Partnering with insurance investors is a key strength of Principal Global Investors. From our own insurance company heritage, Principal Global Investors has grown into a global investment manager with more than $486 billion in assets under management, and over 900 institutional clients globally (as of June 30, 2020). Fifty of those 900 clients are external insurance companies. They trust Principal Global Investors to manage more than $13.5 billion in assets, ranging from private real estate debt and equity, to specialized debt and equity strategies.
We understand the challenges insurers face, and integrate the important accounting and regulatory needs of our insurance clients. In today’s low yield environment, yield and diversification can potentially come from across the real estate spectrum – including public and private markets for debt and equity. With over six decades of real estate investment experience, this report provides our perspective on US commercial real estate opportunities today.
Top U.S. economic issues:
• Upbeat data raises 3Q outlook, but service sector appears vulnerable relative to manufacturing
• Fiscal policy initiatives have stalled which could be costly given weakness in service sectors
• Fed adopts “average inflation targeting”—likely pro-growth longer term but limited impact near term
• Still at odds, equities reached new high and bonds approached prior low, but yield curve volatility may be picking up
• A contentious election, China tensions, Brexit, and social unrest are risk events needing close attention
Implications for U.S. commercial property:
• REITs are range bound and CMBS junior tranche spreads still wide – awaiting the next catalyst
• Real estate quadrants remain divergent with broader markets—modest convergence may lie ahead
• Private equity: cyclical decline in values continues; aggregate downside estimated at 5%+ near term
• Yield curve may steepen near term but likely becomes flatter through policy or weaker economic data
• Strategy positioning: “Value” as a core theme, focus on dislocated segments in search of value add/ opportunistic returns
Data has been resilient and better than expectations, indicating the U.S. economy has been gaining strength entering the 3rd quarter. These trends exhibit broad based healing, supporting the view that policy has substantially backstopped demand deterioration following COVID-19, leading to upward revisions to growth expectations for 3Q. However, the recovery remains fragile as economic activity in various segments remains impaired by COVID-19, fiscal policy support is at risk of downshifting, and recovery ex-US is bifurcated. Capital markets continue to offer mixed messages with equities at all-time highs while bond yields approached all-time lows even as inflation metrics firmed up. Given such mixed messages, there appears to be limited conviction the recovery is on solid footing— sustained strength in equities accompanied by higher bond yields may be a necessary condition to gain confidence the recovery can be sustained, but the likelihood that such conditions can coexist still appears low. A contentious election season, lingering China tensions, Brexit and social unrest are risk events that have the potential to elevate market volatility.
Consensus 3Q growth expectations for the U.S. economy shifted higher to 20%+ as employment, retail sales, housing and industrial production were better than expectations. The Atlanta Fed pegged 3Q growth at nearly 30%. Composite Markit PMI for August moved strongly into expansion territory, and CPI measures surprised to the upside, albeit influenced by strong recovery in sectors where prices had declined sharply. Index of leading economic indicators, driven by employment and housing sectors was also better than expectation at +1.4% and prior period was revised higher. Ex-U.S. growth trends appear bifurcated with EU and China posting relative strength, while weakness was noted in U.K. and Japan. Even within the EU, strength was evident in Germany while Italy and Spain were weak; however, the OECD momentum index rallied in July, suggesting positive momentum in aggregate.
The transitory pause in monetary policy was jolted by the Fed announcing its new average inflation targeting framework which should offer additional flexibility by allowing inflation to overshoot its target for a while. However, it is likely to have minimal impact on Fed policy near term since the Fed has clearly expressed its intention to keep policy rates at the zero bound until 2022 given downside risks to the economy from COVID. Nevertheless, the new framework is supportive of a steeper yield curve if the economy gains traction. More explicit rate guidance or potential for adopting yield curve control measures may lie ahead, but such policy moves are likely mostly priced into the yield curve/asset prices.
