Real Estate: Expect Some Choppy Waters Ahead

• Morningstar's real estate coverage is trading at a 3% premium to our fair value estimates.
• In the U.S., our preferred property sector remains healthcare: HCP, Welltower, and Ventas.
• We continue to view themes in commercial real estate as generally defensive in nature. REITs have been focused on repositioning and strengthening their portfolios, deleveraging, and capital recycling. Construction of new property continues, however, as firms look for higher returns, putting into question levels of new supply as economic uncertainty remains.

 

Morningstar's real estate coverage looks reasonably priced; the sector trades at a 3% aggregate premium to our fair value estimate. Investors should continue to be particularly discriminating because we expect uncertain economic conditions, including potential central bank interest-rate activity through the end of the year, to continue to affect capital access and activity as well as asset pricing in the near term.

The implications of interest-rate expectations will affect real estate valuations, especially as many in the market question whether we are toward a peak of the commercial real estate cycle. 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 and capital preservation, the same funds could flow out of REITs if interest rates rise, further pressuring commercial real estate and REIT valuations. 

In context, however, we still expect U.S. interest rates to remain historically low for an extended period. Global investors still see the U.S. as a relative safe haven for investment capital, and 10-Year U.S. Treasury yields are at a historically low 1.7% today. Although mixed economic signals, including unemployment levels, income growth, and GDP growth, have not made the outlook clearer, the expectation for a rate hike by the end of the year has increased. We still expect policymakers to constantly revisit where they want rates to go and how quickly they want them to get there, especially with the added uncertainty from the upcoming U.S. presidential election.

That said, most of our REIT coverage is positioned well to weather any broader economic volatility. Most are well-capitalized and benefit from in-place long-term leases that can 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. Many firms have mostly repositioned and refined their portfolios, 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, mostly in line with Treasury yields.

As we get deeper into the cycle, increased new supply in localized markets, such as New York and San Francisco, and asset classes, including office, multifamily, and senior housing, have become a greater concern. Eventually, rising interest rates will be viewed as a signal 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 and performance to be increasingly challenged.

As investors and businesses become weary and return expectations decrease, a reduction in overall investment will 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. Companies with solid prospects for long-term growth that can weather the natural cyclicality of the real estate markets are our preferred investment vehicles.

Attractive investment opportunities are much harder to source, though, as historically steep transaction pricing for existing, stabilized institutional real estate is progressively railroading many capable U.S. REITs into allocating more capital toward value-creation 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 continue to acknowledge the opportunity for prudent capital allocation to achieve excess returns, we are cautious of firms overextending themselves into riskier investments.

That said, we still believe sensibly priced healthcare REITs--including  Welltower (HCN),  Ventas (VTR), and, for the especially risk-tolerant,  HCP (HCP)--represent a preferred sector due to a robust, relatively noncyclical demand outlook and positive industry trends that should help maintain strong cash-flow generation and insulate these firms from economic volatility.

Within our Australian regional coverage, rents across all the major classes continued to rise, but the pace is moderating. The downward pressure of rising supply and softening economic conditions points to a further slowing in rent growth over the next two years. The strongest subsector is central business district office space in Sydney, which is benefiting from the removal of supply to be converted to apartments, and the toughest conditions are for office landlords in Brisbane and Perth and retail landlords, whose supermarket rent growth is being affected by a price war. Property firms with development and/or funds management divisions outperformed the pure-play property landlords as development remains a key strategy for earnings accretion given the spread between funding costs and development yields.

Our best picks are  Goodman Group (GMG),  Aveo Group (AOG), and  Folkestone Education Trust (FET). Vertically integrated Goodman is well-placed for growth as its development pipeline feeds into a growing base of third-party assets under management. Aveo is well-positioned to benefit from an aging population, with a large development pipeline, innovative retirement products, and a range of value-added services. Folkestone offers a low-risk yield around 5%, but we see significant upside catalysts ahead from a lifting of the government cap on childcare handouts that will improve operator profitability and supports superior rent growth ahead.

Singapore REITs have tracked sideways since its recovery in the first quarter of 2016. There is no change to our preference on defensive retail REITs as opposed to office property given increased office supply in the near term. Completion of office construction in 2016 will add 4.3 million square feet of new supply in 2016. 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, to the city-state. However, we expect the new supply to pressure office rental growth in the near term. We prefer developers such as CapitaLand with geographical diversification across greater China and Asia, and steady earnings underpinned by recurring investment income.

Top Picks

 Welltower (HCN)
Star Rating: 3 Stars
Economic Moat: Narrow
Fair Value Estimate: $76.00
Fair Value Uncertainty: Medium
Consider Buying: $53.20

Healthcare REITs in general are one of the most attractive property sectors in our U.S. real estate coverage on a relative valuation basis, and Welltower is our preferred pick. In general, U.S.-based healthcare REITs should benefit from some favorable, noncyclical 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 healthcare real estate relative to historical levels. Plus, healthcare is a property sector in which the vast majority of assets remain in private hands, so Welltower should have opportunities to further consolidate ownership. We think these current and long-term growth prospects provide investors with a compelling total-return opportunity in the current environment.

 Goodman Group (GMG)
Star Rating: 3 Stars
Economic Moat: Narrow
Fair Value Estimate: AUD 7.70
Fair Value Uncertainty: Medium
Consider Buying: AUD 5.39 

Goodman is one of the top three global industrial specialists. Income comes from owning, developing, and managing premium warehouses and business parks. Recent share price weakness is most likely due to concerns around its exposures to China and Brazil. We think these concerns are misplaced as the balance sheet exposure to these regions is small (China is 7% of assets, Brazil is 1% of assets), and the firm's development exposures to these markets are modest as most have been presold and tenant demand remains robust for its higher-quality assets.

CapitaLand Mall Trust (C38U)
Star Rating: 3 Stars
Economic Moat: Narrow
Fair Value Estimate: SGD 2.14
Fair Value Uncertainty: Medium
Consider Buying: SGD 1.61 

CapitaLand Mall Trust owns a portfolio of 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 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 beverage 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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