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Commercial real estate rates make ‘rent-to-own equation more favorable’ to renters: Expert

PGIM Real Estate Head of Global Real Estate Securities Rick Romano joins Yahoo Finance Live to break down the latest in the commercial real estate industry and how REITS could be impacted by rising interest rates.

Video transcript

- Well, let's switch gears now and take a look at the real estate market because Freddie Mac reporting that mortgage rates are back over 5%, well above pandemic lows. Let's bring in a little bit more expertise on that matter with Rick Romano, PGIM Real Estate head of global real estate securities. It's great to see you again, Rick.

Tell us about how rising rates are impacting investors. I know you live in the world of REITs. I imagine that is a trend that's weighing a lot on whether or not you want to dip in to a little bit more real estate here.

RICK ROMANO: Yeah, thanks for having me, Brian. I think we're seeing rates go up as inflation is occurring and the Fed is continuing to fight inflation by increasing rates. We're seeing the short end go up. We're seeing the 10-year sort of go up as well as a result of that.

And what does that mean in terms of the impact on real estate? It means homeownership affordability is going up. It's getting harder to afford a home today as rates go up.

And when you think about how does that impact commercial real estate, there's actually a benefit to commercial real estate because it makes that rent-to-own equation more favorable towards renters, towards apartments. And also, when you think about the market for the single-family rental home, which has sort of developed after the GFC, we're seeing rents go up pretty significantly there, and we're seeing an opportunity there for landlords to get good pricing power and take advantage of sort of this rent-to-own equation.

- And, Rick, in your notes, you talk about the four Rs to keep in mind in this environment. Break some of those down for us.

RICK ROMANO: Sure. Yeah, so we're seeing some trends that are providing tailwinds for commercial real estate right now. And when we think about the four Rs, that's reflation, it's rising interest rates, it's recalibration, meaning how is technology disrupting real estate like we've never seen before, and it's also the reopening. We still have some opportunities in the reopening as a result of the pandemic.

Now, when you think about inflation, real estate has historically benefited in periods of high inflation. And there's some intuitive reasons for that. Number one, within the lease construct, you've got built-in inflation protection often in the leases, so CPI escalators built right into the leases, which can be very attractive during inflation because it provides that perfect hedge.

But then you also have, generally speaking, the cost to build goes up significantly during inflationary periods. So what does that mean? That generally means less supply is out there. And you had a story of a hotel developer who had a piece of land in Florida that they were looking at prepandemic, and they started to look at it again postpandemic.

But what they saw was that when they went to reprice that, when they went to reprice the cost to build that, it was up 40%. And that means they're not gonna do the project. So it means less supply, which is good for existing landlords.

And the other area that is interesting during inflation, or as far as rates are concerned in real estate, is that the expense side, when you think about the expense component of a property, the landlord can pass across many of those inflationary expenses to the tenant-- so less exposure there for landlords. When you think about rising interest rates, what is the Fed doing? They're increasing rates to combat inflation. They're doing that across the world, with the exception of, I would say, Japan.

And in periods of rising rates, what can happen with real estate and REITs is that if the economy is growing, again, real estate can have this pricing power. And they're not bonds.

So they're not this fixed payment. They can grow as rents grow over time. So they can pass across a lot of any increase in interest costs, you know, along in rent gains. So that can be very attractive as well.

And then, when we think about the reopening-- we saw this occur in a big way in 2021, we saw this occur in the US where retail, hotels, you know, everything was very crowded. We saw investors. We saw shoppers out there. We saw consumers traveling. We have that opportunity now outside of the US.

- Right.

RICK ROMANO: We see that in Asia, in Europe occurring today.

- Rick, I guess the natural question, though, is, I mean, you look at the inflation prints that we got yesterday and today. If that story starts to reverse in the high inflation that may have been benefiting based off of what you just said, could that all reverse-- all of those trends and the pricing power among some of these, you know, real estate properties-- actually do the opposite?

RICK ROMANO: Yeah, it's a good question. And there's really a sweet spot, you know, when you think about inflation for real estate. In periods of 3% to 4% inflation, real estate has performed very well. It's outperformed stocks. It's outperformed bonds. We've seen the dividend growth rate historically of about 8% for REITs.

So if we get this tempered inflation down from what we've seen-- these prints are very high at 8%-- you can still get strong pricing power at the top line in areas like shelter, where we've seen apartment rents go up significantly, self-storage. As long as supply and demand are favorable to the landlord, you can continue to get these pricing increases across.

And then, embedded in the leases, you're getting leases signed today that have inflation protection of 4% to 6% in it. So it's a pretty good place to be, even if inflation moderates.

- So, Rick, when you look at some of the best-performing real estate investments out there, for people who are perhaps new to this or would like to get into real estate investing, what are the most attractive areas, and how to go about that right now?

RICK ROMANO: Yeah, we're seeing great opportunities in areas that can offer defensive demand characteristics that have top-line revenue growth that's above and beyond inflation, that have expense lines that are not very exposed to inflation, and that are trading at big discounts to private real estate value. So what fits that bucket?

I would say apartments, needs-based demand, right? You have shelter, manufactured housing, single-family rental, and then, you know, even when you think about defensive demand, you have to think about self-storage a bit. There's demand driven by life changes, so death and divorce. So very defensive demand that generates revenue growth, that's been double digits for self-storage.

And then health care needs-- so think about senior living, where you have very defensive demand characteristics, demographics on your side, really good pricing power still in place from the reopening that we're seeing.

So those are areas-- three areas, really-- that we see good opportunities where defensive demand, revenue growth, expense line that's not too impacted by inflation, and importantly, they trade at big discounts to their private real estate value, which provides a really good arbitrage opportunity right now to buy real estate at wholesale levels in the public markets versus buying it at retail in the private markets. The types of discounts that we're seeing today, we don't see too much historically.

- Rick Romano, the head of global real estate at PGIM and fellow New Jersey resident, by the way, thanks so much for stopping by. Really appreciate it.