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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.

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Larry Antonatos, managing director and portfolio manager with Brookfield Asset Management.

With inflation running higher for longer, global central banks, including the U.S. and Canada, are 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. With many investors anticipating recession, 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 very different business models. Real estate is a free market business driven by the traditional interplay of supply, demand, and pricing. Growth in supply is cyclical driven by the optimism of property developers and the availability of construction financing. Demand for space is also cyclical, driven by economic activity. Pricing, 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 this negotiation.

In contrast to real estate, infrastructure is generally a regulated business where regulation can significantly impact supply and pricing. Supply growth can be limited by government regulation or by a first mover advantage. 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. Pricing for infrastructure services is generally predictable because it was 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, these predictable revenues derive from long-term regulated pricing or long-term contracted pricing. And 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 want to highlight that both real estate and infrastructure includes sectors with a wide range of sensitivity to economic growth, this creates more granular investment opportunities.

Within real estate, growth sensitivity is higher for property types with shorter lease durations, such as hotels, which have nightly leases, storage with monthly leases, and residential with annual leases. Growth sensitivity is lower for property types with longer lease duration, such as industrial, office and retail. Within infrastructure, growth sensitivity is higher for the transport sectors of airports, seaports and toll roads due to traffic and volume sensitivity. Growth sensitivity is lower for essential services sectors, such as utilities and communications, due to steady demand.

Accordingly, there are cyclical and defensive sectors within both real estate and infrastructure. It is also important to consider sector fundamentals in forecasting performance to a recession. Within real estate logistics will benefit from a shift in just in time inventory management to just in case inventory management, which will reduce supply chain disruptions. Logistics will also benefit from a continued growth in eCommerce and cold storage. Multi-family real estate will benefit from strong fundamentals and pricing power. Housing is in short supply, housing affordability is low due to recent strong home price appreciation and current rising mortgage interest rates. Office will be driven by a flight to quality. Employers are seeking high quality office space to attract employees back to the office. Accordingly, the highest quality office buildings are achieving the strongest leasing success.

Within infrastructure, data infrastructure will benefit from demand growth in both wireless and fiber. Energy infrastructure will benefit from energy security, renewables will benefit from energy transition, and transportation will benefit from onshoring to reduce supply chain disruptions.

Regarding recession, our outlook is a high probability of slowing growth with no recession. Infrastructure and real estate should outperform traditional sectors. There’s a moderate probability of a short and shallow recession. Again, infrastructure and real estate should outperform traditional cyclical sectors.

And finally, we see a low probability of a deep and prolonged recession. In this environment, infrastructure should outperform both real estate and traditional cyclical sectors.

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2022 has been a difficult year for investors with both equities and bonds declining dramatically. With inflation running higher for longer, global central banks, including the U.S. and Canada, are fighting inflation with an aggressive tightening cycle, reducing monetary stimulus by raising benchmark interest rates and tapering asset purchases. The good news is that high inflation is a tailwind for infrastructure and real estate cash flows. The bad news is that rising interest rates are a headwind for infrastructure and real estate valuations.

The high inflation tailwind is stronger for infrastructure than it is for real estate. This is because the contractual cash flow linkage with inflation is tighter for infrastructure than for real estate. Pricing for infrastructure services is generally based on long-term regulation or long-term contracts, both generally allowing price increases tied to inflation. In contrast, pricing for real estate rent is based on lease contracts with terms generally ranging from one year to 10 years, and with rental rates determined by negotiations between landlords and tenants, and heavily influenced by supply and demand conditions at the time of negotiation.

Real estate leases also frequently include annual rent increases of either a specified amount or amount tied to inflation. The inflation linkage is looser for real estate than for infrastructure because expiring real estate leases will roll over to new market rents, which may be higher than expiring rents in a high-growth economic environment or lower than expiring rent in a slow-growth economic environment. Accordingly, we would expect infrastructure to outperform real estate in a high inflation but slowing growth environment such as we have had in 2022.

Let’s now review the actual results. All quoted returns are for year to date through September 30th, 2022 in U.S. dollars.

2022, Q3 marked the third consecutive quarter of declines for global equities, bringing the MSCI World Index down to minus 25% year to date. Infrastructure equity benchmark outperformed, down 15% year to date, while real estate equity benchmark underperformed, down 29% year to date.

