Inside Real Estate A year of known unknowns Annual strategy outlook for 2021 - Principal Global Investors
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Inside
Real Estate
A year of
known unknowns
Annual strategy outlook for 2021
For Public Distribution in the U.S. For Institutional, Professional, Qualified, and/or Wholesale
Inside Real Estate 2021 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
Senior Director, Research & Strategy
Madhan Rengarajan
Senior Director, Research & Strategy
Jonathan Frank
Manager, Research & Strategy
Sarah Bogus
Manager, Research & Strategy
Jonathan Ling
Senior Research Analyst, Research & Strategy
2 Inside Real Estate 2021
Executive summary
Key themes
Global outlook: A “new normal” for the world economy. Under our base case, the Contents:
global economy will continue down the path of recovery but with a wider range
of possible outcomes. Normalization in advanced economies will likely start in the
second half of 2021 following the distribution of vaccines, though full global herd
4 Chapter 1:
immunity will be further away. We expect the world economy to be dealing with a
“new normal” for a few years. Global outlook
Redefining live, work, and play. New patterns in consumer and business behavior and key themes
are likely to be felt most acutely in commercial real estate, a fundamentally human-
centric asset class. The pandemic has rapidly disrupted long-held behaviors, though
time will tell if changes are structural or deep cyclical. 16 Chapter 2:
Geopolitics is a key theme for 2021. In addition to pandemic-driven uncertainty, Property type
investors will also need to navigate heightened geopolitical risk. Some key events outlook
are the U.S. election, Brexit, ongoing U.S.-China trade-tensions, and Iran-centric
potential for volatility.
Globalization on pause or forever altered? We may be witnessing a cyclical zenith 32 Chapter 3:
of globalization across the world economy which began in the 1980s. Although the
Four quadrant
end of multilateralism is still premature, short-term shifts and dislocations linked
to geopolitical stresses are likely. We are hopeful, however, that long-term trends in relative value
trade, capital, and labor will remain relevant. tactical
Technology: friend or foe? Technology has never been such a formidable disrupter, opportunities
innovator, and facilitator of growth in the knowledge-based economy. A holistic
understanding of changes in applied technology will be critical in examining and
identifying investment opportunities in 2021 and beyond. Investors may need 36 Chapter 4:
to adjust their grading rubric for markets as many workers and employers shift
geographical preference, and new growth emerges.
Conclusions
and opportunities
The digital economy accelerates ESG. The growth of the digital economy has
increased visibility into numerous performance metrics, making businesses and
investors potentially more transparent than ever. Better data, information, and
key performance indicators tied to Environmental, Social, and Governance (ESG)
strategies can bring clarity around risks and opportunities.
Widening income inequality furthered by the pandemic. Already a fraught issue,
the pandemic has increased income inequality sharply, bringing more focus on
differences in job skills and wages. Most white-collar workers have pivoted to
working from home with minimal impact on their livelihood. Meanwhile, less-skilled
workers have suffered much greater loss in employment and wages, not to mention
potential health risks from the COVID-19 virus.
Monetary policy even more dovish, but efficacy in promoting growth may be
waning. If there were any doubts that interest rates will remain low, the pandemic
and ensuing global recession has swiftly erased them. Global central banks, led by
the Federal Reserve (Fed), have embarked on a massive policy response, pushing
short-term interest rates close to zero, though questions on their efficacy in
promoting growth are growing.
Inflation or disinflation—a compelling case for both outcomes. The subject of
many debates and disagreements, inflation will figure prominently in 2021 and
beyond. There is scant evidence of budding inflationary pressures in the short
term. Longer term, it is clear that central banks are committed to promoting and
supporting higher inflation but will need to convince skeptical investors.
Defensive investment strategy amid uncertainty. Heading into 2021, our
investment mantra centers on defensive investments supported by secular growth
in select markets. Structural changes in demand will help balance the uncertainty
surrounding our outlook and may lead to growth in various niche sectors.
Inside Real Estate 2021 3
Chapter 1
Global outlook
A reimagined world and a “new normal”
The arc of history is strewn with moments where the course of human
civilization has changed. When historians look back on 2020, they will label
the pandemic as a true “black swan” event which shaped the way we live, work,
and socialize. It is not yet clear as yet if long-term behavior patterns will be
permanently altered. Yet unquestionably, the short-term consequences of the
COVID-19 pandemic will be felt over the next few years.
Of course, this makes penning a year-end 2020 investment strategy outlook
challenging and open to far greater uncertainty. A confluence of numerous
elements suggest the next few months will be volatile and uncertain: a
material shift in policy framework by the Federal Reserve, limiting price
discovery in risk assets; budget deficits at $4 trillion and growing; ongoing
fiscal support; simmering U.S.-China trade tensions; lingering Middle
East volatility; and swirling questions on Brexit. Rather than give in to the
certainty of uncertainty that lies ahead over our annual outlook, we identify
relevant themes that are likely to impact the global economy and investment
environment in 2021 and beyond.
Building on the gains of 2020
Our base case outlook assumes that the global economy
will continue on a path of recovery but with a wider range of Key takeaway
possible outcomes. We make several assumptions, starting Our base case outlook
with the view that the world does not resort to widespread assumes that the
and prolonged lockdowns which characterized the first global economy will
half of 2020 and disastrously impacted economic output. continue on a path
Instead, localized and regional lockdowns are more likely of recovery but with
responses to virus flare-ups until herd immunity is achieved. a wider range of
While our base case does not include an explicit timeline possible outcomes.
for the successful development of global herd immunity, we
are hopeful that initial vaccination will be underway in early
2021. The catalysts for our upside and downside scenarios
are binary, revolving around infection levels. A surge in case
levels in the winter could force drastic shutdowns, leading
to a more dire outcome. On the other hand, successful
containment would generate a modestly more positive
outlook (Exhibit 1).
