Inside Real Estate Annual strategy outlook for 2020 - Principal Real Estate Europe
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Inside
Real Estate
Annual strategy outlook for 2020
For Public Distribution in the U.S. For Institutional, Professional, Qualified and/or Wholesale
Inside Real Estate 2020 1
Investor Use Only in Permitted Jurisdictions as defined by local laws and regulations.
Authors
Indraneel Karlekar, Ph.D.
Senior Managing Director, Global Head, Research & Strategy
Arthur Jones
Director, Research & Strategy
Madhan Rengarajan
Director, Research & Strategy
Rachel Shone
Manager, Research & Strategy
Jonathan Frank
Manager, Research & Strategy
Sarah Bogus
Manager, Research & Strategy
Jonathan Ling
Research Analyst, Research & Strategy
2 Inside Real Estate 2020
Executive summary
Key themes
Global economy down but not out – The global growth slowdown is back. Instead of Contents:
finding its much needed “escape velocity,” the global economy is on a weakened growth
track for 2020, buffeted by elevated uncertainty surrounding trade and geopolitics,
macroeconomic strain in several emerging market economies, and structural factors 4 Chapter 1:
such as aging demographics in advanced economies. As dark as the storm clouds may
be, we believe that the global economy has more going for it than against it and assign
Global economic
a high probability (70%) that the expansion remains intact over the next 12 months. outlook
Underpinning our base case are the assumptions that geopolitical fault lines ebb;
weakness from manufacturing does not impact services; labor markets remain stable;
central banks remain accommodative; and China stabilizes on the back of further 16 Chapter 2:
stimulus spending. Commercial real
Central banks will do “whatever it takes” – In July 2012, the president of the European
estate outlook
Central Bank (ECB), Mario Draghi, remarked he would do “whatever it takes” to stabilize
the Euro. Seven years later, major central banks appear to have collectively usurped that
phrase and embarked on a renewed phase of monetary accommodation in order to
24 Chapter 3:
support slowing growth. Monetary policy has been eased almost simultaneously across Tactical real estate
advanced and developing economies, with central banks all swimming in the same opportunities
direction. Financial conditions should be considerably eased entering 2020, reducing
downside risks.
30 Chapter 4:
Real estate to benefit from the confluence of low rates and modest growth – Slow
growth and an accommodative global central banking policy regime should create a Demographics
conducive environment for real estate investment strategies. Since supply is expected to as a pillar of our
remain modest by historic standards, a “not too hot, not too cold” economic environment “DIGITAL” strategy
should allow owners to continue pushing rents above inflation. Central banks are not
likely to rush the removal of monetary accommodation and, thus, keep low interest rates
in place which support property valuations. When coupled with the ongoing demand for
income, commercial real estate should remain an attractive choice within the suite of
global options investors consider in 2020.
Asset and market selection will be key to real estate performance – Our “stock-picking”
theme remains intact with real estate investors advised to focus on fundamentals and
markets that can harness clearly discernible drivers of growth. We continue to believe
the industrial/logistics and multifamily property types, along with select European
offices, may be the best sectors to drive relative income growth. Investors may also wish
to consider a “barbell” strategy pairing two distinct risk-and-reward buckets. On the
core, low-risk spectrum, we believe U.S. high-yield real estate debt along with U.S. and
European long-duration private real estate with strong credit provide opportunity. On
the high-risk, opportunistic spectrum, we continue to favor “shovel-ready” development
projects given strong margins and superior yield on cost.
Structural trend of demographics will evolve over years – The demographic structure
of the world economy will undergo profound shifts over the coming decades with
consequences that will emerge over time for real estate investors. The way people live
and work will evolve and offer real estate investors multi-dimensional opportunities to
meet growing space needs. The demand for real estate will be fluid and increasingly
impacted by both active policy, as well as idiosyncratic demand drivers such as mobility,
affordability, and advancements in technology. Investors that recognize the multiple
layers and nuances of global demographic changes and adopt a flexible approach to
meeting this changing need will find success in creating long-term strategies that can
successfully harness one of the greatest structural shifts of the 21st century.
Inside Real Estate 2020 3
Chapter 1
Global economic outlook
Haze notwithstanding, our glass is half–full
The global economy has entered a phase of synchronized, slower growth,
where an uncertain geopolitical environment and a weakened manufacturing
sector have diminished its ability to withstand shocks. However, as dark
as the potential storm clouds may be, we believe that the global economy
has more going for than against it and assign a high probability (70%) that
the expansion remains intact over the next 12 months. Underpinning our
base case are several assumptions that include dissipation of some major
geopolitical fault lines, including a de-escalation of U.S. and China tensions
and declining tail-risk from Brexit, ongoing monetary accommodation by
major central banks, services not succumbing to contagion from weakness
in manufacturing, labor markets remaining resilient, and China continuing to
add stimulus to its economy and achieve stable growth.
Though it appears that the stars would need perfect alignment to avoid a
slower growth or recessionary scenario, economic cycles tend to be resilient,
and this one has already weathered several storms following the global
financial crisis (GFC). Exhibit 1 shows key forecasts for the global economy
under our base case as well as a downside case scenario.
Exhibit 1: Global economic growth outlook is below trend
Global GDP growth
Base case (p=70%) Moderate recession (p=30%) Long-term average (2002-2018)
8
6
GDP growth year-over-year (%)
4
2
0
-2
-4
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019(f)
2020(f)
2021(f)
2022(f)
Source: Moody’s Analytics, Principal Real Estate Investors, November 2019.
Global GDP calculations based on USD purchasing power parity (PPP) terms, 2011, year-over-year change.
4 Inside Real Estate 2020
Chapter 1: Continued
Services positive despite weaker manufacturing
While global manufacturing has been weak and may reflect a worrying
development, the larger services sector remains relatively strong
“
and has yet to be impacted by weaker fundamentals in other sectors
(exhibit 2). In the U.S., though service Purchasing Managers' Index (PMI)
readings have declined, the share of industries reporting an expansion
We view the enduring
(65%) remains higher than in manufacturing (17%) as of October 2019.