Fiscal policy is approaching a critical phase as key programs have expired and President Trump’s executive actions to
provide a temporary bridge ($400 per week in supplemental insurance) and payroll tax rollback remain just that— temporary and underfunded given no congressional action. As such, support for the unemployed may only be a fraction of the levels offered through the CARES act. This could be costly as there are early indications that better performance in 3Q may be offset going forward; consensus growth expectations for 4Q 2020 and CY 2021 have ticked down, not surprising given the weakness evident across broad segments of the economy, including airlines, lodging, retail/restaurants, tourism, city/local governments, energy
etc. Layoff announcements have been ramping up in these sectors, small business formation has come to a standstill and bankruptcy filings are at a record pace per S&P. Also, virus spread concerns remain, while a contentious election season, lingering China tensions, Brexit, and social unrest are risks that appear poorly priced in.
Capital markets continue to offer conflicting perspectives. Equities reached all-time highs accompanied by elevated multiples (near highest levels on a cycle-adjusted basis) and thus appear aligned with extended accommodation. Inflation metrics firmed up and were better than expectations. Although both services and goods inflation rose, services appear more vulnerable given policy risks, while strength in industrial commodities (oil, iron ore, copper) along with recovery in China suggests relative strength in the industrial sector. The yield curve steepened a tad but has yet to offer conviction durable growth lies ahead, while corporate bond spreads remain tight as Fed policy to backstop has traction. Under these conditions, the set-up appears straight-forward—equities to hold recent gains, accompanied by a steeper curve amid a positive trend in inflation across services and goods, will offer confidence the recovery is intact. For now, given fiscal policy inaction, risks are skewed to the downside— increased market volatility is better aligned with that view.
Equities exhibited broad-based strength led by homebuilders, transports, consumer discretionary and technology segments. Defensive sectors (staples, utilities and REITs) underperformed while industrials’ relative strength appears to be gaining momentum. Relative weakness in small caps and financials may be an indication that policy has yet to drive small business formation while low rates weigh on bank profitability. Energy has been consistently weak, although the steep decline in drilling activity may find a floor if global industrial activity has traction. Further, on a cautious note, inflation indexed bonds continue to outperform corporate bonds and Treasuries while the 5-year/5-year forward breakeven is rising sharply, an indication inflation risks are being more aggressively priced in. If so, increased volatility in Treasury markets may lie ahead and will likely elicit a policy response.
A summary of recent fundamental data:
• Labor market’s recovery appears to be on track as the August non-farm employment gain was 1.37 million (although boosted by census hiring) and the participation rate as well as the average work week ticked higher. The unemployment rate dropped sharply to 8.4% as the Household Survey was much stronger at +3.8 million, but this should converge over time with non- farm payroll series. However, the labor market remains vulnerable (after factoring recent change in seasonal adjustment methodology) as initial unemployment claims appear to be stabilizing at very high levels and the total number reliant on some form of unemployment assistance, including Pandemic Assistance programs, is estimated at 27 million which highlights the importance of additional fiscal support
• Sentiment was softer, but strength in the housing sector was noticeable. The National Federation of Independent Business’s optimism index for July slipped, but the home builders’ sentiment index rose sharply to its highest level in over 2 decades. From a consumer perspective, the University of Michigan Index rose a tad and the Bloomberg Consumer Comfort Index appears to be consolidating, but the Conference Board Index dropped sharply.
• Retail sales for July rose 1.2%, less than expectations but prior period was revised higher; ex-auto, sales were up 1.9%. Moderation in retail sales was anticipated, and the slowdown appears reasonable. Nine of the thirteen categories posted gains with electronics and appliance stores up 22.9% and even food/drinks sales rose 5% despite the weak pace of re-openings. The control group which factors in GDP calculations rose 1.4% which suggests consumption trends in 3Q may be modestly better than expectations. However, the recovery is still concentrated in goods and not services and purchases were driven by groceries and online sales, so further gains remain vulnerable to inadequate stimulus and a persisting virus.
• Industrial production rose 3% in July, manufacturing gained 3.4% driven again by a robust auto sector (+28%) and aircraft manufacturing (+7.5%) but could be vulnerable given recent trends in auto sales and on-going lockdown in global air travel. Durable goods orders rose 11.2% as orders for autos/parts jumped 21.9% (2.4% ex-transports). Capital goods orders and shipments (non-defense, ex-air) were up 1.9% and 2.4%, respectively. Activity has been upbeat with core orders for durable goods at near pre-COVID levels and is only 5% lower than pre-COVID primarily as a result of a drop in aircraft orders. Inventory slipped which suggests activity has more room to run; goods production sector of the economy appears better positioned than services.