Within infrastructure equities, there was a wide range of performance by sector. The strongest performing sector was the oil and gas storage and transportation sector, down 2% year to date. The sector benefited from strong supply-demand fundamentals and high commodity prices in the underlying oil and gas sectors. Strong performance has been accompanied by strong earnings growth. Accordingly, valuations remain reasonable and we expect sector outperformance will continue.

The weakest performing sector was communications, down 29% year to date. Although this sector benefited from strong supply-demand fundamentals, and strong revenue and cash flow growth, the sector began the year at very high valuations. Following this year-to-date decline valuations are now reasonable and provide an attractive entry point for this high-growth infrastructure sector.

Within real estate equities, there was meaningful divergence in performance by both geography and property type year to date. By geography, Europe, which faces the greatest risk of recession, was the worst-performing region, down 48% year to date. While Asia was the best-performing region, down 18% year to date, and North America was in line with the global average, down 29% year to date.

By property type, within North America, hotels were the best performing sector, down 20%, as leisure travel demand remains strong and business and group travel demand continued to recover. There was a close race for worst performing property type, with industrial down 36%, office down 36%, and data centers down 35%. All very weak. Industrial and data centers benefited from strong supply-demand fundamentals and strong revenue and cash flow growth, but these sectors began the year at very high valuations. Following the year-to-date declines, valuations are now reasonable and provide an attractive entry point for these high-growth sectors. In contrast, office suffered from a lack of demand and continued uncertainty surrounding work from home.

In summary, 2022 has been a very difficult year for investors. However, year-to-date price corrections have created attractive entry points for equities in select infrastructure and real estate sectors with strong fundamentals, strong growth potential, and pricing power. This includes communications, infrastructure, data, and industrial real estate.

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With respect to other real estate sectors, the pandemic created both headwinds and tailwinds, and these headwinds and tailwinds are continuing to wane as the pandemic fades and return to normalcy progresses. I do want to say that one factor that is supporting the real estate market and the infrastructure market in particular is that many of these assets are held in private hands. And investors have an incredible appetite for private real estate and private infrastructure, and that plays through to the public securities markets.

So within real estate, let’s think about some of the traditional asset classes. We’ve talked about office, but let’s also consider residential, logistics and retail. Residential has traditionally been multi-family apartments, but we are seeing strong growth in single-family for rent. This is driven by an overall housing shortage, coupled with continued rapid price appreciation for single-family homes. And those trends are actually supportive for growth and rental rates for both single-family rentals, as well as for multi-family rentals. Multi-family performed very well as did single-family during the pandemic, and we think those trends will continue.

Logistics was another area that was very positively impacted by the pandemic as many supply chains were disrupted. The importance of logistics was emphasized. Businesses have shifted from just-in-time inventory management to having more inventory on hand for more flexibility. There is a very competitive investment landscape for logistics as many investors see this as a truly wonderful asset class to be in right now. We find it very competitive and while we like the fundamentals, we see there is perhaps some slowdown in appreciation coming.

For retail, this is a sector that much like office was negatively impacted by the pandemic. We think the long term trends for retail in many ways are similar to the long term trends for office. Higher quality property located in the best markets will dominate. This is something that we have seen over many decades within retail, where the stronger retail with the highest sales per square foot continues to get stronger. Whereas, weaker retail draws fewer shoppers, but also fewer retailers and leads to long term decline in values and rents.

Where we are seeing some particularly attractive opportunities is in alternatives. These are things like student housing and life science buildings. Student housing could be considered a specialized form of residential, and life science could be considered a specialized form of office with high amounts of laboratory space, but really focused on research. We see these spaces as each having very strong, specific fundamentals, but also fewer investors participating. So the prospects for higher returns in both of these alternative spaces.

Now, shifting to infrastructure, same story as real estate, pandemic related headwinds and tailwinds continue to wane. One thing that’s very important about infrastructure is inflation. Inflation has been high for the past 18 months and we anticipate inflation slowing, but continuing to be higher than the prior 10 to 20 year average. And because many infrastructure assets have pricing mechanisms index to inflation will feel very strongly that infrastructure cash flows have a tailwind behind them of inflation indexing.

