Resilience Through Real Assets

Markets tend to function best during periods of certainty, which is notably absent in the current economic environment. Surging inflation, rising interest rates and elevated market volatility—in addition to the war in Ukraine, geopolitical turmoil, weakening global growth and the persistence of the COVID contagion—have left investors looking for shelter to help alleviate stress from the reset that is occurring across asset markets.

Outlook

For long-term investors in search of diversification, “hard” assets may become more attractive on a relative basis to help ride out the challenging economic conditions and above-average inflation that could persist for some time. Tightening monetary policy and corresponding higher bond yields will likely result in continued pressure and risk in the more vulnerable areas of the market. Investor demand for real assets will likely increase in this environment, driven at least in part by the potential diversification benefits they can add to an investment portfolio.

Investor expectations of deteriorating growth in corporate earnings are consistent with an economic slowdown and are being priced into the equity markets. Private market real assets have some natural insulation from this temporary downward pressure on corporate earnings, while serving as a hedge against inflation and a continued source of cash flow. In part, this is attributable to the term and structure of leases associated with real estate and farmland, along with the embedded optionality unique to investments in timberland.

The current economic environment is largely characterized by the reset occurring across asset markets and a shift to a macro regime of above- average inflation with tighter global monetary policy. This, along with concerns of lower earnings, suggests that the contribution from current income to total returns may be higher going forward than it was during the previous 10 years. As a result, the long-run compounding thesis of non-correlated real assets—such as real estate, farmland and timberland— helps make the portfolio diversification effect more attractive over time.

Farmland

Farmland values are being driven higher by rising commodity prices, still relatively low interest rates and the continuation of strong investor demand for a limited supply of investable land. On the global front, commodities have exhibited increased volatility and higher prices since the Russia/Ukraine conflict began, bringing global food security concerns to the forefront as the region in conflict accounts for nearly 30% of global wheat exports. While concerning, this is viewed as supportive for U.S. agricultural commodities. Farmland is positively correlated with inflation and offers investors an effective hedge, as well as helping to reduce portfolio volatility. Demand for farmland investments is expected to remain strong in the second half of 2022 and the first half of 2023. Despite high agricultural input costs, farmers are likely to have another profitable growing season due to the high commodity price environment.

Energy

Many factors play a role in elevated demand and high pricing for oil and gas. With the start of 2022 and the global pandemic still present, oil and gas prices started to rise and were exacerbated by the Russia/Ukraine conflict. These unforeseen circumstances, depleted supply and higher demand have led to elevated prices. Higher prices have impacted the economy and have caused inflation to surge, leaving investors searching for diversification and shelter from the resulting volatility.

Timberland

The global timber markets maintained strong pricing and continued robust consumption throughout 2021 and into 2022. Challenges have arisen with labor shortages in U.S. construction, logging and trucking industries, which have challenged markets. As a result of the Russia/Ukraine conflict, important timber supplies are at risk of being removed from the global markets, which will likely cause a pullback from North American markets, leading to less competition from European suppliers and potential upward pressure on U.S. timber pricing. Accordingly, investments in timberland, along with other real assets, demonstrated stable and favorable relative performance in volatile market conditions.

Commercial Real Estate

While rising interest rates generate headwinds for the capital markets by pressuring return thresholds, inflation typically provides lift for real estate investors as the sector is positively correlated with rising inflation. Higher interest rates suggest the need for income growth in order to maintain expected returns. Real estate is resilient, as it offers stable current returns with potential for growth in response to inflation, which may partially offset the effect of rising benchmark yields that are pressuring capitalization rates ("cap rates") and market pricing calculus.

Farmland

Farmland experienced robust appreciation in 2021, which persisted during the first half of 2022, with continued land value increases in many key agricultural growing regions. Land values have been driven higher by increasing commodity prices and low interest rates, as well as a continuation of relatively limited supply of land for sale compared to the strong demand from investors and farmers alike.

