In a nutshell:
- U.S. real estate performed remarkably well in 2021. With vacancy rates sitting near historic lows across most sectors, real estate is starting 2022 on a strong footing.
- We believe that an unusually supportive macro environment — above-trend economic growth, elevated inflation, and low real interest rates — will continue to support real estate performance this year and likely beyond.
- Outcomes will remain highly divergent across sectors and markets, in our view. Technology and migration, together with idiosyncratic factors, will favor warehouses, garden apartments, and grocery-anchored retail centers in tech hubs, the Sun Belt, and the Mountain West. Malls and office buildings may struggle in demographically challenged locations.
- Risks to the outlook are relatively subdued, in our view. A COVID resurgence could dampen economic, leasing, and investment activity. Longer-term, inflation could sow the seeds of the next recession, although likely not for another few years.
U.S. real estate performed remarkably well in 2021. Although the year began tepidly amid a surge of COVID infections, the steady rollout of vaccines unleashed a resurgence of economic, leasing, and transactions activity in the spring and summer. By the third quarter, overall vacancy rates had dropped to nearly their lowest levels in more than 30 years.1 Net Operating Income (NOI) increased 9% year-over-year, a rate eclipsed only once (during the dot-com boom) since 1983.2 Transaction volume of $462 billion in the first three quarters of 2021 was the highest in at least 20 years.3 Finally, the fund-level ODCE real estate index delivered its strongest total returns in history (since 1978).4
A flood of capital, reflected in compressing cap rates, played a role in pushing values higher. Yet the rebound was largely driven by fundamentals. The apartment sector absorbed 251,000 units in the third quarter — more than the annual average over the past decade (208,000).5 Absorption of nearly half a million units in the first three quarters shattered annual totals back to 1996.6 Industrial absorption of 432 million SF was the highest since at least 1989.7 Even the retail sector, which suffered well-documented pressure from e-commerce as well as mandated store closures, registered its fifth consecutive quarter of positive net demand.8 In all three sectors, vacancy rates dropped to their lowest levels in history, underpinning solid year-over-year rent growth (about 10% in the case of apartments and industrial buildings; 2% for retail centers).9
Amid last year’s upswing, the office sector stood out as a notable exception. To be sure, valuations held steady, and the market displayed scant signs of distress (office CMBS delinquencies of 2.4% in October were below pre-pandemic levels and a fraction of their 10%+ Global Financial Crisis (GFC) peaks).10 Regardless of whether they were using their space (national office usage remained mired at 40% in December), tenants generally continued to meet their lease obligations, keeping NOIs stable.11 Yet a second year of negative absorption reduced office demand by a cumulative total of 100 million SF, more than twice as much as in 2009 (40 million SF), driving vacancies to dot-com and GFC era highs.12
1 / Real Estate Outlook
We believe that U.S. real estate is poised to sustain its strong momentum, courtesy of an unusually favorable set of macroeconomic and financial conditions. Fueled by extraordinary fiscal stimulus (approximately $5.5 trillion, equivalent to 25% of GDP), we estimate that the economy expanded by about 5.5% in 2021.13 In our view, we are unlikely to see similar levels of fiscal support in 2022. Nevertheless, we believe that a strong labor market and elevated asset prices ((home prices and the stock market are up 25% and 35%, respectively, since before the pandemic) will motivate consumers to release at least some of the $2.5 trillion (12% of GDP) in surplus savings that they accumulated during the pandemic.14 GDP growth may slow toward 4%, but this would still rest well above trend levels (about 2%) and cap the fastest two-year expansion since the early-1980s.15 Consistent with last year, we expect that strong economic growth (characterized by healthy job, wage, and business revenue gains) will fuel robust leasing activity across most types of residential and commercial property.