Thinking of infrastructure by sector, the fundamentals do vary by sector. Utilities, which dominate the infrastructure space should continue to very well, and particularly those that are focused on the clean energy transition should do well. We are definitely undergoing a transition from fossil fuels to renewables, that will require not only a change in generation of electricity from coal and oil-powered plants to wind, solar and hydro. But because those new wind, solar and hydro assets are in different locations, and because they are in some ways intermittent rather than consistently reliable. We need to improve and strengthen and make the electricity distribution grid more resilient. That will require capital spending by utilities, and most utilities are allowed to earn an attractive return on their capital base. So higher capital spending results in higher revenues. So that’s a great tailwind for utilities.

Transports, airport, seaports and toll roads definitely faced headwinds, a traffic slowdown during the pandemic. And that is slowly but steadily reversing with a recovery in traffic volumes across all of the transports. Energy midstream, which is principally oil and gas, storage and transportation, has been very much out of favour as the trend from oil to renewables has played out over the last five to 10 years. However, the Russian-Ukraine conflict heightens attention on energy security. The transition from oil and hydrocarbons to renewables will take decades. And in the meantime, we need secure sources of hydrocarbons, and the Russia-Ukraine conflict shines a bright spotlight on that. In particular, within our portfolio in the US, liquified natural gas export facilities are booming as Europe seeks to replace natural gas from Russia with natural gas from other sources, including the US.

Data infrastructure was a huge beneficiary during the pandemic. And we think that will continue to grow because data usage is increasing. It increased in a step-wise manner during the pandemic as everyone shifted to remote work and WebEx and Zoom calls. We think data consumption, particularly streaming data, movies, video, et cetera, will continue to drive demand and growth in the data infrastructure network.

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The COVID 19 lockdowns have definitely impacted both real estate and infrastructure. Top of everyone’s mind is the office market. Let’s start there. The COVID 19 lockdowns highlighted the ability of many office employees to work from home. Now, as reopening progresses, some companies are moving to a more flexible hybrid work structure, including both work from home and work from office. This has prompted a big question among real estate industry observers. Will work from home become an important part of the norm over the longer term, leading to perhaps a permanent drop in demand for office space? We believe the answer is no. In our view, both successful companies and successful employees value the power of in person collaboration. While remote work has been effective in the short and in the medium term, it cannot replace human interaction in the long term.

We anticipate three trends emerging over the longer term. First, working from home will ultimately become a supplement to, rather than a substitute for, working from the office. While remote work can provide flexibility, office work allows for collaboration, connection, and culture, and these are essential ingredients for enterprise growth, risk management, and employee development. This is particularly important for newer and younger employees.

Second, we think that COVID 19 will reverse the office densification trend that we’ve seen over the past few decades. With certain social distancing norms and health and safety protocols likely to endure, office square footage per employee will likely increase. This is counter to the historical trend where office square footage per employee decreased from 425 square foot per employee in 1990 to 225 square foot per employee in 2010 and 150 square foot per employee in 2020. That reversal will lead to an increase in demand for office space.

Third, and I think most importantly, is that 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 that brings people and ideas together.

Now, viewing office markets through two lenses, market size and market desirability, and viewing specific office property through the lens of quality, I have a few observations and expectations. Market size. Major markets will continue to be important, particularly for global companies and also for deal oriented business and creative industries, where in person contact and sharing of ideas and collaboration are critical. For this reason, Toronto, New York, and London will always be important office markets.

Second, market desirability. A better quality of life due to better weather, better schools, easier commutes or lower taxes will allow smaller newer markets to attract sufficient jobs and talent that these markets can attain the critical mass of larger older markets. In the United States, Austin, Texas, and Nashville, Tennessee are success stories in this regard. We think this trend will continue.

And third, through the lens of property quality, and this applies across all markets, the highest quality property will get stronger and we expect lesser property quality will become less desirable and perhaps even become obsolete. We think that employers are competing and will continue to compete for employee talent. Modern well located and amenity rich office environments will attract top talent. This means competitive office buildings will have gyms, they will have outdoor spaces, they will have retail, they will have dining, they will have entertainment. And this I think really reinforces the long term trend that we have seen across many decades and many market cycles is that property quality is extremely important.