• Housing: Some emerging catalysts offer a constructive back drop: relatively low mortgage rates over the intermediate term with the Fed likely to keep short rates anchored near zero bound, declining desirability of urban living due to retail/restaurant closures, increasing social unrest and weakening city finances, and pent up demand driven by household formation from millennials. Nevertheless, affordability is modest, although low inventory may further boost prices near term. In summary, a period of weakness/reset in prices may still lie ahead but with the potential for more sustainable demand and durable strength longer term. Recent activity has been positive with starts +17%, permits +2.1% (single family +17%), existing home sales +20.7% and new home sales +13.8% (the highest level in 12+ years).
U.S. COMMERCIAL REAL ESTATE:
Public quadrants diverged modestly as REITs were mostly rangebound despite a strong rally in CMBS, historically low cost of REIT debt capital and strength in employment data. The cyclical drawdown in private equity remains in place, relative value across fixed income segments is attractive but vulnerable to (policy supported) corporate bond pricing, especially on a cycle-adjusted basis. The “holding pattern” in REITs and persistently wide spreads in junior CMBS tranches suggest the wait for the next catalyst maybe underway. Under most outcomes, at least a modest pullback in valuations near term across the quadrants appears reasonable before values can begin to increase over the intermediate term. The next material change in long term Treasury yields in response to inflation/growth is likely to be instructive, although a volatile path is expected near-term.
Real estate quadrants are likely in a holding pattern awaiting the next catalyst: REITs tend to lead price discovery within the real estate quadrants and have been range bound for several months following the initial surge during the March to May time frame. This has been partly due to limited direct policy support for the real estate sector as well as the impact of lockdowns which had a disproportionate impact on retail, restaurant and lodging sectors. However, emerging weakness in office and select multifamily sectors suggests a cyclical recovery is not yet evident, despite strength in jobs growth and policy support for the economy. Equity risk premia remains at/ near widest levels with implied cap rate spreads over 10- year UST estimated at 400 to 450 bps for core sectors and junior CMBS tranches are still priced for aggregate value declines of around 20%. In contrast, broader equities are at all-time highs, priced at 25x forward earnings (based on earnings estimated at $140), and investment gradecorporate bond yields set new all-time lows at spreads 100 to 150 bps tighter on a cycle-adjusted basis. As such, real estate is still pricing for weaker economic fundamentals to unfold in contrast to broader public markets. A reasonable expectation would be for such divergence to come under pressure and begin to converge.
However, the constructive outlook faces policy headwinds near term: Unless there is another round of fiscal support which remains highly contentious at present, the outlook over the next 12+ months is likely to darken. Among headwinds are  expiration of the Paycheck Protection Plan and Supplemental Unemployment Insurance provisions under the CARES act;  ongoing trade and other disputes with China (and others); and  Fed’s policy to “fall behind” inflation that is viewed as an extended period of accommodation, but without additional QE/yield curve control, financial conditions could well tighten through a steeper yield curve.
Also, hard economic data has become more mixed recently with still elevated initial unemployment claims, slippage in consumer confidence, weakness in small business formations and rising bankruptcies. A satisfactory resolution of all these issues is probably necessary to not derail the progress to date. Even if such is the case, under most reasonable outcomes the federal deficit, already trending over $2T for the last 12 months, is likely to worsen ($3.3 trillion for CY 2020 per Congressional Budget Office). If so, the Fed’s $1T in annual Treasury purchases appears inadequate. On the other hand, a generous policy framework (for example, a repeat of the CARES act) raises inflationary risks—a negative feedback loop of concern from at least a policy perspective.
