A new round of economic forecasts come with a warning: Don’t count on the high stock market returns of the past. Economists are lowering their projections for corporate earnings. That unwelcome news might bring stock market investors to private equity real estate and its innate advantages in building wealth.
Still, real estate is not immune from market forces. To meet their long-term goals, investors must understand the risks of adhering to strategies that were successful in the past and broaden their focus to total returns—the combination of earnings, dividends and capital gains.
Slower Growth Drags Down Equities’ Earnings Outlook
After a decade-long expansion, the economic outlook for stocks in the next 10 years is subdued. In its 2019 outlook, Vanguard Group estimates a 3 to 5 percent to annualized return in U.S. equities, a contrast to the 10.6 percent generated over the past 30 years. “Our expectations have clearly come down,” says Greg Davis, Vanguard’s chief investment officer. The largest U.S. mutual fund manager is not an outlier in its long view: Morningstar expects a 3.7 percent return on U.S. stocks, J.P. Morgan 5.25 percent.
The gloomy outlook is no mystery. When Vanguard or any other fund manager evaluates stocks, it’s looking at two things—the company’s ability to grow and increase earnings or dividends, and the stock price, which reflects the present value of the future earnings stream.
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When valuing stocks, the price of the stock isn’t as important as the price-earnings ratio, and P/E ratios haven’t been this high since the dot-com bubble of 2000. Based on current earnings, stocks in the Standard & Poor’s 500 index are trading at 21 times earnings. Using 10-year average earnings—the formula that economist Robert Shiller uses in his book Irrational Exuberance—stocks are currently selling for 30 times earnings.
Vanguard’s 2019 outlook calls these P/E levels “alarming” after 10 boom years. But in a low-growth decade, they may be the new normal. A sluggish economy cannot be expected to produce earnings at previous levels. With a diminished ability to generate cash flow, dividends will face headwinds as well. And with share prices already at the high end of their range, the chance for investors to improve their total return in the stock market is constrained.
Real Estate’s Appreciation Builds Wealth
By contrast, a notable attraction of real estate is the potential to accumulate wealth through dividends and appreciation. As interest rates have fallen in this decade, many high net worth professionals have allocated a greater share of their portfolio to real estate, a tangible asset with upside potential.
Still, in a recession commercial real estate will feel the same headwinds facing the equity markets. Even owners who recession-proof their holdings should expect passive income streams to be vulnerable in an economic slowdown. As an asset class, real estate should perform above average. And fortress real estate asset classes, such as multi-family, should fare the best because regardless of the economy, people still need a place to live.
Our acquisitions team takes a conservative approach to risk, and has adjusted their underwriting assumptions. For comparable risks where we might once have estimated a 16 percent internal rate of return, we now target 14 percent. Of course, we’d rather under-promise and overdeliver on IRR, and some properties should still outperform the market. But given the economic outlook, the only way to achieve the same total return would be to take on more risk.
Some fund managers will do just that. They’ll deal for distressed properties, borrow more heavily, cede control to partners or cut back on marketing for new tenants—all the tactics that might boost results if things go right but create real problems if things go wrong. Not all such moves will be obvious, so it’s imperative that investors do independent research, question the fund manager’s plans and assumptions, and demand regular reports on the status of a fund portfolio.
Real Estate’s Returns Offer Greater Advantages Today
When well-managed, real estate’s inherent advantages—from passive income streams to appreciation to longer fixed periods of ownership that ensures lower volatility—gives it an edge over stocks. Public REITs have consistently outperformed the S&P 500 because of their steady rental income and favored tax status. Private equity real estate and direct ownership enjoy the same advantages.
However, as an illiquid asset, private real estate should require a premium over assets that can be easily sold. But if the expected returns on stocks are 5-to-6 percent going forward, and real estate offers returns are 9-to-11 percent, the return premium for private real estate is out-sized in this new low-return world.
Most significantly, investors need not rely on income alone to bring higher total returns. Land has an intrinsic value that endures no matter how valuations are disrupted. The combination of income and capital gains makes real estate a solid choice as the ground shifts in equity markets.
