01 Nov 2021 3 min read

Real assets: real returns?

By Bill Page , Lushan Sun

In this blog, we ask how private credit and real estate investments are likely to be affected by rising rates.

 

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It now feels inevitable that, bar a major economic shock, both the UK and US central banks will increase interest rates soon. The sentiment of “it’s really happening this time” is causing investors to consider implications for their portfolios and future decision-making. But what does this mean for real assets investors?

Private credit

We believe private credit is reasonably well positioned for rate rises, given the breadth of the investment opportunity set, and the fact that many investments still offer a premium against publicly traded bonds. In addition, some assets offer floating-rate or inflation-linked coupons.

The impact from rising rates on borrowers’ ability to service debt depends on their financial health and how they use the loan, the strength of the economy, and the structural protection the lenders have. Robust underwriting, ongoing monitoring and engagement are, therefore, in our view crucial to mitigating any deterioration in credit risk (and asset valuation).

With respect to supply/demand dynamics, we have seen a recent pickup in opportunities and think this could accelerate further over the next few months as issuers seek to lock in lower rates. In the medium term, however, higher interest costs may affect borrowers’ business investment plans, which could have a knock-on impact on deal flow.

The tapering of quantitative easing and any subsequent reduction in market liquidity could reduce banks’ appetite for lending. Since banks are a key player in the private credit market, this could result in higher spreads for new transactions and create better value opportunities. On the other hand, the strong demand from institutional investors could potentially offset any increase in spreads.

While higher interest rates (and higher inflation) could present some challenges to certain borrowers and are likely to have some impact on deal flow and pricing, we nevertheless expect assets with good credit quality and robust underwriting to remain resilient, and the end of quantitative easing could drive market dynamics in favour of institutional investors.

Real estate equity

In a previous blog we discussed how the drivers of inflation were relevant to the sector’s ability to hedge. It is no different with interest-rate rises: if they are associated with genuine economic growth, property income should grow. However, if rate rises reflect policy to combat cost-push inflation in an otherwise sluggish economy, this would create greater challenges, particularly for assets which are already struggling, for example through inferior quality or poor location.

The outlook for property income, based on its own history and relative to other asset classes, remains strong, in our view – assuming that all contracted rent is received. As real estate yields compress over 2021 and 2022 (according to our forecasts) this spread should narrow but remain positive.

We also need to consider whether tenant default risk and occupational costs might increase as the cost of servicing debt goes up. Again, expected rate rises seem unlikely to be of a magnitude to move solvency at the market level, but there may be some companies for whom the additional squeeze will prove terminal. Meanwhile, operational exposures – specifically where extra costs can be passed through to customers – should offer greater resilience within this strategic investment style.

More important is the implication of increasing development finance: development viability has already been challenged by rising construction costs and supply-chain uncertainty, and investors need to decarbonise assets through refurbishment. A funding gap may also emerge as the government’s debt-servicing costs increase. This could create an opportunity for equity investors.

We believe that good management of assets is key to navigating the impact of a rise in rates upon the sector and that, over the long term, opportunities enabling resilient income flows via good management, engagement and strategic operational exposures will be key to ensure income growth compensates for any changes in costs.

Bill Page

Head of Real Estate Markets Research

Bill has responsibility for the formation of house views and inputs into fund strategies. With 19 years’ industry experience, Bill is a voting member of the real-estate investment committee and actively contributes to the platform’s office and industrial strategy.

Bill Page

Lushan Sun

Private Credit Research Manager

Lushan joined LGIM in 2021 and is responsible for private credit research within our Real Assets division. Prior to LGIM, Lushan was a senior consultant at Mercer, providing advice to UK DB pension schemes on asset allocation, portfolio construction and manager selection. Lushan has a MSci from Imperial College in Chemistry and is a Fellow of the Institute and Faculty of Actuaries. Outside work she spends most of her time pursuing her passion for food, exercise and the latest foreign dramas on Netflix.

Lushan Sun