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With inflation having run “higher for longer,” global central banks, including the U.S. and Canada, have begun a tightening cycle, reducing monetary stimulus by raising benchmark interest rates and also tapering asset purchases. This will slow inflation, but will also slow economic growth. And the risk is that economic growth will slow too much resulting in a recession. In response to this recession risk, the global equity market has moved lower in early ’22 and many investors are thinking about recession proofing their portfolios. Real assets, both infrastructure and real estate, offer attractive defensive characteristics that can contribute to this recession proofing. Relative to many other businesses, many infrastructure businesses and real estate businesses offer more predictable revenues and predictable cash flows. For infrastructure, predictable revenues are due to long-term contracted or regulated pricing. For real estate, these predictable revenues are due to long term leases. Broadly speaking, infrastructure is even more defensive than real estate because real estate and infrastructure 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 and it’s driven by the optimism of property developers. Demand for real estate space is also cyclical, driven by economic activity. It goes up in a growth environment and demand goes down in a recession. Pricing or the real estate rental rate can be volatile because it is determined by negotiations, free market negotiations, between landlords and tenants. And this is impacted by the levels of supply and the strength of demand at the time of the negotiation.

Infrastructure, in contrast to real estate, is generally a regulated business where governmental involvement can play a role in the drivers of supply, demand, and pricing. For infrastructure, supply growth can be limited by government regulation, a first mover advantage, or the required functional location of an infrastructure asset. 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 as frequently regulated or contracted with price escalations that are tied to inflation.

Now in an environment characterized by modestly slowing economic growth, both real estate and infrastructure should deliver moderate returns and both should outperform traditional cyclical businesses. This is due to the defensive benefit of predictable revenues and cash flows from both real estate and infrastructure.

In a true recessionary environment characterized by negative economic growth, infrastructure with less sensitivity to economic growth should outperform real estate and also outperform traditional cyclical businesses. Going just a bit deeper, I want to highlight that within both real estate and infrastructure, there are sub sectors and property types with a range of sensitivities to economic growth. This creates more granular investment opportunities. Within real estate, growth sensitivity is higher for property types with shorter lease durations. Such as hotels, which have nightly leases or self storage with monthly leases or residential with annual leases. So these are sectors you may want to avoid in a recession. Growth sensitivity is lower for property types with longer lease duration, such as industrial and office. And these are sectors that you may want to emphasize in a recession.

Shifting to infrastructure, the one area of infrastructure where growth sensitivity is higher is the transport sectors. That is airports, seaports, and toll roads. And this is because of volume sensitivity. There are more passengers, more volumes of goods, moving through the airports, seaports, and toll roads in a growing economic environment and less in a shrinking economic environment. Other than those transport sectors, the other sectors of the infrastructure space, utilities and communications generally have steady demand and are good places to be in a recessionary environment. So accordingly within both real estate and infrastructure, there are property types and sub sectors that are attractive in any market environment. Cyclical growth environments, as well as recessionary environments.

Now regarding our economic outlook for a recession, over the next year, I want to give you three levels of probability. First, there is a high probability of slowing growth, but no recession. In that environment, slowing growth, no recession, infrastructure and real estate should both perform well and both perform well relative to traditional businesses.

Second, we think there is a moderate probability of a short, but shallow, recession. Again, infrastructure and real estate should both perform well and well relative to traditional asset classes. Third and finally, we think there is a low probability of a deep and prolonged recession. This would be essentially a policy error by central banks prompting a recession. In that environment we think infrastructure should continue to perform well, but real estate may be impacted by that long, deep recession. In particular cash flows that are predictable while leases are in place are great to have. But when those leases expire, if there is no tenant to renew or a tenant to replace an expiring lease, cash flows can fall off.

So in that order, we think the highest probability is slow growth with no recession. And we feel good about the performance of both real estate and infrastructure in that environment.

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The hotel sector is particularly interesting now as the reopening continues and more people begin to travel. There is good opportunity here, but hotel investing is not without risk. It is the most volatile of the real estate sectors, driven by the short lease duration. Hotels essentially are a collection of one night leases. Covid had an acute negative impact on the hotel sector.

