MetLife Investment Management - Wed, 11/03/2021 - 15:57

Fall 2021 Real Estate Outlook: Two Steps Forward, One Step Back

  • The growth trajectory of the U.S. economy exceeds its preCOVID path, and we continue to believe real estate investors should consider modestly higher risk/return strategies.
  • We believe the commercial real estate sector is uniquely suited to benefit from current monetary policy, which may allow for higher inflation.
  • Out of favor property types including retail, office, and hotel may offer attractive relative value today, and should not be ignored by investors seeking a diversified portfolio.

We believe the U.S. economy is on a strong growth path, with GDP on track to exceed its pre-COVID trajectory. Specifically, had the COVID-19 pandemic never occurred, the Congressional Budget Office estimated in 2019 that 2021 U.S. GDP would have been $19.9 trillion1, but today we expect the year to finish at $20.0 trillion. If realized, this will be the first post-WW2 economic recovery where the size of the economy grows above the pre-recessionary trend in the year following the end of the recession. While the late summer and early fall months have continued to exemplify strong economic growth, they also brought risks, with rapid spread of the highly contagious COVID Delta variant, as well as some concern regarding the prospects of economic turmoil faced by several major Chinese property developers. Nonetheless, we remain positive on the economic outlook, and forecast 5.5% GDP growth for 2021. As a result, when considered alongside our analysis of current market pricing that we will outline later in the report, we believe real estate offers attractive relative value, and that investors may benefit from higher risk, and modestly higher yielding real estate investments.

Made-for-CRE Monetary Policy 
Although some segments of commercial real estate were squarely in the crosshairs of the COVID-19 impact, we believe the sector may be uniquely suited for current economic conditions. Namely, the economy is in a not-often-seen position where inflation is increasing while interest rates and yields across investment sectors have remained low. Real estate prices have historically benefitted from both low interest rates and rising inflation. Usually, these two conditions do not occur at the same time. We believe the fact that this is occurring simultaneously today exemplifies the Fed’s 2020 updated policy guidance allowing inflation to exceed their 2% target (even when the economy is in a rapid growth mode). The Fed itself is forecasting above 2% inflation all the way through its forecast horizon (2024), and as evidenced in exhibit 1, expectations among market participants appear to be anchored in that range. Although our base case view is not that inflation will run significantly above the 2% target, the possibility of a bout of sustained 3% or higher inflation has grown. 


As exhibit 2 shows, periods of higher inflation have often been positively correlated with higher real estate returns<sup>2</sup> . “Modeled returns” are simply comprised of the real estate sector’s average cap rate, plus average annual inflation as measured by the consumer price index. As is depicted, the relationship is not perfect, especially during the 2000-2010 decade when two recessions occurred, but we feel it may be a reasonable indicator of unlevered private real estate returns nonetheless.

To apply this methodology to the outlook, we combine expectations for cap rates and interest rates through 2025. As we outlined in our Summer 2021 report <i>Open for Business</i>, we expect average real estate cap rates to remain in the low 4% range in the near and medium term. Additionally, forecasts suggest inflation could average 2.7% through 2025.<sup>3</sup> Adding these figures together suggests that unlevered returns could average 6.7% per year from 2021-2025, as measured by the NCREIF Property Index, an industry benchmark.<sup>4</sup>

Investors concerned that inflation could exceed the current market expectations can take some comfort in this relationship, as an increase in the outlook for inflation would lead us to increase our outlook for NCREIF total returns.

Overall, this cap rate and inflation forecast is an admittedly simple way to consider real estate returns, one that has been somewhat imprecise in the past, and will undoubtably not be perfect in the future. We nonetheless think it is worth consideration given a shifting inflation outlook. One additional use for this framework is to consider the modeled returns as a spread to current corporate bond yields, which we believe can indicate both if the real estate sector offers attractive relative value, and if it’s worth increasing or decreasing the risk profile of real estate investments. From 2000-2020 the historical average spread between unlevered real estate returns and Baa corporate bond yields was 3.5%. Using the 6.7% modeled return outlined above, and a 2.2% average Baa bond yield, the spread would be 4.5%, above the 3.5% long term average<sup> 5</sup>.