Scenarios of Interest: A steeper yield curve will support a constructive outcome while further flattening will suggest otherwise—i.e. the shape of the yield curve is likely to be instructive. Under a constructive outcome, upside potential for the 10-year Treasury yield could be in the 1.5%+ range over 12+ months, representing levels at which it broke down as the COVID-19 recession unfolded. Under our Base Case scenario which expects a 3+ year recovery phase, growth in net operating income/FFO is unlikely to offset such a move in yields. On the other hand, a bear flattening of the yield curve would suggest weaker growth/ inflation and further put pressure on equity risk premia. So, valuations are likely to be under pressure regardless of the outcome—i.e. path to higher prices longer term is likely to follow lower prices over the near to intermediate term.
Strategy considerations: The coming months should offer some clarity regarding the economy as the divergence between real estate and the broader markets is resolved. The bias to extend duration remains in place since tightening of financial conditions through a steeper yield curve demanding a policy response, or a weaker economy resulting in a flatter curve, is an opportunistic set-up. Given the dislocation in various sectors of the economy, such as lodging, airlines, and retail, is likely to persist, tighter lending standards and a slow recovery in household and corporate earnings may be a central tendency over the intermediate term. Under these conditions, a significant portion of households and corporations are likely to be “price sensitive”.
If so, from an equity perspective, focus on “value” may be an attractive theme. Value retailers (those operating at low breakeven points/lower cost to consumers), non- major markets offering lower rental cost, power centers anchored by value merchants and expanded housing opportunities are interesting from this perspective. Recent trends in the REIT segment also suggest an ongoing bias towards niche strategies may be in order. Data centers and self-storage have been among the top performers, and some shifts in grocers buying former gas station locations to focus on smaller footprints suggest closer scrutiny of convenience retail. In contrast, sub-sectors of core property segments that have come under pressure, such as malls, lodging, luxury multifamily, and major/population dense markets, may be attractive targets for longer-term core strategies as well as higher yielding intermediate term strategies as traditional sources of capital become scarcer. The attractiveness ranking is likely to evolve along these lines going forward.
ADDITIONAL COMMENTARY ON THE 4 QUADRANTS
The corrective phase remains in place and, given REIT share prices are at 10%+ discount to NAV, downside risks may be 5%+ from current levels near term. CPPI declined 0.2% for July, driven by weakness in retail, which was expected, and office, which is more noteworthy as it may be an indication of weakness beyond retail and hospitality segments. Transaction volumes were sharply lower, down 70% overall. Industrial transaction volumes were down 53%, which could be a pre-cursor of widening bid/ask in this top performing segment. Major markets underperformed, suggesting a shift may be underway with potential negative catalysts over the intermediate term including COVID-related closures of business/entertainment businesses, civil unrest leading to safety concerns and poor city finances.
Public equity (U.S. REITs)
Share prices have remained range bound for a couple of months with a central tendency of ~1,020 on MSCI and continue to be sensitive to virus surge and renewed shutdowns, despite expectations for more stimulus and cost of borrowing in the public markets approaching all- time lows. REITs still appear to be in a corrective phase and vulnerable to downward revisions to earnings with equity risk premia (implied cap rate less Treasury) at widelevels, signaling the potential for further weakness in earnings. However, risk premia is supportive under more constructive outcomes, such as if the downside to earnings has indeed moderated.REIT shares have continued to mostly move sideways as distribution of earnings tighten in the 15%+ decline range for CY 2020 and the balance of price adjustment is attributable to a modest decline in multiples. Borrowing costs are at historic lows offering the potential to lower interest rates by 100 bps for legacy debt. At current levels (MSCI at 1,070), the index is trading at sub-5% cap rates on a trailing basis for core property sectors and 10%+ discount to NAV. The sector appears priced for modest upturn in yields (10-year yields capped under 2%) over the next 3+ years during which time earnings in aggregate could recover to pre-COVID levels.
Spreads expressed a tighter bias; relative value was stable and nominal yields stable amid an ongoing price discovery process. Excess spreads over comparable corporate bonds ranged from 100+ bps (AA rated credits) to 130+ bps (BBB) range, for 10-year tenor and ~125 bps for 5-year, A-rated credit quality. Excess spreads are attractive but remain sensitive to policy influenced tight spreads in corporate bonds as investment grade bond yields made new all-time lows. CMBS/mortgage differentials remain supportive of high-quality transactions.
