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Seizing Today’s Private Real Estate Opportunities
May 1, 2024
PGIM Real Estate discuss market dynamics, repricing and investment opportunities in private real estate.
Authors
- Caitlin O’Connor, Portfolio Manager, PGIM Real Estate
- Brandon Short, Portfolio Manager, PGIM Real Estate
Commercial Real Estate At Inflection Point
The U.S. economy remains resilient, led by strong employment, wage growth, and consumer spending despite a higher interest rate environment and growing geopolitical conflicts. While inflation is directionally headed towards the Fed’s 2.0% target, the strength of the U.S. economy may roil the market’s expectation for the pace and extent of rate cuts in 2024, leading to a higher-for-longer rate environment.
The elevated interest rate environment has had a broad, negative impact on real estate valuations. For many sectors, we think we are getting close to the bottom and our outlook in the near term is for limited or more muted value corrections. Underlying real estate fundamentals remain a bright spot. Most property sectors are healthy despite some near-term supply noise that will dampen, but not extinguish, income growth.
We believe we’re at an inflection point for commercial real estate. The Fed’s aggressive contractionary monetary policy that started in 2Q22 led to 18 months of very limited transactions activity within commercial real estate as values adjusted to a higher interest rate environment. By the end of 2023, values have reset about 16% on average from the peak. The repricing in the real estate sector has resulted in higher yields and asset pricing below replacement cost, creating potentially attractive buying opportunities today.
Structural Tailwinds And Tactical Opportunities
At a structural level, there continues to be growing demand for necessity real estate. Sectors that benefit from demographic tailwinds and technological advancements will be the long-term winners. These include necessity-based real estate, including all types of housing, grocery-anchored retail, e-commerce-driven industrial space, self-storage, and life science.
While higher rates and limited debt availability have led to real estate repricing, real estate fundamentals in most sectors remain strong, supported by demographic and technological tailwinds.
Supply-side constraints are also favourable for real estate investors. In the U.S., there is a current deficit of 3.2 million homes and 15 million additional homes are needed over the next decade. The housing crisis was further exacerbated by limited new construction starts over the last couple of years as high interest rates ballooned construction budgets. High mortgage rates also put additional strain on would-be homeowners. This supply/demand imbalance and expensive for-sale homes will be a tailwind for all types of rental housing.
In the retail sector, necessity-based retail has maintained a much higher occupancy than discretionary retail, such as malls. Population migration to the suburbs will further drive demand for neighborhood grocery-anchored retail. Retail remains attractively priced and may provide positive leverage from accretive debt.
Technological advancements are driving continued demand expansion in e-commerce, with consumers becoming increasingly reliant on online purchases. As a result, the industrial sector has been the direct beneficiary of large e-retailers focusing on same-day delivery with growing demand for big box distribution centers and smaller, last-mile box warehouses.
On the real estate debt side, a tactical investment window exists until capital markets normalize and debt availability improves. Rapid interest rate rise led to a dislocation in the capital markets constraining liquidity. The challenged debt market results in lower loan proceeds, providing an opportunity to invest in debt-like instruments higher in the capital stack at potentially attractive risk-adjusted return levels.
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Past performance is not a guarantee or a reliable indicator of future results. 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. Investing in real estate may involve additional risks due to its narrow focus; is non-diversified, so a loss resulting from a particular security or sector will have a greater impact on an investment’s return; invests in derivative securities, which may carry market, credit, and liquidity risks; and invests in foreign securities, which are subject to currency fluctuation and political uncertainty. These risks may increase an investment’s share price volatility. Investment strategies such as diversification and asset allocation do not guarantee a profit or protect against loss in declining markets.
References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in the portfolio at the time of publication and, if such securities are held, no representation is being made that such securities will continue to be held.
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