When the yield curve inverted at the end of March, it compounded already volatile market conditions for the private real estate sector. For some managers, the answer was to stick to strategies, for others, a pivot was necessary.
On March 29, the curve between the two-year and 10-year treasuries inverted by three basis points. It was the most recent occurrence of such a shift since August 2019. Typically, an inversion has preceded a broader economic recession. But with current markets anything but typical, that outcome is less certain.
Bryan Donohoe, co-head of US real estate at Los Angeles-based manager Ares Management, told affiliate title PERE the inversion should create a pensive environment around forward commitments, especially as investors already need to factor in rising inflation, supply chain and other macroeconomic issues, including the consequences of Russia’s invasion of Ukraine.
“There’s an evolving playbook for navigating all of the factors in the market today, such as geopolitics and inflationary pressures,” Donohoe said, adding selectivity and downside mitigation are key tenets to a general approach to investing currently.
Yet dealmaking is not on hold at Ares, or other managers in the market, despite the shifting conditions. Donohoe said capital flows are still high and need deploying. Subsequently, managers are still trying to widen their portfolios, particularly in the multifamily and industrial sectors. As such, they cannot place equity investments on hold.
Lee Menifee, head of Americas investment research at Newark, New Jersey-based PGIM Real Estate, said the manager is specifically focusing on more recession-resistant property types in response to the inversion. Storage, senior housing, life sciences and ‘close-to-consumer’ industrial assets in metropolitan areas with significant populations lead the firm’s priority list.
“We have focused our incremental investments on property types and markets where we have high conviction anchored in demographic shifts that will outline the cyclical headwinds that the yield curve inversion signals,” Menifee said. “Our base case is not a near-term recession. But we are stress-testing our underwriting under recession scenarios.”
Jim Costello, head of real estate economics and chief economist at MSCI Real Estate, told PERE the yield curve’s inversion does not change the equation on investing and serves better as an indicator of more near-term fearfulness around economic growth. For the direct impact on managers, Costello said any economic slowdown could result in a broader cutback on hiring, office occupancy and weakening in new building demand for borrowers and investors.
“This is a weird combination, especially in the light of the high rates of inflation,” Costello said. “It’s not clear it would behave quite like things have done in the past.”
Leveraged buyers retreat
The yield curve between the two-year and 10-year Treasuries inverted as low as 5bps as of March 31 and has subsequently entered back into positive territory of 23bps as of April 11, according to US Department of the Treasury statistics.
Menifee said the briefness of the inversion has not deterred real estate investors and, so far, they are not assuming a near-term recession. “However, as with prior periods when the yield curve inverted, borrowing costs now exceed cap rates for some property types, and highly leveraged buyers are pulling back,” Menifee said. “At a minimum that will slow price growth and potentially pressure cap rates higher.”
The gray conditions have another layer of complexity to them stemming from the Federal Reserve’s ongoing plans to hike interest rates in the coming months. On March 16, the central bank approved a 25-basis-point hike and chairman Jerome Powell has since maintained the Fed’s position of issuing at least six more rate hikes during 2022.
PGIM expects short-term interest rates to rise by about 200 basis points from their current state, putting the landscape closer to the present long-term interest rate of about 2.7 percent.
“Our expectation is those long-term rates will move up from today’s level, keeping the yield curve upward sloping,” Menifee said. “In that non-recessionary scenario, real estate cap rates rise slightly from today’s levels. But that is at least partially offset by income growth, and core real estate returns move back down, but stay positive.”
Donohoe said managers need to be confident in the rent growth, assets and markets being underwritten to not lose momentum from the rising interest rates, even if the Fed tapers its plans. “The industry is too important to the global economy, so there is a little bit of a seatbelt the industry believes will be put in place as rates rise,” he added.