Resilient Global Real Estate Opportunities
May 5, 2023
In its 2Q23 outlook, PGIM Real Estate shares views on global real estate and where it sees resilient, secular-based demands that will help weather an economic slowdown.
STRONG SETUP FOR U.S. REITS
Recent stability in rates (albeit early) and easing inflation pressure are very encouraging for REIT performance for the balance of 2023. The U.S. REIT market suffered a dramatic rerating in 2022, given the 26% price correction1 with minimal negative earnings revisions. Despite the dramatic increase in debt costs, REITs are still expected to generate more than 4% funds-from-operations per-share growth in 2023, followed by 7% in 2024. Barring a major economic contraction, we expect REIT fundamentals to remain steady for most property types given long lease durations, low supply risk, and defensive and secular-based demands.
Furthermore, REIT balance sheets are in considerably better shape than they were during the global financial crisis. Most management teams took full advantage of the historically low interest rate environment to lock in long-dated fixed debt costs. As a result, most REITs are likely to be in positions of offense if private owners come under any distress because of the capital markets’ dislocation. This is likely to be especially true for the net lease sector.
The current spread between REIT implied valuations and private real estate appraised values is historically wide—at roughly 16% on an equally weighted basis. As rates stabilize, that valuation discrepancy is likely to lead to increased M&A opportunities for private equity players looking to deploy capital toward the discounted REIT sector. We would also expect large institutional investors to rotate their real estate allocations from private to public to take advantage of this arbitrage opportunity. The liquidity benefit of the publicly traded REIT structure has become abundantly clear in recent months, and that benefit will likely have long-term implications for real estate allocations.
CAUTIOUS OUTLOOK AMID ECONOMIC AND GEOPOLITICAL RISKS
Inflation figures have been on the decline in the region since November 2022, and that trend continued through March, but the level of inflation still remains high throughout Europe. Investors are hoping that the turn in inflation will permit central banks to slow their interest rate increases and end their tightening sooner. However, headline inflation is coming down only slowly, and core inflation is resisting the pressure of higher interest rates. Companies with weak balance sheets remain on near-record discounts to net and gross asset values because they are still exposed to refinancing risk and falling cash flows. Cap rates moved up quickly in the second half of 2022 in response to major upward moves in bond yields last year, but share prices are still implying further moves in private market-cap rates. We remain cautious on the European region in a global context. Our focus remains on companies better equipped to withstand the risk of further corrections as economic and geopolitical risks remain prevalent in the region.
ALL EYES ON CENTRAL BANKS
As global central banks converge on tighter monetary policies in the past 12 months, expectations are solidifying around a mild U.S. recession that would slow further rate-hike momentum. The situation presents an interesting dilemma: where bad macroeconomic news could benefit real estate equities as long as interest rate hikes slow while net operating income is maintained. In Asia Pacific, attention would center on how the Fed, the Bank of Japan, and the People’s Bank of China move in the coming months.
We remain positive on Australian self-storage and manufactured housing. Demographic and market-consolidation trends provide structural tailwinds to these sectors. As Hong Kong’s reopening is progressing well, the retail and residential sectors are expected to benefit from the reopening. Given rising interest rate pressure, we prefer Japanese developers that exhibit strong shareholder returns with greater reopening exposure. We favor J-REITs in hospitality that benefit from tourism reopening. In Singapore, we prefer the fund manager/landlord plays. For S-REITs, we prefer diversified office/retail REITs that benefit from reopening. We also like industrial names with solid dividend growth underpinned by strong fundamentals.
Market focus is now centering on the depth and scale of a potential U.S. recession as the Fed maintains interest rate hikes aimed at arresting domestic inflationary pressures while at the same time having to handle U.S. regional banking issues. Deglobalization and geopolitical discords such as the prolongation of the Russia–Ukraine conflict are other factors that continue to warrant concern. In Asia, reopening remains fraught with the risk of subsequent COVID-wave impacts amid growing economic and social marginalizations. How China manages its fiscal and monetary policies to boost its economic growth, as well as its policies in support of its housing market presents uncertainties with regard to the country’s economic outlook. For the rest of Asia, economic growth and monetary policy outlook remain dependent largely on Fed policy and global growth. On the flip side, a resilient U.S. economy could further stoke inflationary pressures and reaccelerate expectations of rate hikes. Within our individual sectors, a sharper rise in long-term real interest rates could negatively affect regional REIT valuations. And in the event of setbacks on the geopolitical front, a potential U.S. recession or potential new COVID-19 variants, risk appetites could remain in check heading into the year.
For Professional Financial Use Only. Not for use with the public.
- Represents the U.S. portion of the FTSE EPRA NAREIT Developed Index as of December 31, 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. 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.
Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information, nor do we make any express or implied warranties or representations as to the completeness or accuracy. Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated, based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
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