The underlying conservatism of public real estate investment markets can provide an inflation-proof cushion for institutional investors in uncertain times, said Corrado Russo, managing partner and head of global securities at Hazelview Investments, speaking at the Canadian Investment Review’s 2023 Risk Management Conference.
In fact, public markets are on average more conservatively leveraged than private markets, with a leverage ratio of just 32 per cent, he added.
When investors bought property in 2021, they were expecting cap rates to average 4.5 per cent with expected growth of just under three per cent, Russo said, implying high single-digit returns going forward.
Currently, the public markets are suggesting that investors in real estate today would receive a cap rate of around six per cent, with growth rising to 4.2 per cent due to inflation and supply/demand imbalances. This implies that property return expectations today are in the low double digits on an unlevered basis.
In addition, near-term earnings growth is expected to catch up with rental growth over the past three years and rise to around 10 per cent today, Russo said, suggesting public real estate returns could rise to between 20 per cent and 30 per cent if interest rates settle in the 3.5 per cent range. “It feels like an opportunity where credit spreads, which are higher than they’ve been historically, are going to come in. . . . You’re probably going to get outsized returns on the public side.”
To gauge where the public markets would be in different economic recoveries, the Hazelview investment team analysed three different scenarios that could affect public asset values relative to their private counterparts. The analyses looked at the impact of each scenario on rents, vacancy rates and capital expenditure costs, and compared their future value to today’s share prices.
The first – and most likely – case is that interest rates have already risen to a sufficient level to bring down inflation, but at a slower pace, Russo said, noting that this means the period of high interest rates will continue and spur a moderate recession. The worst-case scenario would be persistent inflation and more rate hikes, which would likely mean a deeper and longer recession that would put more pressure on property fundamentals.
Another bold scenario would be one in which central banks realise that interest rates have risen too high, and inflation falls rapidly until it hits a cliff. “That means we’re likely to see 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 have a more positive impact on overall fundamentals and values on the property side.”
The analysis found that the base case, in which the economy suffers a recession but inflation is lower, would see private market values fall by around 10 to 15 per cent, with the expected upside or opportunity for public markets in the region of 30 per cent.
The worst-case scenario, says Russo, would imply a decline in private market values of around 20 to 30 per cent, 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 if we do that, we still get significant upside in the public real estate space.”
