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Quarter-End Insights

Real Estate: 'Safety' Becomes More Expensive

Attractive investment opportunities still exist but are much harder to come by, as wary investors flock to 'safer' REIT names.

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  • Morningstar's real estate coverage is trading at a 3% aggregate discount to our fair value estimates.
  • In the U.S., healthcare remains our preferred property sector, and our favorite firm in the sector is  Welltower (HCN), while real estate service firms  CBRE Group (CBG) and  Jones Lang LaSalle (JLL) represent attractively priced long-term opportunities.
  • We continue to view themes in commercial real estate as generally defensive in nature. REITs have been net sellers of real estate and are focused on repositioning and strengthening their portfolios, deleveraging, and capital recycling, while being opportunistic about capital deployment. Development of new supply continues, however, as firms look for higher returns.
  • After a soft start to the year, property stocks have surged in both Australia and New Zealand, with most stocks now at all-time highs. Corresponding with this, we see little value in the sector, which is trading on a forward P/E (interest-rate normalized) roughly 50% above the long-term average. A lurking headwind is the reduced cost of capital having driven an escalation in developments, which points to lower rent growth in outer years. One firm we see as offering an attractive risk/return dynamic is  Goodman Group (GMG).

 

Morningstar's real estate coverage looks reasonably priced; the sector trades at a 3% aggregate discount to our fair value estimates. We believe investors should continue to be selective in the sector, as we expect increasingly uncertain economic conditions to continue to affect capital access and activity, asset pricing, and operating fundamentals throughout the year.

The market is still attempting to reconcile the implications of interest-rate expectations for real estate valuations. Higher interest rates could put pressure on growth rates, cap rates, and return expectations. Also, to the extent that low interest rates have diverted investor funds to REITs searching for higher yield, the same funds could flow out of REITs if interest rates rise, further pressuring commercial real estate and REIT valuations.

However, we still expect U.S. interest rates to remain historically low for an extended period. Investors see the U.S. as a relative safe haven for investment capital, and 10-year U.S. Treasury yields continue to compress, at historically low rates of roughly 1.6% today, even compared with 1.8% in our previous quarterly update, amid global yields coming down overall. Additionally, the U.S. economy seems more and more vulnerable to a slowdown, highlighted by weakness in recent job reports. Altogether, this has prompted policymakers to revisit where they want rates to go and how quickly they want them to get there.

That said, most REITs are in a good position to weather potential broader economic volatility. Many are well capitalized and benefit from in-place long-term leases that can potentially still be re-leased at higher current market rents, giving these firms embedded cash flow growth, if not a safety cushion for future economic weakness. REITs have also been net sellers of assets, trading out of weaker, more vulnerable assets into moatier assets with better long-term growth prospects. And as the operating performance, demand outlook, and ultimately cash flows for many REITs remain solid, albeit decelerating, for the time being, asset values have largely stayed intact and mostly in line with Treasury yields.

Eventually, rising interest rates will be viewed as a sign of a strengthening economy, which could benefit real estate fundamentals, although we see that scenario as being unlikely in the near term. If effective debt yields ultimately rise relative to overall performance, we would expect asset values to be increasingly challenged. 

Nonetheless, as investors and businesses become wary and return expectations decrease, a reduction in investment will help slow demand and reinforce negative outlooks. Logically, this has caused capital to flock to "safer" REIT names and assets. We generally categorize these as firms with reasonable leverage, moaty assets or businesses, demonstrated historical success across economic cycles, identifiable internal and external growth drivers, and reasonable margins of safety to our estimates of value. While these are our preferred investment vehicles, we think it makes sense to focus not only on firms with these attributes, but also on those that also have well-covered dividends with strong prospects for growth over time.

Attractive investment opportunities are much harder to come by, though, as safety becomes more expensive. Furthermore, aggressive transaction pricing for existing institutional real estate assets are progressively railroading many capable U.S. REITs into allocating more capital toward value-creating opportunities, such as the redevelopment of existing assets or the development of new properties in order to further grow and achieve required returns. Although we generally acknowledge the opportunity for prudent capital allocation to achieve excess returns, we remain wary of firms overextending themselves into riskier investments, especially as concerns rise about oversupply or slowing demand.

