Real Estate: REITs That Can Weather a Rising Rate Environment

• U.S. real estate investment trusts appear overvalued as a group, with pockets of opportunity in the health-care, retail, and cell tower property sectors. We maintain the view that Australian property stocks are similarly expensive, but with higher yields than similar REITs elsewhere.
• Capital is increasingly flowing across borders for property investments, and property values are high.
• With acquisition prices high, more REITs are expanding their development pipelines, with initial yields projected to be 200 basis points or more above acquisition cap rates.
• We generally expect REIT prices to move inversely with changes in long-term government bond yields, so we expect REITs to underperform in a rising interest-rate environment.

U.S. REITs appear overvalued as a group, with pockets of opportunity in the health-care, retail, and cell tower property sectors. Most Australian property stocks appear fully valued, but we see some value in the industrial and senior living sectors. Singaporean REITs are fairly valued, but we prefer office over retail. Limited new supply of office space in the central business district in 2015 is supportive of rental growth. Although office construction will add meaningful new supply in 2016, this should be absorbed by increased tenant demand as Singapore remains a premier location for multinationals' regional headquarters. In general, we think global commercial real estate investors should be cautious in the current environment and focus on the highest-quality firms and property portfolios.

Although the Asia-Pacific property sector offers attractive yields relative to conventional income products such as bonds, the risk of capital loss is elevated, as property values are likely to be hit hard if the yield curve eventually rises. In this context, our preferred long-term property exposures are firms owning quality assets in the most desirable locations. These firms should have negligible vacancy during periods of economic weakness and command rents at healthy premiums to others.

While property remains a business that requires local market knowledge, global capabilities are becoming increasingly important, as capital seeks diversification and opportunity across borders. This global flow of capital is not just intraregion, cross-border, but increasingly cross-continent as well. This, combined with the generally low interest-rate environment, is keeping cap rates low (and property values high), especially for the highest-quality assets in global gateway markets, where global investment flows are especially strong. Global capital flows typically introduce increased competition for property acquisitions, a slight negative for REITs. But global capital flows generally require specialized local-market knowledge for deployment, a boon for the largest global commercial real estate services firms.

With acquisition prices high, more REITs are expanding their development pipelines, targeting initial yields that exceed acquisition cap rates by 200 basis points or more. If such yields are realized, REITs can theoretically create immediate value upon stabilization of these developments, as the market recognizes the earnings power of the developments in light of lower cap rates for stabilized, operational properties. Although construction levels seem reasonable currently, oversupply of incremental square footage generally corresponds with commercial real estate downturns. Although we are not overly concerned with current construction levels, this is an area that bears watching.

We expect REIT prices to generally move inversely with changes in long-term government bond yields. Although higher interest rates would take some time to show up in REIT financial metrics, eventually higher rates could cause higher debt financing costs, put pressure on traditional after-interest expense measures of REIT cash flow (such as funds from operations, adjusted funds from operations, and funds available for distribution), and lead to higher cap rates, which could pressure investment spreads. Also, to the extent that low interest rates have diverted investor funds to REITs searching for higher yield, funds could flow out of REITs if interest rates rise, pressuring commercial real estate and REIT valuations.

Although rising interest rates might signal a strengthening economy, which could benefit real estate fundamentals, we do not expect the macro environment to improve enough to offset what could be another 200-basis-point (or more) rise in U.S. government bond yields to levels nearer historical norms.

In a rising interest-rate environment, we'd prefer REIT investment exposure weighted toward reasonably priced, narrow-moat firms with attractive internal and external growth prospects, conservative capital structures, and well-laddered debt maturity schedules. Many property sectors with shorter lease durations (of a year or less) that REIT pundits traditionally favor during rising interest-rate environments look to offer investors an insufficient margin of safety today. In the U.S., we are generally cautious on multifamily and self-storage REITs, while we see relatively attractive valuations among health-care REITs and cell tower REITs, with pockets of opportunity in other property sectors.

Top Real Estate Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
HCP		$51	Narrow	Medium	$35.70
Goodman Group		AUD 7.50	Narrow	Medium	AUD 5.25
Sun Hung Kai Properties		HKD 141	Narrow	Medium	HKD 98.70
Data as of 03-26-2015

 HCP (HCP)
Health-care REITs in general are one of the most attractive property sectors among our U.S. real estate coverage on a relative valuation basis, and HCP--which owns senior housing facilities, skilled nursing facilities, life science properties, medical office buildings, and hospitals mainly in North America and leased to tenant operators on a long-term basis--is currently attractive. In general, U.S.-based health-care REITs should benefit from some favorable tailwinds, including an expanding and aging population and potentially tens of millions of people added to the ranks of the insured because of the Affordable Care Act--all of which should drive incremental demand for health-care real estate relative to historical levels. Plus, health care is a property sector in which the vast majority of assets remain in private hands, so HCP should have opportunities to further consolidate ownership. We think HCP's current yield near 5.5%, combined with growth prospects in the low- to mid-single-digit range (if not higher, depending on external growth opportunities), provide investors with a compelling total-return prospect in the current environment.

 Goodman Group (GMG)
Goodman's geographically diversified and vertically integrated business model is well-positioned to deliver solid medium-term earnings growth. The low global interest rate environment has piqued interest in property investments, and Goodman's strong relationships with large wholesale investors puts it in the enviable position of turning away investors. Goodman operates at the upper end of the industrial spectrum where there are fewer competitors because of higher capital requirements, supporting returns. Additionally, we believe the upper end of the market has the most favorable growth outlook given the importance of large-scale, modern warehouses in efficient distribution chains, playing to Goodman's strengths.

 Sun Hung Kai Properties (00016)
As one Hong Kong's largest holders of retail and office properties, underlying economic growth positions Sun Hung Kai's property assets to generate solid rental growth in the coming years. Sun Hung Kai's established assets in well-located areas under single landlord management will remain attractive for wholesale property investors, supporting asset values. A positive catalyst is that prime office space in Hong Kong is valued far below similar financial centers in other major business hubs. New supply is being added, but not in Sun Hung Kai's core market, rather mostly in Kowloon East over the next few years. Continued infrastructure investments by the Hong Kong government will further integrate the city with its neighbors across the Pearl River Delta and encourage the growth of new towns in the city's outlying areas. This trend will benefit the company's regional malls, which are well-placed to serve an increasing suburban population as well as an enlarged number of day-trip tourists from across the border. While the city's residential property market may be at a cyclical high, the company can successfully navigate the difficulties ahead given its competitive advantage in sourcing land through the conversion of industrial and agriculture land.

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