Tapering and rate hikes are lingering over the financial market since December and they will be the biggest drivers of the stock market in 2022. What should we invest in a rising inflation and interest rate environment?
If you follow my blog, you will understand that there is no long term investment. Every investment moves in cycles. For many reasons, the environment was conducive for growth stocks in the past two years. But the same may not be true in 2022.
A perfect example is the ARK Innovation ETF (ARKK), run by the “Female Warren Buffett”, Cathie Wood. The fund made 156% in 2020 and only to see its return fall 23% in 2021. In fact, from the peak of the ARKK fund, its price has dropped nearly 50%!
Because of these cycles, I think it is time to revisit an asset class called Real Estate Investment Trusts (a.k.a. REITs), particularly Singapore REITs. If you are not familiar with REIT investments, I recommend you read this article to gain a basic understanding of this asset class.
REITs used to be the meme in Singapore
New investors may not know this, but before the crypto and NFT mania, Singapore investors used to be obsessed with REIT investing. There was a sort of “REIT bubble” in 2019. I pointed out in this article (July 2019) that you can still suffer massive losses even if you invest in REITs. Back in 2019, I said,
Despite the seemingly endless US-China trade war, the market prices of REITs have increased sharply since the beginning of the year. If you have substantial holdings of Real Estate Investment Trusts, you need to be careful.
At that time, REIT investing was as hot as cryptocurrency is today in Singapore’s investment community. Back then, if you didn’t talk about REITs, you were not an “expert”. If you cautioned people about the risk of investing in REITs, you had the whole investment community against you.
Fast forward to today, we witnessed Singapore REITs crashed, along with a lot of other asset classes, when the Covid-19 pandemic broke out in early 2020. At that time, a lot of people believed that it was a golden opportunity to buy even more REITs. And I wrote another article in May 2020 to caution investors about it. Here is what I said,
Even if Singapore REITs had a glamorous past, it doesn’t mean the same success can be repeated in the near future. The recovery of Singapore’s REITs sector may be very choppy and it may not go back to the previous level anytime soon.
Since then, Singapore’s REIT market has been flat for nearly 2 years as you can see from the chart below.
It was no coincidence that the performance of Singapore REITs suffered past 2 years. While I have helped my clients invest in global REITs this year, I was reluctant to go back to Singapore REITs. You can read this article to understand my rationales.
Why REITs, why now?
Before we tackle this question, we need to understand why there is inflation and what it means for different asset classes. I recommend you read this article to understand more.
Additional reading: 5 ugly truths of the upcoming retirement crisis and how to deal with it.
In a nutshell, in a developed country, inflation is a man-made process to serve two purposes:
- Decrease savers’ purchasing power so you have to keep on working.
- Reduce liability of the borrowers because future money is worth less.
Note I emphasized a “developed country” because the situation in a “developing country” is the opposite. A developed nation, like the USA, borrows a lot of money by issuing debt, while most developing countries are creditors and have a lot of savings.
If you understand this, you can see that inflation is particularly bad for retirees and pre-retirees. Because “savers are losers” in an inflationary environment.
If you belong to this group, you know that you don’t want to take excessive risks to generate your retirement income, but time is not in your favour.
Years ago, you may have still found shelter in bond markets. Yes, the bond returns were pathetic, but with the extremely long period of the low-interest-rate environment, the increase of bond prices would have helped cushion the effect of a low yield. The total return was still acceptable.
But not anymore. As a result of the Fed tapering and rate hikes, most traditional bonds are going to become trash. So you are forced to increase your risk exposure, just to get the same return as before.
In today’s markets, I think REITs will be a good fit. Why?
First of all, remember that we just talked about the real effects of inflation are to reduce liability and reduce purchasing power? A REIT typically borrows a lot of money to fund its property purchase. Their debt benefits from inflation as the future payout become less in real terms.
Secondly, a REIT is an inflation pass-through asset. It means the landlord can increase the rent and “pass it on” without much risk of losing tenants and it is up to the tenants to manage the increased business costs.
Thirdly, bond investors are pushed to become REIT investors. If they want the same yield but are reluctant to invest in growth stocks that come with high volatility, they have to move up the risk ladder. It is a form of “financial repression” that I talked about before.
What is the best way to invest in a REIT?
Yes, Singapore private home prices have done better than Singapore REITs last year. But my issue with physical property investments is that it is a hit or miss, with too much at stake and the liquidity is also poor.
Plus, even though the property index return may look good, the real return on a property is much lower due to the high costs involved. There are tons of fees to pay such as agent fees, stamp duties, maintenance fees and property taxes.
Just last week, it was reported that “more people couldn’t fully repay CPF after selling property”. This shows that the property investment return (after costs) is far less than what people have imagined. Even lower than CPF’s 2.5% interest rate.