Hotel revenues are frequently expressed as RevPAR, or revenue per available room, RevPAR, which is a function of average daily rate and occupancy. Relative to 2019, pre-Covid, U.S. RevPAR collapsed to -80% in April 2020. This was principally driven by a collapse in occupancy from 70% to 20%. As the reopening has progressed, U.S. RevPAR has steadily recovered, and as of December 21, relative to 2019, it is +4%.

However, there is still wide dispersion among markets and segments, creating significant opportunities for active management. Within the U.S., the top five best performing markets have RevPAR, revenue per available room, 10% above 2019 levels. These markets are generally characterized by leisure travel, warm weather, and drive-to destinations. For example, Miami, Phoenix, Tampa, and New Orleans. In contrast, the bottom five worst performing U.S. markets have RevPAR 37% below 2019 levels. These markets are characterized by business travel, convention travel, and international tourism. For example, San Francisco, Chicago, and Oahu, Hawaii. By segment, the extended stay segment, which focuses on stays of one week, one month, or longer has been particularly strong, while any segment focused on business travel, upper upscale, luxury has tended to be weak.

As Covid restrictions have loosened, we see acceleration of demand. There is what we would call pent-up demand for leisure travel. People who have been cautious are now finally getting back to traveling, and that will drive continued growth in these leisure markets. We’re very excited about that. Within the business and convention market, it may not necessarily be pent up demand that drives acceleration of RevPAR. We’re very much tied to the return to office. As return to office accelerates, we do expect a return to business travel for face-to-face meetings. One of the risks we face in this market is that the growth of virtual meetings will not immediately go away. There is value in face-to-face. There is value in convention. There is value in networking. But, we believe that the growth of virtual meetings may mean that business travel will take much longer to return to its previous levels of RevPAR than leisure travel.

Significant recovery is still to come within business, convention, and international tourism markets. We are particularly excited about hotel investments here. Hotels in these markets tend to be very high quality, and therefore attractive to institutional investors and international investors, which is supportive of long term value and long term liquidity. We are taking advantage of these opportunities, but are prudently managing our position sizes so that we generate attractive risk-adjusted returns, and limiting our downside due to this higher volatility sector. We are very excited about hotels, but again, are remaining prudent in our investments.

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In 2021, real assets produced strong returns as global economic growth accelerated on post-Covid reopening and central banks maintained low policy interest rates. 2022 will bring a very different macroeconomic background with global economic growth slowing from the very high level of 2021 and central banks, including the U.S. Federal Reserve and the Bank of Canada, poised to begin raising policy interest rates. High inflation complicates the macroeconomic outlook. Infrastructure and real estate can continue to perform well in this slowing growth, rising rate and high inflation environment. I want to discuss the impact of each of these three factors on infrastructure and real estate and show how active management can identify areas of investment opportunity.

Let’s start with growth. Broadly speaking, infrastructure and real estate have very different economic sensitivities, leading infrastructure to be more defensive and real estate more opportunistic. Infrastructure tends to have limited economic sensitivity due to the supply, demand, and pricing dynamics. Supply of infrastructure assets is limited. And many infrastructure assets are monopolies or semi-monopolies facing limited competition. Demand for infrastructure services tends to be steady as infrastructure provides essential services with limited GDP sensitivity. Pricing of infrastructure services tends to be either regulated or subject to long-term contracts.

In contrast, real estate tends to have meaningful economic sensitivity due to meaningful cycles of supply, growth, demand change, and pricing change.

Now slowing growth, in general, may not translate into slowing growth for all infrastructure and real estate. Keep in mind that certain mobility sense of infrastructure sectors, such as airports and toll roads, and real estate sectors such as hotel, office, and retail, were acutely and negatively impacted by Covid. As mobility increases and return to office accelerates, these specific sectors may achieve outsize earnings growth as well as sentiment improvement, leading to strong investment performance. Active management can identify these areas of opportunity.

