In its 2019 Outlook, PGIM Real Estate’s research team noted that investors will face increasing challenges in the coming year, yet the firm is cautiously optimistic about the investment market in the months ahead. NREI recently spoke with Lee Menifee, head of Americas investment research at PGIM Real Estate, to hear more about some of the key trends that will likely shape commercial real estate investment in 2019.
NREI: What do you see as some of the top challenges facing investors this year?
Lee Menifee: We mentioned a few challenges in the report, including slowing returns and the shifting occupier and investment market dynamics. The two are very closely related. It is also helpful to decompose the composition of slowing returns, because there are two things going on there. One is the end of yield compression around the world. We don’t worry about that all that much, because it’s something that is out of our control. The other part about slowing returns that we do worry about is the durability and growth of income streams.
The durability of income streams looks very favorable to us in almost every market in the world. We would say that is still the case, even in a slower economic environment, due to pretty low new supply. Where we are concerned more for the coming year is about the growth of income stream. Distinguishing between which income streams have the most and least growth potential is really top of mind for us. That varies by geography and more so by property type, logistics being the obvious near-term standout. Retail fits on the other end of that, where it remains a challenged environment.
NREI: The current global real estate cycle is now one of the longest in recent history. What do you see as the biggest potential disruptors to end the current cycle?
Lee Menifee: It is almost certain to be something that happens outside of real estate, which is almost always the case, one notable exception being the oversupply that occurred in the early ‘90s. Global economic expansion is one of the longest on record. So, whenever that comes to an end, we expect that to coincide with a real estate downturn. I wish we new more about the timing of this cycle end. We do monitor many things to make sure that we’re not caught on the wrong end of this. Those indicators, from the best that we can tell, show that the end doesn’t seem to be imminent.
NREI: Investors are bracing for tighter monetary conditions related to rising interest rates and scaling back on quantitative easing programs. Yet dry powder available for real estate investment is at record levels. Do you think investors will see some pinch points ahead in reduced access or more expensive capital, or could all of the capital from private equity/debt funds serve as a counter balance to sustain transaction activity and cap rates?
Lee Menifee: How dry powder is deployed and when is going to determine whether we see transaction activity rise this year, and what happens on pricing. Based on what has happened over the last few years, we would expect that this bid-ask spread will continue to hold, and hold back some trading with dry powder that continues to pile up. I don’t think there’s a lot of urgency to get dry powder out too quickly.
One area where there is good synergy is in the debt funds and funds that have raised money for transitional loans. That money does seem to be very well matched to the value-add capital that is also looking to get deployed. There will be a lot of value-add capital that gets invested around the world this year. Those value-add buyers will need transitional financing, and they won’t be able to get as much as they need from traditional lenders. So that is an area where you could see more investment activity that is aided by the dry powder that has piled up.
NREI: Do you think the bid-ask gap is going to remain prevalent in 2019 and put a lid on some of the transaction activity?
Lee Menifee: Our outlook for transaction activity this year is for it to be about the same as the last few years—which have been record-setting transaction levels. So, it is not as if things are frozen. But until there is some urgency of owners of real estate to sell, which we don’t see as being imminent at all, we do see that bid-ask spread continuing.
One area where the bid-ask spread appears to be a little lower and buyer and seller expectations are closer together appears to be around large portfolios or M&A transactions. That segment of the market increased as a share of overall transaction activity last year, and we think that there is the potential for that to increase this year.
NREI: Rising construction costs have had a broad impact on new development projects, as well as property improvements and tenant build-outs. Any expectations on whether costs will continue to rise in the coming year?
Lee Menifee: Rising construction costs have a few different drivers that are going in different directions right now. The first driver is the spike in materials costs that started a few years ago. For the most part, materials costs are already plateauing in many markets, or in some cases, there is even a little bit of relief in costs. So that pressure is subsiding, although the caveat that any big trade wars with tariffs could cause costs to rise again.
The two areas where costs are still going up are labor availability and scarcity of skilled tradespeople. That will continue to contribute to cost increases in many markets. Another area where we don’t see any reversal is that office tenants simply require higher cost buildouts than they have in the past. A lot of that relates to density, with co-working and flexible space providers being an extreme example of that. That side of the cost equation (related to dollars spent on tenant improvements) is only going up, especially as real estate owners increasingly adopt a service provider model.
NREI: Your report also noted that PGIM’s research team remains cautiously optimistic on the outlook for commercial real estate in 2019. What are some of the reasons for that optimism?
Lee Menifee: The optimism for this year really comes from a few things that are mostly tied to the broader macro-economic environment, but there are some real estate drivers as well. In the U.S., tighter monetary policy has been offset by continued stimulus from tax cuts and fiscal expansion. Real estate supply pipelines are also very moderate by historic standards.
NREI: Where does PGIM see the biggest opportunities for investing in 2019?
Lee Menifee: One area that we highlight are niche property types. There are many options available to investors right now. One of the criteria for evaluating niche product types is that it needs to be needs- based. What is the underlying tenant demand? Is it sustained by demographic trends or other cyclical drivers? The second criteria is that it needs to offer a risk-adjusted return over major property types. One of the opportunities that we see as attractive for this year in the U.S. is manufactured housing, which has a very stable and growing demand base and very little new supply.
NREI: Are there any other key trends that are on your “watch list” for 2019?
Lee Menifee: One area we are looking at pretty closely is the uptick in investor interest in impact investing. Impact investing is not just a current opportunity, but something that is going to be a permanent part of their real estate investing strategy. I would further divide that by traditional investors in real estate who are looking to add an allocation to impact investing, and separately those that are already experienced impact investors and are looking at real estate as something they want to add with their impact investing dollars. So that is one area that we are looking at, because we do think it will affect where the investment opportunities will be, both to buy and sell, because we are expecting to see a lot of growth in that impact investing sector around the world.
NREI: Do you think that could also fuel more capital going into Opportunity Zone funds?
Lee Menifee: Opportunity Zones is one area that has attracted a lot of attention in the U.S., with many funds that have been set up already. There may be opportunities there, but we are also mindful of the intense competition to invest in them. A lot of the capital that has been raised appears to be more retail capital. The type of impact investing capital is looking beyond the tax credit advantages that come through something like Opportunity Zones into more of a permanent allocation without explicit consideration to preferential tax treatment.
NREI: Is there anything else that you would like to add?
Lee Menifee: Overall, when we look at the trends we have identified in our Outlook report, in what seems to be a very changing environment, there is actually a lot of continuity. Staying the course still makes a lot of sense. In hindsight, when we have invested in uncertain environments, more often than not, discipline in that plan has led to a better outcome than if we had stayed on the sidelines. So, I think 2019 is likely to be a repeat of that for us.