PGIM Real Estate is predicting that the property sector – which has delivered strong performance since the global financial crisis – will see returns moderate in the coming years.
In spite of low productivity growth and low inflation, the asset class has generated robust returns over the past five years, which can be attributed to declining bond yields, narrowing spreads of real estate income over bonds and low supply growth, the Madison, New Jersey-based real estate investment manager noted in its latest global outlook report, Looking beyond the cycle.
After the global financial crisis, real estate generated high initial yields – where existing income on properties was high relative to their purchase price – and also saw a pick-up in rents. But the primary driver of returns has been yield compression, with property values rising from a combination of falling interest rates and narrowing spreads, the authors said: “The overall result has been a period of strong nominal returns, at a rate not seen since the 1980s, when economic growth and inflation were much higher.”
But “a golden period for aggregate global property returns appears to be coming to an end,” researchers and authors Cuong Nguyen, Greg Kane and Kelly Whitman wrote in the report. In fact, “assuming inflation stays low, returns [are] likely to be much lower over the next decade.”
For example, levered returns for value-added real estate are projected to be in the low-to-mid teens, compared with recent returns nearing and sometimes surpassing 20 percent, while core levered returns are expected to go back to their historical range of 7-9 percent, down from the low-to-mid teens in recent years, according to PGIM Real Estate.
The report noted there is less yield compression in real estate globally, as the volume of capital targeting real estate has declined and pricing pressure in property markets has eased. “In many markets with already low yields, transaction volume has only been sufficient to keep pricing stable, rather than drive further yield shift,” the researchers wrote.
Indeed, about two-thirds of all global real estate markets saw yield compression until mid-2016, according to the report. However, by year-end 2016, yields had lowered in only 54 percent of global markets.
Falling interest rates and tightening spreads are unlikely to continue, they wrote. Amid moderate economic growth projections, rental rates are not expected to rise significantly, while real estate yields are at all-time lows and interest rates are now creeping up, according to the report.
“With low starting yields and a lack of capital value growth drivers, it is hard to envisage returns matching the pace of recent years,” the authors noted. One bright spot for returns is low supply, which could help to bolster rental growth above what is justified by current economic conditions, they said. “Even so, investors would be wise to prepare for a more modest period of performance than has been recorded in recent years.”