In anticipation of the upcoming 2022-2023 agricultural production year, important considerations center on whether this upward trend will continue or if rising interest rates and high agricultural input costs will lead to land values leveling out. Data would suggest that there is still room to rise in the current environment. Real farmland values—adjusted for inflation—suggest that all-time highs may still be a ways off, even though nominal values are at all-time highs in many areas.

THE RUSSIA/UKRAINE CONFLICT

Many commodities have experienced increased volatility and higher prices since the Russia/Ukraine conflict began. The conflict has also driven the issue of global food security to the forefront as the region in conflict accounts for nearly 30% of global wheat exports. These concerns played out in dramatic fashion in the wheat markets shortly after the start of the invasion. At the end of the first quarter, wheat and corn prices were approximately 60% and 30% higher, respectively, than a year earlier. Broadly, agricultural prices were nearly 40% higher than at the beginning of 2020.

Market pressures resulting from the conflict are seen as supportive for U.S. agricultural commodities, as the relative stability of U.S. supply which helps to fill the gap is also generating some premium over the market risk premium attributable to global supply uncertainties. There are still risks to a continuation of elevated commodity prices, but with the backdrop of already tight global supplies, this type of supply disruption is likely to remain generally positive in the near-term for U.S. agricultural commodity prices, albeit with the expectation of continued and substantial volatility.

Moreover, this conflict has exacerbated the already tight fertilizer supply situation, and expectations for fertilizer prices to decline near-term are looking increasingly less favorable. Higher fertilizer and fuel costs could limit production in some areas around the world, presenting a continuing production challenge that has potential to extend the duration of currently elevated agricultural commodity prices. The estimated average variable input costs to grow an acre of corn in the U.S. has increased approximately 50% over 2021, rising from approximately $450 an acre to over $650 in certain situations. The dramatically higher input costs have been a factor in limiting rental rate growth in many areas. According to the Kansas City Fed, “rental rates were up about 10%”¹ or about half of the increase in land values over the last year. Additionally, this data suggested that, when adjusted for inflation, non-irrigated crop rents in the district were approximately 15% below the all-time highs set in 2012.

SUPPLY AND DEMAND FUNDAMENTALS

For the 2022-2023 agricultural marketing year, continued tightness in U.S. supply and demand dynamic for corn and soybeans is anticipated. Low inventories and stocks-to-use ratios indicate the potential for future price volatility, including price reactions to future supply and demand news. Near-term, the focus will be on growing conditions in the U. S. as the size of the U.S. crop is determined. After a slow start to the 2022 planting season, progress improved quickly in late May.

However, this somewhat later-planted crop has been followed by extreme heat and dry conditions in many key growing areas. While the prospects for actual yield will still be dependent on the crucial July and August months, the probability of record crop production lessens as time goes on. The June World Agricultural Supply and Demand Estimates (WASDE) report from the USDA suggests declining ending stocks for corn and wheat, with moderate increases to the historically tight soybean carryout for the 2022-2023 marketing year.

Old-crop and new-crop U.S. balance sheets for corn, soybeans and wheat

Timberland

Global timber markets have maintained and supported strong pricing. The continuation of robust consumption and growing market uncertainty has created stronger demand for real assets in general, including timberland, as reflected in enhanced sector valuations. Surging inflation, the impacts of the Russia/Ukraine conflict and the ongoing impacts of the COVID contagion have been key drivers of this economic turbulence and the corresponding volatility in financial markets during the first half of 2022. Timberland total return increased from 0.8% in 2020 to 9.2% in 2021, with appreciation returns growing by 724 basis points to 5.6% in 2021.

The market also experienced strong deal flow and increased timberland transactions in the last quarter of 2021 and the beginning of 2022.

