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Taking Clues from Past Cycles

Posted by: | Posted on: July 7, 2020

It may feel like we’re in uncharted waters with COVID-19, but Lee Menifee, PGIM Real Estate’s Head of Americas Investment Research, says there are things we can learn from history.

“I absolutely do think there are clues from past downturns,” Menifee says. “The thing that I’m looking most carefully at [this time] is how real estate is priced, both in an absolute sense and versus other asset classes, in this downturn relative to previous downturns.” 

In past downturns, real estate values have fallen for two reasons, according to Menifee. One reason was that the underlying income in properties fell. The other was that investors attached a higher risk to certain properties.

Previous economic cycles have also shown that investors favor real estate, but they see a significant distinction between the different types of real estate. That should play out again in this cycle.

Given what is happening with interest rates and other asset classes, Menifee sees a possible scenario where certain parts of the real estate market have limited value declines. 

“The underlying incomes fall, and the value of the assets should fall, but we’re not sure that we’re going to see a lot of cap rate compression,” Menifee says. “We’re not sure that the risk premium line up. That’s true in the residential sectors and in the industrial sector.”

But other sectors, such as office and retail, are looking at larger income declines than other property types. Given what is happening with tourism, hotels may be in a separate class right now. 

“It’s hard for us to tell you what the risk premium in the hospitality looks like because there is very little trading,” Menifee says. “Even the debt on some of these properties isn’t trading that much. So it’s very difficult to estimate what that risk premium is, but I think what we’re observing in the public markets indicates that the risk premium is very high.”

Ultimately, Menifee thinks distress in many segments of commercial real estate plays out slowly. “I don’t see a lot of pressure on sellers, either from their balance sheets or the lenders, to force a sale,” he says. “There obviously will be a few sales, but I think that’s going to be slow to evolve. To the extent that you have cash flow, the lower rate environment helps there.”

Menifee expects the price discovery process in retail, hospitality and parts of the office sector to be very prolonged. “I wouldn’t be surprised if, in three or six months, we’re still asking ourselves the question, ‘What is the average cap rate for those properties?’” He says. 

But the process will move quickly for other CRE segments. “I think we’ll probably have a lot more visibility for apartments and industrial sooner rather than later,” Menifee says.

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