REITs at Their Peaks?
Long in the tooth, the current real estate cycle keeps going.
As we get deeper into the current real estate cycle, many investors are wondering if the sector is nearing its peak. Meanwhile, interest-rate expectations are weighing on the sector’s valuations. Higher interest rates would put pressure on growth rates and return expectations. Morningstar analysts think rates will remain historically low for the foreseeable future, but any uptick will have short-term implications on the sector.
To get a better read on the real estate cycle, how a rise in interest rates would affect real estate markets, and the long-term risks to the sector, I sat down with analyst Edward Mui, who covers the sector for Morningstar. Our interview took place on Oct. 31, and his answers have been edited for clarity and length.
Jerry Kerns: Let’s start by looking at the broad picture. Where are we in the real estate cycle? What’s your current outlook for the next 12 months?
Mui: Like the broader market, the real estate sector has been in prolonged recovery since the recession eight years ago. It feels like we’re currently in the later innings of the real estate cycle; many REITs are experiencing historically high occupancies, there is still robust rental growth, and peak valuations are driven by not only the underlying demand for this real estate but also by the lower interest-rate environment that we’ve been in for quite some time. Numerous people here at Morningstar believe that we’ll remain in an historically low interest-rate environment, which should help support not only economic growth but real estate valuations. But with the potential of a U.S. Fed rate hike, there are a lot of questions right now in the market about where growth and valuations for real estate are going in the next 12 months.
Within the next year or so, I would still expect demand to be cyclically high. There’s not a catalyst that we see right now that would bring growth and demand screeching to a 2008–09 style halt, even though there are signs of deceleration from the cyclical or historical peaks of rental growth and occupancy.
Kerns: If rates go up, what would be the short-term effects to the sector?
Mui: Interest rates matter to REITs and real estate mainly because real estate is a very capital-intensive business. REITs and real estate investors need ample liquidity and access to capital markets to keep the markets going, not only in terms of purchasing buildings but also for developing new supply, signing new tenants, and even just for working capital purposes. The mental benchmark for real estate is the 10-year U.S. Treasury. As we know, the 10-year Treasury has been trading at historical lows for many years.
So, there’s a worry that as interest rates increase, it places pressure on real estate valuations, which are somewhat benchmarked to the yield that real estate provides investors relative to the 10-year Treasury.
That’s the short-term outlook. Right now, in my opinion, any increase in interest rates is more a sign of confidence in the economy in maintaining the Fed’s inflation targets, not necessarily due to the decrease in capital markets activity or the excess liquidity. An increase in interest rates in the near term, even though it may be a drag on performance due to the cost of debt, doesn’t necessarily indicate a negative outlook for the real estate market or the market overall.
Kerns: What about the longer-term effects?
Mui: Longer term, increasing costs across the capital markets should slow down growth. With the rest of the global economy in a low or even negative interest-rate environment, I think future increases in interest rates in the United States will be scrutinized relative to the rest of the world. This leads me to see a lower-for- longer type of environment meant to promote stable growth in the United States.
Kerns: So, higher interest rates wouldn’t necessarily spell the end of the real estate cycle?
Mui: The end of the real estate cycle could be caused by some type of negative, market-jarring surprise that shakes investor confidence, brings capital markets to a halt, and decreases overall demand. In 2009, oversupply, over-leverage, and bankruptcies within the financial markets led to a lack of liquidity and lower demand, affecting real estate performance and valuations. We don’t necessarily see similar risks today; since the recession, underwriting standards for real estate have been more conservative, which has kept levels of new supply relatively low in many cases and added to the relative outperformance of the current real estate market.
Kerns: Is there anything else that you look at besides interest rates in the economy that are risks to the sector?
Mui: The adage for real estate is “all real estate is local.” You have to get down to the underlying portfolio that a REIT owns and what markets they’re in, the quality of their assets, how they’re performing, and the long-term supply-and-demand outlook for each market.
I think we sometimes get caught up a little too much about the broader interest-rate conversation, peak valuations, and past real estate booms and busts. The real estate cycle is going to happen, but the sector has maintained cyclically high performance and demand amid an environment that has limited new supply for the most part. You see some supply pressures in very select markets and select asset classes, but overall, demand has supported the current level of supply that we have in the United States.
Kerns: Where are the strongest areas of the market?
Mui: There are some parts of the real estate market that have been particularly strong over the past several years, mainly due to secular shifts of the marketplace. The effects of e-commerce on industrial real estate has driven demand for warehouses and distribution centers.
At the same time, there’s been an increase in demand for apartments—for real estate driven by the millennial generation’s penchant for renting versus owning. Millennials are delaying major life decisions, such as marriage and having children, choosing to maintain flexibility and mobility. This has driven demand for apartments in the urban core of cities and, increasingly, suburban settings.
Kerns: Let’s talk about retail real estate. You recently wrote a research piece titled, “Is the Mall Dead?” Is the mall dead?
Mui: The mall, on a whole, is not dead. There’s a misconception in the market that physical retail real estate is eventually going toward zero, which I don’t believe. There’s a bifurcation happening between high-quality retail real estate and lower-quality real estate. It’s not necessarily how nice a property is, but the market that it’s located in and its competitive place within that market.
Demand is being consolidated into the top-performing, most competitive malls with the best locations, amenities, and retail offerings. This is what ultimately drives the most customer foot traffic and tenant demand. The most successful malls have what we at Morningstar call moats. The best, most competitive malls are able to create, in moat terminology, beneficial network effects within the malls and benefit from efficient scale. Good malls can attract customers, customers attract tenants, and the mall is, therefore, able to lease to better tenants, which attract better and more customers, which attract better tenants, and so on. It’s becomes a very positive feedback loop, and that’s what you see in the best properties.
