Andriy Yalanskyi
By Indraneel Karlekar, PH.D., Senior Managing Director, Global Head of Research & Portfolio Strategies; Arthur Jones, Senior Director; JD Stehwien, Senior Analyst; Thomas McGing, Research Analyst; Daniel Tomaselli, manager; and Madhan Rengarajan, CFA; senior director
investing through turbulence: separating signals from noise
key themes
- Inflation and central bank policies are the signals, ignore the other noise.
Inflation and corresponding central banking policies will be the two most important signals for investors to focus on. As inflation goes, so will central banks. The unambiguous signal from central banks is a clear focus on moderating inflation and that they will continue to tighten monetary policies until they have proof that their action has been effective.
- Three scenarios for the global economy: rolling recessions, hard landings, or immaculate disinflation.
Our base case envisions a high probability of a series of rolling recessions across the developed world. While we are reasonably confident in our base case, we do believe two other scenarios could play out in the next 12 months: a hard landing, or an immaculate disinflation AKA a soft landing. The former involves persistently high inflation where central bankers continue tightening well into 2023, while the latter foresees a more favorable outcome where inflation recedes sooner than anticipated.
- Outlook suggests slower 2023 for real estate investors.
While 2022 started with sales volumes continuing to grow through the first half of the year, higher interest rates, above-trend inflation, and an uncertain macroeconomic environment have dampened investment activity during the second half of the year. As we enter 2023, commercial real estate will experience a highly uncertain period of price discovery.
- Debt markets will drive price discovery in commercial real estate.
“Debt prices equity,” as the old saying goes, and the most pressing macroeconomic issue for the sector today (and in 2023) is the cost of capital, which has increased significantly since central banks began their tightening cycle. The debt markets will drive price discovery in commercial real estate and provide increasing sense of valuations as we progress into 2023.
- 2023 is about playing defense, preparing for offense.
With a likely recession, we think it is appropriate for investors to think defensively by focusing on resilient cash flows and capital value preservation. The strategic relative value of debt is very compelling. Yet it is also a time when nimbleness and the ability to identify relative values can be enormously beneficial. We believe that 2023 will be a year of playing both defense and offense, as market conditions change and evolve. Investors should consider an investment strategy that allows them to manage risks while also giving them the flexibility to pivot to higher risk when suited to their specific needs.
- DIGITAL1 and niche are merging to be the new core.
Over the past several years, we have noted the increasing prominence of so-called niche property sectors as part of commercial real estate portfolios. As these sectors have become a more important part of the investment landscape, it has become more difficult to lump them into other sectors. We believe that the combination of DIGITAL and niche is creating a large addition to core real estate.
Inflation and central bank policies are the signals, ignore the other noise
Inflation and the actions taken by central banks will be the two most important signals to focus on. The direction inflation takes will determine central bank policies. Arguably, the current economic environment and capital markets are almost entirely the work of central banks “pumping the brakes” to slow growth and cool inflation.
The clear signal they are sending is that they want to firmly re-anchor inflationary expectations. In the 1980s, Federal Reserve (the Fed) chair Paul Volcker pushed the Fed Funds rate to historically high levels in a very short period, creating a severe recession that ultimately quashed inflation.
History shows that few central bank tightening cycles have ended well for the economy (Exhibit 1). Investors will do well to heed this signal. But periods of turmoil also afford unique opportunities that investors should be prepared for as we enter a new cycle.
EXHIBIT 1: US Fed tightening cycles have tended to pre-date recessions
Fed Funds rate during tightening cycles, percentage point
Source: Federal Reserve, Macrobond, Principal Real Estate, 2022
Three scenarios for the global economy: rolling recessions, hard landings, or immaculate disinflation
Our base case envisions a high probability of a series of rolling recessions across the developed world. While we are reasonably confident in our base case, we do believe two other scenarios could play out in the next 12 months: a hard landing or an immaculate disinflation AKA soft landing.
Under our hard landing scenario, inflation remains persistently high, and central banks continue to tighten into 2023. This pulls the global economy into a deep recession.
