Defensive Real Estate Areas To Weather A Slowdown
Nov 9, 2022
PGIM Real Estate shares views on global real estate and where attractive opportunities exist as the global market outlook continues to soften.
PGIM Real Estate shares views on global real estate and where attractive opportunities exist as the global market outlook continues to soften.
U.S. REIT FUNDAMENTALS REMAIN RESILIENT
The recent spike in interest rates has created a challenging environment for the U.S. REIT market. Lack of clarity on the direction of rates and limited transaction data have resulted in reduced transparency into the underlying value of REIT assets. Public markets have likely overreacted to this period of valuation uncertainty by pushing implied cap rates to 6.2% on average for U.S. REITs, or a roughly 250-bps spread to the 10-year note. Furthermore, the underlying fundamentals for most REIT sectors remain favorable with strong, secular demand trends that should serve to cushion operations in the event of a prolonged downturn. This, combined with a relatively defensive and domestic-based business model, should garner increased appeal from equity investors during the next 12–18 months.
We continue to favor a barbell approach, minimizing unintended factor exposure. We remain positive on secular winners—specifically, the self-storage and residential sectors. Demand for both sectors is highly defensive, driven by life events and household formation. In addition, minimal operating costs and strong pricing power should enable them to consistently post better-than-inflationary net-operating-income growth. Both sectors recently posted much-better-than-expected second-quarter 2022 earnings and provided very positive commentary on trends for 2023.
In addition, we continue looking for opportunities to participate in the robust occupancy recovery and improving pricing power across the more-discounted sectors. The recent outsized correction in the industrial REIT sector likely creates a unique opportunity to add exposure to a sector with strong secular tailwinds. In addition, we see significant upside in senior-housing-focused REITs in the next several years. Although labor issues may affect margins in the short term, the sector is well positioned to benefit from an occupancy rebuild and sustained demographic tailwinds for years to come. We’ve become more cautious on lodging and retail because both sectors are more susceptible to an economic downturn. We remain cautious on office, despite discounted valuations, because we view the sector as only in the early stages of a multiyear secular headwind.
GLOOMY OUTLOOK ON EUROPE WITH RECESSION LOOMING
The sharp sell-off in European stock markets this year has opened up historically wide discounts to net asset values, but the outlook for the region’s economy remains highly uncertain. Threats from inflation, extremely volatile energy prices, and potential recession dominate investment markets. Companies with weak balance sheets remain on very significant discounts, as refinancing costs have already increased, and these companies remain exposed to refinancing risk and falling cash flows from further rising debt costs. Cap rates have begun to move up in response to the major upward moves in bond yields, but share prices are implying a much higher move in cap rates to come in private real estate markets. There is a high degree of uncertainty around the future direction of interest rates because inflation has still not been brought under control, and the outlook for demand is weakening as the risk of a recession increases.
We favor a balanced risk profile to help neutralize negative market impacts as much as possible. More-defensive stocks with lower leverages and higher cash flow yields have relatively outperformed on the whole year to date in the market sell-off. The energy dependency of the European region and of several Continental European economies—notably, Germany—does put them at somewhat greater risk of inflation spikes and energy-supply interruptions from the ongoing war in Ukraine, but the whole region is directly affected. Governments throughout the region and at the European Union level are developing policy responses to the cost-of-energy crisis, which could help offset some of the huge anticipated inflationary shocks. We continue to adopt a cautious stance on the European region and to monitor the rapidly changing situation.
POCKETS OF OPPORTUNITIES EMERGE DESPITE STAGFLATION FEARS
COVID-19 ushered in a period of unprecedented global monetary easing and fiscal stimulus as countries coped with the economic fallout. Post pandemic, the result has been widespread and sustained inflation on a global scale, exacerbated by China’s zero-COVID policy and the conflict in Ukraine. Equity markets are focused on the pace of Fed hikes and the potential for policy mistakes as stagflation looms. The ongoing conflict in Ukraine poses another threat to global economic recovery, with surging energy prices adding to tail risks on the downside. In the near term, the following themes could be in focus: (1) stagflation concerns, (2) Fed hikes, (3) energy crisis from the conflict in Ukraine, and (4) recovery in reopening names (retail and hospitality).
We remain positive about Australian logistics, manufactured housing, and self-storage sectors. E-commerce growth and demographic and market consolidation trends provide structural tailwinds for these sectors. The Australian retail sector is also in recovery, as most of the physical-distancing and border restrictions have been lifted. Hong Kong is gradually moving out from the restrictive policies of the COVID era. It could be beneficial to position for reopening of nondiscretionary retail and a potential minimum wage increase in early 2023. In Japan, we prefer companies that exhibit strong shareholder returns and provide greater reopening exposure and favor the heavily discounted hospitality names that benefit from reopening. In Singapore, we like developers in the form of fund manager/landlord plays and prefer diversified office/retail names that are reopening proxies and industrial names with solid rental growth.
Market concern now centers on stagflation fears emanating from rising Fed rates in a backdrop of recurrent COVID impacts, supply-chain disruption, and an energy crisis from the conflict in Ukraine. Global reopening remains fraught with the risk of subsequent COVID wave impacts amid growing economic and social marginalization. China’s current zero-COVID strategy poses significant risk to the government’s 5.5% GDP growth target. For the rest of Asia, domestic recovery and border reopening are coming up against inflationary pressures. Similarly, a strong recovery in the U.S. could stoke inflationary pressures beyond mere transitory impacts, which could drive expectations of quicker and more interest rate hikes. Supply-chain concerns could hamper growth while creating an inflation spiral that would be harder to arrest. A sharper rise in long-term real interest rates could negatively affect regional REIT valuations. In the event of setbacks on the geopolitical front and potential COVID-19 variants, risk appetite could remain in check heading into the year.
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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. Nondiversified investments may be subject to greater volatility or loss resulting from a particular security or sector which would 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.
The views expressed herein are those of 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.
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