Moving on to interest rates. It is important to remember that central bank policy is more impactful on the short end of the yield curve than the long end of the yield curve. The long end is driven by expectations for growth and inflation, and it is the long end that is more impactful to equity investment valuations, and equity investment returns. Due to equity valuation based on the present value discounting of future cash flows, longer duration cash flows are more sensitive to interest rates than shorter duration cash flows. Within infrastructure, utilities tend to be longer duration. Within real estate, duration ranges from hotels with one night leases to self-storage with monthly leases to apartments with annual leases to a commercial property such as office, industrial, and retail with leases of generally 5 to 10 years. Here again, active management can identify sectors with the best investment opportunity.

Finally, inflation. This is where infrastructure and real estate have the potential to really shine. Infrastructure has very high inflation linkage with approximately 70% of cash flows tied to regulation or to long-term contracts, which allow for price increases tied to inflation. Accordingly, infrastructure is a terrific asset for times of high inflation. Real estate can also provide high inflation linkage due to leases which allow for rent escalation and expense pass-throughs tied to inflation. In addition, inflation drives rising replacement costs for real estate, which tends to drive increases in market rents.

Considering these three macroeconomic factors, as well as current evaluations, we are finding many attractive investment opportunities. Within infrastructure, we favor the sectors of electricity, transmission and distribution, gas utilities, rail, toll roads, and midstream. Within real estate, we favor the sectors of life sciences, where vacancy rates are extremely low and growth prospects are strong, as well as hotel and multifamily.

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Larry Antonatos, managing director and portfolio manager, Brookfield Asset Management.

The Covid-19 lockdowns have highlighted the ability of many office employees to effectively work from home. Now, as reopening progresses, some companies are moving to a more flexible hybrid work structure, including both work-from-home and work-from-office. This has prompted a big question among real estate industry observers. Will work-from-home become an important part of the norm over the long term, leading to a permanent drop in demand for office space?

At Brookfield, we believe the answer is no. In our view, both successful companies and successful employees value the power of in-person collaboration. While remote work can be effective in the short and even the medium term, it cannot replace human interaction in the long term. Our view focuses on the area in which Brookfield focuses our investments, that is top-quality office buildings in major urban centers. We expect these assets will generally fare much better than lower quality office buildings in smaller markets.

Big picture, we anticipate three trends emerging 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 employees and younger employees.

Second, we anticipate that Covid-19 will likely reverse the office densification trend of the last few decades. With certain social distancing norms and health and safety protocols likely to endure, office square footage per employee will need to increase. This is counter to the historical trend where office square footage per employee has decreased from 425 square feet in 1990 to 225 square foot per employee in 2010 and 150 square foot per employee in 2020.

A third major trend is we expect 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 the lenses of market size, market desirability and market adjacency and viewing office property through the lens of quality, we have a few observations and expectations.

On market size, major markets will continue to be important, particularly for global companies, for deal-oriented businesses, such as investment banking or M&A, and for creative industries. For example, we believe Toronto, New York and London will always be important.

From a market desirability perspective, 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 that these markets may actually attain the critical mass of larger older markets. In the United States, Austin, Texas and Nashville, Tennessee are success stories in this regard. These markets are prime opportunities for investment.

Considering market adjacency, we expect the most attractive residential suburbs and second home markets convenient to major office markets will see increased demand for satellite offices. Near New York City, for example, Greenwich, Connecticut, and even The Hamptons have seen increasing demand for office space.

In considering property quality within all markets, we believe the highest quality property will get stronger and stronger, and lesser quality property will become less desirable and perhaps will become obsolete.

In summary, Brookfield’s optimistic long term view on Class A office in major markets is perhaps contrarian. We see public real estate companies with outstanding office portfolios in major global cities trading at significant discounts to underlying real estate asset value. This is a compelling investment opportunity, but is not without risk. In the short run, Covid-19 cases may persist, in the medium run, the return of the workforce to the office may be slow, but in the long run, we believe Class A office in major markets is essential to business, is essential to creativity, is essential to employee development and will be resilient.

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Larry Antonatos, managing director and portfolio manager, Brookfield Asset Management.

