Investing in Real Assets Amid Banking Turmoil
Smaller commercial real estate may be more vulnerable to stricter lending after SVB.
- Featuring: Larry Antonatos
- April 24, 2023 April 24, 2023
(Runtime: 9 min, 48 sec; size: 110.46 MB)
Larry Antonatos, portfolio manager with Brookfield Asset Management.
The chance of a recession is growing. With inflation stubbornly high, global central banks, including the U.S. and Canada, have been 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.
The sudden failure of Silicon Valley Bank in March 2023 due to a sudden massive deposit withdrawal exposed risk within balance sheets. As banks and bank regulators increase their focus on stronger balance sheets, we anticipate stricter lending standards. This will tighten financial conditions beyond the already significant tightening by global central banks. Although this may allow central banks to pause rate hikes sooner than we had previously expected, it increases the chance of a recession.
Against this backdrop, 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 different business models. Real estate is generally a free market business driven by the traditional interplay of supply, demand and pricing. Supply growth is cyclical, driven by optimism of property developers and the availability of construction financing. Demand for space is also cyclical, driven by economic activity. And pricing, or 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 negotiation.
Infrastructure, in contrast to real estate, is generally a regulated business where a regulation can significantly impact supply and pricing. Supply growth can be limited by government regulation, first-mover advantage, and/or the required functional location. 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. And pricing for infrastructure services is generally predictable because it is 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, predictable revenues derive from long-term regulated pricing or long-term contracted pricing. 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 wanted to highlight that both real estate and infrastructure includes sectors with a wide range of sensitivities to economic growth. This creates more granular investment opportunities. Within real estate, growth sensitivity is higher for sectors with shorter lease durations, such as hotels which have nightly leases. Growth sensitivity is also higher for sectors tied to consumer spending, such as retail. In contrast, growth sensitivity is lower for sectors with longer lease duration, such as industrial and office. Within infrastructure, growth sensitivity is higher for transport sectors such as airports, seaports and toll roads, and also midstream energy, both due to volume sensitivity. Growth sensitivity is lower for essential services sectors, utilities and communications, due to the steady demand. Accordingly, there are cyclical and defensive sectors within both real estate and infrastructure.
In summary, regarding recession, our outlook is a high probability of a short and shallow recession. In this environment infrastructure and real estate should outperform traditional cyclical sectors.
We anticipate three trends will emerge over the longer term. First, working from home will ultimately become a supplement to rather than a substitute for the office. While remote work can provide flexibility for employees, office work allows for collaboration, connection and culture, essential ingredients for enterprise growth, risk management, and employee development, particularly for newer and younger employees. Second, COVID-19 will likely reverse the office densification trend. This is counter to the historical trend where office square footage per employee has decreased from 425 square feet in 1990 to 225 square feet in 2010, and 150 square feet in 2020. And third, major cities will continue to serve as magnets for talent. Urbanization has been a powerful trend for centuries for one simple reason, commerce and culture thrive in the vibrancy of a great city.
Viewing office markets through two lenses, market size and market desirability, and viewing office property through the lens of quality, we have a few observations and expectations.
Market size. Major markets will continue to be important, particularly for global companies, for transaction-oriented businesses, and for creative industries where in-person contact is critical. Toronto, New York and London will always be important.
Market desirability. Better quality of life due to better weather, better schools, easier commutes or lower taxes may allow smaller, newer markets to attract sufficient jobs and talent to these markets that they can attain critical mass of larger, older markets. In the United States, Austin, Texas, and Nashville, Tennessee are success stories in this regard.
And property quality. Within all markets, the highest quality property will get stronger, and lesser quality property will become less desirable and perhaps obsolete. Employers will be competing for employee talent. Modern, well-located and amenity-rich office environments will attract top talent.
Brookfield’s optimistic long-term view of Class A office in major markets is perhaps contrarian. In the short run the return of the workplace may be slow, but in the long run we believe Class A office in major markets is essential to business and will be resilient.
But what about retail? Will the continued rise of e-commerce lead to a permanent drop in demand for retail space? We believe the answer is yes, and we believe the pain will be greatest in the middle. Top quality retail will thrive. These properties benefit from high sales per square foot, driven by dense population and high income trade areas. This creates a virtuous cycle of high productivity attracting the strongest retailers, restaurants, and other experiential offerings. On the other end, convenience retail such as grocery and drug will continue to be strong. These are necessity driven. It is the middle market properties which may suffer. They may survive, but many will be repurposed to other uses such as multifamily or self-storage.
The sudden failure of Silicon Valley Bank in March 2023 due to sudden massive deposit withdrawals exposed risks within bank balance sheets. Silicon Valley Bank had high-quality, long duration fixed income investments, which had fallen in value due to rising interest rates. Credit defaults were not the driver of value declines. This duration risk may be widespread in the banking system. As banks and bank regulators increase their focus on stronger balance sheets, we anticipate stricter lending standards. Regional banks are important sources of capital for small businesses and owners of small- to mid-size commercial real estate properties. These borrowers may face reduced access to capital. Real estate borrowers may turn to the conduit commercial mortgage-backed securities market, which blossomed in the 1990s banking crisis as a source of capital for their properties. Larger scale real estate owners, such as publicly traded Real Estate Investment Trust are less reliant on regional banks as they have access to the corporate bond market as well as to the single asset, single borrower, commercial mortgage-backed securities market. Accordingly, we believe that publicly traded real estate companies will be less impacted by the fallout from Silicon Valley Bank.
In a slowing growth environment and potentially a recessionary environment, defensive infrastructure, particularly utilities, represent an attractive investment opportunity. Utilities are generally regulated, supply growth and competition are frequently limited by regulation. The demand for utility services, electricity, gas, and water is generally very steady with limited sensitivity to economic activity or recession.
And finally, pricing for utility services is generally predictable because it is frequently long-term regulated or long-term contracted with price increases tied to inflation. For these reasons, utilities represent an attractive investment opportunity today.