Real estate investment opportunities amid macroeconomic uncertainty

The Good Squad

By Tim Wang, Ph.D., Head of Investment Research, Clarion Partners

Macroeconomic uncertainties and tighter financial conditions are weighing on the real estate investment market. Tim Wang, Head of Investment Research at Clarion Partners, discusses the challenges and opportunities of this current environment.

Key points to remember:

  • Macroeconomic uncertainties are currently high due to rising inflation, interest rate hikes, recession risks and the Russian-Ukrainian war.
  • Tighter financial conditions are putting pressure on property cap rates (a measure used to estimate and compare rates of return for commercial or residential real estate properties). However, we believe sectors with strong fundamentals and properties with inflation-linked leases have a competitive advantage in the current environment.
  • Secular and demographic-driven sectors look attractive to us because they tend to have stable cash flows, be less volatile and be more recession-proof.
  • We also believe that environmental, social and governance (ESG) and social impact is an age-old theme that will become an increasingly important investment mandate for institutional investors.

Macro uncertainties affecting real estate investment

The current macro environment is unique and complex with significant uncertainties. The COVID-19 pandemic has disrupted daily life and normal market cycles. It also led to a synchronized global recovery, global inflation and central bank tightening. A synchronized global slowdown therefore seems likely. It is possible that the United States and Europe will experience recessions later this year or early next year.

However, not everything is negative. Consumer spending, particularly in Europe and the United States, held up well. The strength of household wealth, balance sheets and corporate earnings also looks encouraging. Leverage, especially in the banking system, is low compared to 2007 before the global financial crisis (GFC). For all these reasons, we believe that a potential recession or slowdown will not be as severe as the GFC. Consensus forecasts also show possible improvements in 2024.1

Inflation and rising interest rates

In our analysis, US inflation already peaked in June, and while it is currently a headwind for continental Europe, we believe Eurozone inflation will likely peak soon. However, the pace of easing will depend on many factors and is difficult to predict. Analysts’ predictions for the Russian-Ukrainian war, which has affected Europe far more than the rest of the world, range from Ukraine’s victory next spring to Russia’s launching of a nuclear weapon. The global energy crisis has also hit Europe much harder than the United States and Asia, with natural gas being far more important than crude oil. We believe this will be a big shock to everyday life and the economy of Europe, even more so than in the 1970s. Pressures on the global supply chain appear to be easing, but labor shortages artwork will likely continue to have a negative impact, in our view.

Major central banks have raised interest rates to curb demand and inflation, and we have seen bond yields rise. However, we believe that likely in the first half of 2023 there could be a pivot point where central banks may need to revert from quantitative tightening to quantitative easing when signs of an economic slowdown or recession will become a reality. In the meantime, we believe that rising financing costs have led to market dislocation, which could present attractive acquisition opportunities in real estate over the next 12-18 months.

Effect of higher financing costs on mortgages

The rise in interest rates had an impact on real estate loans. For example, the five-year Euro Interbank Offered Rate (Euribor) interest rate swap rose significantly in 2022.2 Rising funding costs added upward pressure on capitalization rates and downward pressure on asset valuations.

In this environment, many investors prefer to invest in assets that provide good current income and a hedge against inflation. Although inflation does not persist in the current range of 9% to 10%, it may remain around 3% to 4% for a few years. Therefore, hedging against inflation is highly desirable.

Real estate offers opportunities for potential inflation hedging and diversification

With a volatile stock market and high inflation eroding the value of cash, many investors are looking for income with inflation hedging characteristics. There is a lot of money currently on the sidelines; there is a record level of liquidity in the US money market in particular. In our view, the real estate asset class is an attractive option in the current environment. For example, over the past 44 years, US real estate total returns have consistently outpaced inflation.3

Commercial real estate in European countries has also generally provided better risk-adjusted returns than inflation over the past 10 years.4 Thus, European properties provided good income as well as a hedge against inflation.

Risk-adjusted total return of European property investment

There are generally two ways in which real estate provides a hedge against inflation. The first is when the fundamentals are strong enough that landlords can raise rents, which drives up real estate net operating income. An example of this is the logistics sector, which has a low vacancy rate and high single-digit rental growth. The hotel industry is another example, benefiting from a wave of American tourists who are flocking to Europe to take advantage of the depreciation of the euro against the American dollar.

The second way real estate can provide hedging is through long-term inflation-linked leases, where landlords can pass on rising costs directly to their tenants. Examples include net leases (where a tenant pays some or all of the other real estate costs in addition to rent) as well as long-term leases in the healthcare, education, and government sectors. Unlike the US, the majority of net leases in Europe have good rental terms tied to the country’s inflation index, making them an effective hedge in the current market environment.

Additionally, real estate tends to be uncorrelated with stocks and bonds, and therefore offers a potential diversification benefit.5

Preferred secular sectors in recessionary environments

There are two types of real estate investment themes. The first is cyclical, where returns are tied to economic and employment growth and boom and bust cycles. Real estate sectors that fall into this category include offices, retail and traditional apartments. The second is secular, which tends to be related to demographics and upheaval. Secular investment themes have very little connection to economic growth and may even be counter-cyclical. Additionally, these tend to be more recession-proof and less volatile than cyclical investments. The aging of populations around the world is an example of a demographic trend that benefits healthcare facilities and senior residences.

Euro area population growth by age group

ESG and e-commerce infrastructure also fall into the category of secular investing themes. Social infrastructure, which includes health care, retirement/serviced residences, affordable housing, social housing and student housing, ranks high among institutional investors.6

WHAT ARE THE RISKS ?

All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Historically, equities have outperformed other asset classes over the long term, but tend to fluctuate more dramatically over the short term. Bond prices generally move in the opposite direction of interest rates. So, as bond prices adjust to a rise in interest rates, the stock price may fall. Special risks are associated with foreign investment, including currency fluctuations, economic instability and political developments; investments in emerging markets involve increased risks related to the same factors. To the extent that a strategy focuses on particular countries, regions, industries, sectors or types of investments from time to time, it may be subject to greater risks of adverse developments in those areas of interest than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.

Risks associated with a real estate strategy include, but are not limited to, various risks inherent in owning real estate, such as fluctuations in lease occupancy rates and operating expenses, variations in rental, which in turn may be affected by general and local economic conditions, real estate supply and demand, zoning laws, rent control laws, property taxes, availability and costs of financing, environmental laws and uninsured losses (usually due to catastrophic events such as earthquakes, floods and wars).

Investments in alternative investment strategies are complex and speculative investments, involve significant risks and should not be viewed as a complete investment program. Depending on the product invested, an investment in alternative investments may only provide limited liquidity and are only suitable for people who can afford to lose their entire investment.

Franklin Templeton and our specialist investment managers have certain environmental, sustainability and governance (ESG) objectives or capabilities; however, not all strategies are managed according to ESG-oriented objectives.

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1. Source: Bloomberg as of September 21, 2022. There can be no assurance that any estimate, forecast or projection will occur.

2. Sources: Bloomberg, Clarion Partners Investment Research, September 2022.

3. Sources: NCREIF, Bureau of Labor Statistics, Bloomberg, Clarion Partners Investment Research, as of Q2 2022. Past performance is not an indicator or guarantee of future results.

4. Sources: PREA, MSCI, Clarion Partners Investment Research, September 2022.

5. Diversification does not guarantee profit or protect against the risk of loss.

6. Sources: PwC/ULI Emerging Trends in Real Estate Europe 2022, Clarion Partners Investment Research, September 2022.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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