4 Inside Real Estate 2021
Chapter 1: Continued
Exhibit 1: COVID-19 drives our global scenarios in 2021
Annual real GDP growth | Percent
10 Asia
8 Asia World
6 World U.S.
Europe
4 U.S.
Europe
2
Asia World
0
-2 Europe U.S.
Baseline Downside Upside
Source: Moody’s Analytics, Principal Real Estate Investors, October 2020
U.S. and Europe: Base case outlook calls for recovery
but with a wary eye to the downside
Global and domestic economic growth plummeted during the first half of
Key takeaway
2020 as Europe and the U.S. imposed dramatic lockdowns to contain the
spread of the COVID-19 virus, leading to peak-to-trough declines of 10% and Although constructive
15%, respectively. Exhibit 2 highlights the steep disruption between pre– on the outlook, we
COVID-19 and current growth forecasts. Thankfully, the severe collapse in are realistic that the
business activity, loss of jobs, and shuttering of small businesses did not have road back will not be
a long-lasting impact on capital markets, which could have resulted in a global linear and is fraught
financial collapse. Swift fiscal and monetary policy actions prevented, or at with uncertainty until
least lessened, the worst effects of the pandemic and have now positioned an effective vaccine is
both regions for a slow recovery rather than a vicious economic collapse. widely adopted.
Exhibit 2: A short recession but a lot of output has been lost
Real GDP level index | Index, 2001 = 100
170
United States
160
United States (Dec 2019)
150
140
Europe
130
Europe (Dec 2019)
120
110
100
90
2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021(f) 2023(f)
Source: Moody’s Analytics; Principal Real Estate Investors, October 2020
Inside Real Estate 2021 5
Chapter 1: Continued
Our base case for both regions is predicated on Virus resurgence triggers the
stability in caseloads, preventing large-scale
lockdowns until a comprehensive medical solution
downside scenario
is found. We also expect strong central bank policy A significant increase in virus activity in the fall and
support to stay in place despite weak political will for winter season or a delayed vaccine is our trigger
additional fiscal stimulus. Businesses and consumers for the downside scenario. Growth starts to fade in
also appear to have adapted to changes required the fourth quarter of 2020 even though large-scale
to keep economies open, though we expect periods national lockdowns are mostly avoided. Under the
of localized shutdowns in the quarters ahead. In downside scenario, job gains fade, and consumer
handicapping the path forward, the U.S. may be spending shrinks, adding additional strain to retailers
better positioned to help lead the global recovery and businesses. Central banks backstop additional
in the developed world. A major advantage is the credit instruments, and the likelihood of additional
coordination between the central bank and fiscal fiscal spending measures increase. Sovereign bond
policy whereas the Eurozone’s nations conduct their yields are likely to hit new lows, and credit stress could
own policy. Moreover, each nation will also need to compare to Global Financial Crisis (GFC) levels. The
reconcile its fiscal balance sheet heading into the ensuing slowdown is likely to result in a double -dip
recovery, while the U.S. Treasury and the Fed can recession in advanced economies, leading to a more
effectively print money to monetize the federal debt, prolonged recovery cycle.
though this may spur the ongoing inflation debate.
After an impressive snapback in third quarter growth, Lower virus caseload and
it is likely the U.S. will see GDP contract by just over
improved medical outcomes lead
4% in 2020, while Europe is forecast to decline by
nearly 6% as the virus surges. Although constructive to a brighter outlook
on the outlook, we are realistic that the road back will
Conversely, successful containment of the virus along
not be linear and is fraught with uncertainty until an
with improved medical solutions are the backbones
effective vaccine is approved and widely adopted. We
of our upside scenario. Consumer confidence soars,
still anticipate annual growth in the U.S. to average
and businesses are able to move to reopen and bring
between 3.5% and 4.0% over the next two years, as it
employees back. Fourth quarter output remains
makes up some of the lost output before reverting to
strong, and the labor market recovery continues with
its long-term potential. Europe, however, has a longer
commodity prices beginning to firm and credit worries
road to recovery and more headwinds to navigate.
diminishing. Long-dated bond yields are likely to
Headline GDP growth is forecast at 3% in 2021 and to
move higher, though central banks are not expected
modestly accelerate further in 2022, provided there
to budge from their highly accommodative monetary
is no hard Brexit. For both the U.S. and Europe, the
stance. GDP growth recovers faster, with the output
acceleration in headline growth doesn’t diminish the
gap recovering by the end of 2021.
fact that the economy will remain below their pre-
“
pandemic capacity for a few quarters. The outlook in
the UK is even more challenged given looming Brexit
For both the U.S. and Europe, the
uncertainty and heavy reliance on the service sector acceleration in headline growth
which continues to face COVID-19 related challenges. doesn’t diminish the fact that the “
As such, we expect the UK to be a relative economic economy will remain below their pre-
underperformer in 2021. pandemic capacity for a few quarters.
6 Inside Real Estate 2021
Chapter 1: Continued
Will an election year cloud the outlook?
The protocols surrounding a U.S. presidential election be governed by potential labor force and productivity.
are well documented and predictable in any normal The most meaningful impact occurs through policy shifts,
election year. However, 2020 is not a normal election which can alter patterns of demand and consumption
year, with a very large number of early and mail in voting where we see significant differences between the two
given health and safety concerns. At the time of writing, parties. We do not expect our scenarios to be materially
it appears that Vice-President Biden has won enough impacted by the outcome of the election in 2021, but
electoral college votes to become President and that the the longer-term direction of the economy could shift
Republicans have held the Senate. The wide variance in depending on which candidate and party emerges
the stated policy objectives between the Republican and victorious. We have outlined the policy paths of the two
Democratic parties makes it tricky to prognosticate the parties along with their longer-term potential impacts for
impact on economic growth and commercial real estate economic growth and the commercial real estate industry.
performance though risk assets have tended to perform We are also aware that many of the policy issues below
well with a divided government. We should point out will require either an aligned congress or widespread
that elections have seldom had an immediate impact on bipartisan consensus, with the latter increasingly rare in
the trajectory of economic growth. Instead, this tends to recent political cycles.