The low interest rate environment of the past 18 months has been a key support for global economic activity during Covid-19 disruption. Low rates have also been a key support for asset valuation. Most visibly, broad public equities, as measured by the MSCI World Index, have delivered phenomenal performance, and as of September 2021 are approximately 30% above pre-Covid highs. In contrast, benchmarks for public real estate and infrastructure equities are only approximately 5% above their pre-Covid highs. Because of this 25% return differential, public real estate and infrastructure appear very attractively valued relative to broad equities. This is an important investment opportunity. Very attractive valuations for real estate and infrastructure today.

As we consider investment opportunities in a future interest rate environment, we should focus on three important drivers of interest rates. First, central bank policy. As economic activity returns to pre-Covid levels, we expect central banks will prudently reduce monetary stimulus by tapering asset purchases and raising benchmark interest rates. Second, economic growth is a powerful macroeconomic force that will drive real interest rates. Higher growth drives higher real rates, and lower growth would drive lower real interest rates. Third, inflation. Inflation will play an important role in the level of interest rates. Higher inflation drives higher nominal rates, and lower inflation drives lower nominal interest rates.

Accordingly, we can consider future interest rate environments by constructing a four-quadrant map of economic growth versus inflation. To visualize this construct, in the upper right quadrant, growth and inflation are both rising. In the lower left quadrant, growth and inflation are both falling. In the remaining two quadrants, one of these factors is rising and the other is falling. The performance of real estate and infrastructure within these four quadrants will reflect different sensitivities to growth and inflation because real estate and infrastructure have very different business models. Real estate is generally 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, is determined by negotiations between landlords and tenants and is impacted by the levels of supply and demand at the time of lease negotiation. And frequently, leases include price escalation tied to inflation.

In contrast, infrastructure is generally a regulated business where government involvement can play a role in the drivers of supply, demand and pricing. Supply can be limited by government regulation, so many infrastructure assets benefit from limited competition. Demand is generally very steady because infrastructure provides essential services that generally have limited sensitivity to economic activity. And pricing for infrastructure services is frequently regulated or contracted with price escalations frequently tied to inflation. Due to these differing business models, real estate is generally more sensitive to economic growth and infrastructure is generally more sensitive to inflation.

So within our four quadrants of growth versus inflation, we would expect real estate and infrastructure to perform as follows. Rising growth, rising inflation: both real estate and infrastructure should deliver strong returns that may fail to keep pace with more cyclical sectors. If growth rises more than inflation, real estate with greater sensitivity to growth should outperform infrastructure. On the other hand, if inflation rises more than growth, infrastructure with greater sensitivity to inflation should outperform real estate.

In a rising growth and falling inflation quadrant, both real estate and infrastructure should deliver strong returns. Real estate with greater sensitivity to growth should outperform infrastructure. In a falling growth but rising inflation environment, both real estate and infrastructure should deliver a moderate return and should outperform more cyclical sectors due to the stability of cash flows and the benefit of inflation escalators. Infrastructure with greater sensitivity to inflation should outperform real estate. And in a falling growth, falling inflation environment, both real estate and infrastructure should deliver moderate returns and should outperform broad markets due to the defensive benefits of long duration cash flows. Within these four quadrants, the sweet spot for an investment performance of real estate and infrastructure is an environment with growth and inflation, both rising moderately, but not aggressively.

In this moderate but not aggressive environment, real estate and infrastructure should deliver strong returns, but should not be outpaced by more cyclical sectors. This is another important investment opportunity. We expect exactly this sweet spot, macroeconomic environment over the next few years.

Finally, I want to highlight that both real estate and infrastructure includes sub sectors with a range of sensitivities to economic growth and inflation. This creates more granular investment opportunities. For example, within real estate, growth sensitivity is higher for property types with short lease durations, such as hotels, which have nightly leases, self storage, which has monthly leases, and residential apartments, which have annual leases. Within infrastructure, place and sensitivity is higher for sectors where pricing is contractually tied to inflation, such as certain utilities and transport. Transport infrastructure offers the added opportunity of growth sensitivity due to volume increases.

So in summary, we see three important investment opportunities. First, as of September 2021, very attractive valuations for real estate and infrastructure. Second, we expect the sweet spot macroeconomic environment over the next few years with growth and inflation both rising moderately, but not aggressively. And third, there are specific growth and inflation sensitive sub-sectors within real estate and infrastructure that offer terrific opportunities.