Is private real estate the next comeback kid?

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The Hunt for Red or Blue November has all the makings of a thriller. That said, we may have to wait to learn how the story ends. Although voters in the U.S. cast their ballots tomorrow, opinion polls show a dead heat, and the outcome could be unknown for days or even weeks. U.S. history offers few examples on how investors might respond to a potential delay, but we know markets hate uncertainty.

The most famous deadlocked result in modern times occurred in 2000, when the presidential contest went all the way to the U.S. Supreme Court in Bush v. Gore. In the 24 trading days between Election Day and the Supreme Court’s mid-December decision, the S&P 500 Index fell more than 4% and was down almost 8% by the end of 2000. Circumstances were quite different then, with the election taking place amid a bursting dot-com bubble, a rising rate environment and a weak earnings backdrop. However, U.S. equity market valuations today are uncannily similar to those in early November 2000 — and likely a warning to expect heightened volatility in the near term (Figure 1).

Investors’ preference on the economy: “Land softly and stop carrying a big stick (of inflation).” Last week’s wave of economic data couldn’t be all things to all people, but on balance it offered financial markets some optimism that labor markets (despite impacts from weather and industrial action), GDP growth, inflation and consumer confidence were trending enough in the right direction to produce an eventual soft landing. For any undecided members on the U.S. Federal Reserve’s policymaking committee, these latest numbers may help sway them toward the 25 basis points (bps) rate cut we expect at their post-Election Day meeting.

An improved earnings season may be shaping up. The S&P 500’s blended earnings growth rate for the third quarter improved to +5.1% as of 1 November, up from +3.5% the week prior. While that’s still lower than the +7.6% pace analysts estimated at the end of June, it keeps the index on track for a fifth consecutive quarter of positive earnings growth. Meanwhile, valuations continue to look frothy, with the S&P 500’s forward price-to-earnings (P/E) ratio currently at 21.3x, well above its 5- and 10 year averages of 19.6x and 18.1x, respectively, according to FactSet.

Portfolio considerations

Private real estate states its case

After seven consecutive quarters of negative total returns, the private real estate sector, as measured by the NCREIF ODCE Total Return Index, was up +0.25% in the third quarter of 2024. The extended downturn for real estate had been triggered by the Fed’s aggressive 2022-2023 rate hiking cycle and post-pandemic stress in the office property sector. Now, however, with the Fed having initiated its easing cycle and projecting further rate cuts over the next two years, the interest rate environment should become a tailwind for the asset class. We believe both stabilizing fundamentals and transaction market pricing point to a broad recovery.

A pullback in new construction activity across property types bodes well in the medium term, helping to moderate supply, a positive for rent growth. In the U.S. apartment and industrial markets, new construction starts are at less than one-third of their peak levels in 2021 (apartments) and 2022 (industrial). Meanwhile, the volume of square footage currently under construction has returned to pre-pandemic levels.

Markets experiencing increased demand due to population growth or other structural changes should see occupancies increase in the medium term. Historically, occupancy rates and rent growth are well correlated, offering investors the potential to realize gains from both, as well as from the associated increase in property values going forward.

Portfolio allocations to private real estate may be funded from either equity or fixed income, depending on the investor’s objectives. Since 2000, private real estate has offered competitive returns versus equities, with less than half the volatility and half the number of negative quarters (Figure 2). During the same period, private real estate has outperformed bonds by nearly 3% annualized, with fewer negative quarters and compelling diversification benefits due to the negative correlation between the two asset classes.

With income a larger component of total return than capital appreciation in private real estate, sourcing a portfolio allocation from bonds can be a way to seek improved risk-adjusted returns, while also improving the tax efficiency of the income. Investors may receive up to the depreciated amount of the asset as return on capital, helping to minimize the impact of income taxes. In our view, the private real estate market correction is nearly complete — and now is a good time for investors to take a fresh look at the asset class.