Hardball: Does real estate still have what it takes?

For years, investors have held steady on their reasons to allocate to private real estate: return potential, income, volatility management, inflation hedging and diversification. But the current environment is testing every asset class. Can real estate continue to deliver?

Can real estate income keep pace with inflation?

Generally, rents rise with inflation, driving income up at a similar pace. However, in certain sectors with high vacancy rates (enclosed malls or central business district office towers), landlords may find it challenging to raise rents.

The key to the inflation hedge is understanding the demand dynamics and vacancy rates of individual markets. Consider medical office properties in high growth cities and suburbs. Or housing properties in the U.S. Sun Belt. Real estate can keep pace with inflation assuming it is the right building, in the right location with sufficient demand to support higher rents.

Is there any upside left to capture?

The pandemic accelerated many real estate trends. For example, e-commerce grew dramatically during the lockdowns and drove up demand for industrial space. However, we expect returns to reset to more typical levels, or even below average in some sectors. While those sectors will impact the overall market average, we still see opportunity in strategic market segments.

Sector dispersion has been a long-term trend, and active managers are building portfolios accordingly. Short-term returns will likely be driven by noncyclical properties less affected by downturns: medical offices, data centers or self-storage. Active portfolio management will be key to driving performance in a slow growth economy.

Does the promise of managing volatility still hold true?

Many investors allocate to real estate as a steady source of total return, and they have been surprised by outsized performance over the past few years. However, that is not the norm. As a real asset, real estate values are generally more stable than traditional equity investments. In fact, in the past 40 years, annual private real estate index performance has been negative in only two years. In the same period, more traditional asset types have seen multiple years of negative performance.

What is driving high housing prices and rents?

Housing prices in many parts of the U.S. have been driven by a supply/demand imbalance. Supply chain issues and labor shortages slowed production in many key markets. Meanwhile, demand grew as people were no longer constrained by an office location, opting to move to fast-growing Sun Belt markets.

This imbalance has created an opportunity for institutional investors. Previously, institutions made up only 2% of the single family rental housing market, but that number could double in the coming decade. Professional investors are creating new supplies of housing where the local market could not meet demand. We believe new housing supply will continue evolving as millennials seek alternative ways to enter the housing market: renting for longer, purchasing town homes or condominiums, or renting single-family homes for the long-term.

What would a recession mean for real estate?

While we do anticipate slower rates of growth for real estate, fundamentals remain strong.

Vacancies are at record lows in residential and industrial sectors. Developers across property types have been much more supply-disciplined during the recent build-up (partly due to supply chain issues), which should help keep rental levels high. And a recession would not affect all global markets equally, which should help global well-diversified investors achieve a smoother ride.

We believe real estate markets should benefit from long-term structural trends. Urbanization continues, as well as the drive for more sustainable buildings. Technology should continue driving job growth, and e-commerce supports growing market share. In addition, some trends favoring local real estate may gain traction, such as re-shoring of production to developed markets in the U.S. and Europe.

How will rising rates affect real estate?

Historical data going back to the 1970s show that real estate tends to perform relatively well in rising rate environments in absolute terms, but even more so relative to interest-rate sensitive assets. Since 1977, U.S. core real estate (as measured by NCREIF ODCE) has averaged annualized returns of 12.6% during rate hike cycles and 10.2% in the year following.

Even in this rising rate environment, we believe private real estate offers opportunity. Public REITs behave very differently compared to private real estate because values may be influenced more by equity market sentiment. Public REITs have significantly higher volatility and offer shallower markets, as not all property types are represented in REITs in all markets. In Europe and Asia-Pacific, REIT markets are a small fraction of the size of private markets.