Service sector readings in other major economies paint a mixed picture.
strength of services as
a positive guidepost for
”
In the UK, readings have been weak reflecting Brexit uncertainty, while
China and France have shown stronger service PMI readings. Given the global growth in 2020.
importance of the service sector to developed economies and its direct
impact on consumption and profits, it is reassuring that we remain
in positive territory. We view the enduring strength of services as a
positive guidepost for global growth in 2020 and consider the latest
global slowdown more akin to the 2015 to 2016 lull in global activity
rather than the recessions of 2001 or 2007 to 2009.
Exhibit 2: U.S. and European services continue to expand
U.S. and Eurozone services PMI (3 mo. MA) | Index > 50 indicates expansion
U.S. services PMI Eurozone services PMI
58
57
56
55
54
53
52
51
50
Jan-2017 Jan-2018 Jan-2019 Oct-2019
Source: Bloomberg, Principal Real Estate Investors, October 2019.
Inside Real Estate 2020 5
Chapter 1: Continued
Labor markets strong
Our second pillar of strength is the global labor market, which has been remarkably resilient
despite the contraction in manufacturing and the clear downside impact from the U.S.–China
trade conflict. Developed markets, as represented by the OECD, have added nearly 60 million
jobs, pushing down the unemployment rate across countries to their lowest levels since before
the global financial crisis (exhibit 3). In the U.S., the unemployment rate hovers near a 50-year
record low, while conditions point to underlying strength in the recovery. In both Europe and the
U.S., healthy job markets are supporting wage growth and consumption but could face some
challenges in 2020. With employment near capacity in certain economies, additional hiring and
maintaining worker productivity will also be more difficult due to the reduced size of the labor
pool. This is already a problem in the U.S., Netherlands, Germany, and in parts of France where
current job openings continue to exceed the number of unemployed.
Exhibit 3: Unemployment rates continue to trend lower
Unemployment rate, OECD countries
Europe OECD United States
12 Forecast
10
Unemployment rate (%)
8
6
4
2
0
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
Source: Moody's Analytics, OECD, Principal Real Estate Investors, November 2019.
“ Developed markets ... have added nearly 60 million jobs, pushing down the
”
unemployment rate across countries to their lowest levels since before the
global financial crisis.
6 Inside Real Estate 2020
Chapter 1: Continued
Central banks to do “whatever it takes”
In July 2012, the president of the European Central Bank (ECB), Mario Draghi, famously remarked
that he would do “whatever it takes” to preserve the Euro and restore confidence in the eurozone.
In recent months, global central banks—led by the U.S. Federal Reserve—appear to have
embraced and applied that sentiment to monetary policy. The “whatever it takes” mantra has
become universal. With an acceleration in world growth unlikely, the Fed cut rates by another
0.25% in late October. The Bank of Japan signaled more easing ahead. The ECB—not to be left
behind—promised to stay ultra-accommodative for the foreseeable future. So, it is unlikely that
U.S. 10-year bond yields could rise materially beyond 2.5% without an obvious burst of growth. If
stronger growth doesn’t emerge and a recession looms, bond yields could potentially reach a new
record low. Ongoing monetary accommodation has continued to place downward pressure on
bond yields, both through interest rate cuts as well as targeted bond purchases. This global effort
to lower yields has made monetary policy extremely accommodative (exhibit 4). There are several
short-term positives from global easing. Low rates support risk assets and provide a positive
psychological boost to consumer sentiment. It should also—if effective—help push inflation
higher through wage growth. Importantly, global easing reinforces the pro-growth sentiment
articulated by major central banks and, thus, mitigates against a growing concern that monetary
policy would become an anchor around growth, which occurred in 2018 when the Fed tightened
rates in the U.S. four times.
Exhibit 4: Monetary policy is extremely accommodative
U.S. and European 10-year bond yields (%)
U.S. 10-year bond U.S. long-term avg. Eurozone 10-year bond Eurozone long-term avg.
16
14
12
More restrictive
10
8
6
4
2
More accommodative
0
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2019
Source: Moody's Analytics, Principal Real Estate Investors, September 2019.
Inside Real Estate 2020 7
Chapter 1: Continued
China stays committed to growth
China, a vital and increasingly important component increasingly consumer driven, which means its global
of the global economy, has continued to add stimulus growth multiplier is larger than ever before. What
in the trade war environment. All levers available is also important is that China is applying fiscal and
to government—fiscal, monetary, and regulatory— monetary policy measures in a counter-cyclical manner
have been applied. According to Morgan Stanley, relative to other major economies. That should be
China has delivered approximately $250 billion in very beneficial to those markets (e.g. Germany and the
stimulus (equivalent to approximately 1.75% of its U.S.) that are particularly reliant on Chinese demand.
GDP) with expectations of another $100 to $150 With China leading by example, it could potentially
billion to be provided in the form of lower taxes and/ raise the pressure on other countries to consider fiscal
or infrastructure spending over the next 12 months. tools to help growth also. There is already talk of
The increased spending is starting to pay off as Germany running a budget deficit in 2020 and the U.S.
China’s leading indicator has turned up nicely over the potentially implementing a payroll tax cut. Such fiscal
past six months (exhibit 5). China’s role in the global measures, if implemented over the next 12 months,
economy is of a manufacturer, but it is becoming would be very positive catalysts for global growth.
Exhibit 5: China is committed to stimulus for growth
China credit impulse vs. OECD leading indicator
OECD total leading indicators CLI amplitude adjusted SA
Bloomberg Economics China credit impulse 12-month change
101.0 25
100.8
Bloomberg China credit impulse
20
100.6
OECD leading indicator
100.4 15
100.2
10
100.0
5
99.8
99.6 0
99.4
-5
99.2
99.0 -10
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Source: Bloomberg, OECD, Principal Real Estate Investors, November 2019.
Our confidence in the global outlook is more tenuous that a number of potential catalysts could undermine
than it has been in recent history, and we are keenly global growth, including: (a) the still unresolved global
aware that several material challenges, if unresolved geopolitical tensions such as the U.S.–China trade
or escalated, can tip the global economy into recession dispute, Brexit, and Middle East tensions, (b) a global
(30% probability). In fact, the yield curve, which is an manufacturing recession, and (c) an acceleration in
important barometer of future sentiment on growth the decline in corporate profits, all of which could
and inflation, had been inverted for several months in have a negative impact on asset prices, labor markets,
many major economies. Investors are clearly concerned and consumption.
