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Larry Antonatos, portfolio manager, Brookfield Asset Management.
In 2021, real assets produced strong returns as global economic growth accelerated on post-Covid reopening and central banks maintained low policy interest rates. 2022 will bring a very different macroeconomic background with global economic growth slowing from the very high level of 2021 and central banks, including the U.S. Federal Reserve and the Bank of Canada, poised to begin raising policy interest rates. High inflation complicates the macroeconomic outlook. Infrastructure and real estate can continue to perform well in this slowing growth, rising rate and high inflation environment. I want to discuss the impact of each of these three factors on infrastructure and real estate and show how active management can identify areas of investment opportunity.
Let’s start with growth. Broadly speaking, infrastructure and real estate have very different economic sensitivities, leading infrastructure to be more defensive and real estate more opportunistic. Infrastructure tends to have limited economic sensitivity due to the supply, demand, and pricing dynamics. Supply of infrastructure assets is limited. And many infrastructure assets are monopolies or semi-monopolies facing limited competition. Demand for infrastructure services tends to be steady as infrastructure provides essential services with limited GDP sensitivity. Pricing of infrastructure services tends to be either regulated or subject to long-term contracts.
In contrast, real estate tends to have meaningful economic sensitivity due to meaningful cycles of supply, growth, demand change, and pricing change.
Now slowing growth, in general, may not translate into slowing growth for all infrastructure and real estate. Keep in mind that certain mobility sense of infrastructure sectors, such as airports and toll roads, and real estate sectors such as hotel, office, and retail, were acutely and negatively impacted by Covid. As mobility increases and return to office accelerates, these specific sectors may achieve outsize earnings growth as well as sentiment improvement, leading to strong investment performance. Active management can identify these areas of opportunity.
Moving on to interest rates. It is important to remember that central bank policy is more impactful on the short end of the yield curve than the long end of the yield curve. The long end is driven by expectations for growth and inflation, and it is the long end that is more impactful to equity investment valuations, and equity investment returns. Due to equity valuation based on the present value discounting of future cash flows, longer duration cash flows are more sensitive to interest rates than shorter duration cash flows. Within infrastructure, utilities tend to be longer duration. Within real estate, duration ranges from hotels with one night leases to self-storage with monthly leases to apartments with annual leases to a commercial property such as office, industrial, and retail with leases of generally 5 to 10 years. Here again, active management can identify sectors with the best investment opportunity.
Finally, inflation. This is where infrastructure and real estate have the potential to really shine. Infrastructure has very high inflation linkage with approximately 70% of cash flows tied to regulation or to long-term contracts, which allow for price increases tied to inflation. Accordingly, infrastructure is a terrific asset for times of high inflation. Real estate can also provide high inflation linkage due to leases which allow for rent escalation and expense pass-throughs tied to inflation. In addition, inflation drives rising replacement costs for real estate, which tends to drive increases in market rents.
Considering these three macroeconomic factors, as well as current evaluations, we are finding many attractive investment opportunities. Within infrastructure, we favor the sectors of electricity, transmission and distribution, gas utilities, rail, toll roads, and midstream. Within real estate, we favor the sectors of life sciences, where vacancy rates are extremely low and growth prospects are strong, as well as hotel and multifamily.