If you believe you can manage a REIT portfolio by yourself, please go ahead and implement it. But I prefer a REIT ETF or fund that has diversification benefits. I think the time and effort to manage an individual REIT portfolio is just not worth it.
You can find the comparison between physical property, an individual REIT and a REIT ETF below.
Since the Singapore market is so small, there aren’t many choices for REIT ETFs. There are only two REIT ETFs in Singapore:
- Lion-Phillip S-REIT ETF, and
- CSOP iEdge S-REITs Leaders Index ETF.
I will discuss the CSOP iEdge S-REIT ETF a bit more as it is new and it hasn’t been discussed much.
What is unique about the CSOP iEdge S-REIT ETF?
First of all, you need to understand that not all ETFs are the same.
For example, the Lion-Phillip S-REIT ETF tracks the Morningstar Singapore REIT Yield Focus index while the iEdge S-REIT Leaders tracks the iEdge S-REIT Leader SGD Index.
In case you don’t know, iEdge is Singapore Exchange’s index arm. You can find out more about iEdge’s indices using this link.
What I like about the iEdge S-REIT Leader index is that they have an emphasis on liquidity. It shares a similar principle with my Global Momentum Compass, that we are better off following where the money flows.
The iEdge S-REIT index adopts a “liquidity-adjusted” free-float market capitalization-weighted methodology to choose and rebalance the portfolio. So as a result, you will get a portfolio of Singapore REITs that are highly liquid and of large-capitalization.
Below is the current index methodology and allocation as of Sep 2021. Note the index is rebalanced every 6 months, so the next rebalance will be in March 2022.
Why are liquid large-cap REITs better?
It is not hard to imagine that in an inflation environment, it will be difficult for some businesses to survive. After all, when the economic times are good, everybody is a genius, but in a tough time, only the strongest and fittest survive.
Most large-cap REITs in Singapore are government-linked with experienced managers. They have the following characteristics:
- Quality assets in a well-located area
- Operational efficiency due to scale
- Sponsor pipeline and global outreach
- Higher yield due to the low cost of funding from both equity and debt
- More opportunities for overseas expansion.
High liquidity also means a lower bid-offer spread and lower trading costs for the ETF vehicle. This will help improve the long term returns of the REIT.
How does a rising interest rate impact REIT return?
Empirically, a rising interest rate will cause short term fluctuation in the stock market and thus impact the REIT. But from a long term perspective, it may be beneficial to the REIT as income investors will be pushed out of their comfort zone.
The chart below shows the performance of the S-REIT compared to the Straits Times Index over the past 10 years. After the “Taper Tantrum”, which was the start of the previous rate hike, the S-REIT has outperformed the STI for the past few years.
But we need to bear in mind that this was a period where the Fed rate was still below 2%. So it appeared that REITs performed well during a moderate rate hike environment.
As I discussed in my earlier article (June 2021) there are 3 stages of inflation and rate hikes. Therefore, it’s possible that a REIT may not be a good investment during an aggressive rate hike environment.
Buying a low volume REIT through unit creation
Since we have discussed liquidity, you may notice that compared to the Lion-Phillip S-REIT ETF, the CSOP iEdge S-REIT Leader ETF has a lower transaction volume. If you understand how an ETF works, you may know that the trading liquidity of an ETF and underlying liquidity of an ETF is not the same.
It is a common misunderstanding that you must buy an ETF from the stock exchange. After all, an ETF is called an exchange-traded fund right?
The truth is, sophisticated investors can buy ETFs off the exchange through the unit creation and redemption process. For the CSOP iEdge S-REIT Leader ETF, you only need as little as 50,000 units to create or redeem the ETF without suffering the trading spread.
This is technical so I won’t go into the details, but you may contact me or your own financial advisers if you want to find out more.
Let me summarize
I think the REIT asset class has a role to play in a rising inflation and interest rate environment. It is possible that a REIT can be an inflation hedge asset and it can perform well during a moderate inflation and rate hike environment.
Singapore REITs have been underperforming their global peers and play a catch-up game.
If you were to invest in a REIT, you would need to focus on large-cap REITs with good liquidity. The easiest way to get into it is through purchasing a REIT ETF such as the Lion-Phillip S-REIT ETF or CSOP iEdge S-REIT Leaders Index ETF.
A good REIT ETF allows you to invest in REITs without the hassle of selecting individual REITs and it also provides diversification across various sectors.
Real estate investing doesn’t mean old school thinking. There’s now a whole new way of thinking about REITs. Besides cyclical REITs such as retail REITs and office REITs, there are also emerging REITs benefiting from the “new economy” such as logistics REITs, warehousing REITs and data centre REITs.
With the global economy soon to re-open to pre-pandemic levels, I think this is a sector worth considering.
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As an independent investment adviser, I help my clients manage their investment portfolios for retirement. If you are interested in finding out more, you can apply for a non-obligatory discovery meeting using the form below.