The immaculate disinflation scenario revolves around the idea that the impact of monetary policy tightening will start to pull back inflation by year-end 2022 or early 2023, allowing central banks to pause. Given the uncertainty, we believe either a hard or soft landing have reasonable probabilities.
The key drivers across all scenarios are inflation and central banks’ policies. We believe that fear of 1970s-style stagflation will motivate central banks to keep monetary policy tight until inflation metrics are measurably lower.
Thus, the idea of a quick central bank “pivot” is somewhat low since we do not envision a scenario where a sustained increase in interest rates would be followed by an equally sharp loosening in monetary policies. This is a key reason why we believe that recessions across developed economies are a high probability in the next 12 months (Exhibit 2).
EXHIBIT 2: Rolling regional recessions are our base case
Three scenarios for the global economy, November 2022-2023
Source: Principal Real Estate, December 2022
2023 is about playing defense, preparing for offense
With a recession looming, we believe it is appropriate for investors to think defensively by focusing on resilient cash flows and capital value preservation. The strategic relative value of debt is very compelling. Yet, it is also a time when nimbleness and the ability to identify relative values can be enormously beneficial.
We believe that 2023 will be a year of playing both defense and offense, as market conditions change and evolve. Investors should consider an investment strategy that allows them to manage risks they deem appropriate, while also giving them the flexibility to pivot to higher risk when suited to their specific needs.
Use debt for defensive cash flow strategies
A key bookend in our investment strategy is debt with its defensive position in the capital stack and a focus on current cash flow. A rising interest rate environment helps floating rate loans while conservative underwriting ensures subordination levels stay preserved.
Both private debt and Commercial Mortgage-Backed Securities (CMBS) can bookend such an approach, though the latter has greater volatility. A steep credit curve rounds out the strong relative value position of debt over our forecast period.
Public quadrants for risk-on nimble pivots
Investors with a higher risk bucket or a more tactical bent could opportunistically focus on investing in liquid public market instruments (CMBS and Real Estate Investment Trusts – REITs).
Public market quadrants not only reflect a repricing in real estate values, making them relatively attractive (as of December 2022), but also allow investors to rapidly implement a risk-on tilt in their portfolios.
While timing the trough in public quadrants is nearly impossible, particularly with a recession likely, they allow investors to nimbly access periods of market dislocation as well as be positioned for recovery when central bank policies shift, which is likely at some point over the time horizon of this report.
Opportunistic private real estate may offer additional alpha
As a result of current economic and capital market uncertainty – particularly in debt markets – 2023 may offer some interesting opportunistic investment possibilities as deals get re-priced and capital stacks need recapitalization.
Investors should keep dry powder available. We also feel ground-up development continues to provide a potentially favorable return profile if properly executed.
Sectors of particular interest, which we discuss in chapter 3, are residential properties for rent and industrial warehouse sectors. Investors will need to be highly selective on location and quality to differentiate between existing or legacy assets in an uncertain environment.
Exhibit 5 reflects our investment strategy mix, with debt as a cornerstone, and public quadrants and opportunistic private real estate allowing more risk-on tactical tilts.
EXHIBIT 5: Stay defensive but prepare for offense in 2023
Investment strategy evolution
A thematic approach to real estate investment opportunities
Strategic property investment strategy: DIGITAL2 and niche are merging to be the new core
In an uncertain economic and capital market environment, we believe it is important for investors to anchor their portfolios around DIGITAL property types and markets, with their resilient tenant drivers and cash flows.
These should be a core underpinning of real estate portfolios and strategies. We believe a portfolio with DIGITAL markets and property types is potentially expected to outperform given the resiliency of their tenants, location, and cash flows. DIGITAL real estate will be the new core in our expectation, and we feel all investment strategies should try to overweight these drivers.
US & Europe DIGITAL Markets
Source: Principal Real Estate, December 2022
1, 2 DIGITAL – Demographic, Innovation, Globalization, Information & Technology long-term drivers
