Before Donald Trump’s election as U.S. president, pricing of many real estate-related assets generally reflected low discount rates and low funding costs underpinned by modest growth and inflation expectations.
Now market participants are grappling with whether that paradigm – what we’ve called The New Neutral – still holds or if Trumponomics will usher in a “new paradigm” of stronger growth, higher inflation and higher natural interest rates.
While we at PIMCO generally expect the existing paradigm to persist, we believe the tails of the distribution of possible macro outcomes have become fatter; that is, the probability that our baseline scenario will unfold is less certain. With that in mind, it’s important to consider which variable would dominate real estate-related asset prices in the potential new paradigm: higher rates or stronger growth.
Risks and benefits
The obvious risk to prices in a “new paradigm” scenario is higher discount rates, particularly if real rates rise. By extension, higher nominal rates would lead to higher funding costs, which would hurt asset prices. Moreover, real assets may become less attractive relative to nominal assets, particularly if they are less liquid.
The flip side, of course, is higher growth, which would allow for asset appreciation from a combination of inflation and income growth: Think rent growth for multifamily properties or personal income growth for housing (see table). And to the degree that lending regulations loosen, wider access to borrowing could mitigate or even outstrip the impact of higher funding costs.
Investors must be poised for either scenario
Given the uncertainties surrounding these dynamics, along with other geopolitical and policy risks, it’s tough to predict which way the markets will turn. For now, we favor U.S. housing and select multifamily for which the potential for income growth and credit expansion could offset higher discount and funding rates.
Ultimately, however, we believe investors must be prepared to navigate both the existing and new paradigms as well as the rate-versus-growth dynamic. Last year, pockets of market volatility allowed investors to be tactical and opportunistic. While tactical positioning is still necessary, the current market environment may require portfolios, at some point, to lean hard in one direction – particularly at the asset level – to target the desired returns, all while aiming to protect the downside. As such, market indicators such as equity multiples and inflation breakevens bear close watching to help ascertain which way to lean.
Joshua Anderson is a lead portfolio manager for PIMCO’s mortgage and real estate-related opportunistic strategies and oversees European opportunistic investments.