PGIM: an analysis of vintage risk in late cycle investing

In real terms global all property prime capital values have now increased for 36 consecutive quarters, according to PGIM research, which represents a longer unbroken run of growth than at any time since at least 1980.

PGIM says identifying which phase of a cycle the market is in at a given point in time – especially in real time, when the benefit of hindsight is not available – requires subjective analysis.

Certainly, recent signals are mixed:

  • slowing yield compression;
  • modest rate of rental growth, moderating capital growth to their slowest pace since 2013;
  • increased broader market volatility; and
  • economic growth outlook deterioration.

Greg Kane, Executive Director, Head of European Research at PGIM Real Estate, explains:

“The message is clear: there is a risk that global capital values are either already peaking or, at least, are soon to be. Investors are undoubtedly concerned by the cycle, not least as yields are at historically low levels. Pricing in major markets is viewed as expensive and, according to CBRE’s 2019 Global Investor Intentions Survey, two-thirds of investors view prices as being a significant obstacle to acquiring assets, up from about 50% the previous year.

“Concerns that an economic shock could hit real estate values have also risen. Armed with the knowledge that the cycle may come to an end in the near future, the question is: what should investors do about it?

“On a simple level, it is important to remember that downturns differ in magnitude and duration, and also vary significantly across sectors and geographies. Of the four downturns recorded at a global level since 1980, two have been relatively mild with peak-to-trough value falls of 2% to 3% in real terms, which translated into either flat or moderately increasing nominal capital values.

“In part this reflects the benefits of diversification as some individual markets will have fared worse alone. It also demonstrates that a downturn can simply be a pause in market momentum rather than necessarily a full-blown crisis like in the early-90s or the global financial crisis.”

Vintage risk

Investors understand that the point at which they invest in a cycle – often referred to as vintage risk – can play a significant role in determining performance. Of course, it is the peak phases that is of most interest given how the current cycle is progressing for which there is a wide range of potential outcomes, PGIM Real Estate research shows.

Greg Kane, Executive Director, Head of European Research at PGIM Real Estate, explains:

“In an upswing phase, the estimated probability that an investment into a diversified global real estate portfolio would suffer a capital loss in a given year of a five-year investment period is 23%, rising to 33% when investing in a peak. While the analysis points to caution, it does not mean investment activity should cease altogether.

“For short-term investors, there is still plenty of upside potential in a late upswing or peak phase of the cycle, although that depends on not having a severe global financial crisis-style correction. For long-term buy-and-hold investors, the analysis matters less still as the risks of capital value losses diminish significantly once the hold period extends beyond 10 years – given enough time, values tend to recover eventually.

“Given the length of the current cycle, it is understandable that there is growing interest in more defensive real estate sectors – such as apartment and logistics that offer relatively stable income receipts – and in capital structures that offer downside protection.”

PGIM Real Estate’s analysis continues tomorrow.

james.wallace@realassetmedia.com