DEMAND

The first half of 2021 saw strong demand for home building and remodeling, which in turn resulted in historic spikes in lumber prices. The pandemic also caused major supply-chain disruptions which tightened the lumber supply for months. Although prices returned to pre-pandemic levels in the last half of the year as production caught up with demand, lumber prices soared again in the first five months of 2022 due to high labor costs, recent doubling of tariffs on Canadian lumber imports into the U.S. and historic flooding that significantly damaged infrastructure in British Columbia and Washington—two key lumber producing regions.

Strong lumber prices and consumption, combined with ongoing demand for home construction, have put upward pressure on timber prices. In the U.S. South, timber prices for all five major products continued to improve through the first quarter of 2022 and reached their highest levels over the past decade. In the Pacific Northwest and the Northeast, domestic demand also remained robust and kept timber prices elevated. In addition, raw wood materials responded to inflationary pressure like many other commodities, with the price of stumpage increasing materially in recent quarters. In the decade after the housing crash, timber appreciation was relatively flat as inflation was low at an annual average of about 1.8%. This positive correlation with inflation helps illustrate the protective hedge embedded in timberland.

Rising inflation and resulting higher interest rates have also attracted more investment in low-risk, low-volatility assets like timberland. Since timberland is an asset class with the ability to hedge against inflation, growing market uncertainty has materially increased investor demand for the sector. In addition, housing starts and remodeling activities are expected to stay strong (albeit at a decelerating pace) and should continue to support income returns from timberland.

In response to rising interest rates and a cooling housing market, lumber futures may soften, but timber demand is expected to remain strong over the next year. The existing spread between housing starts and completions, which was exacerbated during the pandemic, will be able to maintain the busy pace of home construction activities and support robust wood consumptions. A slowdown in housing starts will allow housing completion rates to catch up and stabilize with potential implications for timber demand over the long-term.

SUPPLY

A range of largely supply-side cross-currents seemingly complicates the markets for timber in the near-term, as supply-chain issues persist in the forest industry. Labor shortages continue to create challenges for operations at sawmill production and logging activities. Labor scarcity in the trucking sector put a dent in the ability to haul timber products to processing mills. High energy prices due to inflation have also worsened conditions across the board.

From a political perspective, the Russia/Ukraine conflict has been inflationary, imposing more constraints on the global wood supply and driving up prices. According to RISI Fastmarkets, 12 million cubic meters of timber are estimated to be at risk of being removed from the global supply due to the war and related political actions. In a global market of 350 million cubic meters in 2021, this represents 3 to 4% of total trade and a potential significant short-term supply shock.

A lumber shortage might be mitigated by a reallocation of supply. For Russian producers who are shut out of U.S. and European markets, China is a logical destination for Russian timber since it has shown a willingness to accept targeted goods from Russia. However, the effects of COVID lockdowns and global inflation on China’s economy remain to be seen and may depress Chinese demand for timber.

Reallocation may also come from European suppliers. European softwood lumber exports to the U.S. have grown in recent years and constitute about 3.2% of 2021 U.S. consumption. If Europe faces a timber shortage due to sanctions/boycotts on Russia and Belarus, it could result in a pullback from the North American market. However, wood demand from the European market may reduce due to high prices resulting from inflation and heightened susceptibility for the region to recession.

For the North American market, less competition from European suppliers is expected to put upward pressure on wood prices. However, a potential contraction of the Chinese economy due to the pandemic and global inflation might create some headwinds in the export markets. In addition, a smaller Chinese market share due to supply reallocation by Russian producers may create downward pressure on prices for wood products from the North American market.

Energy

Oil and gas prices have escalated dramatically for the first half of 2022. The major component of global supply and demand factors after emerging from the pandemic, coupled with a now struggling economy and a war in Europe, has drastically changed the dynamics and impact of the energy industry. The price of oil surged over $100/Bbl* in March, and natural gas prices have tripled from their typical $2–$3/McF† range. High energy prices have affected nearly every aspect of the U.S. economy and are contributing to high inflation. But, while there is pain at the pump, oil and gas income returns for investors have reached some of the highest levels experienced in years.

