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Quarter-End Insights

Real Estate: Slow but Steady Climb Continues

Though fairly valued overall, we see attractive investment opportunities scattered across various asset classes.

Mentioned:
  • Morningstar's real estate coverage is trading at a 4% premium to our fair value estimates. 
  • We view themes in commercial real estate as generally defensive in nature, with lingering concerns about increasing bond yields associated with future rate hikes. However, we continue to focus on underlying performance, which has remained healthy overall, as REITs have been focused on repositioning and strengthening their portfolios, deleveraging, and capital recycling. Construction of new property continues as firms look for higher returns, putting into question levels of new supply as economic uncertainty remains. 
  • At current pricing, we see attractive investment opportunities scattered across various asset classes within our REIT coverage.  Vornado (VNO) and CapitaLand Mall Trust (SGX: C38U) are each trading at noteworthy discounts to our respective fair value estimates.

America Real Estate Outlook
Contributed by Brad Schwer

Investors should continue to be skeptical of opportunities across different industries, as we expect actions by the new administration as well as potential for increased central bank interest-rate activity throughout 2018, to affect property and capital markets activity, asset pricing, and overall volatility in the near term. While we don't view the tax plan as having significant effects on the overall sector, we do think elements of the plan could affect certain asset classes such as multifamily REITs given the potential elimination of the mortgage interest deduction.

As the new administration looks to enter its second year in office, details surrounding infrastructure spending, tax reform, general deregulation, and many other matters had the markets hitting all-time highs on the increased expectation for overall economic growth, while the 10-year U.S. Treasury yield had increased to 2.4% by mid-December.

Relatively little movement in Treasury yields, often used as a benchmark for real estate valuation, has equated to relatively stable performance in REIT share prices over the quarter. Given the circumstances, many investors continue to wonder whether we are near the peak of the commercial real estate cycle; higher interest rates could pressure growth rates, cap rates, return expectations, and ultimately asset prices. 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 valuations.

Despite the December rate hike, U.S. interest rates are expected to remain historically low in the near term, which we view as a plus for real estate in general. Additionally, several economic signals, including unemployment levels, wage growth, and GDP growth, support the case for positive momentum going into the end of the new administration's first year in office.

Although we now expect increased near-term volatility as market speculation and expectations eventually converge with economic reality over the next several months (or years), the same perceived positive catalysts for the market that have affected interest rates should only help to support fundamental demand for real estate and offset pressure on relative valuations.

That said, much of our U.S. REIT coverage still enjoys healthy underlying operating performance. Most portfolios are characterized by historically high levels of occupancy and durable balance sheets, and they benefit from in-place leases that can potentially be re-leased at higher current market rents, giving these firms embedded cash flow growth if not a safety cushion for future economic weakness.

Although growth has slowed from elevated levels seen in recent years, we believe the market has been expecting this slowdown and has priced it into the sector. Many firms have also continued to recycle capital, trading out of weaker, more vulnerable assets into stronger assets with better long-term growth prospects and risk profiles. Although near-term uncertainty has affected leasing and transaction volumes, private-market asset values have largely stayed intact and should continue to serve as an anchor for public-market valuations.

However, 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 greater concerns. Furthermore, a wave of legacy, peak-market property debt maturing over the remainder of the year may cause significant disruption in real estate property and capital markets. And 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 wary and return expectations decrease, a reduction in overall investment will slow demand and reinforce negative outlooks.

Given that our real estate coverage is fairly valued as a whole, it's important that investors enter the sector with caution. Historically high asset prices for existing, stabilized institutional real estate is forcing the hand of many U.S. REITs to focus on new development and redevelopment opportunities. Although we still acknowledge the opportunity for prudent capital allocation to achieve excess returns, we are cautious of firms overextending themselves into riskier investments. Reasonably leveraged companies with solid prospects for long-term growth that can weather the natural cyclicality of the real estate markets are our preferred investment vehicles.

Australian and New Zealand Real Estate Outlook
Contributed by Tony Sherlock

We forecast nearly all property firms to generate earnings growth over 2018 as most tenant leases contain contracted rental escalations, and occupancy should remain high for most property categories. The unwinding of unprecedented quantitative easing policies in 2018 risks pushing up long-term bond yields faster than anticipated, subsequently weighing on the values of all property--the timing of which and amount of change is highly subjective. Caution is warranted. This is reflected in the dearth of positive recommendations across our coverage.

We're generally wary of shopping centers due to multiple threats, the most significant being online retail, rising competition from global players, slowing wage growth and high household leverage. Strategies of landlords are fairly uniform, with more space being allocated to dining and services. Unfortunately, most strategies are analogous to tinkering around the edges, and it is inevitable that slowing sales growth will translate into lower rental growth over the longer term.