Exhibit 3: U.S. presidential election scenarios and potential impact
Policy Issue Biden Trump
COVID-19 Federally coordinated effort; vaccine by mid-2021 State-led effort; vaccine by mid-2021
Clean energy initiatives; increased focus on government-sponsored
Climate change Further deregulation
enterprise; Paris accord
Create a $2 trn clean energy and infrastructure fund to be deployed Invest in America's infrastructure; establish a national
Infrastructure
in the first term; invest $300bn in domestic R&D high-speed wireless network
Fiscal policy More aggressive Less aggressive
Monetary policy No change No change
Higher taxes on top of income distribution; roll back 2018 Trump tax
Taxes More tax cuts across the board
cuts to corporations
Increased immigration and establish roadmap to citizenship for Block illegal immigrants from taxpayer -funded benefits;
Immigration
unauthorized migrants; restore DACA repeal DACA
Lead multilateral/cooperative approach with allies; strategic
Foreign policy Unilateral approach; continued decoupling with China
competion with China; modified Trans-Pacific Partnership (TPP)
Affordable Care Act (ACA); plan for public option; lower prescription Repeal ACA; lower prescription costs; lower healthcare
Health care
costs; lower medicare eligibility age from 65 to 60 premiums; cover all preexisting conditions
Raise federal minimum wage to $15/hour and index to the median
Labor hourly wage; establish a federal right to union organizing and Return manufacturing jobs from China
collective bargaining for public sector employees
Increased spending on more progressive programs; higher taxes;
Federal budget Maintain spending levels; lower taxes; wider deficit
wider deficit
Impact
Job market Evolves on its own Evolves on its own
Increased trade as a result of more open policy; reduction/ Tariffs and trade war continue; lower flow of goods from
Trade
elimination of tariffs abroad
Near term moderate; longer term sets the stage for moderate Near-term potential for favorable growth assuming
Economic growth
lengthy expansion pandemic is resolved; longer-term growth slower
Continued elevated volatility; slightly favorable overall
More stability in messaging; but slower growth due to less business-
Capital markets performance; further disconnected with underlying
friendly tax policy and more progressive agenda
economy
Near-term price discovery in private market values; longer-term
Commercial real Near-term stability; risk for pricing dislocations when
stronger growth with focus on ESG and demographic themes sets
estate capital market correction occurs
stage for sustained growth; favorable cross-border capital flows
Source: Principal Real Estate Investors, October 2020
Inside Real Estate 2021 7
Chapter 1: Continued
Redefining live, work, and play
“
New patterns of human behavior are likely to be felt most acutely in real estate,
Until the world
a fundamentally human-centric asset class. The pandemic has rapidly disrupted
long-held patterns of human behavior, from mundane tasks like shopping to
achieves a
mass transit. Health and safety concerns have become paramount in everyday comprehensive
life and are having cascading effects on all property types. For example, grocery medical solution to
purchases conducted online have led to a surge in warehouse and cold storage COVID-19, it may
demand. Until the world achieves a comprehensive medical solution to COVID-19,
be safe to assume
it may be safe to assume that current conditions are the “new normal” driving
human behavior and impacting all aspects of commercial real estate. that current “
conditions are the
For investors, the challenge is to decipher where behavioral change is structural
“new normal” ...
or related to health and safety, with the latter potentially reversing when the
pandemic fades. The range of outcomes are wide, making it likely that investors
will take divergent views. For example, an investment in CBD office may be
anathema to one investor but offer significant opportunity for another. Investor
perception will also drive valuations and vary materially by market and property
type. Therefore, our recommendation is to separate structural and cyclical shifts
while defining investment strategies.
8 Inside Real Estate 2021
Chapter 1: Continued
Geopolitics to be a challenging backdrop
In addition to the pandemic, investors will need to navigate a heightened level of
uncertainty around geopolitical, national, and globalization risks in the coming Key takeaway
months, along with growing concern on the policy efficacy of central banks (Exhibit While we don’t
4). Interestingly, the U.S. elections and Brexit are tied to underlying structural expect globalization
themes of nationalism, globalization, and a heightened sense that a golden period of to end, the next few
cross-border trade and collaboration is ending. years are likely to
see shifting alliances
The U.S.-China trade tensions are another ongoing geopolitical risk which is likely
and restructured
to result in collateral damage. The recent events surrounding the Chinese social
partnerships.
media company TikTok is one example of how this stress may impact corporates.
Regardless of the outcome of the presidential elections, trade and intellectual
property tensions between the U.S. and China have risen sharply in recent years and
are unlikely to fade away. While we don’t expect globalization to end, the next few
years are likely to see shifting alliances and restructured partnerships. Therefore,
investors should prepare to reexamine historical relationships and their potential
impact on investment strategy.
Exhibit 4: Key global geopolitical risks for investors to consider
Europe
• Resurgence in COVID-19 cases,
especially in southern and eastern Europe
• Uneven recovery across the continent
Canada • Brexit negotiations
• Accelerating COVID-19 cases
• Risk of a double-dip recession
United States Asia-Pacific
• Election volatility and • U.S.-China trade tensions
potential for limited • Slower growth in China
policy coordination • Uncertainty with North Korea
• Trade and tariffs • India-China border dispute
• Fiscal policy debate
• High risk of COVID-19-
case increase in winter
months
Africa
• Political instability and lack of national
coordination
South America • Less developed infrastructure/risk
• Decline in demand of raw/ will be stressed by a broadening of
intermediate materials the pandemic
• Energy-dependent nations • Chinese investment has dropped
hit hard by continued dramatically since 2017
malaise in crude markets
Source: Principal Real Estate Investors, October 2020
Inside Real Estate 2021 9
Chapter 1: Continued
Globalization on pause or forever altered?