8 Inside Real Estate 2020
Chapter 1: Continued
Geopolitics has impacted global economic growth
The impact of geopolitical tensions is no longer tensions (the solid lines in exhibit 6) is expected to
theoretical, and early data suggests that the effect increase through early 2020, cumulating to an impact
has been universally negative. Perhaps most harmful of just above one percent. The effects are similar across
to the global economy to date has been the ongoing the United States, advanced economies, and emerging
U.S.-China trade conflict, which remains the top ranked market economies. The dashed lines in exhibit 6 show
threat to global growth in 2020. Recent analysis by the effect on GDP of the first wave of trade policy
the Federal Reserve has quantified the impact of trade uncertainty alone. The report suggests that, had there
tensions on the global economy, estimating that trade not been an escalation again in May and June of 2019,
policy uncertainty shaved 0.8% off global growth in the drag on GDP would have eased in the second
the first half of 2019.1 The analysis further indicates half of 2019.
that the total drag on GDP from the two waves of trade
Exhibit 6: Trade policy uncertainty is impacting economic growth
U.S. GDP Advanced economies, GDP
U.S. total U.S. first wave AFE total AFE first wave
0.0 0.0
Percentage point drag from tariffs
Percentage point drag from tariffs
-0.2 -0.2
-0.4 -0.4
-0.6 -0.6
-0.8 -0.8
-1.0 -1.0
-1.2 -1.2
Q1-2018
Q2-2018
Q3-2018
Q4-2018
Q1-2019
Q2-2019
Q3-2019
Q4-2019
Q1-2020
Q2-2020
Q3-2020
Q4-2020
Q1-2018
Q2-2018
Q3-2018
Q4-2018
Q1-2019
Q2-2019
Q3-2019
Q4-2019
Q1-2020
Q2-2020
Q3-2020
Q4-2020
1
Source: Caldara, Dario, Matteo Iacoviello, Patrick Molligo, Andrea Prestipino, and Andrea Raffo (2019). "Does Trade Policy Uncertainty
Affect Global Economic Activity?," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, September 4, 2019.
https://doi.org/10.17016/2380-7172.2445
If trade hostilities between the U.S. and China continue, with other potential geopolitical shocks that remain
it would imply that the negative effect on global unresolved – Brexit, Iran, Turkey – an unsatisfactory
growth could be more significant in 2020, given the lag resolution to the U.S.-China trade conflict presents the
between policy and implementation. The impact is not most clear and quantifiable danger to global growth in
only limited to the main protagonists since other major 2020 with the potential to inflict material damage on
manufacturers, such as Germany, have also suffered corporate profits and consumer spending.
from the fallout of the trade war. When layered
Inside Real Estate 2020 9
Chapter 1: Continued
Is manufacturing the canary in the months to come—number of job openings
and number of hours worked. Though job openings
in the coal mine?
remain elevated, they have declined more recently,
The continued trade tensions centered around the falling by 560,000 year to date. Hours worked for
U.S. and China, along with a steady strengthening private workers has softened, following a peak in 2016.
of the U.S. Dollar, has negatively impacted global Similarly, overtime hours in the manufacturing sector
manufacturing. Global manufacturing PMI weakened experienced the largest percentage decline since the
further to a fresh post-GFC low, led by further run-up to the GFC. A job market correction in the U.S.
weakness in the U.S. Institute of Supply Management has never occurred without a broader recession and
(ISM) and euro area PMI. The decline in the respective would be a telltale sign that the cycle has ended; it
PMIs remains broad-based, with 60% of manufacturing could also prove to be a significant catalyst for a global
PMIs still contracting as of October 2019. On a correction, perhaps as early as 2020.
Purchasing Power Parity (PPP)-weighted basis, 78%
of the global economy had reported a manufacturing
Falling profits and their
PMI below 50, the expansion-contraction threshold.
Two key sub-components of the PMIs—new orders
multiplier effects
and employment—remained weak in September. The If corporate profits continue to decline, it could have
global new orders index stayed relatively stable at fairly negative consequences on valuations and equity
48.5, its fourth consecutive month of contraction. For prices, as well as business and consumer sentiment,
most developed markets, while manufacturing is a and labor markets. The most recent data from the U.S.
smaller part of the overall economy (Germany being Bureau of Economic Analysis reveals that after-tax
an obvious exception), it remains an important sector profits have been essentially flat since 2016, despite
that can generate relatively high-paying jobs and the substantial cut in U.S. tax rates in 2017 (exhibit
carries a high multiplier for economic activity relative 7). If profits continue to be squeezed, it could deter
to other industries. investment on already declining capital expenditures
globally, since businesses will discount the future
The continuing contraction in global manufacturing is
of their returns on invested capital going forward.
likely to impede growth through declining production
Simply put, if sales and profits stagnate, businesses will
payrolls, and there are some early signs that weakness
naturally be reluctant to add capacity.
in economic activity is spilling over to the labor market.
In the U.S. labor market, two areas are worth following
1010 Inside
Inside
Real
Real
Estate
Estate
2020
2019Chapter 1: Continued
Exhibit 7: Ex-corporate tax cuts, U.S. corporate profits have declined
Corporate profits ($ billion)
Corporate profits after tax (without IVA and CCAdj)
Corporate business: Profits before tax (without IVA and CCAdj)
2,500
2,000
1,500
1,000
500 2018 corporate tax cuts
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: FRED, BEA, Principal Real Estate Investors, June 2019. IVA = Inventory Valuation Adjustment; CCAdj = Capital Consumption Adjustment
Declining profits could put additional pressure on Similar to last year, we attempt to handicap the
the labor markets, limiting the capacity of firms to probability and impact of the various challenges ahead
expand workforces and, in turn, dampening consumer to the world economy (exhibit 8 below). We are clearly
sentiment and spending. With manufacturing in at an inflection point for global growth where any of
contraction, it would not take a huge push to tip labor these potential catalysts may damage the economy.
markets into a softer patch. Of course, falling profits We would probably rank geopolitical tensions as the
could impact valuations, and if global equity markets most dangerous given the scale and non-linear nature
see a sustained decline, credit spreads could widen and of such risks. However, because such risks are so
constrain access to debt capital. In turn, reduced access political, they also offer the most upside in the event of
could be highly problematic for entities that have positive resolutions.
survived on cheap credit despite declining profits
and/or unsustainable business models. Falling corporate
profits may therefore trigger other related weaknesses
that can metastasize into a global recession.
