Economy
Based on research conducted by PGIM’s David Blanchett, Head of Retirement Research, and Sara Shean, the Global Head of Defined Contribution, there is a strong case that private real estate debt can be an effective source of diversification for fixed income portfolios, while also modestly boosting returns. It’s of increasing salience given that fixed income portfolios are once again a meaningful source of income for investors.
Blanchett and Shean conducted an analysis of various asset classes to determine how they would have improved the return and risk profile of a fixed income portfolio. They used the Bloomberg US Aggregate Bond Index as their benchmark. In addition to this benchmark and real estate debt, they also included emerging market debt, commercial mortgage-backed securities, leveraged loans, and high-yield bonds.
Interestingly, the benchmark had an annual return of 4% with a standard deviation of 4%. In contrast, private real estate debt had an annualized return of 6% with a similar standard deviation. The analysis also gives insight into the optimal weights of various asset classes in terms of impacting the efficiency of a bond portfolio. The biggest takeaway is that allocations to real estate debt led to a positive impact on risk and expected returns, leading to a higher risk-adjusted performance.
Finsum: Research conducted by PGIM shows that private real estate debt can boost the risk and return profile of fixed income portfolios.
High rates have severely impacted the real estate market. In terms of commercial real estate (CRE), higher rates mean that financing costs have risen, but more pain will come when they have to roll over debt in the coming years, assuming that rates remain elevated.
According to Rich Hill, the Head of Real Estate Strategy & Research at Cohen and Steers, Head of Real Estate Strategy & Research, REITs are in a much better position to handle these stresses than the larger CRE market.
Many REITs have delivered their balance sheets with 86% of debt fixed for around 6 years which means there is much less exposure to interest rates than other CRE operators and investors. Additionally on the aggregate, REITs have a loan to value of 35% which is quite conservative relative to historical standards.
So far, high rates have had a muted impact on earnings, about 1.4%, making it more of a mild headwind. Thus, valuations for REITs have become quite attractive, while they remain on strong footing fundamentally, especially in relation to the broader CRE market. As a result, Hill notes that valuations for REITs have stabilized, while private valuations continue to move lower.
Finsum: High rates are leading to significant amounts of stress for parts of the commercial real estate market; however REITs have been less affected so far.
Many investors are hopeful that inflation will continue moving lower which will provide relief for fixed income and equities as the Fed could start loosening monetary policy. However, KKR does not believe it’s likely. Instead, they believe we are in the midst of a ‘regime change’ in terms of the macroeconomic landscape which will require investors to adopt new portfolio management strategies.
In essence, they see inflation being structurally higher due to factors such as entrenched fiscal deficits, labor shortages, energy transitions, and increased geopolitical risk. With these conditions, stocks and bonds are more correlated as evidenced by the last 2 years. The firm believes that investors need to increase their allocation to real assets with recurring yields as a source of diversification, given the increase in bond market volatility.
Rather than the traditional real assets such as REITs, TIPs, and precious metals, they find value in real assets that have collateral-based cash flows like private real estate to provide positive returns while dampening portfolio risk.
Even if their outlook on inflation proves to be incorrect, KKR believes that real assets should outperform given that they remain bullish on economic growth and see Q4 and 2024 GDP coming in above expectations.
Finsum: KKR is bullish on real assets including private real estate as it believes inflation is going to remain structurally high and that bonds are not providing sufficient diversification.
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Nuveen believes that real estate is an integral asset for multi-asset portfolios especially during periods of volatility and the recent tight correlation between stocks and bonds. Within real estate, the firm favors private real estate due to attractive yields, diversification, and uncorrelated returns.
According to the firm, private real estate outperforms during bear markets because prices are based on real transactions rather than public markets. This dampens volatility especially during periods of market stress when public equities can go haywire.
In terms of both public and private real estate, Nuveen favors the industrial sector due to expectations of continued growth in e-commerce and investments in logistics near urban locations. Another factor supporting growth is supply chain diversification which is boosting demand for space near ports on the East Coast and the US/Mexico border.
It’s also constructive on healthcare, residential, and self-storage. Within the public REIT space, the gaming sector is in favor due to high dividends and strong cash flows. Another tailwind has been consolidation in the space which is leading to upward pressure on rents.
Nuveen also believes that we are in the final innings of the Fed’s hiking cycle due to inflation moderating which could be a major catalyst for the sector going into next year.
Finsum: Nuveen is bullish on real estate particularly for the industrial, healthcare, and residential sectors. Also, it believes that we are close to the end of the Fed’s hiking cycle.
The rising rate environment has been brutal for REIT stocks with double-digit losses in 2022. In 2023, the sector saw decent gains in the first-half of the year, however these gains have been wiped out amid the breakout in longer-term yields.
However, this could be setting up a contrarian opportunity especially as the odds of a ‘soft landing’ continue to inch higher. Inflation is moderating, while the economy continues to modestly expand as evidenced by the September jobs report and upwards revisions to the July and August payroll data. In addition, Q2 GDP was better than expected, and consumer sentiment continues to move higher.
In essence, a soft landing scenario would be bullish for residential REITs. It implies no significant spike in defaults, while lower rates would also lead to a generous tailwind for the sector. In contrast, commercial REITs are facing more significant challenges and have more structural issues especially with offices and retail.
To be clear, the odds of a soft landing have increased, but it’s far from a certainty. Some threats to this outlook include a resurgence of inflation or the economy suddenly deteriorating due to pressure from higher rates.
Finsum: The odds of a soft landing have moved up higher after a recent spate of positive economic data. Here’s why residential REITs would outperform in such a scenario.
A combination of factors has led to the worst housing affordability in decades. During the pandemic, there was a surge in real estate prices as many moved out of urban locations to the suburbs due to the rise of remote and hybrid work arrangements.
This increase in demand also coincided with a tight supply-demand dynamic as new home construction has lagged population growth ever since the Great Recession and subprime mortgage crisis. Another factor supporting demand is that Millennials are entering their peak consumption years in their 30s and 40s.
Additionally, after more than a decade of low rates, current monetary policy is at its most restrictive in decades. Thus, mortgage rates are now hovering above 7%, while they were at 3% for most of 2020.
According to Andy Walden, the VP of enterprise research for ICE Mortgage Technology, household incomes will have to increase by 55%, home prices decline by 35% with mortgage rates back to 3%, for affordability to revert back to historical norms, or some combination of these factors.
Of course, such dramatic developments are unlikely. Walden believes that inventories are a key leading indicator for home prices. In recent months, there has been a modest bump in listings, but nothing significant enough to affect affordability.
Finsum: A combination of factors has led to housing becoming unaffordable for many prospective buyers, creating a major challenge for the real estate market.