Weekly View from the Desk
Overshoot First, Ask Questions Later
Key Real Estate Themes in a Slowing Economy
Dec 28, 2022
PGIM Real Estate discusses opportunities in key markets and implications for investors as the global economy decelerates.
As a downturn hits, analysis very quickly shifts from how likely it will happen to how bad it will get. And this downturn is no different. But by degrees, the answers to that question vary across regions. In terms of investment implications, several key factors—weaker growth outlook, inflation pressures, higher interest rates, and debt financing constraints—apply in almost all markets. At the same time, we know from history that outcomes will vary across global sectors and regions. This serves as another reminder, especially in uncertain times, of the advantages of holding a globally diversified portfolio, whether it be for debt or equity investment strategies.
In its latest Quarterly Insights, PGIM Real Estate examines the risks and opportunities across the globe in a slowing economy.
REITS REMAIN ATTRACTIVE DESPITE MODERATING GROWTH
Public equity and bond markets have already undergone significant repricing in response to higher interest rates and a deteriorating economic outlook. We are just starting to see the knock-on impact on private real estate values, with more to come for two reasons: portfolio rebalancing and a repricing of real estate cash flows.
First, substantial equity and bond market declines mean there will be less capital available for real estate investment as investors now find themselves overallocated to the asset class. Since 2015, institutional real estate exposure has consistently trailed target allocations. The opposite is now true due to simultaneous declines in bond and equity prices in 2022. The abrupt need to rebalance portfolios will place upward pressure on real estate yields, since the risk-free rate is much higher than it was at the beginning of the year. Lower transaction volumes tend to go hand in hand with narrowing yield spreads vs. the risk-free rate, as would-be sellers are slow to adjust their pricing expectations to buyers’ required yields. Assuming risk-free rates remain well above early-2022 levels, we expect owners to accept lower prices in the coming year.
Second, given the rapid repricing already experienced in public equity markets, real estate owners can look to REIT shares for where private market values may be heading. While estimates of cap rates in the transaction market have already moved up an average of 80 basis points across the apartment, industrial, office, and retail (non-mall)1 sectors, REIT shares indicate further price adjustments are on the way.
Given the lagging nature of private real estate values, history tells us REITs offer an attractive entry point for real estate investors around turning points in cycles. Based on data from the three recessions that occurred between 1990 and 2009, the NAREIT All Equity REIT Index outperformed private real estate as represented by the NCREIF Property Index (on a leveraged basis) by an average of 8.8% per year in the five years from the start of a recession. By comparison, the difference in long-term (1983-2022) average annual returns between the two series is just 0.5%. Even if an investor’s entry point is a few quarters before or after the start of the recession, REITs still have produced, on average, higher five-year forward returns.
RAPID REPRICING AND WEAKER OCCUPIER MARKET IN 2023
In REIT markets, where repricing—and often overshooting—can occur rapidly, European-listed real estate values are down 36% year-on-year, which is beyond our estimated -20% threshold that typically indicates it is more than just noise and that a broad correction in private values is going to take place. The key driver of the repricing in public and private markets alike is the sharp rise in market interest rates. This raises the required return for real estate, pushing up yields if not accompanied by either higher growth expectations or lower risk perceptions, neither of which apply today.
As households and businesses face higher costs and falling demand, a sharp drop in consumer confidence and hiring expectations—key components of our leading indicator—point toward more challenging conditions for occupier markets.
Leasing demand always lags pricing, and it is worth remembering that until the second quarter, monetary policy—which takes effect over a period of up to two years— was still very supportive for businesses, so we shouldn’t expect to see an immediate adjustment. As such, data on occupier activity has held up fairly well this year, with much demand likely reflecting corporate decisions taken before the negative implications of the Russia-Ukraine war and aggressive central bank action became as clear as they are today. However, our leading indicator has turned sharply downward, suggesting that we will see a material downward shift in demand next year.
Weaker occupier conditions typically follow upward yield movement, lagging by a year or so based on historical analysis. Importantly, all past real estate downturns since 1980 have featured a significant adjustment in real rent levels on top of any yield expansion. The magnitude of correction has consistently been about -5% per year for the first two years or a correction, leveling off after that, unless there is a real oversupply problem, such as there was in the early 1990s. Ultimately, vacancy will dictate whether there is additional distress on top of the financial repricing, much as there was in the early 1990s.
POCKETS OF CYCLICAL RESILIENCY REMAIN
Global real estate investors often come to Asia in search of stronger growth and diversification from their home markets2. Data from the Global Real Estate Fund Index (GREFI)3 shows that annualized real estate returns in the APAC region have outperformed the global average since 2005, noting the delivery of return premium as expected. The dynamism of market conditions in Asia also offers investors the benefits of intra-regional diversification, helping pan-regional portfolios avoid a synchronized decline during market downturns. Evidence from previous down cycles shows that Asia Pacific, as a region, has weathered both regional and global headwinds relatively well.
With the U.S. and major European economies being on the edge of falling into recession, Asian economies are certainly feeling the chilly headwinds of slower global demand. Growth momentum is expected to slow down in the coming quarters4. And higher interest rates will build pressures on cap rates and capital values in a number of markets. Nevertheless, pockets of cyclical resiliency remain. Japan can still benefit from the recent border reopening in October. And the Chinese economy could regain some strength after the government starts relaxing its highly strict zero-COVID policy, which has been hamstringing its economy over the past two years.
Looking forward, we expect cap rates to expand in a number of markets, most notably in Australia and South Korea. Among major sectors, office and logistics are facing more intense upward pressures on cap rates, leading to capital value declines in some markets. However, at the same time, we think a number of markets, particularly in Japan and Singapore, will have their values hold up relatively well. Reflecting this intra-regional dynamic, capital values are expected to mildly decline at the regional average level but have a wide range of outcomes among individual markets.
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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 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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