As the economy has recovered, inflation concerns have taken center stage. Consumer prices soared 7.1% year-over-year in 2021, the most since the early-1980s; the Federal Reserve’s (Fed) preferred measure, which strips out surging food and energy prices, jumped the most since 1989 (4.7% year-over-year in November 2021).16 There has been a raging debate about whether inflation is transitory or more persistent. We believe that transitory supply-side issues have played a role. Yet it is also worth noting that the Federal Reserve has more than doubled its balance sheet, creating more than $4 trillion in base money.17 While the Fed embarked on a similar program during the GFC without igniting inflation, this latest iteration differs in two respects: First, it amounts to roughly twice the stimulus over a third of the time (two years instead of six). Second, unlike during the GFC, when much of the liquidity was trapped in a broken financial system, this time it has entered circulation via debt-financed fiscal channels. The result: Broad (“M2”) money supply has jumped 40%, an order of magnitude above anything seen in more than 50 years (see Exhibit 1).18 Experience from the 1970s suggests that money growth can feed inflation with a lag of two to three years.19 Regardless of the catalyst, once ignited, inflation can become self-perpetuating if it is embedded in expectations, spawning a wage-price spiral.
Exhibit 1: M2 Money Supply And Inflation
The “transitory versus persistent” debate has not been conclusively settled. However, it has rekindled interest among investors in strategies to mitigate inflation risks. Property has traditionally been viewed as an inflation hedge, and for good reason: Commercial real estate has historically exhibited a strong correlation and an even stronger sensitivity (or “beta”) to rising price levels (see Exhibit 2).20 These relationships appeared even more powerful during the 1970s and early-1980s, when inflationary pressures were more acute. There are two mechanisms through which inflation feeds into real estate prices: Rising (nominal) wages and sales can augment renters’ spending power. Higher construction costs can also constrain competitive supply. Materials prices soared 35% year-over-year in November, while a broader measure that includes wages increased 14% — the fastest increases in 50-70 years.21 Over time, real estate prices have tracked replacement costs, which are directly tied to inflation.
Exhibit 2: Inflation And Real Estate Prices
With inflation mounting, the Federal Reserve has signaled its intention to suspend asset purchases in March and lift short-term interest rates several times in 2022. Some investors may wonder whether higher interest rates will undermine real estate valuations. We do not believe so, for several reasons. First, monetary tightening will not necessarily translate into higher long-term interest rates. Second, even if long-term rates were to increase, they should not be divorced from the inflationary context. Given that property is a real asset whose cash flows and intrinsic value increase with inflation (unlike nominal Treasuries), we believe that its valuations are driven more by real interest rates. Real yields (measured by the 10-year Treasury Inflation Protected Security (TIPS)) have hardly moved from their record lows of about -1%, and futures markets imply that they will remain below -60 basis points through 2022 (see Exhibit 3).22 Third, the spread between cap rates and TIPS yields, about 500 basis points (bps), is well above its long-term average (400 bps), suggesting that there is room for real estate to absorb any upward pressure on real rates.23
Exhibit 3: Tips Yield
1 NCREIF. As of September 2021.
2 NCREIF. As of September 2021.
3 Real Capital Analytics. As of September 2021.
4 NCREIF. As of September 2021.
5 CBRE-EA. As of September 2021.
6 CBRE-EA. As of September 2021.
7 CBRE-EA. As of December 2021.
8 CBRE-EA. As of December 2021.
9 CBRE-EA. As of December 2021.
10 NCREIF (valuations); Moody’s Analytics (CMBS delinquencies). As of October 2021.
11 Kastle (office usage); NCREIF (NOI). As of December 2021.
12 CBRE-EA. As of December 2021.
13 Moody’s Analytics (fiscal stimulus); DWS (GDP growth). As of December 2021.
14 Case-Shiller (home prices); S&P 500 (stock prices); DWS (savings). As of December 2021.
15 DWS. As of December 2021.
16 Census Bureau (consumer prices); Bureau of Economic Analysis (Fed’s preferred personal consumption expenditure price index). As of December 2021.
17 Federal Reserve. As of December 2021.
18 Federal Reserve. As of December 2021.
19 Federal Reserve (money supply); Bureau of Economic Analysis (inflation); DWS. As of December 2021.
20 Federal Reserve (commercial real estate prices); Bureau of Economic Analysis (inflation); DWS. As of December 2021.
21 Census Bureau (construction materials costs); Engineering News-Record (building costs). As of November 2021.
22 Bloomberg. As of December 2021.
23 NCREIF (cap rates); Federal Reserve (TIPS); DWS (spreads). As of September 2021.
Kevin White, CFA
Global Co-Head of Real Estate Research
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