Outlook for asset class remains upbeat
The performance, however, was somewhat uneven: The industrial segment boomed, while malls and a handful of apartment and office markets (e.g.,Chicago and NewYork) struggled. But overall, the combination of low vacancy rates, balanced supply and demand, strong rent growth, and stable (to modestly lower) cap rates continued to support investment returns.
Positive outlook despite some risks
The outlook for U.S. real estate remains upbeat. Although economic growth is not expected to sustain the roughly 3% annualized pace set in the first quarter, the Federal Reserve’s decision to keep interest rates on hold—and possibly to lower them—has helped to dampen near- term risks. Meanwhile, new supply appears to have peaked, amid acute skilled-labor shortages, allowing vacancies to remain anchored near today’s historically low levels. Financial markets are volatile, but lower interest rates could bolster capital flows into real estate, keeping cap rates steady.
However, there are looming medium-term risks. Among the greatest of these is that leading indicators such as the yield curve point to a rising probability of recession after next year, a scenario that would undermine occupational and investor demand for property. But while
real estate is not impervious to the economy, it should prove resilient, thanks to a moderate supply pipeline, reasonable valuations (relative to interest rates), and manageable debt burdens (Table 1). Timing the cycle precisely is difficult to impossible, but given these initial conditions, real estate should hold up well, relative to stocks and bonds, over a five-year horizon, particularly on a risk-adjusted basis.
Portfolio positioning
A combination of positive near-term momentum and rising medium-term risks has important implications for investment strategy. Given the inherent uncertainty around timing and the expectation that the severity of the next downturn will be limited, it is not advisable to batten down the hatches—but it may nonetheless be prudent to trim risk. Extending lease duration, improving tenant quality, and reducing value-add exposure should help to fortify cash-flow durability, while controlling leverage can help to mitigate valuation risks. There are also important implications for sector and market allocation.
If history is a guide, rising medium-term risks would argue for tilting away from office realty, a pro-cyclical sector, toward retail, a defensive one (apartment and industrial are historically market-neutral). At the same time, it is important to consider how structural forces may alter historical patterns: in particular, we believe that e-commerce will continue to benefit and challenge industrial and retail, respectively. Accordingly, our strategy assigns a strong over- weight to industrial, an underweight to office, and market weights to apartment and retail.
Market-level performance hinges on several factors, including occupational demand, supply, and pricing. Over the long term, it seems that supply—more specifically, constraints on development— predominate, assuming, at minimum, a modest pace in population and economic growth. From a strategic perspective, the large, coastal, gateway cities (i.e., San Francisco, Los Angeles, New York, Washington, D.C., and Boston), which tend to impose greater physical and regulatory barriers to new supply, look promising.
However, over shorter time periods, occupational demand, driven largely by the local economy, often plays a greater role. Over the next five years, it appears that these will largely consist of low-cost Sun Belt metropolitian areas that can attract corporate relocations and domestic in-migration (e.g., Texas, Florida, Atlanta, Phoenix, and Nashville) and markets with significant exposure to the technology industry (e.g., San Francisco, Seattle, Portland, Austin, and Boston), in which America enjoys a global competitive advantage (Figure 1).
Debt market not to be overlooked
Real estate debt performed well at the beginning of 2019. Senior mortgages produced total returns of 5.9% (trailing four quarters) in the first quarter, the highest level since 2016.
2 While returns on senior mortgages were below those of core equity real estate, the gap (90 basis points) was at its lowest since 2010.
3 Returns on high-yield mortgage debt were also strong, at 11.2% (trailing four quarters) in the fourth quarter of 2018 (the latest data available).
4 Two factors buoyed real estate debt returns: First, mortgage rates declined, particularly after the Federal Reserve signaled at the end of 2018 that it intended to put further interest-rate hikes on hold.
5 Second, real estate fundamentals remained robust, pushing delinquency rates to cyclical (in the case of CMBS) and in some cases historic (insurance and bank loans) lows.
6
* 1⁄2 standard deviation.
Note that past performance is not an indicator of future results. Some of the above information is a forecast or projection. Any projections are based on a num- ber of assumptions as to market conditions and there can be no guarantee that any projected results will be achieved.
Sources: Federal Reserve (Treasury yields, BBB yields, mortgage debt), NAREIT (REIT NAV and prices), NCREIF (cap rates), Real Capital Analytics (LTV), Barclays Live (CMBS spread), Bureau of Economic Analysis (GDP), DWS calculations. As of June 2019.
Within the debt space, the stock of outstanding mortgages increased by 6.0% (year-over-year) in the first quarter of 2019, nearly the slowest pace since 2014, when the market was still recovering from the financial crisis.
7 Government-sponsored entities and life insurers expanded their mortgage books by 10% and 11%, respectively, while commercial mortgage-backed securities (CMBS) debt rose modestly (3%) after falling almost continuously since 2008. But growth in bank debt (more than 50% of outstanding mortgages) was at its slowest pace (4%) since turning positive in 2013. Ironically, despite the enactment of Dodd-Frank reforms loosening real-estate lending rules in May 2018, a majority of banks subsequently reported a tightening of real-estate lending standards, through the second quarter of 2019.
8 In March 2019, average loan-to-value ratios hovered around 60%, near their lowest levels on record (since 2004).
9 In our view, strong real-estate fundamentals, healthy transaction volumes, moderate institutional debt originations, disciplined underwriting standards, and ample spreads to risk-free interest rates will continue to support positive real-estate debt returns at least through 2020 and possibly longer.
Keeping the core in real estate
For insurance companies, core real estate assets continue to be a stable part of an overall portfolio because they are high-quality properties that can provide a consistent source of stable investment income, along with long-term price appreciation potential. Focusing specifically on Open End Diversified Core Equity (ODCE)-type investments, with insurers being predominantly investment-grade fixed-income (IGFI) investors, ODCE investments can make a strong strategic holding given their diversification benefits, income return component, and potential inflation protection. In addition to favorable correlations to IGFI, ODCE investments have lower volatility than other equity-like investments with typically less than half the realized standard deviation (DWS, December 2018).
References
1. Giliberto-Levy Monitor, as of March 2019.
2. NCREIF, as of March 2019.
3. Giliberto-Levy Monitor, as of March 2019.
4. Real Capital Analytics, as of March 2019.
5. Federal Reserve (banks), American Council of Life Insurers (insurance), Moody’s (CMBS), as of March 2019.
6. Federal Reserve, as of March 2019.
7. Federal Reserve, as of March 2019.
8. Real Capital Analytics, as of March 2019.
9. DWS, 2019.
Disclaimer
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This document is intended for discussion purposes only and does not create any legally binding obligations on the part of DWS and/or its affiliates. Without limitation, this document does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for DWS to enter into or arrange any type of transaction as a consequence of any information contained herein. The information contained in this document is based on material we believe to be reliable; however, we do not represent that it is accurate, current, complete, or error free. Assumptions, estimates and opinions contained in this document constitute our judgment as of the date of the document and are subject to change without notice. Past performance is not a guarantee of future results. Any forecasts provided herein are based upon our opinion of the market as at this date and are subject to change, dependent on future changes in the market. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. Investments are subject to risks, including possible loss of principal amount invested.