Exhibit 8: We propose the following potential downside catalysts and probabilities
Event/catalyst Impact Probability
Geopolitical tensions, U.S.-China trade conflict worsen High Medium
Manufacturing recession High High
Falling corporate profits and multiplier effects Medium Medium
Source: Principal Real Estate Investors, November 2019.
Inside Real Estate 2020 11Chapter 1: Continued
1. U.S. macro outlook
Despite mounting headwinds, the U.S. economy is has been for over a decade. The other historical culprit
poised to deliver growth in the 1.8% to 2% range for recessions has been overly tight monetary policy,
in 2020, a little bit lower than its average pace of a path that we thought the U.S. was headed towards
approximately 2.3% since 2010. This somewhat bland in 2018. However, three interest rate cuts, with the
statistic hides the fact that the current expansion potential for more over the next 12 months as part
is the longest the National Bureau of Economic of the Fed’s “mid-cycle” adjustment, appears to have
Research has on record since it started tracking headed off this risk for the short-term. Time will tell
business cycles in 1854. Entering its 11th year of whether the Fed was able to time its interest rates cuts
expansion, the U.S. economy will continue to face well or if it was too late.
high levels of geopolitical uncertainty, a potentially
Elsewhere, key economic indicators suggest that the
volatile presidential election year, as well as internal
modest pace of economic expansion is likely to remain
disagreement on the future path of monetary
intact over the next 12 months. The labor market
policy. Not surprisingly perhaps the most common
remains healthy and continues to be a source of
question we have been asked this year is “when is
consumer strength and a key bulwark against a slip in
the recession coming?” As we have reiterated before,
consumer confidence. While momentum in monthly job
expansions do not die of old age but rather because
growth has clearly slowed, it remains well above what is
of fault lines or imbalances in the economy’s balance
needed to keep the unemployment rate below its full-
sheet. Typically for the U.S., these have been either
employment threshold. Tight labor conditions will keep
financial imbalances or policy-driven tightening, which
wage growth healthy, which is critical to maintaining
have often been exacerbated by catalysts such as
current levels of consumer spending. A potential
commodity price spikes or geopolitical shocks like the
structural improvement to the economy may also
terror attacks of September 11, 2001.
come from an uptick in productivity growth. Output
In analyzing financial imbalances today, we note that per hour of non-farm business sector workers averaged
corporate debt coverage ratios are generally healthy, 1.45% on a four-quarter moving average in the third
though balance sheets are certainly more levered than quarter and beat the 1.3% average registered so far in
they were earlier in the cycle. Consumer balance sheets the expansion (exhibit 9).
also appear to be in good shape, and the savings rate
is nearly 8%, indicating that the average household is
better prepared for the next stage of the cycle than it
The structural challenge of an aging population
A key structural challenge facing the world economy is of a major growth driver. As an example, the annual
the reality of an older and aging population. In contrast potential growth of U.S. real GDP averaged better than
to the post-WWII baby boom, the U.S. and most other 4% a year between 1950 and 1970. Today we face the
developed economies face slower rates of population prospect of just 1.8% potential growth annually over
growth. Declining fertility rates have pushed the the next decade, according to the Congressional Budget
birth rate below replacement levels across nearly all Office. In Europe and Japan that number will be far
developed economies, as well as many emerging ones, lower. While this may lead to a structurally lower growth
resulting in much slower population growth. In many path, for real estate investors the picture is much
cases, populations are declining—especially in the more nuanced with a variety of different investment
important working-age segment—depriving economies opportunities that we will discuss later in this report.
12 Inside Real Estate 2020Chapter 1: Continued
Exhibit 9: Worker productivity is trending upwards
Non-farm output per hour (Quarter-over-quarter, % chg.)
Four quarter moving average Non-farm output per hour
10
8
6
4
2
1.45
0 -0.3
-2
-4
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: National Bureau of Economic Research, Principal Real Estate Investors, September 2019.
Headwinds, however, are on the horizon, mirroring some of the challenges facing the global
economy, though some are unique to the U.S. Primarily, the impact of the 2017 tax stimulus
has worn off, reducing the incentive for U.S. corporations to invest with the result that real
private fixed investments have shifted downwards. The labor market, which we believe is a point
of strength for the U.S., is slowing along with the number of hours worked—though it is too
early to determine whether nascent signs of broader deterioration or the lack of a more vibrant
labor pool are responsible. If it is indeed the former, persistent weakness in the labor market
could start to impact consumer spending and put further pressure on corporate profits already
facing a material slowdown. The importance of sentiment, be it consumer or business, will take
on a greater role in an environment where policy-making is fraught with traditional as well as
idiosyncratic challenges.
“
The Fed has, and will, play a meaningful role, though the
efficacy of its policies will increasingly come to be questioned in
an environment where problems center around risk avoidance,
aggregate demand, and capital expenditure needs. With the
With the eurozone under
eurozone under even greater pressure, we expect the U.S. to even greater pressure, we
”
modestly outperform in 2020, which is a change from our 2019 expect the U.S. to modestly
outlook when we expected the growth trajectory between outperform in 2020 ...
the two regions to drift closer together. While that did occur,
unfortunately both markets saw growth shift lower as well.
Inside Real Estate 2020 13Chapter 1: Continued
2. European economic outlook
European economic performance entering 2020 remains slow and bifurcated. The collateral
damage from the U.S.-China trade war has hit Germany, Europe’s largest economy, hard.
Meanwhile, uncertainty around Brexit has whittled away consumer and business confidence in
the UK. France, Spain, and Portugal have held up quite well but appear to be losing momentum
as the global manufacturing sector slows. We do not anticipate a quick turnaround for the
manufacturing sector amid slower global demand. With Europe more exposed to the sector than
the U.S., this poses a significant threat to growth.