Public debt (CMBS)
The credit curve flattened further in response to stronger economic data and tightening in corporate bonds down in credit (BBB+ and lower) that appears primarily yield driven as higher credit quality spreads for CMBS, and corporates expressed a neutral to wider bias. Credit spreads in junior tranches remain wide with BBB bonds trading at spreads of 500 to 550 bps, in line with B+ rated corporate bond spreads but appearing reasonable given the Base Case projected deterioration in collateral values. Excess spreads over comparable corporate bonds remains attractive across the curve. However, spreads are sensitive to upbeat pricing in corporate bonds (policy influenced) that are trading 100 to 150 bps tighter on a historical, cycle- adjusted (early phases of a recovery) basis.
Given our views on the factors influencing the commercial property markets, the following is a summary of the current conditions and investment themes for the four U.S. commercial real estate quadrants.
• CPPI declined, driven by retail and office sectors; major markets underperformed
• Transaction volumes dropped nearly 70% in July
• Near-term downside risks to asset values estimated at 5% to 7%
• Value/price sensitive households/ corporations is an emerging theme longer term
• Sectors with secular drivers are better positioned longer term—data centers, logistics, and workforce housing
• Suburban office has tactical appeal given the prospects for a “distributed work force”
Public equity (U.S. REITs)
• Shares remain mostly range bound and appear to be awaiting the next catalyst
• Lackluster response despite stronger economic news and declining cost of debt capital
• Better supported if broader equities hold, but vulnerable otherwise
• “Central tendency” of return profile is constructive, but weakness in office suggests downside risks
• New low in share prices is likely to offer an attractive, tradeable entry point
• Nominal yields were stable as spreads offset Treasury yields
• Post-COVID pricing filtering though the underwriting process, but more to go
• Spreads remain attractive across the credit curve with liquidity spread premium likely priced in
• Subordinate debt: limited transactions near term, but opportunity set is likely to expand
• Senior mortgages are very appealing for ALM investors
• High quality, long duration investments attractive near term as Treasury market volatility may drive demand for quality and duration
Public debt (CMBS)
• Delinquencies still have an up-bias; on watch for stress in the office sector
• Spreads tightened but increasingly more sensitive to very tight spreads in corporate bonds
• BBBs are trading like B+ rated corporates given subordination levels relative to downside risks for collateral
• A/AA tranches are of interest, offering attractive YTM/TR potential with abilityto absorb collateral deterioration
• Reasonably attractive on a risk- adjusted total return basis
• Wider spreads represent an opportunity to upgrade credit quality at attractive prices
• Select BBB bonds have the potential to be accretive, especially under more constructive outcomes
REAL ESTATE ATTRACTIVENESS RANKING/RISKS
|New issuance AAA CMBS (cash equivalent)||CMBS 2.0 AAA bonds at T+95 to 100 bps (10- year term). Potential for near term volatility may be an opportunity to accumulate. Total return (TR) potential of 2% to 3%.||Highly collateralized investments and modest carry awaiting further clarity before being invested in more attractive risk/reward positions.|
|Subordinate debt (tie with REITs)||Early stages of price discovery. TR potential likely to move up to 7% to 10% as credit curve steepens. Expecting an expanded opportunity set as capital gaps develop, but limited transaction activity near term.||Weakness near term as drawdown in collateral values gets priced in but prepared to add positions at attractive spreads, well supported by collateral valuation using post-COVID underwriting. Core equity risk with core-plus equity return potential.|
|Select CMBS (A/AA) composite|
(tie with REITs)
|4% to 7%+ TR potential. Given potential for collateral volatility, accumulate if spreads widen further with a up in quality bias. Select BBB rated bonds could add to risk-adjusted return potential.||Target accumulation of current A/AA rated tranches with potential to absorb weakness in collateral values under modest downside scenarios with some cushion. Core equity risk with core to core plus equity return potential.|
|U.S. REITs||TR potential suggests a wide range of potential outcomes at 4% to 10%+ over a 3-year time frame but a constructive “central tendency” in the mid to high single digits at current price level with the MSCI at around 1,070.||Remain in a broad trading range and sensitive to a steeper yield curve. Core plus equity risk with core to opportunistic equity return potential.|
