A REIT Rebound On The Horizon
Oct 25, 2023
In its 4Q23 outlook, PGIM Real Estate discusses secular demand opportunities across global real estate that will weather the economic slowdown amid rising macro and geopolitical risks.
Since 2022, REITs faced a perfect storm composed of rising inflation, sustained rate hikes, the Ukraine–Russia war, and COVID-19-disrupted supply chains that affected millions of people. The pandemic ushered in a period of unprecedented global monetary easing and stimulus. As a consequence, the world is now witnessing sustained and heightened inflation. Equity and bond market volatility is the norm as markets alternate between greater rate-hike expectations induced by strong inflation data and slower hikes on indications of weaker economic data. The consequence of that volatility presents an interesting dilemma wherein bad macroeconomic news could benefit real estate equities as long as interest rate hikes slow while net operating income (NOI) is maintained.
PGIM Real Estate discusses secular demand opportunities across global real estate that will weather the economic slowdown amid rising macro and geopolitical risks in 2024 and beyond.
IMPROVED SENTIMENT WITH M&A ON THE RISE
Recent volatility in interest rates has created a sentiment headwind for the U.S. REIT market. However, given the group’s significant underperformance since the beginning of 2022 and its discounted valuation, we believe the market has already priced in that incremental risk. Moreover, a more resilient labor market, combined with softening inflation data, bodes well for a near-term end of the Fed’s current rate-tightening cycle and improved REIT sentiment. Outside the office sector, fundamentals remain steady, with roughly 4% funds from operations per-share growth expected 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 demand.
The current spread between REIT implied valuations and private real estate values is at a historically wide spread, at roughly 24% on an equally weighted basis. As rates stabilize, that valuation discrepancy is likely to lead to increased M&A opportunities for private-equity players that are looking to deploy capital toward the discounted REIT sector. We 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 will likely have long-term implications for real estate allocations.
Public REIT-to-REIT M&A has also increased in recent months. The current environment is rewarding REITs with better balance sheets and superior platforms with premium valuation. As such, many REITs are taking advantage of the valuation spread to consolidate attractive, smaller-cap peers. We’ve even witnessed some hostile REIT-to-REIT M&A activity in the past 12 months. Without a dramatic change in the current macro backdrop, we see that trend as likely to continue. In our opinion, REIT privatization is likely limited to smaller transactions until we see an improvement in the debt markets, but plenty of opportunity exists today.
We continue to favor a barbell approach, minimizing unintended factor exposure. We prefer data centers given attractive valuation and defensive NOI growth. Despite data centers’ outperformance year to date, the sector remains discounted and represents the only sector in REITs to directly benefit from the artificial-intelligence-related demand. In addition, we remain positive on sectors with embedded occupancy upside and limited economic sensitivity, such as healthcare and cold storage. Occupancy overall remains roughly 400–600 basis points below pre-COVID levels, which should allow for significant top-line growth as trends continue to normalize. A recent decline in retail at both shopping centers and malls has increased the attractiveness of the sector given decent growth prospects for 2024 and beyond. In retail, we’ve become slightly more constructive on the mall sector relative to shopping centers’ given valuation. We remain cautious on office despite discounted valuations because we view the sector as only in the early stages of a multiyear secular headwind.
INFLATION RISKS REMAIN
While inflation figures have been on the decline in Europe since November 2022, the level of inflation still remains high throughout the region relative to other global regions. That high level is especially true in the U.K. and Sweden despite gradually declining figures for both headline and core. Inflation levels in the U.K. remain materially higher than in Continental Europe and much higher than in the United States. Government bond yields at both the short and long ends of the curve have been climbing throughout the region and remain elevated.
Companies with weak balance sheets remain on near-record discounts to net and gross asset values, as 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 in that year, and they moved out further in 2023. However, share prices are still implying further moves in private market cap rates. Our focus remains on companies better equipped to withstand the risks of further corrections because macroeconomic and geopolitical risks remain prevalent in the region.
ALL EYES ON CENTRAL BANKS
In Asia Pacific, attention is centered on how the Fed, the Bank of Japan (BOJ), and the Chinese government move in the coming months. With increasing evidence of inflation slowing at the margin—but without a recession looming—the Fed has sounded less hawkish in recent times. The market expects, at most, a further hike in 2023 followed by rate cuts in 2024. With 2024 an election year, the Fed would likely be pragmatic on rates, especially if inflation does moderate more. In China, the central government has announced relaxation measures in the property sector in an effort to spur a market rebound. Without a necessary increase in consumer confidence, we think any economic recovery could be short-lived. The BOJ adjusted monetary policy at its most recent meeting as a result of stronger wage and inflation data. However, we doubt that the BOJ would tighten more unless inflation expectations surprise significantly on the upside. The BOJ still expects a new core consumer price index, excluding fresh food and energy, to come in below 2% in 2024.
We are positive on Australian data centers and self-storage. Artificial intelligence, cloud-computing-driven demand, and increasing self-storage penetration trends provide structural tailwinds for the two sectors. In Hong Kong, which is saddled by a slow economic outlook, we favor the retail sector because tourist arrival recovery is the most visible upward trend in the market. We also favor Japanese developers that exhibit strong shareholder returns with greater reopening exposure, as well as hospitality names that benefit from the reopening of tourism. In Singapore, we prefer fund manager and landlord plays. For SREITs, we like hospitality and industrial names with solid dividend growth underpinned by strong fundamentals.
Deglobalization and geopolitics such as continuation of the war in Ukraine and U.S.–China relations are other factors that warrant concern. In Asia, managing higher costs of living while ensuring economic growth remains the predominant challenge. The path by which China manages its fiscal and monetary policies to boost economic growth, as well as the country’s housing market policies, presents an uncertain economic outlook. For the rest of Asia, economic growth and monetary policy outlook remain largely dependent on Fed policy and global growth. Within our individual sectors, 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 the severity of a potential U.S. recession, risk appetite could remain in check heading into the latter half of the year.
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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