There are some positive signs, however, such as the consumer and services sectors that support a
brighter economic outlook in 2020. The strength in the labor market persists, and wages continue
to climb. Consumption has also underpinned respectable retail sales, which have sustained
above-average performance. Furthermore, consumer confidence remains above its long-term
average and is indicative of expansionary conditions. Performance in the consumer sector is
driven primarily by the resiliency of employment in the services sector, which continues to thrive
with unemployment at 7.4% across the eurozone (exhibit 10). At the end of the day, real estate—
particularly office and retail—is more dependent on services than manufacturing, a reality that is
even more stark in urban economies where most investment is focused.
Exhibit 10: Eurozone labor market remains healthy
Eurozone employment and unemployment
Eurozone unemployment rate [L] Eurozone employment, Y/Y chg. mil. [R]
13 4
3
12
2
11
Unemployment rate (%)
Employment change
1
10
0
9
-1
8
-2
7
-3
6 -4
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: Moody’s Analytics, Eurostat, Principal Real Estate Investors, June 2019.
14 Inside Real Estate 2020Chapter 1:
2: Continued
Germany is the key cog in the eurozone economy, EU federal policy point to the many challenges that lie
where the export industry continues to face headwinds ahead. Geopolitical fault lines can cause real economic
from global uncertainty and both slower domestic damage. According to a recent analysis, the uncertainty
and foreign demand for its goods. Persistent external around Brexit has cost the UK economy approximately
weakness could bleed into consumption and labor £70 billion in real growth over the past three years.2
markets, which in turn could trigger a negative cycle
In a positive development, Britain is expected to finally
of private sector investment. To counter the growing
see a way out of the European Union with the risk of a
weakness, the ECB further cut its deposit rate and
hard Brexit now greatly diminished, though not entirely
embarked on additional bond purchases with the
eliminated. While the political situation is fluid and will
clear intent of maintaining low borrowing costs for
likely take a convoluted route to the end game, the
businesses and consumers. In order to truly make
most significant concern for both Britain and the EU—a
monetary policy more effective, substantive fiscal
hard Brexit—looks remote and thus should remove a
stimulus is likely to become necessary across many
material headwind to growth and investment activity
European nations. So far, only the Netherlands has
in 2020. Clarity on Britain’s future would be positive for
stepped up while Germany and France appear hesitant
risk assets such as commercial real estate, with London
to deploy the necessary support.
in particular, a prime beneficiary of improving tenant
Manufacturing weakness notwithstanding, political and and investor sentiment.
economic uncertainties are the primary challenges to
Europe. Apart from Brexit, growing nationalism—such
as right-wing protectionist governments (e.g. Poland’s
Law and Justice (PiS) party)—or outright challenges to
2
Centre for European Reform, October 2019.
Inside Real Estate 2020 15Chapter 2
Commercial real estate outlook
A decade of modest but positive economic growth, low interest rates, and strong
gains in occupancy has created a Goldilocks environment for commercial real
estate globally. Occupancy rates are generally well above equilibrium, and the
outlook for space absorption remains quite strong despite the slowing of many
major economies. In an environment with low yields, global capital has remained
plentiful for commercial real estate, pushing property values higher across most
markets. Unlike previous cycles, loan underwriting has been generally prudent, and
securitization disciplined, leading to lower systemic debt worries (so far) and credit
quality superior to what real estate has been accustomed to over extended cycles. As
a result, most property types are either in expansion or late-cycle phase (exhibit 11).
Exhibit 11: More sectors transition to late-cycle phase
Europe office
Europe industrial
Recovery Expansion
phase phase
U.S. retail
Contraction Late-cycle
phase phase
U.S. industrial
U.S. apartment
UK office U.S. office
Source: Principal Real Estate Investors, November 2019.
Absent too has been the rash overbuilding commercial real estate investors are
accustomed to dealing with during long cycles. More discipline in the debt market
(largely a result of a much more restrictive regulatory environment) has helped limit
development globally, despite the emergence of high-yield debt funds over the past
several years. That said, we are starting to see signs that forward completion rates
may create issues in some property types. For the time being, office, industrial, and
multifamily markets appear in balance, and capital markets are operating efficiently.
Both sales volume and pricing have shown some signs of moderating, which are
typical indicators of late-cycle market dynamics with investors worrying over the
potential landing spot for the global expansion.
16 Inside Real Estate 2020Chapter 2: Continued
U.S. occupier market should stay firm
The current situation for commercial real estate in the commercial real estate demand and performance.
U.S. is healthy. From an investor perspective private What we lack in knowledge about when and how
equity real estate remains competitively priced. the current cycle will end, we can make up for with
Although prices have long surpassed replacement our understanding of where commercial real estate
costs, new supply has broadly remained contained, and, fundamentals and capital markets are today.
where it is evident, it is in markets and property types
Whether space- or capital-market fundamentals, by
that are most adequately prepared to absorb it. With
most measures commercial real estate is in a vastly
the notable exception of the retail sector, occupancy
better position today than it was in any of the prior
levels are at a two-decade high, and rent growth has
three cycles. First and perhaps most important, new
been well ahead of broader inflationary benchmarks.
supply has been both measured, and focused, during
As the expansion ages, asset-level appreciation will
the past decade. In the office and industrial sectors
moderate, and investors will see performance converge
particularly, supply has been slow to manifest as a
further toward income yields.
result of high levels of vacancy and rent declines
As we look toward 2020, the primary difference during the GFC (exhibit 12). Office has only recently
between our outlook now and that of the past few seen development numbers that remotely approach
years is the impending probability of slower growth its historical averages. With the exception of a few key
in the U.S. Recession probabilities have risen over the gateway markets such as New York and Boston, the
past 12 months, and traditional signposts suggest focus has largely been on west coast technology hubs
that the current cycle will not last in perpetuity. More that have experienced significant economic and labor
important for U.S. investors, however, is how slower market growth that has justified proportionally higher
growth or a potential downturn will translate into crane counts.
Exhibit 12: Market supply largely balanced across property types
Completion rates index (100 = historical average)
Apartment Industrial Office Retail Historical average (1999 Q3 - 2019 Q3)
300
250
200
150
100
50
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: CBRE EA, Principal Real Estate Investors, September 2019.
