In a shallow recession, both real estate and infrastructure should outperform traditional cyclical sectors due to the defensive benefit of predictable revenues and cash flows. In a deep recession, infrastructure with less sensitivity to economic growth, should outperform both real estate and traditional cyclical sectors.
Going a bit deeper, I want to highlight that both real estate and infrastructure includes sectors with a wide range of sensitivity to economic growth, this creates more granular investment opportunities.
Within real estate, growth sensitivity is higher for property types with shorter lease durations, such as hotels, which have nightly leases, storage with monthly leases, and residential with annual leases. Growth sensitivity is lower for property types with longer lease duration, such as industrial, office and retail. Within infrastructure, growth sensitivity is higher for the transport sectors of airports, seaports and toll roads due to traffic and volume sensitivity. Growth sensitivity is lower for essential services sectors, such as utilities and communications, due to steady demand.
Accordingly, there are cyclical and defensive sectors within both real estate and infrastructure. It is also important to consider sector fundamentals in forecasting performance to a recession. Within real estate logistics will benefit from a shift in just in time inventory management to just in case inventory management, which will reduce supply chain disruptions. Logistics will also benefit from a continued growth in eCommerce and cold storage. Multi-family real estate will benefit from strong fundamentals and pricing power. Housing is in short supply, housing affordability is low due to recent strong home price appreciation and current rising mortgage interest rates. Office will be driven by a flight to quality. Employers are seeking high quality office space to attract employees back to the office. Accordingly, the highest quality office buildings are achieving the strongest leasing success.
Within infrastructure, data infrastructure will benefit from demand growth in both wireless and fiber. Energy infrastructure will benefit from energy security, renewables will benefit from energy transition, and transportation will benefit from onshoring to reduce supply chain disruptions.
Regarding recession, our outlook is a high probability of slowing growth with no recession. Infrastructure and real estate should outperform traditional sectors. There’s a moderate probability of a short and shallow recession. Again, infrastructure and real estate should outperform traditional cyclical sectors.
And finally, we see a low probability of a deep and prolonged recession. In this environment, infrastructure should outperform both real estate and traditional cyclical sectors.