Office assets in Sydney and Melbourne are set for very strong rental growth over 2018-2020, but this is already fully reflected in valuations. New supply is scheduled to come to these markets in 2021, causing a retracement in rents.

Of all property categories, we're most positive on retirement living, with owners set to benefit from favorable demographic trends as the number of people exploring retirement living options surges over the next five years. Given most incoming residents fund the purchase of their retirement unit by selling the family home, the strong appreciation in house prices has significantly increased the purchasing power of incoming residents. This, plus an undersupply of modern retirement units, is contributing to solid price growth for retirement unit stock and hence the profit that operators generate on each resold unit. 

Singapore Real Estate Outlook
Contributed by Michael Wu

Residential property markets in Singapore have seen a slight improvement in the last quarter with prices in the city-state improving 70 basis points after 13 consecutive quarters of decline. We think it is too early to conclude a turnaround is sustainable, and we do not see a meaningful improvement in prices until the regulatory Monetary Authority of Singapore lifts its restrictive policies on loan-to-value limits and income tests for borrowers.

The two Singapore developers under our coverage have shown discipline in land acquisitions and participated in land auctions prudently. We note that land sales remain competitive despite a decline in residential prices. We believe  City Developments (SGP: C09) will benefit more from improving residential prices given its larger landbank relative to  CapitaLand (SPG: C31). However, this is factored into the former's current share price.

Property conglomerate CapitaLand has prudently diversified away from Singapore residential development into China and Vietnam, and expanded its retail mall and serviced residence businesses. A recent pullback in its share price after a strong run earlier this year, along with companies with Chinese exposure, presents an opportunity to enter the narrow-moat developer. We believe its regional exposure and growth is not factored into its share prices, with the current share price implying a price/book of 0.9 times.   

The turnaround in office property prices was slightly ahead of our expectation, with Grade A office prices also improving in the quarter after successive monthly rental declines as the new office supply is slowly digested by the market. The timing was slightly ahead of our expectations as we anticipated rentals to improve from early 2018, but pre-commitment to the new supply has accelerated, reducing concerns of an inventory overhang and pressure on rentals. Still, this will not flow through to the rental revisions for the office REITs under our coverage, and negative rental reversion is expected next year as average expiring rents in 2018 are above the current average market rent for Grade A office.

We remain positive on the Singapore office property sector in the long term and expect strong regional growth to underpin office demand from multinational corporations, absorbing the new office supply, which we view largely as a timing issue, as highlighted in our previous notes.

Hong Kong and China Real Estate Outlook
Contributed by Phillip Zhong

In Hong Kong, the physical property market trended higher toward the end of the year, outpacing the slight gain seen during the last quarter. Primary market sales are running 10% ahead year-over-year, supported by developers' financing.

The secondary market continues to suffer with only two secondary market transactions for every primary market transaction year-to-date. Secondary market transactions are half of the historical average, possibly setting a 15-year low.

Given the lack of efficient price discovery and the rising funding rate for HK banks, we expect the residential housing market to be volatile and with significant downside risk. With the elevated market risk and the recent entry of Chinese developers, we prefer developers with alternative means (other than government auction) of replenishing their landbank to ensure adequate returns.

The Hong Kong office market is still robust, while the retail environment has begun to recover. As a result, the market has seen several high-valued transactions of listed entities selling noncore office and retail assets in the private market. Given the listed real estate market returns generally lead private market returns by two to four quarters, we prefer those firms with effective capital management focused on recycling proceeds into higher-yield assets outside of Hong Kong or returning capital to investors through share buybacks or special dividends.

During the fourth quarter, major Hong Kong property developers and investors' shares trended sideways or headed slightly lower, underperforming the Hang Seng Index, reflecting the heightened risk in the physical market. In our coverage universe,  Sun Hung Kai Properties (HKG: 00016) and  CK Asset Holdings (HKG: 01113) are priced attractively, at price-to-fair value ratios of 0.85 and 0.86 times. We prefer Sun Hung Kai Properties for its successful farmland conversions and resilient suburban retail assets. We also like CK Asset Holdings for its active capital management, including asset sales in Hong Kong and non-real estate acquisitions outside of Hong Kong.

The Chinese property sector is slowing under the weight of government policy, with sales up 6% year on year through October, compared to 27% a year ago. But listed developers' sales are stronger (up 10% to 20%) due to a continuing consolidation trend. We expect the tightening policy to persist, capping volume and price growth, creating headwinds for the sector, especially for mass residential developers.