|Longer duration mortgages & sale- leaseback bonds (tie with REITs)||High quality mortgages and sale-leaseback bonds secured by credit leases offer 100+ bps excess spread potential over comparable bonds. Attractive for ALM investors and as a short-term trade as the steeper yield curve may be an attractive tactical buying opportunity.||Buy into duration as steeper yield curve likely to demand a policy response. TR potential of 4% to 6%. Sub-core equity risk, core equity return potential and more volatile spreads near term.|
|Emerging opportunistic Investments|
in debt & equity (tie with levered core)
|Expecting an incomplete capital stack at the end of this cycle given lack of policy support for high yield segments and efficacy concerns, especially if social distancing is extended and inflationary pressures become evident.||Debt and equity opportunities are likely to emerge in retail and lodging sectors. Office is under watch. Seek core to value-add equity risk with value-add toopportunistic equity return potential.|
|Downtrend over the next few quarters, targeting negative total returns. Near term downside is 5% to 7%.||In a cyclical bear market. Assets with long leases and high-quality credit may outperform near term.|
|Private equity— niche development/ re-development|
(tie with levered core)
|High risk of delivering product in a weak environment.||Construction as well as marketing risks are elevated. Value add to opportunistic risk with core to sub-core return potential.|
Indy is a senior managing director, and global head of research & strategy at Principal Real Estate Investors, the dedicated real estate unit of Principal Global Investors. He is an important team member when discussing allocation of capital allocation of capital via the creation of real estate portfolio strategies across the four quadrants of commercial real estate. He also disseminates our economic and real estate views to external clients and is a member of Principal Global Investors Economic Committee. Indy joined the industry in 1999 and Principal Real Estate Investors in 2013. Prior to his current role he has served as an executive vice president and chief investment strategist at Cole Real Estate Investments and head of global research and strategy at ING Clarion. At ING Clarion, he worked on creating global top-down asset allocation strategies by analyzing macroeconomic and real estate variables and was also responsible for investment research, white papers, and new product development. Prior to ING, Indy was a member of the global research team at AIG Global Real Estate. Indy started his career as an Economic Analyst at The Economist Intelligence Unit. He received a Ph.D. in economics from University of Cambridge and is a member of PREA, NCREIF and AFIRE.
1. Series of “stop and go” lockdowns increasing the possibility of a “double-dip” recession
2. Lack of meaningful fiscal support lays stress on consumers and households with negative consequences on demand 3. Job losses in service sector become permanent, leading to broader weakness in office/FIRE sectors
4. A contentious election amid civil unrest leads to elevated capital market uncertainty
5. Fed inflation averaging policy leads to sharp steepening of the yield curve that weighs on risk assets
6. Simmering geo-political tensions (China, HK, NOK, Iran) could add stress to an already weakened economic framework 7. Disinflation or deflation near term, but potential for rising inflation (de-globalization, currency driven) longer term
8. Reflation of housing/housing costs, may be indirectly limiting aggregate consumption, investment and growth
9. Accelerating deficits weighs on long-term yields, limiting policy flexibility and efficacy
10. In an upside scenario, a promising, widely available therapy for COVID-19 could be a catalyst
Investing involves risk including possible loss of principal. Past performance is no guarantee of future results. Potential investors should be aware of the many risks inherent to owning and investing in real estate, including: adverse general and local economic conditions that can depress the value of the real estate, capital market pricing volatility, declining rental and occupancy rates, value fluctuations, lack of liquidity or illiquidity, leverage, development and lease-up risk, tenant credit issues, circumstances that can interfere with cash flows from particular commercial properties such as extended vacancies, increases in property taxes and operating expenses and casualty or condemnation losses to the real estate, and changes in zoning laws and other governmental rules, physical and environmental conditions, local, state or national regulatory requirements, and increasing property expenses, all of which can lead to a decline in the value of the real estate, a decline in the income produced by the real estate, and declines in the value or total loss in value of securities derived from investments in real estate. Direct investments in real estate are highly illiquid and subject to industry or economic cycles resulting in downturns in demand. Accordingly, there can be no assurance that investments in real estate will be able to be sold in a timely manner and/or on favorable terms.”
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