Investors May Have Learned Their Lesson From the Housing Bubble

Real estate is notoriously cyclical. But investors and developers burned by the financial crisis have been so restrained that there are few signs of a bubble even ten years into the bull market, according to PGIM’s real estate arm.

“Investors have been broadly very cautious since 2010, 2011,” managing director Peter Hayes said in an interview. “They’ve been focusing on investments in major markets, on cash flow, looking for core real estate and income producing assets.”

Hayes, who serves as PGIM Real Estate’s global head of investment research, said he doesn’t see worrying signs of bubble behavior, such as huge amounts of capital moving into emerging markets, excessive leverage, or outlandish growth forecasts. 

“It’s a tricky environment that investors find themselves in,” he said. “Do they wait for what they think is an inevitable market correction? Or do they carry on because it’s hard to see what would trigger a turning point? It’s a late-cycle conundrum.”

According to PGIM Real Estate’s soon-to-be released report, “Striking the Right Balance,” the possibility of “a downturn striking before too long seems to have been factored in as an inevitability by investors, encouraging cautious behavior.”

“Unlike prior to the global financial crisis – when escalating risks were explained away with concepts such as ‘the end of cycles’ and ‘paradigm shifts’ – there is little sense that underlying drivers of real estate performance have changed permanently,” the report stated.

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PGIM is recommending that clients diversify their holdings by geography and between debt and equity. The firm is also telling clients to invest around themes such as senior housing and fast growing metropolitan areas with highly educated populations. 

The report noted that while capital raising continues to be strong, more investors are sitting on dry powder, or cash, and waiting for opportunities, such as in the U.K. where investors remain uncertain about Brexit. According to the report, the volume of investment in the U.K. was significantly lower than the preceding five-year average during the fourth quarter of last year and first quarter of 2019, when Brexit negotiations were in the headlines.  

“Investors say, ‘Let’s see if there is news here that will allow us to jump in and take advantage of a dislocation,” Hayes said. Uninvested cash can be a buffer in a downturn as investors take advantage of lower prices. But if cash is idle for too long, asset managers and investors often push to put it to work regardless of the price or quality of deals. Hayes said he’ll be looking at dry powder levels in six to 12 months to see what happens.

PGIM’s report also pointed out that the global debt markets in real estate have changed significantly over the last decade, providing new opportunities. 

“It’s just another way of investing in real estate,” Hayes said. “You focus on income, and get capital protection because of the equity above you. There’s always a case to hold debt in a real estate portfolio. It can mitigate the change in values.”

Like investors, developers have also been prudent, and supply has been constrained. 

“There hasn’t been more development even when rents are at levels that are attractive,” Hayes said. One of the likely causes is the high cost of construction due to a shortage of workers, a scarcity of materials, and tenants that are cost-conscious and looking for efficiencies. 

According to PGIM, there’s been a noticeable lack of exuberance in real estate, constraining some of the worst behaviors of investors in previous cycles. “Everybody has been waiting for a shoe to drop,” Hayes said.