by Indy Karlekar, Senior Managing Director, Global Head of Research and Strategy, Principal Real Estate Investors
There’s no doubt 2020 has been an interesting and challenging year. As we look forward to 2021, we explore a number of key themes expected to play out that may impact commercial real estate and share some relative value tactical opportunities we believe may be of interest to real estate investors.
U.S. and Europe: Base case outlook
- Our base case for both regions is predicated on stability in caseloads, preventing large-scale lockdowns until a comprehensive medical solution is found. We also expect strong central bank policy support to stay in place despite weak political will for additional fiscal stimulus.
- Businesses and consumers also appear to have adapted to changes required to keep economies open, though we expect periods of localized shutdowns in the quarters ahead. In handicapping the path forward, the U.S. may be better positioned to help lead the global recovery in the developed world.
- A major advantage is the coordination between the central bank and fiscal policy whereas the Eurozone’s nations conduct their own policy. Moreover, each nation will also need to reconcile its fiscal balance sheet heading into the recovery, while the U.S. Treasury and the U.S. Federal Reserve (Fed) can effectively print money to monetize the federal debt, though this may spur the ongoing inflation debate.
- For both the U.S. and Europe, the acceleration in headline growth doesn’t diminish the fact that the economy will remain below their pre-pandemic capacity for a few quarters. The outlook in the UK is even more challenged given looming Brexit uncertainty and heavy reliance on the service sector which continues to face COVID-19 related challenges. As such, we expect the UK to be a relative economic underperformer in 2021.
U.S. election impact
- The wide variance in the stated policy objectives between the Republican and Democratic parties makes it tricky to prognosticate the impact on economic growth and commercial real estate performance though risk assets have tended to perform well with a divided government.
- We should point out that elections have seldom had an immediate impact on the trajectory of economic growth. Instead, this tends to be governed by potential labor force and productivity. The most meaningful impact occurs through policy shifts, which can alter patterns of demand and consumption where we see significant differences between the two parties.
Redefining live, work, and play
- For investors, the challenge is to decipher where behavioral change is structural or related to health and safety, with the latter potentially reversing when the pandemic fades. The range of outcomes are wide, making it likely that investors will take divergent views.
- For example, an investment in CBD office may be anathema to one investor but offer significant opportunity for another.
- Investor perception will also drive valuations and vary materially by market and property type. Therefore, our recommendation is to separate structural and cyclical shifts while defining investment strategies.
Technology: friend or foe?
- Technology has never before been such a formidable disrupter and source of growth in the knowledge-based economy. As such, investors may need to adjust their grading rubric for markets, as many workers and employers begin to exhibit shifting geographical preference, and new growth emerges.
- We believe that a holistic understanding of the changes that applied technology brings will be a critical lens in examining and ultimately identifying investment opportunities in the years to come.
Goodbye cities, hello suburbs?
- Although the data on an exodus to the suburbs are not yet conclusive, it is worth keeping a watchful eye as millennials enter a new life stage, and preferences shift toward single-family home ownership.
- In fact, the shift out of urban markets could be a temporary phenomenon and quickly revert should employers decide to pull their employees back to the office. In that sense, it is likely not the opening of the floodgates but rather an exploratory trial for many renters.
Retail: strong price discovery may unearth selective opportunities
- A key challenge for existing brick-and-mortar retailers is their high-cost structure, particularly at a time when value and convenience are highly prized for health and safety.
- E-commerce, already a beneficiary of structural tailwinds, has been a clear winner. However, given the tight margins for online retail, it is not yet clear if the current surge toward e-commerce represents a permanent shift or a temporary dynamic. Nevertheless, online shopping provides consumers a safe and convenient choice at reasonable value when it is needed most.
- Our focus remains on convenience and well-positioned grocery-anchored centers, with a decided focus on high-quality credit, which has the potential to generate strong cash flows. Off-dollar retail is also a critical component of our consideration, particularly in the U.S. where such stores generate significant foot traffic.
- On a more selective basis, power centers and lifestyle centers in both the U.S. and Europe could be viewed as effective tactical plays under the right pricing and tenancy scenarios. The underlying themes across our retail recommendations are squarely centered around value and quality from a consumer and tenant perspective.
Office market at a crossroads
- Yields on office properties have shown little signs of upward movement at this point, but this is also a function of significant net operating incomes (NOI) declines through the first half of the year paired with appraisal lags. This should true up as we enter 2021, however.
- Discount rates remain extremely low as a result of the abnormal interest rate environment and the accommodative policy rates globally. As a result, we anticipate some retracing of cap rates but perhaps less than in past cycles.
- Given the office sector’s cyclical nature, we remain watchful for a sudden upward shift in interest rates if they are not accompanied by an increase in economic growth.
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Investing involves risk, including possible loss of principal. Potential investors should be aware of the risks inherent in owning and investment in real estate, including value fluctuations, capital market pricing volatility, liquidity risks, leverage risks, credit risk, occupancy risk and legal risk. Expressions of opinion and predictions are accurate as of the date of this communication and are subject to change without notice. There is no assurance that such events or projections will occur and actual conditions may be significantly different than that shown here.
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