That said, we believe there are still strategic investment opportunities in the U.S. market. In particular, healthcare REITs--including Welltower--remain preferred, owing to a robust demand outlook and positive industry trends that should help maintain strong cash flow generation and insulate these firms from economic cyclicality. On the other hand, particularly moaty real estate service firms such as CBRE and Jones Lang LaSalle represent an attractively priced long-term opportunity for companies that, in our view, enjoy strong and enduring competitive advantages.

As with other major markets, Asia-Pacific property appears undervalued and offers attractive yields relative to conventional income products, such as bonds. A pullback in the equity markets in the region has provided new opportunities in the property space. We prefer developers such as  CapitaLand (C38U) with geographical diversification across greater China and Asia and steady earnings underpinned by recurring investment income.

The shares of Hong Kong developers and landlords have remained subdued in recent months, owing to a continued pessimistic outlook in the residential sector and a poor retail environment, particularly in the tourism-driven luxury sector.

Singapore REITs have tracked sideways since the sector's recovery in the first quarter of 2016, performing largely in line with the Strait Times Index. There is no change to our preference on defensive retail REITs as opposed to office property in the near term, given increased office supply. Completion of office construction in 2016 will add 4.3 million square feet of new supply. With limited new supply of 0.4 million and 0.6 million square feet in 2017 and 2018, respectively, and no planned supply thereafter, we expect the large addition to be slowly absorbed. The above new supply averages to 1.06 million square feet per year over the next five years, in line with historical annual net office demand of 1.1 million square feet. Singapore's steady political and transparent regulatory regime underpins the city-state as a premier destination for global multinational corporations in setting up or moving their regional headquarters. However, we expect the new supply to pressure office rental growth in the near term.

Top Picks

Sun Hung Kai Properties (00016)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: HKD 141
Fair Value Uncertainty: Medium
Consider Buying: HKD 98.70

 Cheung Kong Property Holdings
(1113)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: HKD 70
Fair Value Uncertainty: Medium
Consider Buying: HKD 49

The shares of Hong Kong developers and landlords have remained subdued in recent months, owing to a continued pessimistic outlook in the residential sector and a poor retail environment, particularly in the tourism-driven luxury sector. As the bellwethers and pure plays of the Hong Kong real estate sector, Sun Hung Kai Properties and Cheung Kong Property retreated 13% and 20%, respectively, since late 2015, when residential prices peaked. The Hang Seng Index registered a 7% decline over the same time period. As the leading developers in Hong Kong, these companies are mainly exposed to development risks related to large-scale residential projects. Although a weak physical market certainly means lower selling prices, the companies can benefit from a less competitive land auction market, leading to lower input costs. Further, as holders of large agricultural land banks, the companies have the opportunities to negotiate favorable conversion premiums with the government.

Sun Hung Kai Properties holds a large portfolio of retail assets focusing on nondiscretionary spending, shielding the company from the current headwind in the luxury- and tourism-driven retail sector. Its large holding of office assets has performed very well in recent months.

Cheung Kong Property employs a flexible pricing strategy and full cycle view, allowing it to achieve good sell-through regardless of the physical market conditions. It focuses on quick asset turns and maintains a strong balance sheet, leaving ample opportunities for countercyclical land acquisitions. As of its reorganization in early 2015, the company is not overly exposed to residential trading, as 45% of its income now comes from rentals, hotels, and REITs.

 CapitaLand Mall Trust (C38U)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: SGD 1.80
Fair Value Uncertainty: Medium
Consider Buying: SGD 1.61

CapitaLand Mall Trust owns a portfolio of high-quality malls around Singapore and boasts the city-state's greatest market share. Its malls are well managed, situated in densely populated areas, and close to mass transport hubs with high levels of foot traffic. These attributes are attractive for its diverse tenant base, resulting in high retention rates and near-full occupancy across its properties. Nondiscretionary products and services, such as food and beverages, drive repeat customer visits and account for 30% of gross income. This high occupancy and staggered lease expiry profile helps reduce rental cyclicality and is conducive to stable distributions to unitholders.

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Edward Mui does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.