As most real estate markets are either in or heading for a downturn, all eyes are focused on the capital markets. After all, capital markets move first. But that gets everyone thinking each downturn is the same. They’re not. Each downturn is unique in its own way. And that speaks to the opportunity sets that arise in times like these.
In its latest Quarterly Insights, PGIM Real Estate explores the risks and opportunities across the globe in today’s highly uncertain environment.
COMING OF AGE IN AUSTRALIA’S RENTAL HOUSING SECTOR OFFERS OPPORTUNITIES
For many years, strong economic growth and expanding demographics have been key drivers of the Australian housing market. House prices in Australia’s capital cities have grown by an average of 7.5% per annum in the past decade1. However, with house prices rising fast, affordability levels across major Australian cities have been declining as reflected in the lower home ownership ratio and steady increase of private renters. Rental expenditures on housing in Sydney and Melbourne are forecast to double in the next decade, making these markets among the fastest growing rental housing markets in APAC2.
To attract more private investment in the sector and stimulate more supply, the Australian government is instituting policy initiatives, including reducing land taxes of eligible build-to-rent developments, and plans to revise the withholding tax rate. Investors are responding, and there has been a noticeable increase in interest in the build-to-rent sector. We believe the combination of favorable secular demand factors and a supportive policy environment will drive strong growth and maturity of the rental housing sector in Australia in the coming years.
THE OCCUPIER MARKET HAS TURNED, CONFIRMING A DOWNTURN IS UNDERWAY
Our leading real estate demand indicator, which is constructed by combining economic surveys and some hard economic data, has turned negative, pointing to tougher times ahead for commercial property occupier markets. This confirms that a broad-based downturn is now underway.
We are seeing clear signs that, in particular, rising energy prices and rising borrowing costs are hitting the household sector hard and are undermining a modest post-pandemic economic recovery. This is directly affecting logistics and retail occupier markets, while the hit to sentiment and pressure on corporate earnings is feeding through to a weakening office occupier market outlook.
However, there are multiple factors that mean the downturn might not be as severe. These factors include low vacancy and low supply across Europe in recent years; low loan-to-values and limited leverage through the last cycle; the prospect that a recession (or falling commodities prices) quickly dampens inflation and scales back the need for further interest rate hikes; the fact that some sectors (such as retail) have already been through a significant price correction; and the persistence of long-term structural trends, for example for distribution, living, life sciences or data centers, that boost prospects of a swift demand recovery.
Given that real estate is a long-term investment asset class, the implication is clear: as downside risks have materially increased, deploying equity and debt capital over the next few quarters should be highly selective as we monitor the situation and try to assess the scale of the market correction and prospects for a swift recovery.
FOCUS ON HIGH LONG-TERM RENTAL GROWTH MARKETS AS RECESSION LOOMS
The average apartment rent in the U.S. has risen by nearly 16% since mid-2020, the fastest pace in at least four decades. While a boon for apartment owners, a decelerating U.S. economy means that pace will slow. It also raises a question: have rents already risen too high? The answer to the national question is heavily dependent on the future of markets with the largest recent gains.
There is also a link to other migration drivers, notably including remote working and the growth of technology jobs outside of the established hubs of the Bay Area, Boston and Seattle. Lifestyle changes since the onset of the COVID-19 pandemic accelerated shifts that were already underway. Rents in these recent outperformers began to track above their long-term trend around 2015, reaching 10% above trend by 2019. After the run-up of the past two years, they’re 31% above trend.
If the U.S. enters a recession, rents in the recent outperformers will fall, particularly with swelling supply pipelines in many of these markets. By contrast, we expect many of the laggard markets to be relative safe havens, such as Washington, DC, and Boston. Despite its history of steep rent declines in downturns, even San Francisco may prove less volatile given the lack of rent gains in recent years.
Faced with heightened economic uncertainty, investors will be well served by focusing on markets that offer high long-term rental growth rather than overvaluing potential short-term growth that is increasingly at risk. While recent capital flows have been out of Gateway markets and into Sunbelt markets, we have evidence that the ideal combination is a subset of both of these broader categories.
With an economic slowdown a certainty and a recession a rising possibility, the short-term outlook for rent growth ranges somewhere between underwhelming and poor. Given this uncertainty, a focus on markets with superior long-term rent growth drivers is more important than usual.
- Source: SQM Research, PGIM Real Estate. As of August 2022. Note: Capital cities include Adelaide, Brisbane, Canberra, Darwin, Hobart, Melbourne, Perth and Sydney.
- Source: Oxford Economics, PGIM Real Estate. As of August 2022.
Risks— Investing in real estate poses certain risks related to overall and specific economic conditions, as well as risks related to individual property, credit, and interest rate fluctuations. Non diversified investments may be subject to greater volatility or loss resulting from a particular security or sector will have a greater impact on the return. Foreign securities are subject to currency fluctuation and political uncertainty. Real estate investment trusts (REITs) may not be appropriate for all investors. There is no guarantee a REIT will pay distributions given the inherent risks associated with the market. A REIT may fail to qualify as a REIT as defined in the Tax Code, which could affect operations and negatively impact the ability to make distributions. There is no guarantee a REIT’s investment objectives will be achieved.
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