A Bumpy Road to a Familiar Low-growth Destination
PGIM Fixed Income explains why it expects to see secular factors overtake cyclical trends as already-building headwinds slow the global economy.
As the world recovers and reopens at varying speeds, the real estate industry is transforming and offering new opportunities. While the uncertainty caused by the war in Ukraine and increased rate-hike expectations remain wild cards, the worst of the COVID-19 pandemic has passed.
Higher interest rates are undoubtedly a concern, but there are good reasons that the tightening cycle now underway in the U.S., or those that are expected to commence soon in most major global economies will not last long. Inflation should recede from its four-decade high, although stay elevated for some time given the lingering impact of supply-chain disruptions. Real estate is well positioned to perform well against this challenging macro backdrop.
Real estate’s recent performance in a turbulent economy suggests the industry is well positioned to weather whatever comes next—recession or no recession. Data from the first half of 2022 are holding up well—even in Europe, which is absorbing a direct impact from the war. However, real estate data typically lag other economic data as a result of such factors as fixed-term lease contracts, index linking, and infrequent valuation cycles.
Rising Rates: After the global financial crisis, real estate investment trusts (REITs) restructured their debt to strengthen their balance sheets and operating efficiencies. Today, REITs tend to have long-term fixed rate debt, which have largely been locked in at low levels. Additionally, net operating income margins have risen sharply and are now back near pre-pandemic levels. This has reduced their leverage ratios, meaning REITs should be minimally impacted by rising interest rates.
Reflation: Historically, real estate has demonstrated strong correlation with inflation, particularly in assets with short-lease duration and strong operating leverage. Shorter-lease-duration assets tend to appreciate the most when reflation takes hold, particularly those seeing strong demand, which allows lease holders to pass expenses along to their tenants. Residential properties, which offer inflation protection, are poised to benefit from reflation as improving cost controls and supply/demand imbalances should lead to above-Consumer Price Index operating income growth. Other sectors, such as self-storage and data centers, have little exposure to wage inflation.
Reopening: As the U.S. has largely reopened from the pandemic, U.S. real estate markets have seen a robust recovery from pandemic lows. Using the U.S. as a proxy for international real estate markets, hard-hit sectors should recover as business operations return to normal as economies around the world fully reopen. While many regions are currently trading at significant discounts, we expect share prices to bounce back strongly in consumer industries and travel, particularly in lodging and urban real estate. Because COVID-19 vaccinations are progressing at varying speeds across the world, this trend will likely continue for months, if not years.
Recalibration: Technology has enabled some REITs to take advantage of their scale and operating history to incorporate vast volumes of data into various aspects of their business. What will follow is a period of consolidation as some REITs acquire small to midsized trusts to realize value through efficiency gains.
Risks—Investing involves risks. Some investments are riskier than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, and political and economic uncertainties. Investing in emerging markets is very risky due to the additional political, economic, and currency risks associated with these underdeveloped geographic areas. Investments in growth stocks may be especially volatile. Value investing involves the risk that undervalued securities may not appreciate as anticipated. It may take a substantial period of time to realize a gain on an investment in a small or midsized company, if any gain is realized at all. Real estate investment trusts (REITs) may not be suitable 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. Diversification and asset allocation do not guarantee profit or protect against loss. Investments in in Master Limited Partnerships (MLP) and MLP-related investments are subject to complicated and in some cases unsettled accounting, tax, and valuation issues, as well as risks related to limited control and limited rights to vote, potential conflicts of interest, cash flow, dilution, and limited liquidity and risks related to the general partner’s right to force sales at undesirable times or prices. MLPs are also subject to risks relating to their complex tax structure, including losing its tax status as a partnership, resulting in a reduction in the value of the MLP investment. Many MLP investments are in the energy sector and subject to a greater degree to risk of loss as a result of adverse economic, business, regulatory, environmental, or other developments affecting industries within that sector than investments more diversified across different industries. Diversification and asset allocation do not guarantee profit or protect against loss.
The views expressed herein are those of investment professionals PGIM Real Estate at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. This commentary is not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services. This commentary does not constitute investment advice and should not be used as the basis for any investment decision. This commentary does not purport to provide any legal, tax, or accounting advice. PGIM Investments LLC is a registered investment advisor with the U.S. Securities and Exchange Commission. PGIM Custom Harvest does not provide tax, legal, or accounting advice. This material is for information purposes only, and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
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