Trade tensions between the U.S. and China have been one offshoot of growing geopolitical stress. We
may be witnessing a cyclical zenith of globalization in the global economy which began in the 1980s
(Exhibit 5). Although it may be premature to declare the end of multilateralism, short-term shifts and
dislocations linked to geopolitical stresses are likely. We are hopeful, however, that long-term trends
in global trade, capital, and labor will remain relevant. Moreover, globalization is not monolithic but
a multi-layered phenomenon. Although a temporary dislocation in global trade flows is likely, it is
difficult to foresee an abrupt end to decades of carefully built relationships. Instead, a resurgence of
regional and even smaller trading blocs may emerge. Real estate investors need to closely analyze
their exposure to global drivers of demand, such as trade, technology, and human capital, to see how
relationships may change. A prudent diversification strategy would involve investors increasingly
opening themselves to potential shifts as new global trade relationships emerge.
Exhibit 5: Has globalization peaked?
World trade as a percent of GDP
65
60
55
50
45
40
35
30
25
20
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
Source: World Bank, Principal Real Estate Investors, October 2020
Globalization also revolves around capital and technology, which are equally relevant to real estate
investors. Both have been impacted by geopolitics and nationalism. However, we are confident
that relative values offered by real estate and an ongoing search for yield will keep global capital
markets and cross-border flows functioning efficiently, particularly in advanced economies. Although
globalization may be disrupted, we don’t necessarily foresee material changes in the long-term trend of
labor mobility. We are watchful for short-term disruptions, such as Brexit, that may create dislocations
and challenges. In turn, this could lead to softness in office and retail demand for cities reliant on deep,
global talent pools. Nevertheless, over the long run, we believe global labor mobility will remain an
important driver of growth and innovation.
10 Inside Real Estate 2021Chapter 1: Continued
Technology: friend or foe?
Technology has always been a great disrupter and has become an even greater facilitator of change
amid the pandemic. Once again, the relationship between technology and real estate is under the
spotlight, forcing the industry to pause and reevaluate. As we have highlighted in our DIGITAL1
strategy previously, innovation and technology will continuously repurpose the use of real estate.
Increasing government intervention and regulation have also accompanied the growing, global
footprint of technology and are unlikely to lessen going forward. Regulation may also impact how
data relevant to real estate investors, such as locational data, is monitored and used.
Technology’s impact will be uneven across markets as businesses and workers assess how to deal
with changes to human behavior. This poses a significant question for commercial real estate: Will
there be a structural shift away from cities that have traditionally pulled a wide variety of labor and
industries? Global gateway cities have historically dominated the commercial real estate investment
landscape with their entrenched networks of industry and labor, creating a virtuous cycle of
growth and regeneration through past cycles. Technology has never before been such a formidable
disrupter and source of growth in the knowledge-based economy. As such, investors may need to
adjust their grading rubric for markets, as many workers and employers begin to exhibit shifting
geographical preference, and new growth emerges. We believe that a holistic understanding of the
changes that applied technology brings will be a critical lens in examining and ultimately identifying
investment opportunities in the years to come.
The digital economy accelerates ESG
The growth of the digital economy has increased visibility into numerous
Key takeaway
performance metrics, making businesses and investors potentially more
transparent than ever. Consequently, this flood of information is allowing the The digital economy,
market to start measuring and assessing the impacts of ESG initiatives. With this paired with data analytics,
increasing availability of performance data, numerous market drivers such as can aid investors in
generational wealth transfer, social and economic anxiety, climate change, and understanding climate
even the pandemic, are coming into sharper focus. This has prompted discussions risks, assessing stakeholder
on sustainability and social governance in the office and also at home. engagement and
satisfaction, capturing
As one might imagine, the digital economy and flood of information raises more pricing advantages
questions than answers at this time. Many owners and investors, therefore, through renewables, and
are working to assess the ultimate value of these measures, new emerging assessing regulatory risks...
regulations, and compliance standards and how to mitigate risks in a market
with high-velocity sharing of information. The digital economy, paired with data
analytics, can aid investors in understanding climate risks, assessing stakeholder
engagement and satisfaction, capturing pricing advantages through renewables,
and assessing regulatory risks (such as the European Union’s commitment with
the Green Deal to cut greenhouse gas emissions by 2050). There is much work to
be done in tying this data to material investment impacts in real estate, but the
foundation is being built today.
1
DIGITAL refers to key long -term growth drivers centered around demographics, innovation, globalization,
infrastructure, and technology that Principal has identified as metrics of long-term market outperformance.
Inside Real Estate 2021 11Chapter 1: Continued
Widening income inequality furthered
by the pandemic
“
The pandemic has increased economic and social inequality sharply, bringing
into focus the differences in job skills and wages. Most white-collar workers
The affluent in the
have been able to pivot from an office setting to remote work with minimal U.S. have been
impact on their livelihood. Meanwhile, less skilled workers have experienced able to socially
much higher unemployment and suffered far greater exposure to the distance better “
COVID-19 virus. A study by the Brookings Institute demonstrated this stark
than those who
divide in skills and wages, illustrating how the affluent in the U.S. have been
able to socially distance better than those who are less affluent (Exhibit 6). are less affluent.
Exhibit 6: The affluent social distance more
Percentage who avoided going to public places, such as stores or restaurants
Percentage who avoided small gatherings of people, such as with family or friends
71
67
62 64
59 56 59
54 51 53
Bottom quintile Lower-middle quintile Middle quintile Upper-middle quintile Top quintileChapter 1: Continued
Monetary policy—will low interest rates trigger growth?
If there were any doubts that interest rates will remain low, the pandemic has swiftly erased them.
The Federal Reserve’s explicit pivot to lower interest rates continues to align with the world’s
central banking response. Central bank policy is fully engaged at mitigating the worst impact of
the pandemic given the political reluctance to provide additional fiscal support. As illustrated
in Exhibit 7, forward curves show that markets anticipate rates will remain low across all tenors.