Inside Real Estate 2020 17Chapter 2: Continued
Industrial demand is strong, but we are watching supply
Occupier demand for industrial assets has been very robust, which unsurprisingly has led to
a pickup in new development. Although not yet a material concern, industrial development
has begun to trend slightly above its long-term average. While this has yet to manifest in any
material increase in vacancy rates, there are signs of softer demand emerging in some markets
that has resulted in a plateau of occupancy rates through the first half of the year. Notable
markets such as Orange County, Oakland, Boston, and Nashville have shown signs of softer
demand over the past two years. However, our demand outlook for industrial remains favorable,
owing to e-commerce growth, which has been a tailwind for the industrial sector. While supply
is not yet a problem, we want to be on guard against investor optimism not being offset by
adequate tenant demand. This mismatch could be particularly problematic in this relatively easy-
to-build property type.
While industrial—and warehouses in particular—has been the top performer so far as income
growth and appreciation are concerned, the apartment sector continues to be one of our primary
defensive investment recommendations. Record levels of new supply notwithstanding, apartment
investors have remained active, accounting for more than a third of all transaction volume year
to date, with sales up 26% on a year-over-year basis through the first half of 2019. From a space
markets perspective, low vacancy and sustained rent growth have helped drive continued growth
in appreciation, particularly in the low-rise and garden sectors—a rough proxy for affordable
housing. In fact, garden style apartment returns are behind only industrial, based on total returns
in the last 12 months, and have seen appreciation, and income returns hold steady over the past
several quarters, even as pricing for workforce and affordable housing has caused cap rates to
compress significantly as the cycle has matured (exhibit 13).
Exhibit 13: With the exception of retail, returns have held steady
NCREIF NPI annualized total returns (%)
16
Industrial
14
Ind. R&D
Ind. Warehouse
12 Ind. Flex
3-year total returns
10 Apt. Garden Ind. Manufacturing
Apt. Lowrise
Apartment
8
Ret. Neighborhood Ofc. Suburban
Ret. Power Center
6
Ret. Community Office
Ret. Super Regional Mall Line of equivalence
4 Ofc. CBD
Apt. Highrise
2 Retail
Ret. Regional Mall
0
-2 0 2 4 6 8 10 12 14 16
1-year total returns
Source: NCREIF, Principal Real Estate Investors, September 2019.
18 Inside Real Estate 2020Chapter 2: Continued
The retail sector remains maligned, not only because of the structural
shift away from traditional brick and mortar formats, but also due
to several decades of overbuilding and an aging, high-cost mall
“
subsector, which has recently fallen on hard times. Until just three
years ago, super-regional and regional malls were considered one of
the stronger subtypes within the institutional universe and provided The retail sector
consistently high returns with a relatively low beta compared to the
remains maligned ...
office and industrial property types. The shift began in 2016 when
several traditional mall tenants, particularly mid-level commodity due to several decades
sellers, began to lose ground more rapidly to online merchants. of overbuilding and
”
Though this was widely viewed as a generic retail problem, malls were an aging, high-cost
hit the hardest, particularly regional malls that were considered below
mall subsector ...
class A in quality. If there is one upside for retail looking forward, it
is the lack of development with barely a handful of malls built in the
U.S. during the last decade. Still there is much more work to be done
as several obsolete malls and retail centers will face repurposing over
the next several years while investors consider a new highest and best
use for many of these sites. Exhibit 14 tracks the performance of U.S.
malls versus other property types.
Exhibit 14: Mall performance has declined precipitously since 2016
Total return, Y/Y change (%)
All property Regional mall Super regional Apartment Industrial Office Retail
25
Regional and super regional
20
malls lead the way
15
10
5
0
Value declines sink returns
-5
2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: NCREIF, Principal Real Estate Investors, September 2019.
Inside Real Estate 2020 19Chapter 2: Continued
Investment appetite, ultimately, is perhaps the best barometer of sentiment, and, following a slow
start to the year, transaction activity has remained on par with 2018. Single asset sales—perhaps
the best indication of the market’s underlying strength—remain healthy despite the lack of entity-
and portfolio- level sales we saw last year. Office, industrial, and apartment properties continue
to trade near or above volumes seen last year over the same period, while retail sales are down
significantly. The dearth of retail activity relative to 12 months prior is not entirely surprising, as
2018 was a year marked by large portfolio deals, particularly malls. Although interest rates—
particularly the 10-year treasury yield—have fallen in recent months, relieving some pressure on
relatively tight spreads, cap rate compression has moderated. Such stable capital flows are a sign
of investor confidence, and our anticipation is for ongoing strength in real estate transactions but
with a heightened focus on asset and market quality.
Europe’s heterogeneity is a strength for real estate
Given the heterogeneity of Europe, it is more difficult appears to be slowing—particularly in the office and
to quantify the property market in broad strokes, industrial property types with rent inflation that is on
as market-by-market performance varies greatly par or better than broader inflationary trends (exhibit
given macro-level trends. However, viewed at the 15). Also important to note is that Europe’s major
regional level, continued strength in tenant demand markets have experienced faster economic growth
(seemingly disconnected from the worries in capital than national level statistics imply. This is important in
markets so far) has positively impacted space market the context of global investors that tend to favor larger
fundamentals in Europe with prime vacancy declining and more liquid markets. Investment performance has
to 6.8% as of late 2019, according to CBRE, which also held steady and compares well with those in the
is the lowest it has been since before the GFC. Rent U.S. over the past 12 months, at least insofar as large
growth has also been impressive—though it now primary markets are concerned.
Exhibit 15: Moderating but positive rent growth outlook for Europe
Eurozone prime rent, Y/Y change (%)
Retail Industrial Office Combined
12
10
8
6
4 3.9%
2 2.3%
0.8%
0
-1.1%
-2
-4
-6
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: CBRE ERIX, Principal Real Estate Investors, June 2019.
