Outlook
Outlook

Inside Real Estate Strategy Outlook 2023

Investing through turbulence: Separating signals from noise

January 3, 2023
Download PDF

Key themes

  • Inflation and central bank policies are the signals, ignore the other noise.

    Inflation and corresponding central banking policies will be the two most important signals for investors to focus on. As inflation goes, so will central banks. The unambiguous signal from central banks is a clear focus on moderating inflation and that they will continue to tighten monetary policies until they have proof that their action has been effective.

  • Three scenarios for the global economy: Rolling recessions, hard landing, or immaculate disinflation.

    Our base case envisions a high probability of a series of rolling recessions across the developed world. While we are reasonably confident in our base case, we do believe two other scenarios could play out in the next 12 months: a hard landing, or an immaculate disinflation AKA a soft landing. The former involves persistently high inflation where central bankers continue tightening well into 2023, while the latter foresees a more favorable outcome where inflation recedes sooner than anticipated.

  • Outlook suggests slower 2023 for real estate investors.

    While 2022 started with sales volumes continuing to grow through the first half of the year, higher interest rates, above-trend inflation, and an uncertain macroeconomic environment have dampened investment activity during the second half of the year. As we enter 2023, commercial real estate will experience a highly uncertain period of price discovery.

  • Debt markets will drive price discovery in commercial real estate.

    “Debt prices equity,” as the old saying goes, and the most pressing macroeconomic issue for the sector today (and in 2023) is the cost of capital, which has increased significantly since central banks began their tightening cycle. The debt markets will drive price discovery in commercial real estate and provide increasing sense of valuations as we progress into 2023.

  • 2023 is about playing defense, preparing for offense.

    With a recession likely, we think it is appropriate for investors to think defensively by focusing on resilient cash flows and capital value preservation. The strategic relative value of debt is very compelling. Yet it is also a time when nimbleness and the ability to identify relative values can be enormously beneficial. We believe that 2023 will be a year of playing both defense and offense, as market conditions change and evolve. Investors should consider an investment strategy that allows them to manage risks while also giving them the flexibility to pivot to higher risk when suited to their specific needs.

  • DIGITAL1 and niche are merging to be the new core.

    Over the past several years, we have noted the increasing prominence of so-called niche property sectors as part of commercial real estate portfolios. As these sectors have become a more important part of the investment landscape, it has become more difficult to lump them into other sectors. We believe that the combination of DIGITAL and niche is creating a large addition to core real estate.

Inflation and central bank policies are the signals, ignore the other noise

Inflation and the actions taken by central banks will be the two most important signals to focus on. The direction inflation takes will determine central bank policies. Arguably, the current economic environment and capital markets are almost entirely the work of central banks “pumping the brakes” to slow growth and cool inflation. The clear signal they are sending is that they want to firmly re-anchor inflationary expectations. In the 1980s, Federal Reserve (the Fed) chair Paul Volcker pushed the Fed Funds rate to historically high levels in a very short period, creating a severe recession that ultimately quashed inflation. History shows that few central bank tightening cycles have ended well for the economy (Exhibit 1). Investors will do well to heed this signal. But periods of turmoil also afford unique opportunities that investors should be prepared for as we enter a new cycle.

EXHIBIT 1: U.S. Fed tightening cycles have tended to pre-date recessions
Fed Funds rate during tightening cycles, percentage point

Fed funds rate during tightening cycles, from 1970-2022

Federal Reserve, Macrobond, Principal Real Estate, 2022

Three scenarios for the global economy: Rolling recessions, hard landing, or immaculate disinflation

Our base case envisions a high probability of a series of rolling recessions across the developed world. While we are reasonably confident in our base case, we do believe two other scenarios could play out in the next 12 months: a hard landing or an immaculate disinflation AKA soft landing. Under our hard landing scenario, inflation remains persistently high, and central banks continue to tighten into 2023. This pulls the global economy into a deep recession. The immaculate disinflation scenario revolves around the idea that the impact of monetary policy tightening will start to pull back inflation by year-end 2022 or early 2023, allowing central banks to pause. Given the uncertainty, we believe either a hard or soft landing have reasonable probabilities.

The key drivers across all scenarios are inflation and central banks’ policies. We believe that fear of 1970s-style stagflation will motivate central banks to keep monetary policy tight until inflation metrics are measurably lower. Thus, the idea of a quick central bank “pivot” is somewhat low since we do not envision a scenario where a sustained increase in interest rates would be followed by an equally sharp loosening in monetary policies. This is a key reason why we believe that recessions across developed economies are a high probability in the next 12 months (Exhibit 2).