We favor the quality names with operational focus in higher-tier cities, which typically have more constrained supplies, lending some support to the current price level. Major Chinese developer shares have weakened during the quarter, reversing the earlier trend. With some developers' shares still overvalued, we remain positive on  China Overseas Land & Investment (HKG: 00688) and  Shimao Property (HKG: 00813), which are trading at the largest discount to our fair value at price-to-fair value ratios of 0.75 and 0.73 times. We consider them credible value plays backed by solid operations. 

Japanese Real Estate Outlook
Contributed by Mari Kumagai

We see the Japanese property sector as fairly valued as soft industry headwinds remain predictable during the quarter. Our preference for developers over J-REITs remains the same. The sign of small interest rate increase is adding headwinds to J-REITs, increasing distribution yields to 4.15%. In our view, J-REITs will need to be more selective on their pipeline as the overall cap rate is expected to fall further to 4.5% for 2017 and 4.3% for 2018 according to the Japan Real Estate Institute.

The property sector remains sensitive to interest rate increases, but interest rates in Japan remain near zero with the political attempt to keep the government debt under control. Investors should still be aware that domestic banks started to take a more cautious stance to the real estate sector. Having increased the outstanding balance at a compound annual growth rate of 6.6% for the past three years, lending to the sector has finally turned negative since quantitative easing started under the Abe administration.  

We still see some limited upside in Sumitomo Realty & Development as the company is better positioned to benefit from its larger landbank in selective locations over the next two years. However, its concentrated investment positions do not bode well for the investment beyond the cyclical horizon.

The recent pullback of shares for Mitsubishi Estate indicates investors' fading patience with its plan of capital deployment for the future. But three major developers' earning fundamentals, after adjusting for temporary factors, remain steady. Year-to-date monthly data still suggests consecutive rent increases across all asset classes except for some dips in logistics due to temporary oversupply. The mainstay Grade A office leasing markets remain steady as limited supply within Tokyo's central business districts still supports steady rent levels with the vacancy rate tracking around 2.5%. Residential property markets also started to see some rebound with the rent level increasing for the first time in 16 consecutive months, and the vacancy rate dropping near 6%. Given limited supply over the near term, we do not expect the city's premium rent to fall until after late 2018.

Top Picks

 Vornado Realty Trust (VNO)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $92.00
Fair Value Uncertainty: Medium
5-Star Price: $64.40

We still like high-end Class A office providers such as Vornado, which is currently trading at a 15% discount to our $92 fair value estimate. As its competitors continue development of the upcoming Hudson Yards project, Vornado remains set to benefit from the improving neighborhood with 6.5 million square feet of office space and half a million square feet of retail property just east of the incoming development. We were pleased with rental rates surrounding Penn Plaza, which continued to climb this year. We see this trend continuing, as half of lease expirations for 2018 are concentrated in One Penn and Two Penn Plaza, so next year serves as a real opportunity to realize higher rental spreads given the greater appeal for that submarket.

CapitaLand Mall Trust (SGP: C38U)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: SGD 2.35
Fair Value Uncertainty: Low
5-Star Price: SGD 1.88

Within our REITs coverage in Singapore, we continue prefer CapitaLand Mall Trust given the trust is trading at the largest discount to our fair value at price/fair value ratio of 0.88. The trust posted another mixed third-quarter result as rental renewal was pressured once again this quarter given the generally weaker retail environment, but higher occupancy levels and lower operating expense helped cushion the softer top line.

Despite the negative rental reversion for five of its 16 malls for the quarter, the result reaffirms our view that the trust possesses good-quality, defensive malls. The occupancy level edging higher by 40 basis points to 99% reflected this. Medium-term growth is supported by the redevelopment of the Funan project. The serviced residence component of the Funan project was divested to Ascott, the serviced residence arm of CapitaLand, in the quarter, and as noted previously, the decision was a natural one considering the original trust structure and parent CapitaLand's partial ownership of this trust.

Quarter-End Insights

Stock Market Outlook: A Dearth of Opportunity Amid the Rally
Credit Market Insights: Flattening Yield Curve Impacts Performance
Basic Materials: The Most Overvalued Sector We Cover
Energy: A False Sense of Security for Oil Markets
Communication Services: A Deal Eludes Sprint and T-Mobile
Consumer Cyclical: E-Commerce a Key Threat for Some, But Not All
Consumer Defensive: Hungering for Top-Line Gains
Financial Services: Asset Managers Are Forced to Adapt
Healthcare: Pick Carefully as Valuations Head Higher
Industrials: Pockets of Uncertainty Present a Few Opportunities
Technology: Most Bellwethers Are Overvalued
Utilities: A Weak December Could Foreshadow a Tough 2018
Venture Capital Outlook: Dry Powder for Late-Stage Deals
Private Equity Outlook: Eyewatering Acquisition Multiples
Crypto Asset Outlook: Installation Phase

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