However, as recent commentary has indicated, the Fed is becoming increasingly concerned that
monetary policy by itself may not be enough to support the ongoing recovery. Instead, it has
indicated that fiscal and monetary policy need to work hand-in-hand to support consumption and
growth in aggregate demand.
Exhibit 7: Forward curves are signaling lower rates for longer
Forward curve projections | Yield, percent
U.S. one-year projection Europe one-year projection
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
0 5 10 15 20 25 30
Tenor
Source: Bloomberg, October 2020
The anchoring of short-term interest rates could be quite beneficial for equity real estate investors,
keeping the cost of debt low. We may even see a return to higher leverage, particularly in markets
where investors anticipate some distress. Conversely, a steepening of the yield curve may also
be positive for real estate as a signal for future growth. Competition is likely to intensify for well-
located and leased assets, with strong sponsors putting a challenging environment in place for debt
investors to achieve return hurdles. We warn against complacency, however, in light of the potential
for inflation to escalate. The Fed has even indicated its desire to see inflation overshoot its 2% target
for a period of time.
Inside Real Estate 2021 13Chapter 1: Continued
Inflation or disinflation—
a compelling case for both outcomes
The subject of many debates and disagreements, inflation will figure
prominently in 2021 and beyond. The Fed has telegraphed its intentions Key takeaway
on letting inflation run hot, which is driving the debate. A key factor If inflation is
therein is the unprecedented fiscal stimulus, worth approximately indeed caused by
$4 trillion between the U.S. and Europe. Central banks have also economic growth,
already seen significant expansion of their balance sheets. Over the the implications
intermediate term, these asset purchases, fiscal support, and a weaker would be positive
U.S. dollar could put upward pressure on consumer prices, particularly for rent growth and
for imported goods and services, and lower real wages. This would occupancy trends.
map with historical periods where significant fiscal outlays and
accommodative monetary policy have been followed by accelerating
inflation amidst an increase in the velocity of money.2 The money supply
has already increased by nearly 10% in Europe and more than 20% in
the U.S. since February (Exhibit 8). There is limited evidence, however,
of budding short-term inflationary pressure. Commodity prices are
reflecting some pressure, but the energy sector has experienced weaker
demand for fuels related to both ground and air travel, and consumer
price inflation remains below target.
Exhibit 8: COVID-19 recession has increased central bank money supply
Change in M2 money supply | Year-over-year percent change
U.S. Europe UK
30
25
20
15
10
5
0
-5
1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015 2019
Source: Federal Reserve Economic Database, Bank of England, European Central Bank, October 2020
2
Milton Friedman wrote, “Inflation is always and everywhere a monetary phenomenon.” According to the widely accepted monetarist view,
inflation occurs because there is too much money available to buy the same amount of goods and services produced in the economy. This view
can also be represented by the “quantity theory of money,” which relates to the general price level, the total goods and services produced in a
given period, the total money supply, and the speed (velocity) at which money circulates in the economy.
14 Inside Real Estate 2021Chapter 1: Continued
Despite the swirling uncertainty surrounding inflation, we do know
that central bank policy is eager to see a return of higher inflation
“
in the long term. For real estate investors, a wait-and-see approach
may not be enough. Instead, it would be beneficial to proactively It would be beneficial
analyze and add assets that may provide some protection against to proactively analyze
high inflation. From our perspective, if inflation is indeed caused
and add assets that
by economic growth, the implications would be positive for rent
growth and occupancy trends. Under this scenario, we expect may provide some “
income growth for lodging, multifamily, and high-quality office to protection against
match or exceed inflation. Industrial properties are also likely to high inflation.
outperform as tenants benefit from secular tailwinds. However, if
rising inflation is not accompanied by strong growth (for example,
some form of stagflation), we would favor property types that
offer defensive, income protection capabilities, such as residential
properties, over the longer term.
Inside Real Estate 2021 15Chapter 2
Property type outlook
A decade of strong occupancy gains has ground to a halt as a result of the COVID-19
pandemic. So far, large government fiscal support programs for consumers and
businesses and the staggered nature of leases have limited distress in occupier
markets. Fortunately, space markets were generally well positioned and in
equilibrium before the pandemic, providing landlords some cushion as rents adjust.
Prudent loan underwriting, accompanied by reasonable valuation assumptions
through the recent cycle in public and private markets, have also lowered systemic
capital market concerns.
Our base case does not foresee wholesale dislocation in occupier markets across
all property types as the recovery continues. However, challenging situations are
expected in property types where tenants remain vulnerable to changing behavioral
patterns without effective medical solutions. Thus, we expect occupancy in property
types that are most exposed to virus mitigation measures, such as social distancing,
to face the most severe challenges. Exhibit 9 illustrates our bird’s-eye view on where
major property types are in the real estate cycle.
Exhibit 9: More sectors are in a vulnerable phase
Contraction Recovery Expansion Late cycle
• Data centers: U.S., Europe
• Cold storage: U.S., Europe
• U.S. office: Primary/CBD
• U.S. retail: Malls and power centers
• U.S. student housing
• U.S. senior housing
• U.S. apartment: Luxury Industrial warehouse &
• Europe gateway office logistics: U.S., Europe
• U.S. office: Suburban
• European office: Second tier
U.S. and European retail: Grocer,
convenience, stand-alone big box
Source: Principal Real Estate Investors, October 2020
16 Inside Real Estate 2021Chapter 2: Continued
Multifamily: Past, present, and COVID-19
Key takeaway workers. Highly competitive amenities, which have
With offices shut or at minimal capacity and been de rigueur in many urban multifamily assets,
amenities unused due to pandemic-related and commanding rent premiums have been rendered
restrictions, paying a premium for an urban unusable due to the pandemic. Urban living, which has
long been considered a prized amenity, is no longer
location appears to be temporarily waylaid.