THE RUSSIA/UKRAINE CONFLICT

The war in Europe has led to disruptions in the energy market as the U.S. and many European countries, along with others worldwide, have begun to stop energy imports from Russia. The loss of Russian barrels for western markets and the loss of Russian gas to Europe puts a significant dent in the global supply. This has exacerbated not only the supply as-is, but also the cost of getting supply from somewhere else. While it used to take a Russian oil tanker 2-3 weeks to deliver oil to Europe, European Union ("EU") countries that now need to buy oil from alternative suppliers in Africa and the Middle East are experiencing much longer delivery times. Longer transportation periods mean more expensive financing, insurance and overall costs. This disruption and rearrangement of flow in the global market has added to the increase in prices.

DOMESTIC ENERGY

On the domestic front, despite the resurgence of high prices, energy companies have taken a slower-growth approach when it comes to their capital investments. This new mindset stems from the opposition and failed support with the industry from the current administration, and its focus on environmental, social and governance (ESG) objectives.

Commercial Real Estate

Commercial real estate is at the nexus of continuing healthy fundamentals across most property types and forceful transitions rapidly unfolding in the capital markets, the most prominent influencer on the sector right now. On the one hand, real estate is in a sweet spot as inflation surges and investors increasingly seek a hedge from the corresponding volatility in the equity and fixed income markets. On the other hand, market and policy responses have begun a rapid and steep upward trajectory in benchmark interest rates putting upward pressure on cap rates with further implications for tenants, supply and investors. Important cross-currents are emerging that highlight potential near-term risks for the sector and are worth keeping an eye on going forward.

PERFORMANCE

On the heels of recovery and strong, annual investment performance (almost 22% in 2021), real estate continued to show solid performance in Q1, returning 5.33%, well above the long-term average for the index. Repeating as top performers were industrial and apartments returning 10.9% and 5.25% for the first quarter respectively, while retail and office lagged, returning 2.2% and 1.8%, respectively (NCREIF NPI).

FUNDAMENTALS

Supply and demand fundamentals in the occupier market are in good shape right now with vacancy rates continuing at or near record lows for the major property types, except for office and retail, which have remained stubbornly high (NCREIF Q1 2022). Even though growth in new supply has been relatively low, a weaker economic outlook may have important go-forward implications for the occupier market.

During the 1st quarter, continuing high occupancies and strong tenant demand helped drive growth in property income, especially for industrial. Apartments and retail softened somewhat while office continued to struggle to grow income (NCREIF Q1 2022).

CAPITAL MARKETS

The market for real estate capital is global, with flows expected to remain positive for the year, driving private and public market allocations to both debt and equity. Deal volume hit a record level in 2021 and finished Q1 at about $180MM (Real Capital Analytics), which was up year-over- year. During April, however, deal volume tailed off as leveraged buyers began to feel the effects of rising rates with a sharp upward trajectory in benchmark yields.

Debt markets are open for business with project- and entity- level financing readily available from regulated and non- regulated lenders, albeit with increasingly expensive pricing. The current zip code for the 10-year Treasury yield hovers around 2.8-3%, up sharply since January, and Secured Overnight Funding Rate (SOFR) roughly tripled since mid-June, now standing about 2.28%. Credit spreads also widened this year, reflecting a perception by lenders of potentially increasing risk. This transition in the debt markets has introduced negative leverage to the mix and is dampening the acquisition appetite of leveraged investors while also pumping the brakes on new projects by driving up the cost of development.

Equity markets weigh all of these factors—supply, demand, leverage, rates, growth, inflation—and price it with cap rates, which are roughly the inverse of price/earnings multiples and have recently come under pressure as rates move up. Currently, buying power is high, with significant global dry powder aimed at U.S. real estate. The prospects of higher cap rates can be attractive to un-invested capital sitting on the sidelines and may, in turn, serve to attract additional capital over time as the real estate playing field tilts toward buyers.

