Q4 2023 Capital Market Assumptions
Global economic activity remained resilient, although uneven, through the third quarter of 2023. Read on to find out more.
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.
Q: What are the biggest trends driving the real estate market today?
A: 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.
Q: Starting with the first theme, how does real estate perform during inflationary periods?
A: 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.
Q: How does diversifying portfolios with real estate help in inflationary environments?
A: Bonds tend to suffer in an inflationary environment because they have fixed payments that don’t increase over time. There's no growth. Most equity sectors are also pressured by inflation, which increases expenses and reduces earnings. Real estate is a hybrid between stocks and bonds, combining stable income with potential for equity-like growth. Landlords can increase rents or incorporate bumps into lease terms to increase rents above and beyond inflation. For instance, leases signed five years ago in the industrial space are now rolling over and delivering rent increases of up to 50%.
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.
Q: But with inflation comes rate hikes. How will that impact REITs?
A: 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.
Q: What is your view on the valuation dislocation between public and private markets? Where should investors allocate capital now?
A: 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.
Q: How are you positioning portfolios given high inflation and rising recession fears?
A: We believe properties with the following characteristics are attractive in this challenging macro environment:
Defensive tenant demand. Shelter, which everyone needs, is an example of defensive tenant demand. Mortgages become more expensive with rising rates, making renting more attractive than buying. Self-storage is also historically defensive, with job loss, movement, death, and divorce all creating demand. Health care, such as assisted living, medical premises, and hospitals, is another example. We look for long-lease durations, high-credit-quality tenants, and a diversified tenant base.
Pricing power. 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. ese leases are being signed with annual CPI protection or fixed rent bumps of 4%-6% for five years.
Limited inflation exposure. 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.
Attractive valuations. The “best buy” candidates are companies with the characteristics above 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.
Q: Which areas do you see as the best prospects in the current environment?
A: Given their defensive tenant characteristics, we like apartments, manufactured housing, self-storage, assisted living, and health care. Regionally, we selectively favor Europe, where the market has been particularly hard-hit with war in Ukraine. Japan is also interesting because it’s one of the few developed economies with accommodative interest rate policy now. A weaker yen has historically been constructive for Japanese developers, Japanese REITs currently have high dividend yield spreads compared with sovereign bonds, and Japanese hotels should be aided by reopening in other parts of the world and some consumer spending programs.
Q: How do you see technology transforming the real estate landscape?
A: 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. For example, Prologis, a logistics company that tracks every leasing decision made across 450 million square feet of U.S. real estate, uses large data sets and algorithms to examine historic leasing decisions and leverages that intel to improve decision-making on rents, helping Prologis derive more revenue from existing assets.
Q: Why should investors choose an active manager over passive investing options?
A: Investors need active management because there has been severe dislocation in real estate since the onset of the pandemic, with sharp drawdowns across many sectors and regions. With private markets ripe for adjustment, active managers can identify areas most at risk for large write-offs and the sectors offering the best M&A potential. A skilled active manager can also monitor secular forces that represent market headwinds or tailwinds, to potentially capture the most compelling opportunities while managing short- and long-term risks.
REITs should do well in a rising rate environment given they now have lower leverage and attractive dividends with strong dividend growth potential.
As economies reopen, hard-hit sectors should recover as business operations return to normal, especially in Asia, where lockdowns and border restrictions continue to lift.
REITs could see stronger M&A activity as technology drives gains in real estate efficiencies.
Index Definitions—The FTSE EPRA/NAREIT Real Estate Index Series reflects the stock performance of companies engaged in specific aspects of the major real estate markets/regions of the world - Americas, EMEA (Europe, Middle East and Africa) and Asia. The Index Series is designed to represent general trends in eligible listed real estate companies and REITS worldwide, covering Global, Developed and Emerging indices, as well the UK’s AIM market. Relevant real estate activities are defined as the ownership, disposure and development of income-producing real estate. Dividends, using their ex dividend dates, are used to calculate the Total Return Indices on the FTSE EPRA/NAREIT Global Real Estate Index Series. All dividends are applied as declared. “FTSE®” is a trademark of the London Stock Exchange Plc and The Financial Times Limited and is used by FTSE under license. Note: A benchmark Index is not professionally managed, does not have a defined investment objective, and does not incur fees or expenses. Investors cannot invest directly in an index.
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. 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 realise a gain on an investment in a small or midsized company, if any gain is realised at all. Real estate investment trusts (REITs) may not be suitable for all investors. There is no guarantee a REIT will pay distribu- tions 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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