as valued, with some renters seeking to relocate to
suburban locations, where possible, for health and
Entering 2020, the multifamily sector was well safety concerns or larger living space. This sudden
positioned after a decade of unprecedented change in renter lifestyle has prompted significant
demand. The sector benefited from slow household conversation on the future of multifamily.
income growth relative to more rapidly rising home
prices, especially in gateway markets, which made Rising unemployment—a result of the pandemic—is
homeownership fiscally unattainable for many the most significant challenge for renters and owners.
households. A chronic shortage of mid-range and National and state-mandated regulations, aimed to
affordable single-family homes provided a steady protect renters, have been temporarily enacted yet
pool of renters. Reflecting demographic shifts, Baby have not disrupted rent collection meaningfully. Large
Boomers started to pivot away from home ownership fiscal spending programs in the U.S. (CARES Act) and
to renting particularly in amenity-rich urban markets. Europe (Recovery Fund) have provided much-needed
In short, multifamily was seeing both investor and support in the form of direct payments and increased
occupier appetite prior to the recession. Yet, the nature unemployment benefits. As a result, rent collections for
of the pandemic warrants some caution, and investors multifamily have held up quite well with the hope that
will need to closely follow shifting geographical the economic recovery will begin to alleviate the need
preferences, recent increases in homeownership rates, for government programs (Exhibit 10). Europe has
or a possible slowing household formation. seen even greater support at the national level but also
remains challenged as another wave of virus activity
Multifamily has been particularly impacted due threatens economic activity, leaving some fiscally
to strict social distancing measures and increased sound nations better equipped financially than others.
prevalence of remote working among white-collar
Exhibit 10: Rent collections have benefited from stimulus spending
Percentage of rent payments made by end of month
2019 2020
98 97.7
97 96.6 96.6
96.0 95.9 95.8
96 95.7 95.5
95.1
95 94.6 94.5 94.6
94
93
92
April May June July August September
Source: National Multifamily Housing Council, October 2020
Inside Real Estate 2021 17Chapter 2: Continued
Goodbye cities, hello suburbs?
Many people have flocked to cities over the past and relocating—closer to family or to areas with more
decade—particularly large, urban cores—attracted affordable housing options.
by diverse labor markets, efficient mass transit, and
In addition to location, renters are also relocating
the many social and cultural amenities available. With
to find more space to accommodate the current
offices shut or at minimal capacity and amenities
work- from-home environment. Historically, studios
unused due to pandemic-related restrictions, paying
and one-bedroom units were highly sought after in
a premium for an urban location appears to be
urban locations, but more recent amenities such as a
temporarily waylaid. As a result, never before has such
home office or gym have increased in value to renters.
a large portion of the workforce had the option to
This has also rekindled the urban versus suburban
choose where they want to live, irrespective of their
argument, as there is no better location on a cost-
employer’s office location. A vast majority of these
space basis than the suburbs. Although the data on an
workers are high earners in white-collar positions
exodus to the suburbs are not yet conclusive, it is worth
and are now more mobile than ever. An example of a
keeping a watchful eye as millennials enter a new
prime urban rental market undergoing this dislocation
life stage, and preferences shift toward single-family
is San Francisco, which is seeing the early effects of
home ownership. In fact, the shift out of urban markets
shifting demand as renters move away in light of
could be a temporary phenomenon and quickly revert
numerous employers notifying their workforce that
should employers decide to pull their employees back
they would not return to the office until at least 2021,
to the office. In that sense, it is likely not the opening
if at all. Seemingly overnight, units were sublet, and
of the floodgates but rather an exploratory trial for
rents began falling (Exhibit 11). Unencumbered by
many renters.
cost, these workers are packing up their belongings
Exhibit 11: San Francisco apartment rents come under pressure
San Francisco daily asking rent per square foot | $
4.00
3.95
3.90
3.85
3.80
3.75
3.70
3.65
3.60
3.55
3.50
Jul-17 Jan-18 Jul-18 Jan-19 Jul-19 Jan-20 Jul-20
Source: CoStar, October 2020
Tactical opportunities:
Over the short term, we expect dense, urban gateway markets to be challenged by soft occupier markets. In the
long term, affordability will likely remain a limitation. Our near-term preference would be to identify suburban
locations with larger unit sizes that may benefit from weakness in urban areas. Development strategies around
workforce housing could also be considered in markets where policy support is possible. Additionally, opportunities
may arise in formats challenged by cyclical demand, such as student and senior housing, along with luxury product
in core locations, if accompanied with appropriate price dislocation. Investors seeking a value-add/opportunistic
play could buy back into urban locations in late 2021.
18 Inside Real Estate 2021Chapter 2: Continued
Industrial: Secular demand drivers still in
place but monitoring valuations
In the pecking order of property types over the past decade, industrial
Key takeaway
has been the undisputed champion (Exhibit 12). As a beneficiary of
positive macroeconomic trends and our DIGITAL themes, industrial The industrial sector was
has been the best beta investment strategy of the past decade. The already a major beneficiary
industrial sector was already a major beneficiary of secular trends of secular trends prior to
prior to the pandemic, particularly with e-commerce providing the pandemic, particularly
significant tailwinds to demand. The pandemic has seemed to act as with e-commerce
kerosene on a well-lit campfire, not only speeding up the penetration providing significant
of e-commerce but also increasing demand for niches, such as data tailwinds to demand.
centers and cold storage facilities.
