Macro Tail Risk: A Targeted Equity Protection Solution
PGIM Wadhwani highlights the main attributes of the Macro Tail Risk strategy, a liquid alternative solution.
Rick Romano, Head of Global Real Estate Securities at PGIM Real Estate, shares his outlook on why the current market environment is ideal for public real estate securities and how investors can take advantage of the significant dislocation between private and public real estate markets.
There are four key trends driving opportunity within real estate that either grew out of the pandemic or were accelerated by it—namely reflation, rising rates, reopening, and recalibration. Shorter term, real estate around the world is recovering in a reflationary environment that is forcing central banks to raise interest rates. Also, the reopening play still exists in certain parts of the world, such as the reopening of borders in Asia. Longer term, real estate is recalibrating to how the world is changing, with technology pulling forward trends that have been gaining traction for some time. These include the digital transformation of our personal and work lives, the need for affordable housing, an aging population across much of the world, and sustainability concerns.
Historically, real estate investment trusts (REITs) have outperformed stocks significantly during periods of elevated inflation. Lease structures allow landlords to directly pass along CPI-type increases to tenants. At the same time, inflation increases construction costs, which deters new projects by making them less profitable. This keeps supply low, driving up the value of existing properties.
A rising rate environment can benefit real estate markets, as the focus on risk premium for these assets shifts toward their higher income potential. Managers learned important lessons from the global financial crisis, so REITs today have stronger balance sheets and should be minimally impacted by rising rates. REIT managers took advantage of the lower rate environment in recent years by refinancing into longer-term, fixed-rate debt. The combination of sharply higher net operating income and dramatically lower interest expenses now reduces leverage ratios and enables decent dividend growth.
Dividend stability and dividend growth are two key factors to consider for REITs as interest rates rise. Current income from REITs (3.9%) sits just above bonds (3.7%) and well above stocks (1.7%). But unlike bonds, the long-term dividend growth rate for REITs has averaged about 8%. It currently stands at roughly 21%, which is well above the inflation rate and S&P 500 earnings growth expectations for 2022 and 2023 (approximately 8-10%). This positions today’s investors with attractive yields from REITs that have above-average dividend growth and built-in protection against both inflation and rising rates.
Allocating to both public and private real estate can help create a well-diversified real estate portfolio. Public REITs offer exposure to property types that benefit from secular growth tailwinds, compared with the harder-to-access private markets, which tend to be more cyclical. We currently see public REITs trading at a substantial discount to private funds, because REITs have already taken their medicine and probably overshot to the downside, offering investors a compelling opportunity to buy at wholesale prices. Private real estate has not yet corrected as much in terms of valuation write-downs.
Like equity markets, public REITs revalue frequently (daily) based on investor sentiment and changing expectations. Private markets rely on quarterly appraisals—which are often subjective—to reassess property values. The difference in valuation assessments often leads to artificial smoothing of values and returns for private markets that typically corrects over time. This is the reason public markets tend to lead private markets by about six to nine months, on average. In the pandemic, for example, global transactions ceased for a period, so private markets didn’t remark property values. But, as deals have started to close again, transactional evidence of commercial real estate pricing over the coming months should confirm lower property values and force these funds to take markdowns.
The pandemic supercharged trends in technology that we thought would take years to unfold. Two great examples are work from home and e-commerce. While we’ve seen demand come back in hotels and restaurants as people migrate back to cities, office occupancies remain low (~35%). We think offices could be going through the transition we saw with malls 10 years ago, with a widespread re-evaluation underway about how much space is needed. Some of the demand for physical working space will shift to technology-related real estate, such as cell towers and data centers for the cloud-based services that enable work from home and e-commerce. E-commerce should continue to drive increased industrial demand to warehouse goods for quicker delivery. We believe the next wave of growth will center around how well companies leverage technology and big data to drive more cash flow from existing real estate holdings.
We want companies that can pass through rent increases above and beyond inflation. For example, urban apartments in the U.S. have seen double-digit rent increases, with areas like New York City seeing 30% increases. Industrial leases signed five years ago are now renewing with 40% to 50% rent increases. These leases are being signed with annual CPI protection or fixed rent bumps of 4%-6% for five years.
We’re looking for companies that don’t have much wage labor exposure at the property level. These are property types, like self-storage, that require few, if any, on-site employees. Apartments took a lot of labor out of their cost structure at the property level through COVID, and many of those activities remain virtual.
The “best buy” candidates are companies with the above characteristics that trade at large discounts to their real estate value. And the big disconnect between private and public real estate valuations creates a compelling arbitrage opportunity.
*There were 32 periods between 3-4% inflation and 61 periods with 4%+ inflation. REITs represented by FTSE NAREIT Equity REIT Index. Stocks represented by S&P 500 Index. Past performance does not guarantee future returns. Investors cannot invest directly in an index.
**Past performance does not guarantee future returns. Investors cannot invest directly in an index.
The views expressed herein are those of PGIM Real Estate investment professionals at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute an offer to sell or a solicitation to buy any security.
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