EXHIBIT 2: Rolling regional recessions are our base case
Three scenarios for the global economy, November 2022 - 2023

Three scenarios for the global economy, November 2022 - 2023

Principal Real Estate, December 2022


2023 is about playing defense, preparing for offense

With a recession looming, we believe it is appropriate for investors to think defensively by focusing on resilient cash flows and capital value preservation. The strategic relative value of debt is very compelling. Yet, it is also a time when nimbleness and the ability to identify relative values can be enormously beneficial. We believe that 2023 will be a year of playing both defense and offense, as market conditions change and evolve. Investors should consider an investment strategy that allows them to manage risks they deem appropriate, while also giving them the flexibility to pivot to higher risk when suited to their specific needs.

Use debt for defensive cash flow strategies

A key bookend in our investment strategy is debt with its defensive position in the capital stack and a focus on current cash flow. A rising interest rate environment helps floating rate loans while conservative underwriting ensures subordination levels stay preserved. Both private debt and Commercial Mortgage-Backed Securities (CMBS) can bookend such an approach, though the latter has greater volatility. A steep credit curve rounds out the strong relative value position of debt over our forecast period.

Public quadrants for risk-on nimble pivots

Investors with a higher risk bucket or a more tactical bent could opportunistically focus on investing in liquid public market instruments (CMBS and Real Estate Investment Trusts - REITs). Public market quadrants not only reflect a repricing in real estate values, making them relatively attractive (as of December 2022), but also allow investors to rapidly implement a risk-on tilt in their portfolios. While timing the trough in public quadrants is nearly impossible, particularly with a recession likely, they allow investors to nimbly access periods of market dislocation as well as be positioned for recovery when central bank policies shift, which is likely at some point over the time horizon of this report.

Opportunistic private real estate may offer additional alpha

As a result of current economic and capital market uncertainty—particularly in debt markets—2023 may offer some interesting opportunistic investment possibilities as deals get re-priced and capital stacks need recapitalization. Investors should keep dry powder available. We also feel ground-up development continues to provide a potentially favorable return profile if properly executed. Sectors of particular interest, which we discuss in chapter 3, are residential properties for rent and industrial warehouse sectors. Investors will need to be highly selective on location and quality to differentiate between existing or legacy assets in an uncertain environment.

Exhibit 5 reflects our investment strategy mix, with debt as a cornerstone, and public quadrants and opportunistic private real estate allowing more risk-on tactical tilts.

EXHIBIT 5: Stay defensive but prepare for offense in 2023
Investment strategy evolution

Principal Real Estate investment strategy 2023 infographic


A thematic approach to real estate investment opportunities


Strategic property investment strategy: DIGITAL2 and niche are merging to be the new core

In an uncertain economic and capital market environment, we believe it is important for investors to anchor their portfolios around DIGITAL property types and markets, with their resilient tenant drivers and cash flows. These should be a core underpinning of real estate portfolios and strategies. We believe a portfolio with DIGITAL markets and property types is potentially expected to outperform given the resiliency of their tenants, location, and cashflows. DIGITAL real estate will be the new core in our expectation, and we feel all investment strategies should try to overweight these drivers.

U.S. & Europe DIGITAL markets

U.S. and Europe DIGITAL – Demographic, Innovation, Globalization, Information & Technology long term drivers

Principal Real Estate, December 2022


1, 2 DIGITAL – Demographic, Innovation, Globalization, Information & Technology long term drivers

This is just a glimpse at our outlook. Read the full report, including our sector and property type investment strategy.

Download (PDF) - Inside Real Estate Strategy Outlook 2023

About the authors

Indraneel Karlekar, PH.D.
Senior Managing Director, Global Head of Research & Portfolio Strategies

Arthur Jones
Senior Director

JD Stehwien
Senior Analyst

Thomas McGing
Research Analyst

Daniel Tomaselli
Manager

Madhan Rengarajan, CFA
Senior Director

Disclosure

This material is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.

Risk Warnings
Investing involves risk, including possible loss of principal. Past performance does not guarantee future results. Potential investors should be aware of the risks inherent to owning and investing in real estate, including: value fluctuations, capital market pricing volatility, liquidity risks, leverage, credit risk, occupancy risk and legal risk. All these risks can lead to a decline in the value of the real estate, a decline in the income produced by the real estate and declines in the value or total loss in value of securities derived from investments in real estate.