Exhibit 12: Industrial has been an outperformer over the past 10 years
Trailing 10 year return, 2009 – 2019 | Average annual total return, percent
U.S. Europe
12.8
10.2 10.2
9.7 9.4
7.8 8.1 8.0
7.5
6.1
Industrial Apartment Retail Office Hotel
Source: NCREIF-NPI, MSCI-IPD, October 2020
Inside Real Estate 2021 19Chapter 2: Continued
We are confident that some of the secular trends in place before COVID-19
will remain relevant for the industrial sector, although it is likely that some
new patterns of human behavior will persist. For example, the secular growth
in e-commerce appears unaffected, with the pandemic even shifting demand
further in favor of logistics and e-commerce-related warehouses. Through
industrial warehouse demand, driven by e-commerce, we see the themes of
“
value and quality coming together. At a period of heightened economic and
health uncertainty, e-commerce is solving the need for safe, cost-effective, and Through industrial
timely fulfillment of consumer demand. Why should a consumer potentially warehouse
expose themselves to health risks in a physical store if a similar purchase can demand, driven by
be made online? To this point, commodity retail has particularly seen a surge of
e-commerce, we
e-commerce penetration.
see the themes of “
Exponential demand for data centers and cold storage warehouses has been value and quality
an offshoot of health and safety concerns. These niche property types are
coming together.
increasingly becoming more prominent within the broader industrial sector.
With millions of white-collar employees working remotely, the ability to rapidly
scale technology has been facilitated by data centers. While employees are
expected to return to offices once effective medical solutions are found, a
degree of flexible working is here to stay, which is likely to keep data centers
in demand for many years ahead. As Exhibit 13 shows, data needs across the
world continue to grow exponentially.
Exhibit 13: Global demand for data set for exponential growth
Worldwide volume of data | Zetabytes
250
200
150
100
50
0
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020(f) 2021(f) 2022(f) 2023(f) 2024(f) 2025(f)
Source: International Data Corporation (IDC), 2018
20 Inside Real Estate 2021Chapter 2: Continued
Since the pandemic, consumers have embraced online grocery
shopping in order to limit physical shopping. In response to the
surge in e-commerce-driven groceries, refrigerated storage
has become an increasingly important component in the food
“
supply chain, catering to both consumers and businesses.
Until recently, the growth in frozen food has been fairly steady
The uniqueness of
because demand is quite inelastic, regardless of the state of the pandemic and
the economy. However, the uniqueness of the pandemic and newfound concern for
newfound concern for in-person shopping have sharply altered in-person shopping “
demand dynamics. As exemplified in Exhibit 14, U.S. consumers
have sharply altered
have rapidly adapted to e-grocery. It is yet unclear whether this
surge in grocery-driven cold storage is structural or related to demand dynamics.
current health concerns. It is likely somewhere in the middle,
and some consumers will return to in-person shopping when
permitted. There is, however, enough structural change to
continue driving demand for cold storage.
Exhibit 14: E-commerce shifts to e-grocery
Online share of total U.S. grocery spending | Percent
8.2
7.6
7.0
6.3
5.5
4.5
3.4
2016 2017 2018 2019 2020(f) 2021(f) 2022(f)
Source: Brick Meets Click Online Grocery Shopping Surveys, 2016-2019, Brick Meets Click Market Forecasting Model
Inside Real Estate 2021 21Chapter 2: Continued
While a combination of structural and cyclical drivers provides a favorable backdrop for the
industrial sector, we do want to highlight some potential warning flags investors should watch for.
Industrial outperformance continues to attract significant capital, making it increasingly challenging
to execute on strategies around stabilized assets. Core pricing for industrial assets is particularly
strong in gateway markets where investor interest is greatest. We also advise investors to watch for
a mismatch in investor enthusiasm and demand dynamics in certain markets. Prior to the pandemic,
space market fundamentals in the U.S. were showing nascent signs of stress as a result of a surge
in development and waning demand, largely the result of global trade tensions. Imports into the
U.S. from China, for example, were down 50% on an annual basis in 2019. Although some of this can
be attributed to early stages of shutdowns resulting from the COVID-19 outbreak, this can also be
attributed to protective tariffs and trade disputes between the two governments. Global trade itself
has also entered a period of stasis, and we recommend that investors stay on watch for potential
weakness in markets that may be overly exposed to the ongoing trade conflict (Exhibit 15).
Exhibit 15: Global trade has taken a step back
Trade as a percentage of GDP | Index, 1970 = 100
U.S. East Asia & Pacific Europe & Central Asia
290
270
250
230
210
190
170
150
130
110
90
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018
Source: World Bank, October 2020
The pandemic’s massive disruption appears to currently favor
Tactical opportunities: the industrial sector, although long-term changes to the occupier
landscape are yet unknown. We strongly suggest closely watching
Traditional industrial continues
for changing patterns of behavior in the years ahead and the
to outperform and remains well
impact of this change on demand. Will top-performing industrial
supported by secular and cyclical
markets still be located near large coastal markets with large,
demand drivers. However, given
the weight of capital continuing affluent population centers? Or, will we see shifts toward a more
to seek exposure to this sector, we decentralized model, generating demand for industrial assets in
suggest a build-to-core approach previously overlooked markets? Will advancements in technology
where possible to achieve core, make location less relevant going forward? Other factors, such as
stable assets. Furthermore, we national or perhaps state-level fiscal outlooks, will also become
also highlight niches—such as data vital in identifying industrial opportunities. The uncertainty
centers and cold storage—within the around such issues will need to be balanced with the strong
industrial sector as a way to access fundamental demand outlook for industrial properties. This will
emerging secular trends. undoubtedly create opportunities but also require some skilled
navigation in 2021 and beyond.
22 Inside Real Estate 2021Chapter 2: Continued
Retail: No shortages of challenges ahead, but strong price discovery
may unearth selective opportunities
Key takeaway By late 2019, these large retail formats had seen a
“Eatertainment” destinations have been material deterioration in space and capital market
hard hit as their business models cannot fundamentals even as e-commerce continued to make
easily adapt to social distancing restrictions steady inroads. The damage to larger retail formats in
the Eurozone has been slower to materialize, though
and lockdown measures.
there are now signs of tenant weakness emerging.
