Commercial Real Estate: Going Granular

We went underweight private growth assets from a view of five years and over in 2023’s first quarter. That includes broad commercial real estate – a sector we’ve projected negative returns for since June 2022. Yet we know commercial real estate is not a monolith. Case in point: Capitalization rates – a yield metric that rises when valuations fall – have diverged. We expect retail cap rates to keep rising (green line in chart) due to pressure from e-commerce growth. Office cap rates (yellow line) are likely to rise too as they have since 2022. Investors are requiring higher cap rates for offices given rising interest rates and higher vacancy rates due to remote work. We expect industrial cap rates (dark orange line) to stay low relative to peers as we see higher earnings growth for the sector. Private assets can play a sizeable role in long-term portfolios, with the potential to diversify returns, in our view. Private markets overall are complex, with high risk and volatility, and aren’t suitable for all investors.

The impact of the pandemic and bank turmoil on commercial real estate sectors has varied, too. Shifting work habits have cut demand for U.S. offices, based on a high vacancy rate of about 13% in March, National Council of Real Estate Investment Fiduciaries (NCREIF) data show. Banks’ exposure to real estate added to market jitters. Banks held 40% of outstanding real estate debt as of 2022’s third quarter, the Mortgage Bankers Association found. That has raised fears that high-vacancy or highly levered U.S. properties will struggle to refinance debt, causing some to hit the market at cheaper valuations or default. That dynamic may create a funding gap but also chances to scoop up discounted assets – with risks. We see the gap as a bigger concern for U.S. assets: Private European valuations are cheaper than U.S. peers, MSCI and NCREIF indexes show.

We’re cautious on private commercial real estate valuations: We think they need to fall more as rate hikes raise financing costs and cool inflation. That combo will likely bite into commercial real estate income growth. Exchange-listed real estate valuations are largely lower across the U.S., UK, and Europe as real estate investment trusts (REITs) sold off with stocks in 2022, indexes show. Public REIT values tend to lead private markets by a few quarters. Yet REITs’ near-term correlation with stocks means they diversify portfolios less and may see more volatility when stocks fully price in economic damage.

Industrial assets – referring to warehouses used for distribution, manufacturing, and research and development – have fared better than offices. Industrial assets have a vacancy rate of around 2% as of March and their share of the commercial real estate market has doubled since 2016 to take up roughly a third of the market now, according to NCREIF data. This differentiation is why we get granular. We like industrial assets that could see structural trends feeding demand in the long term, like distribution and last-mile logistics centers. The expansion of e-commerce looks set to keep on driving demand as it has for decades, in our view. We also think geopolitical fragmentation will likely shift supply chains and prompt companies to restore operations – bringing manufacturing closer to home. Companies have already been storing more goods locally to prevent renewed supply chain snarls, U.S. Census Bureau data show. Some may aim to widen their web of warehouses to cut transportation costs and support new manufacturing plants. Construction spending on the latter rose to about $147 billion annualized this March vs. $90 billion in March 2022, U.S. Census data show.

Bottom line: Financial cracks have fed concerns over commercial real estate’s outlook. We’re cautious about the sector. Yet we go granular in our portfolio views. We see better value in real estate sectors that may see long-term demand, like industrial.

Market Backdrop

The Fed signaled a pause may follow last week’s rate hike. The U.S. two-year Treasury yield sank 0.5% percentage points near 2023 lows before reversing about half the fall by Friday when April U.S. payrolls beat market expectations. The data also confirmed a tight labor market and wage pressure keeping inflation sticky. That makes rate cuts unlikely this year, in our view. We think that’s true for the European Central Bank, too: It pointed to more hikes after raising rates again last week.

Investment Themes

1. Pricing in the damage

• Recession is foretold as central banks try to bring inflation back down to policy targets. It’s the opposite of past recessions: Rate cuts are not on the way to help support risk assets, in our view. • That’s why the old playbook of simply “buying the dip” doesn’t apply in this regime of sharper trade-offs and greater macro volatility. The new playbook calls for a continuous reassessment of how much of the economic damage being generated by central banks is in the price.
• In the U.S., it’s now evident in the financial cracks emerging from higher interest rates on top of rate-sensitive sectors. Higher mortgage rates have hurt sales of new homes. We also see other warning signs, such as deteriorating CEO confidence, delayed capital spending plans, and consumers’ depleting savings.
• The ultimate economic damage depends on how far central banks go to get inflation down. The Federal Reserve signaled a pause after hiking rates in May. But it also reiterated that persistent inflation means no rate cuts this year. We see the European Central Bank going full steam ahead with rate hikes to get inflation to target – regardless of the damage that entails.
• Investment implication: We’re tactically underweight DM equities. They’re not pricing the recession we see ahead.

2. Rethinking bonds

• Fixed income finally offers “income” after yields surged globally. This has boosted the allure of bonds after investors were starving for yield for years. We take a granular investment approach to capitalize on this, rather than taking broad, aggregate exposures.
• Very short-term government paper looks more attractive for income at current yields, and we like their ability to preserve capital. Tighter credit and financial conditions reduce the appeal of credit.
• In the old playbook, long-term government bonds would be part of the package as they historically have shielded portfolios from recession. Not this time, we think. The negative correlation between stock and bond returns has already flipped, meaning they can both go down at the same time. Why? Central banks are unlikely to come to the rescue with rapid rate cuts in recessions they engineered to bring down inflation to policy targets. If anything, policy rates may stay higher for longer than the market is expecting. Investors also will increasingly ask for more compensation to hold long-term government bonds – or term premiums – amid high debt levels, rising supply, and higher inflation.
• Investment implication: We prefer very short-term government paper over long-term government bonds.

3. Living with inflation

• High inflation has sparked cost-of-living crises, putting pressure on central banks to tame inflation with whatever it takes. Yet there has been little debate about the damage to growth and jobs. We think the “politics of inflation” narrative is on the cusp of changing. The Fed’s rapid rate hikes will stop without inflation being back on track to return fully to 2% targets, in our view. We think we are going to be living with inflation. We do see inflation cooling as spending patterns normalize and energy prices relent – but we see it persisting above policy targets in coming years.
• Beyond Covid-related supply disruptions, we see three long-term constraints keeping the new regime in place and inflation above pre-pandemic levels: aging populations, geopolitical fragmentation, and the transition to a lower carbon world.
• Investment implication: We’re overweight inflation-linked bonds on a tactical and strategic horizon.

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