20 Inside Real Estate 2020Chapter 2: Continued
Office rents surprising to the upside
In somewhat of a positive surprise—since office have remained largely stagnant. London continues
rents tend to move in a more stair-stepped fashion to face the challenge from uncertainty around Brexit,
in most continental European markets—rent growth which has weakened investor appetite (barring
has been stronger in a number of key markets on trophy acquisitions) and has also started to take
the back of declining vacancy rates and restrained a toll on office rents in some submarkets. Office
office supply, giving landlords greater pricing power. development across Europe has been sparse through
Geographically, the spread between growing and the current cycle. Despite the headwinds from slower
slowing (or contracting) markets has continued to economic growth at the national level, the sustained
expand with markets like Amsterdam, Madrid, Berlin, expansion in many metropolitan areas has translated
and Paris (Center West) all posting annual office in increased office demand, rental growth, and
rent growth within the high-single or low- double declining vacancy (exhibit 16). These fundamentals
digits over the past 12 months; meanwhile, several should hold up through the short term, extending the
markets like Dublin, Zurich, and London (West End) office cycle for now.
Exhibit 16: European office development has been restrained relative to the pre-GFC cycle
Cumulative change in office stock pre-GFC vs. current cycle (%)
Cumulative 2004 – 2008 Cumulative 2014 – 2018
15
10 Source: CBRE-ERIX, Principal Real
Estate Investors, September 2019.
5 Note: Markets where the cumulative
change in stock is negative from
0 2014 through 2018 reflect space
conversions in order to correct
-5 overbuilt markets. In most cases,
excess stock was converted to
-10
residential and hotel uses.
nd -
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a
id
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on
ila
ic
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da
Pa
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Be
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W on
Li
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Br
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Ba
Fr
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Though logistics continue to perform well, we investment perspective, in recognizing the inherent
are concerned that investor enthusiasm may be strength of industrial/logistics, we continue to favor
outrunning occupier demand. In some markets, this property type, but strongly advocate markets with
occupier demand has paused—a direct result of slower high barriers to entry for new warehouses and logistics
economic activity across the eurozone. Markets with hubs. As an example of such a strategy in Spain, while
high levels of completions relative to their historical both Barcelona and Madrid have seen strong rental
norm have begun to see rents soften. That said, yields growth, going forward we prefer Barcelona due to
continue to compress and should enhance capital space expansion limitations.
values over the short to medium term. From an
Inside Real Estate 2020 21Chapter 2: Continued
Heterogeneity in retail is a good thing
Exhibit 17: Not all e-commerce is equal
The retail sector has been under tremendous pressure not
across Europe
least because of the rapid growth of e-commerce. While
E-commerce and retail sales
the U.S. is the poster child of how quickly a property type
Offline sales Online sales can fall from grace, European retail has been more resilient
though signs of weakness in tenant credit are appearing. The
Germany 11.0% heterogeneity of Europe’s retail market, its shopping culture,
and strict regulations against new supply have been factors in
France 8.8% limiting broader damage from e-commerce thus far. Analyzing
e-commerce, the varying online shopping levels of European
UK 17.0% markets can be seen clearly (exhibit 17). Some countries
such as Germany, France, and the UK have well-developed
Italy 5.2% internet infrastructure, e-commerce operators, and established
distribution networks. In such markets, traditional and
Spain 4.6% commodity retailers are likely to face pressure similar to that
being experienced by their U.S. counterparts. In such markets,
Poland 6.8%
we recommend that investors focus their retail strategies
on necessity formats and markets where brick and mortar
Netherlands 13.7% E-commerce %
of Retail Sales shopping is more culturally ingrained.
Sweden 9.5% However, it is the diversity of Europe that may make retail
a strategy worthy of investor consideration. Not only is
Portugal 3.7% e-commerce penetration disparate across different countries,
but the cultural approach to the shopping experience also
Czech Republic 11.1%
varies widely. In many countries, the city center remains a focal
point for communities to gather, and, thus, retail centers in such
0 100 200 300 400 500
locations continue to generate strong demand. Consequently,
Total retail sales (Euros, Bil.)
the retail sector is where investors need to carefully balance
the growing spread of e-commerce with cultural norms and
Source: CBRE, Forrester Analytics, Principal Real Estate Investors,
November 2019. regulatory oversight when evaluating opportunities.
22 Inside Real Estate 2020Chapter 2: Continued
Europe remains a global investor target
Perhaps the best testament to the health of a market is investor sentiment, and Europe continues
to remain a strong global destination for real estate investors. Transaction volumes in Europe on
a 12-month trailing basis remained well above historical average (exhibit 18). Strong appetite for
office and industrial properties, particularly in key global markets and in Eastern Europe, have
helped drive capital flows and kept the market liquid. Moreover, European investors have sold
more commercial real estate than they have bought in the U.S. for the first time in seven years—
perhaps a sign that they see the potential for relatively superior opportunities in their home
markets compared to key global gateway markets that appear to be fully priced.
Exhibit 18: Transaction volume remains healthy
Europe transaction volume ($ billion)
Sales volume, 4Q total ($ billion) Historical average (2007-2019)
400
350
300
250
200
150
100
50
0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: Real Capital Analytics, Principal Real Estate Investors, September 2019.
*Includes property or portfolio sales of $10 million or greater across apartment, industrial, office, retail and hotel property types
A fuzzier outlook but real estate is relatively well positioned
Our real estate outlook for 2020 is a little fuzzier than the previous year. Unlike prior cycles,
however, this sentiment has less to do with excesses in speculative leasing, development,
or lending and more to do with the global crosscurrents of volatility and our confidence in
predicting the economy’s path. In fact, the state of the market today is reasonably well-balanced
between occupier demand and capital markets. Barring a global recession, we expect tenant
demand to remain healthy, supporting our base case of slower but sustained growth.