Similar to the U.S., large format retailers in the UK
The retail sector was on shaky ground entering 2020, are under increasing stress. Common across the
and the pandemic has dealt it a sharp blow with board, however, is a large number of transnational
potentially far-reaching consequences. Alongside and regional operators requesting rent relief and the
office, retail real estate is a very people-centric announcement of additional store closings.
property type and is heavily reliant on continuous
human footfall. While there are signs of resiliency Investor concern is mounting, and both public and
in some formats, our view is that the current private market data suggests material stress may
environment will continue to present significant lie ahead, particularly for large retail centers with
challenges to the broader retail sector. The outlook commodity retail tenants. For the U.S., data from Real
is perhaps a touch more favorable in the Eurozone, Capital Analytics reveal a drop in real estate sales
given the differences in structural formats and lower volume beginning in early 2019 with a -25% year-over-
retail density, though the UK faces many of the same year change in transactions. As COVID-19 shut down
challenges as the U.S. activity, sales volumes dropped 70% year over year. In
Europe, transaction volumes were down 37% through
Structurally, the retail sector had been struggling with the end of the second quarter. Large malls in the U.S.
two primary headwinds: an increase in e-commerce have seen private appraisal values decline by 10% to
penetration, particularly in commodity retail products, 12%. In Europe, big-box retail has thus far exhibited
and an increase in financial stress among retailers. the smallest decline in value this year, boosted by
In the U.S., these structural challenges have been home improvement sales. However, the damage is
compounded by a significant oversupply of physical likely not over, if signals from the public market are any
retail that came to a head in 2016 with a spate of indication as they signal additional loss in values for
retail bankruptcies stressing large shopping centers. private real estate investors (Exhibit 16).
Exhibit 16: Retail real estate returns in the public market
1-year REIT total return | Percent
-18.3
Developed -22.4
Asia Pacific
-49.2
The Americas
-64.8
Europe Middle East & Africa
Source: FTSE EPRA NAREIT, September 2020
Inside Real Estate 2021 23Chapter 2: Continued
A key challenge for existing brick-and-mortar retailers is their high cost structure, particularly at
a time when value and convenience are highly prized for health and safety. E-commerce, already
a beneficiary of structural tailwinds, has been a clear winner. However, given the tight margins for
online retail, it is not yet clear if the current surge toward e-commerce represents a permanent shift
or a temporary dynamic. Nevertheless, online shopping provides consumers a safe and convenient
choice at reasonable value when it is needed most. Price transparency and dynamic pricing strategies
have also given a significant edge to e-commerce operators. Prior to the pandemic, brick-and-mortar
stores generated nearly 90% of total retail spending, and e-commerce was forecast to make up over
15% of total retail sales in the next ten years. The pandemic has shifted consumer behavior and may
push that figure upwards of 25% in the U.S., with a similar trend in the UK (Exhibit 17).
Exhibit 17: E-commerce is forecast to gain market share rapidly
E-commerce sales | $ Billions [L], Share of sales, percent [R]
Annual e-commerce sales [L] % of total retail sales [R] COVID-19 structural shift [R]
1,600 25
1,400
20
1,200
1,000 15
800
600 10
400
5
200
0 0
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020(f) 2022(f) 2024(f) 2026(f) 2028(f) 2030(f)
Source: Moody’s Analytics; U.S. Census Bureau, June 2020
A more recent success, experiential-oriented retail has been severely undermined by the pandemic.
“Eatertainment” destinations have been hard hit as their business models cannot easily adapt to
social distancing restrictions and lockdown measures. Some retailers are trying to adapt to remain
relevant amid these restrictions. For example, movie theater operators are setting up mobile screens
in empty mall parking lots, so customers can socially distance while watching a film. Customers can
connect to audio through an application on their cell phone and order food for delivery from the
mall food court. Other retailers have converted vacant space to a “ghost” or virtual kitchen which
provides additional production space to restaurant operators to meet their take-out and delivery
demand. Virtual kitchens condense the restaurant model to accommodate off-premise food sales
without providing traditional dine-in space. Such adaptations, however, do not make up for the full
experience retailers have developed and rely on. In this sense, they are unlikely to ultimately provide
comprehensive economic relief to most landlords.
24 Inside Real Estate 2021Chapter 2: Continued
But not all is lost in retail. Certain formats—grocery-anchored stores, convenience retail, and
discounters—have held their own even in the face of rising e-commerce and the pandemic.
Clearly, not all retailers are equally vulnerable to online shopping. The International Council of
Shopping Centers (ICSC) found that discount department stores showed the highest average share
(96%) of in-store spending over a three-year period, from 2016 to 2019. Automotive products
and food/beverage categories have the lowest level of e-commerce penetration while over 20%
of clothing and clothing accessories sales are online. Europe’s convenience and discount retail
formats have remained resilient and continue to generate reasonable sales given the enormous
heterogeneity of markets.
Furthermore, traditional retailers have responded by enlarging their value proposition as
well as considering more drastic strategies to ensure survival. Traditional retailers are making
sizeable capital investments into digital platforms while expanding order fulfillment and delivery
capabilities. Brick-and-mortar retailers are also aggressively expanding their omni-channel footprint
to position themselves competitively and drive sales between digital platforms and physical space.
According to the ICSC’s 2019 report “The Halo Effect II,” 62% of online apparel shoppers prefer to
pick up their merchandise in the store, which creates an opportunity for customer engagement,
therefore, generating additional sales. Lastly, many retailers, such as value retailers, operate at a
much lower breakeven point and offer a defensible market position to e-commerce encroachment.
Many are big-box or power-center formats, which, given the price correction underway, appear
increasingly more interesting from a value-added or opportunistic perspective.
Tactical opportunities:
Our focus remains on convenience and well-positioned grocery-anchored centers, with a decided focus on
high-quality credit, which has the potential to generate strong cash flows. Off-dollar retail is also a critical
component of our consideration, particularly in the U.S. where such stores generate significant foot traffic.
On a more selective basis, power centers and lifestyle centers in both the U.S. and Europe could be viewed as
effective tactical plays under the right pricing and tenancy scenarios. The underlying themes across our retail
recommendations are squarely centered around value and quality from a consumer and tenant perspective.
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