Bull case for real assets

Wondered what people thoughts are on this thesis:

General view is interest rates going up means cap rate expansion and is a comment that is made for the market as a whole but does it make sense?

Firstly interest rates are a lagging metric, what matters is the risk free rate or US 10Y. Bond yields are what people price investments off. Debt and equity investors price their required rates of return on a forward looking basis, not what the FED is doing now. Margin/spread flexes depending on what people think the monetary environment will be not what it is now.

Moving on from that, when we look at risk premia for real assets versus a risk free rate we should be looking at the 10Y vs the asset IRR. A 10 year is a gross redemption yield, the return you would have if you held the bond till maturity, so it is an IRR. It should be compared to IRRs.

So what are property IRRs going to do given the current macro backdrop - well that depends.

We can state some empirically tested knowns: 1) Over the long term rents largely track inflation with a lag for the market as a whole 2) Asset classes are different and have different drivers 3) Location is always key and will result in different outcomes 4) Supply and demand will always have an impact on markets 5) Historically real estate investors have demanded a 300bps premium over the risk free rate as a minimum return hurdle.

So what do current macro movements mean for valuations? Well, provided we continue to have positive economic growth we should continue to see rents grow in some sectors provided that fundamentals remain sound.

Risk free rates are up so discount rates are increased, forward bond yields are also up so exit cap rates should move up as well. But the spread between the 10Y and the 10Y10Y has narrowed - the curve is flat the further out you look. The expansion on exit cap rates is less. Long term inflation expectations have increased so long term growth rates must increase as well.

What about costs of equity for asset allocators? The 60/40 portfolio is dead in this environment. The new suggested asset allocation is 40 equity/40 bonds and 20 alts. Thats a heap of extra capital. There is still a huge amount of dry powder out there today. Required returns could be pushed DOWN for real estate as so much capital needs to get to work.

So there is give is the IRR spread for a compression, in some sectors there will be outsized rent growth which will compensate for higher discount rates as well plus when we think about what an exit cap rate really is, r/k-g, there are possible levers to see why they won't expand to the degree we initially think they will.

This hasn't even touched on the fact that the FED may be trying to shock the market to quell inflation expectations and may not follow through with what is currently being expected.  

TL/DR

Bond money needs to find a home, the curve is flat the longer out you look and real interest rates are still super negative = buy real assets.