Inside Real Estate 2020 23Chapter 3
Tactical real estate opportunities
In this section, we try to identify pockets of relative value that Exhibit 19: Late in the cycle, higher relative
investors may consider across quadrants, recognizing that returns will require higher relative risk—
markets are inefficient, idiosyncratic, and can offer sources of our four quadrant total return expectations
additional return while mitigating portfolio risk. We overlay for the next 12 months
the areas we see as providing the most opportunities in
2020 with the base premise that the global economy will Private Real Estate Equity Forecast range
slow, with a heightened vulnerability to potential shocks. Core
Our base case establishes a defensive bias where we favor
U.S.* 5-6%
debt over equity opportunities whenever possible along with
Europe (ex-UK) 6-7%
a clear preference for quality. We also prefer private over
public markets since the latter tend to lead and exhibit much
Value-add
higher volatility (particularly in an environment where capital
market uncertainty is likely to be high). Our focus remains on U.S. 7-8%
markets and property types where net operating income (NOI) Europe (ex-UK) 7-9%
growth is strong since we expect it to be the primary driver of
investment performance over the next 12 to 24 months. Opportunistic
U.S. 12-14%
With investment returns across geographies and strategies
narrowing, we continue to suggest that investors consider a Europe (ex-UK) 12-14%
barbell strategy pairing two distinctively different risk-and-
Private Real Estate Debt
reward buckets. On the core, low-risk spectrum, we favor high-
yield real estate debt and private real estate with strong credit Core
and lease durations attached. On the high-risk, opportunistic U.S. 2-3%
spectrum, we continue to favor shovel-ready development
Europe (ex-UK) 1-2%
projects given strong margins. Our expectation for total
returns by quadrant can be seen in exhibit 19 to the right. High-yield
“
U.S. 6-8%
Europe (ex-UK) 5-6%
Our focus remains on markets and Public Real Estate Equity
property types where NOI growth is U.S. 4-5%
strong since we expect it to be the Global 5+%
”
primary driver of investment performance
over the next 12 to 24 months. Public Real Estate Debt
U.S. 4-5%
Source: Principal Real Estate Investors, November 2019.
* Includes 20% leverage
Exhibit 19: The forecasted return ranges are not intended to predict future events or guarantee the return of any fund or strategy managed by Principal Real
Estate Investors. These ranges do not reflect any deductions for investment management fees or expenses that would reduce the actual returns realized
by investors. Investors should keep in mind that the real estate markets are volatile and unpredictable and there is no guarantee that the above forecasted
return ranges will be realized or achieved or that any investment strategy will be successful. This is shown for Illustrative, informational purposes only and
subject to change without notice.
24 Inside Real Estate 2020Chapter 3: Continued
Real estate equity opportunities
Core
Maintain modest preference to eurozone
In 2018, we took the view that core eurozone real and eurozone, with German banks especially strong
estate offered two advantages relative to the U.S. in the latter. The risk premia (measured by cap rate
via (a) lower and more accretive cost of debt capital spreads to bold yields) are higher in the eurozone
and (b) greater rent growth opportunities given the relative to the U.S. (exhibit 20). Yield curve differentials
lag in Europe’s economic recovery. Consequently, we also result in a higher hedging cost for many global
suggested that investors looking for relative value in investors considering U.S. and European opportunities.
the core space consider a modest overweight to the From an occupier perspective, both geographies are
eurozone. Looking ahead at 2020, the fundamental well placed to see rent growth above inflation, though
factors that led to our European preference are some European markets are yet to see rents peak and,
generally intact. With the Fed cutting interest rates thus, offer some upside potential. Consequently, while
and signaling a flexible approach to monetary policy, we acknowledge that the gap between interest rates
the variance in interest rates between the two and rent growth has closed, we give a very modest
geographies has narrowed. However, there is still a edge to eurozone core in 2020 on the back of its cost
material difference in lending costs between the U.S. of capital advantage.
Exhibit 20: European cap rate spreads well above U.S.
All property transaction cap rate spreads, percentage points
U.S. U.S. average (since 2007) Europe Europe average (since 2007)
6
5
4
3
2
1
0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: Real Capital Analytics, Moody's Analytics, Principal Real Estate Investors, September 2019.
Inside Real Estate 2020 25Chapter 3: Continued
Value-add and Opportunistic
A more limited opportunity set
Within the higher risk/return strategies that can offset Our favored opportunistic strategy is developing
the lowered expectations around core performance, shovel-ready projects where entitlement and zoning
we prefer development over value-add. Evidence risks have been removed from the equation. Moreover,
from transaction data shows that the premium we prefer shorter “duration” development periods and,
between value-add and core strategies has narrowed therefore, target property types where the windows
significantly with investors in many instances pricing of stabilization are quite tight (typically multifamily
the latter much like core. A couple of years ago, and industrial projects). We also prefer single-phase
“traditional” value-add strategies (rehab and re-lease) development strategies where the investment outcome
deploying 50+% leverage could be counted on to is not dependent on project delivery over multiple
generate 300+bps of excess return over core. In the years. Investors often ask, does real estate development
current environment that spread premia is very rare to offer enough return to warrant the risk, especially late
find with investors quick to sniff out such opportunities in the cycle? We think it does, provided that safeguards
and reduce the potential arbitrage (cases in point being are embedded in the investment process to help
workforce housing and student accommodation). mitigate construction risk and accelerate the leasing
Value-add opportunities, therefore, are less appealing and stabilization of the asset post completion. We
to us from a risk/reward basis. believe such a controlled development strategy in the
current environment can provide value-add equity risk
with opportunistic equity return potential.
REITs
Performance expected to revert to core after strong 2019
Performance in 2019 was substantially better than where earnings expectations are deteriorating, with the
expectations as global central banks pivoted from a UK as a wild card given Brexit uncertainties and where
tightening to an easing bias during the year, which led recent multiple expansions may not be sustained. This
to significant multiple expansion. However, the outlook suggests a more cautious stance with the potential to
for slower, synchronized global growth is yet to be fully tactically add exposure to REITs when multiples look
reflected in real estate fundamentals as sequential more attractive. Looking toward 2020, total returns
earnings—which typically lag—remain healthy relative across both geographies are forecast to be modest
to other sectors. Regardless, the low cost of debt capital and in-line with core real estate equity performance.
and adequate risk premia (around a 260bps spread over Risk-adjusted returns are likely to be impacted by
sovereign bonds) are supportive. The recent, modest potential volatility as capital markets watch for changes
uptick in earnings growth expectations appears to be in the global geopolitical environment in 2020. From
at odds with moderating economic and job growth. a property type perspective, we continue to prefer
On balance, it appears that the U.S. is still priced for multifamily and industrial, along with niche sectors,
earnings growth in contrast to continental Europe such as self-storage and data centers.
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