<b>Property Market Conditions</b>

<i><b>Apartment </b></i>

The apartment sector was strikingly resilient during the COVID-19 pandemic, and current quarter results indicate continued strength in demand for almost all geographies and formats. A tight for-sale housing market has further supported demand for apartments, with 385 of the 390 U.S. metropolitan areas reporting positive rent growth as of the most recent readings.<sup>6</sup> Even the hardest hit submarkets in dense metropolitan areas like New York and San Francisco are now realizing rent growth rates of 3% or higher.<sup>7</sup>

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1 2019 CBO estimate. 
2 Discussion of real estate returns represents gross unlevered returns as measured by NCREIF. Gross returns will be reduced by costs and expenses, including management fees, and do not reflect, even on a hypothetical basis, net returns resulting from the reduction of these costs and expenses. 
3 Moody’s Analytics, 3Q21. 
4 The index returns shown herein are for illustrative purposes only, and do not reflect actual historical trading results for any product or investment strategy, and are not a guarantee of future performance. Hypothetical results are subject to various modeling assumptions, statistical variances and interpretational differences. No representations are made as to the reasonableness of the assumptions used and any change in these assumptions would have a material impact on the hypothetical performance results portrayed. Hypothetical results have other limitations including: they do not reflect actual trading and therefore don’t reflect the impact that actual market conditions may have had on the investment manager’s decision making process; regulatory or tax rules that may have existed during the periods modeled; and it also does not take into account an investor’s ability to withstand losses in a down market and assumes the strategy was continuously invested throughout the periods modeled. There is no guarantee that any actual product or strategy that followed any of the hypothetical portfolios modeled herein would have had similar performance. A decision to invest in an investment strategy should not be based off of hypothetical or simulated performance. 
5 Moody’s Intermediate-Term Bond Yield Average: Corporate - Rated Baa - Bonds with Seven-year Average Maturities, NCREIF. 3Q21. 
6 CoStar, 3Q21. 
7 CoStar, MIM. 3Q21. 
8 NCREIF, Moody’s. 3Q21. 
9 Ibid. 
10 CoStar/STR, 3Q21.

This material is intended solely for Institutional Investors, Qualified Investors and Professional Investors. This analysis is not intended for distribution with Retail Investors. This document has been prepared by MetLife Investment Management (“MIM”)1 solely for informational purposes and does not constitute a recommendation regarding any investments or the provision of any investment advice, or constitute or form part of any advertisement of, offer for sale or subscription of, solicitation or invitation of any offer or recommendation to purchase or subscribe for any securities or investment advisory services. The views expressed herein are solely those of MIM and do not necessarily reflect, nor are they necessarily consistent with, the views held by, or the forecasts utilized by, the entities within the MetLife enterprise that provide insurance products, annuities and employee benefit programs. The information and opinions presented or contained in this document are provided as the date it was written. It should be understood that subsequent developments may materially affect the information contained in this document, which none of MIM, its affiliates, advisors or representatives are under an obligation to update, revise or affirm. It is not MIM’s intention to provide, and you may not rely on this document as providing, a recommendation with respect to any particular investment strategy or investment. Affiliates of MIM may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives) of any company mentioned herein. This document may contain forward-looking statements, as well as predictions, projections and forecasts of the economy or economic trends of the markets, which are not necessarily indicative of the future. Any or all forward-looking statements, as well as those included in any other material discussed at the presentation, may turn out to be wrong. All investments involve risks including the potential for loss of principle and past performance does not guarantee similar future results. Property is a specialist sector that may be less liquid and produce more volatile performance than an investment in other investment sectors. The value of capital and income will fluctuate as property values and rental income rise and fall. The valuation of property is generally a matter of the valuers’ opinion rather than fact. The amount raised when a property is sold may be less than the valuation. Furthermore, certain investments in mortgages, real estate or non-publicly traded securities and private debt instruments have a limited number of potential purchasers and sellers. This factor may have the effect of limiting the availability of these investments for purchase and may also limit the ability to sell such investments at their fair market value in response to changes in the economy or the financial markets. 
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1 MetLife Investment Management (“MIM”) is MetLife, Inc.’s institutional management business and the marketing name for subsidiaries of MetLife that provide investment management services to MetLife’s general account, separate accounts and/or unaffiliated/third party investors, including: Metropolitan Life Insurance Company, MetLife Investment Management, LLC, MetLife Investment Management Limited, MetLife Investments Limited, MetLife Investments Asia Limited, MetLife Latin America Asesorias e Inversiones Limitada, MetLife Asset Management Corp. (Japan), and MIM I LLC.


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