2023 Risk Management Conference: Public real estate markets offer significant upside during high inflation

In 2021, when investors bought real estate, their expectations were that cap rates were, on average, in the 4.5 per cent range, with expected growth just under three per cent, said Russo, implying high single-digit returns going forward.

Read: 2022 Risk Management Conference: How economic cycles impact global REITs

Currently, public markets are implying investors in real estate today would receive an approximate six per cent cap rate, with growth jumping to 4.2 per cent because of inflation as well as demand and supply imbalances. This implies real estate return expectations today are low double digits on an unlevered basis.

Additionally, earnings growth levels in the near term are expected to catch up from the last three years’ rental growth and rise to about 10 per cent today, said Russo, suggesting returns in public real estate could rise to between 20 per cent and 30 per cent if interest rates settled in the 3.5 per cent range. “It feels like an opportunity where credit spreads, which are higher than they’ve been historically, will come in. . . . You’re probably going to get outsized returns on the public side.”

To gauge where the public markets would stand from different economic recovery standpoints, Hazelview’s investment team analyzed three different scenarios that could affect public asset values compared to their private counterparts. The analyses looked at the impact of each scenario on rents, vacancies and the cost of capital expenditures, comparing their future value to today’s stock prices.

Read: Value creation may be new cap rate compression in real estate investment

The first — and most likely — case is where interest rates have already risen to a sufficient level to bring down inflation but at a slower pace, said Russo, noting this means the high interest rate period will persist and spur a moderate recession. The worst-case scenario will see persistent inflation and will lead to more interest rate hikes, which will likely mean a more severe and longer recession that would apply more pressure on the underlying fundamentals for real estate.

Another bold scenario would be one where central banks recognize interest rates have increased too high and inflation will start coming down fast until it hits a cliff. “That means we’re likely to get some relief on interest rates in the next three to nine months,” he said. “That, potentially, means a softer landing or a milder recession. And that can be a more positive impact for overall fundamentals and for values on the real estate side.”

Read: 2022 DBIF coverage: DB plan sponsors urged to consider value-add of REITs during economic downturns

The analyses found the base case, where the economy endures a recession but lower inflation, would see a decline in private market values around 10 to 15 per cent and an expected upside or opportunity for public markets in the 30 per cent range.

The worst-case scenario, said Russo, would imply a roughly 20-30 per cent decline for private market values but a 10 per cent increase on the public side. And the bold scenario could likely see up to a five per cent increase in the private market alongside a more than 40 per cent return for the public space, he added.

“With these scenarios, we’ve tried to really gauge the potential impact on vacancy in our rents. And even when we do that, we still get significant upside in the public real estate space.”

Read more coverage of the 2023 Risk Management Conference.