So, to answer the question, the mall isn’t dead. Just the bad malls are.
Kerns: Is there any expansion in retail real estate?
Mui: Very few new regional malls have been built within the past 10 years. You can count the number of new malls on your two hands—because at this point, the market probably has too many. Also, it’s incredibly hard to build a new mall because of the potential risk of new supply in this changing retail environment that we’re in.
Kerns: How do you envision the retail experience for consumers in five to 10 years? Can e-commerce and physical malls coexist?
Mui: Long term, malls and e-commerce can coexist. E-commerce as a percentage of retail sales has been steadily increasing, and we expect that percentage to continue to increase. But physical retail will still be a very important part in the retail distribution chain in that many consumers still view physical retail stores as part of their shopping experience—from discovery and trying out new products to purchasing them and returns.
What you’re seeing now is a lot of retailers trying to figure out what people call an omnichannel retailing strategy, which incorporates both e-commerce and physical real estate stores into a distribution chain that is more valuable and creates a more interesting value proposition to consumers than each one separately. Consumers want ultimate flexibility to get what they want, when they want it, and that will require both physical and online options.
For example, there’s a phenomenon in retail called showrooming. Consumers go to physical store to look at a new product and try it. They then go back home and buy the product online. Then, there’s reverse showrooming, where people go online to discover a product, but they want to go into a store to see it or try it, and then they buy at the store. More and more, these lines are being blurred about which channel gets credit even though each could be crucial to the sale.
While retailers are finding that it’s important to have presence online and in physical stores, but the scrutiny for physical stores is increasing. When retailers determine where they want to open or what stores they want to keep open, they’re increasingly narrowing their focus to the best locations and environments for their target customers, and those will be the highest-quality properties in the best markets.
Kerns: You also mentioned apartments and millennial demand. How strong is this demand and will it last?
Mui: We think that the long-term demand outlook for apartments is fairly strong, because the heart of the millennial generation is hitting peak rental periods within their lifetimes. Over the next 12 to 24 months, supply will increase considerably, so in the shorter term there might be more supply than can be absorbed in select markets. But long term we see a lot of strength.
There’s a growing demand for mobility and access that plays into renting—short-term rentals versus the long-term proposition of buying property. Millennials want to be able to move more and be flexible. They value experiences more than physical things. I think cities are playing into that by developing flexible transportation options, closing down streets to create pedestrian or bike lanes that appeal to that urban lifestyle, instead of building infrastructure that creates more traffic and gridlock. Demands are shifting for a generation that will soon dominate consumer spending and decision-making.
And this is a good thing. There’s this misconception that real estate is a tangible asset that is very static. In fact, real estate is a very dynamic business. People have changing needs, changing demands, and there’s always a shift in technology that drives these changes. The environments that we live, work, and play in have to change with those needs. Therefore, there will always be a demand for the new environments. It creates more opportunities than risks for those investors who are able to anticipate and invest in them. The best landlords and the best investors are able to adapt to those changes and meet that demand.
Kerns: So, how should investors approach REITs? What should investors expect?
Mui: Investors in today’s environment should expect increased volatility due to where we are in the cycle. But I think it’s important for investors to understand what is related to cyclical factors and what factors will add long-term value to shareholders. What we try to do at Morningstar is look at the long-term thesis and the moat characteristics of these companies that will allow them to compete into the future. It gets down to the underlying properties that these REITs own.
Kerns: What are some other risks to the sector?
Mui: I think any long-term risks are technology-related. What is the potential of, say, improved distribution capabilities to shorten shipping times for e-commerce players, of self-driving cars to play into that, or drone delivery to lower the friction that exists between online purchases and physical store purchases, which is something that is clearly being explored.
It’s fun to dream about these very large, disruptive concepts playing out within our lifetimes, if not within the next 10 to 20 years. But I think there will always be this immediate demand, not only to buy products, but to have types of environments and real estate that connects people to their communities and gets people outside of their homes and out from in front of their computer screens. It gets down to creating that value proposition for consumers that drives demand for physical real estate.
Kerns: Let’s talk about specific names. Are there any buys valuation-wise?
Mui: The REIT sector has experienced a bit of a pullback, because of, again, concerns about the interest-rate environment and the deceleration in demand, which I think is more of cyclical factor than a structural factor. When we’re looking at long-term value, there still is value that you can find within our coverage.
We cover two high-quality mall REITs, Simon Property Group (SPG) and Taubman Centers (TCO). They have fortress balance sheets, cash flow adequate to reinvest in the properties, and to change with changing consumer demands. They redevelop their properties and are always optimizing their tenant mixes to provide that value proposition to consumers.
One of our favorite real estate sectors right now is healthcare, a sector that has demonstrated a fairly inelastic or less volatile performance in all parts of the cycle. Talking about generational shifts and demographics, you have very large baby-boomer generation hitting Medicare eligibility and driving demand for healthcare services that will continue to benefit healthcare REITs. Within that sector, we like Ventas (VTR) and Welltower (HCN).
Along with that, even though there is this large growth in the baby-boomer demographic, you really have to get down to the companies that have the financial wherewithal and operating track records and management to not only take advantage of the opportunity, but to work with the best service providers and have the best capital allocation. We think that even in a fairly large industry, Welltower and Ventas represent the cream of the crop in terms of healthcare real estate, not only from an underlying portfolio point of view, but also from a management point of view.
Kerns: Any closing thoughts?
Mui: I would just say that even though there is uncertainty about where we’re headed to within the next 12 to 24 months, real estate is the type of investment for long-term, patient investors who don’t have kneejerk reactions to cycles or normal events that happen in the market. There is a lot of potential for pain, but there’s clearly potential to gain.
Edward Mui does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.