Important Information
This material covers general information only and does not take account of any investor’s investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice. The information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that the investment manager or its affiliates has recommended a specific security for any client account. Subject to any contrary provisions of applicable law, the investment manager and its affiliates, and their officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy and any responsibility arising in any way (including by reason of negligence) for errors or omissions in the information or data provided.

This material may contain ‘forward-looking’ information that is not purely historical in nature and may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

All figures shown in this document are in U.S. dollars unless otherwise noted.

Index descriptions: The FTSE NAREIT All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. equity REITs. Constituents of the index include all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property. The NCREIF Property Index (NPI) provides returns for institutional grade real estate held in a fiduciary environment in the United States. Index performance information reflects no deduction for fees, expenses, or taxes. Indices are unmanaged and individuals cannot invest directly in an index. The NCREIF Open-End Diversified Core Equity Index (ODCE) is an index of investment returns reporting on both a historical and current basis the results of 36 open-end commingled funds pursuing a core investment strategy, some of which have performance histories dating back to the 1970s.

This document is issued in:

  • The United States by Principal Global Investors, LLC, which is regulated by the U.S. Securities and Exchange Commission.
  • Europe by Principal Global Investors (EU) Limited, Sobo Works, Windmill Lane, Dublin D02 K156, Ireland. Principal Global Investors (EU) Limited is regulated by the Central Bank of Ireland. In Europe, this document is directed exclusively at Professional Clients and Eligible Counterparties and should not be relied upon by Retail Clients (all as defined by the MiFID). The contents of the document have been approved by the relevant entity. Clients that do not directly contract with Principal Global Investors (Europe) Limited (“PGIE”) or Principal Global Investors (EU) Limited (“PGI EU”) will not benefit from the protections offered by the rules and regulations of the Financial Conduct Authority or the Central Bank of Ireland, including those enacted under MiFID II. Further, where clients do contract with PGIE or PGI EU, PGIE or PGI EU may delegate management authority to affiliates that are not authorized and regulated within Europe and in any such case, the client may not benefit from all protections offered by the rules and regulations of the Financial Conduct Authority, or the Central Bank of Ireland.
  • United Kingdom by Principal Global Investors (Europe) Limited, Level 1, 1 Wood Street, London, EC2V 7 JB, registered in England, No. 03819986, which is authorized and regulated by the Financial Conduct Authority (“FCA”).
  • United Arab Emirates by Principal Global Investors LLC, a branch registered in the Dubai International Financial Centre and authorized by the Dubai Financial Services Authority as a representative office and is delivered on an individual basis to the recipient and should not be passed on or otherwise distributed by the recipient to any other person or organisation.
  • Singapore by Principal Global Investors (Singapore) Limited (ACRA Reg. No. 199603735H), which is regulated by the Monetary Authority of Singapore and is directed exclusively at institutional investors as defined by the Securities and Futures Act 2001. This advertisement or publication has not been reviewed by the Monetary Authority of Singapore.
  • Australia by Principal Global Investors (Australia) Limited (ABN 45 102 488 068, AFS Licence No. 225385), which is regulated by the Australian Securities and Investments Commission. This document is intended for sophisticated institutional investors only.
  • This document is marketing material and is issued in Switzerland by Principal Global Investors (Switzerland) GmbH.
  • Hong Kong SAR (China) by Principal Global Investors (Hong Kong) Limited, which is regulated by the Securities and Futures Commission and is directed exclusively at professional investors as defined by the Securities and Futures Ordinance.
  • Other APAC Countries, this material is issued for institutional investors only (or professional/sophisticated/qualified investors, as such term may apply in local jurisdictions) and is delivered on an individual basis to the recipient and should not be passed on, used by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.

Principal Funds are distributed by Principal Funds Distributor, Inc.

12/2022 | 2646637-123123

Get the latest insights.

Outlook
Inside Real Estate: Annual strategy outlook for 2023

As the world economy begins to stall, headwinds indicate various challenges on the horizon. We expect 2023 will be a year of transition with investors focusing on playing defense, while preparing for offense. Listen as we present our 2023 outlook for commercial real estate.

10:30 a.m. New York, 3:30 p.m. London, 4:30 p.m. Berlin

Speaker
Todd Everett
Chief Executive Officer, Principal Real Estate
Indraneel Karlekar, Ph.D.
Senior Managing Director, Global Head of Research & Portfolio Strategies