PGIM Real Estate offers in its Global Outlook report an interesting stat: In real terms global all property prime capital values have increased for 36 consecutive quarters—a longer unbroken run of growth than at any time since at least 1980.
The cycle’s ongoing duration, of course, has been a topic of great interest and some worry in the real estate community. Theories abound as to when it will end and how. A less explored subject—and one that PGIM took on in its report—is how CRE returns vary throughout the real estate cycle. And perhaps more importantly, what they will look like as the cycle ends.
Indeed, PGIM notes that while much of the period since 2014 can clearly be characterized as an upswing—represented by non-decelerating, above average, real capital value growth—more recent signals are mixed.
Global Capital Values Peaking
Slowing yield compression and a modest rate of rental growth mean that values are still rising, but at their slowest pace since 2013, it said. On a historical analysis, a peak would feature a more rapid deceleration of quarterly value growth towards zero—and that is still showing an upswing—but the message is clear, PGIM says: there is a risk that global capital values are either already peaking or, at least, are soon to be. What Happens Next?
Assuming that cycle may come to an end in the near future, the question is: what should investors do about it? For starters, it is important to remember that downturns differ in magnitude and duration, and also vary significantly across sectors and geographies, PGIM writes in its report. Of the four downturns recorded at a global level since 1980, two have been relatively mild with peak-to-trough value falls of 2% to 3% in real terms, which translated into either flat or moderately increasing nominal capital values.
A more nuanced take is that the point at which an investment was made in a cycle—in other words vintage risk—can play a significant role in determining performance. Investing in a trough or an early recovery phase—as would be expected—offers the strongest capital growth prospects, while losses of capital over an indicative five-year investment period would have been rare, assuming a well-diversified, stabilized global portfolio, according to PGIM.
“In contrast, investing into global real estate at other stages of the cycle—upswing, peak and downturn—leads to a wider range of potential outcomes. “For example, a well-timed investment during a downturn can capture early cycle upside, but move too early and heavy losses can be chalked up before a recovery gets underway, acting as a drag on performance,” according to the report.
Naturally, it is the upswing and peak phases that are of most interest given how the current cycle is progressing and in both cases, there is a wide range of potential outcomes. But PGIM found that in an upswing phase, the estimated probability that an investment into a diversified global real estate portfolio would suffer a capital loss in a given year of a five-year investment period is 23%, rising to 33% when investing in a peak.
However, from a total returns perspective, income receipts would likely offset much of any value decline—meaning situations of outright losses of capital in a fully-diversified, representative global portfolio over time are rare. Also, assuming the cycle is currently in an upswing or peak phase, once income is factored in, an investment today has about a 10% chance of recording a negative return over five years.
Diversification Is Important
One important takeaway from PGIM’s research is that it is important to diversify across sectors and geographies to mitigate specific risks, as well as have a solid asset management strategy in maintaining occupancy and cash flow throughout the cycle.
For short-term investors, PGIM says that there is still plenty of upside potential in a late upswing or peak phase of the cycle, although that depends on not having a severe global financial crisis-style correction. That said, investing prior to a downturn can drag on portfolio performance, especially if capital value losses are generated.
PGIM’s bottom line? “Given the length of the current cycle, it is understandable that there is growing interest in more defensive real estate sectors—such as apartment and logistics that offer relatively stable income receipts—and in capital structures that offer downside protection.”