INFLATION, INTEREST RATES AND REAL ESTATE

Inflation—actual and expected—and interest rates have implications for real estate capital and occupier markets alike. Rising rates generate headwinds for the capital markets by pressuring return thresholds, while inflation may provide lift for rents, as the real estate sector is positively correlated with inflation. All else equal, higher interest rates suggest the need for income growth in order to maintain expected returns.

Higher interest rates impact real estate in several important ways, including driving up discount rates, making future cash flows less valuable, and making credit more expensive for leveraged buyers, thus muting—and potentially negating— return benefits typically derived from leverage. The larger proportion the risk-free rate makes up of cap rates, the more sensitive cap rates become to changes in interest rates. At some point, extremely low cap rate deals may experience strong pressure to shift up, as there simply may be nowhere else to go.

Real estate offers stable current returns with potential for growth in response to inflation pressures, potentially offering a hedge against inflation and (partial) offset to rising benchmark yields pressuring cap rates.

This protection can be found in the structure and term of leases, which helps generate durable and often growing cash flows with the ability to pass on increases in costs— operating expenses, real estate taxes, construction—to tenants. All else equal, shorter leases are generally more responsive to inflationary pressures than longer leases. Real estate can provide a range of diversifying inflation protection alternatives, from short- dated structures consistent with residential and storage to medium and long-dated structures associated with warehouses and retail. The trade-off is potentially more rent growth at the cost of less certainty.

Rising construction and replacement costs also put upward pressure on rents as the cost of alternatives increase, while simultaneously dampening new development projects, which in turn further buoys rents by restricting new supply.

On the tenant front, jobs and growth are the fuel for demand, helping drive the current strong appetite for space. The Fed  is looking to reduce this growth by tightening monetary policy. Historically low unemployment levels may be difficult to defend—potentially softening demand for space—as interest rates (sharply) rise. Meanwhile, lenders are being urged to start considering tighter standards for commercial borrowers to head-off potential loan trouble that may occur in a slowing economy. Real estate is partially insulated from potential future pressure on tenants by low market vacancies, general lack of new construction in many sectors during the recovery, and leasing structures that can act as shock absorbers by bridging through periods of moderate stress with steady current returns for investors.

AROUND THE HORN

Industrial is a pro-cyclical sector, generally with medium-   to long-term leases that can be well-positioned to capitalize on inflationary pressures with potential mark-to-market opportunities to increase rents as leases roll. Industrial remains a top performer as the undersupply of space will persist and landlords maintain pricing power that stems from continuing tenant demand.

Apartments are also attractive from an inflation perspective because lease tenor is generally short and allows for mark-to- market pricing more rapidly than many other property types. Apartments may soften somewhat in the current environment, but tailwinds centered on demographics, reduced affordability in the for-sale housing market, and a continuing shortage of housing overall should be net positives for apartments.

Storage has mostly short leases and permits landlords to capture mark-to-market increases due to growing rents resulting from inflationary and scarcity pressures. Storage properties have benefited from a strong housing market, resulting in high occupancy and renewal rates which likely come under near-term pressure as increased mortgage rates impact housing and COVID-related demand unwind somewhat. Investor interest in the subsector remains strong.

Retail comes in a variety of flavors producing a range of performance results. Omni-channel retailers find value in physical stores, both as quasi-last mile delivery and pick-ups made by customers who buy online. Some parts of the retail sector—particularly tertiary market centers, lesser quality malls and power centers—will likely struggle as it’s tough to escape secular pressure. Necessity retail and well-located functional neighborhood strip centers should perform well versus retail overall based on tenant demand, leasing tenor and relatively little new supply built over the last decade.

Office continues its complicated story as pandemic-related factors present challenges resulting in continuing vacancies, low utilization rates and sluggish leasing. Slower return to office likely extends this period with lingering questions about future demand for space—how much, what type, where—bifurcating along quality lines—class “A” versus everything else with higher quality performing best. A weakening economic outlook may have an outsized impact on office markets.