Real Estate: Fundamentals Still Show Solid Growth
Amid rising interest rates and slowing construction starts, underlying commercial real estate performance is healthy.
U.S. Real Estate Outlook
By Kevin Brown
The U.S. real estate market increased slightly in the third quarter, performing relatively in line with the broader U.S. market. The 10-year U.S. Treasury yield increased rapidly at the start of the year but has stayed near 2.9% since mid-February, bringing relative stability to real estate stocks. Given the circumstances, many investors 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 steered investors searching for higher yield and capital preservation toward REITs, the same funds could flow out of REITs if interest rates rise, further pressuring commercial real estate valuations.
However, rising interest rates also signal that the economy is healthy enough to support a rising-interest-rate environment. Continued economic growth will support the fundamentals of all commercial real estate. Real estate companies will benefit from the continued stabilization and growth of the acquisitions and developments they completed this cycle. Higher interest rates will make financing more expensive, not only reducing the return potential on new acquisitions and developments but also reducing the number of construction starts. REITs strengthened their balance sheets in the low-interest-rate environment, reducing near-term maturities and locking in low rates on long-term debt. There is still a shrinking but significant spread between real estate cap rates and interest rates, which combined with growing net operating income supports current real estate prices. Future interest-rate increases should be more gradual, and the growth of the underlying fundamentals should support current valuations.
The Trump administration could have an impact on several real estate sectors. Policies such as infrastructure spending, tax reform, general deregulation, and many other matters have extended the length of the current economic cycle. Additionally, several economic signals, including unemployment levels, wage growth, and GDP growth, support the case for positive momentum as we enter the back half of the year. However, the potential for a trade war with China could have an impact on several real estate sectors, particularly retail and industrials. Tariffs will increase costs on goods produced in China, reducing imports that drive traffic to warehouses owned by industrial companies and increasing costs of goods sold by retail tenants. Rising prices on steel and lumber would increase construction costs, making accretive development more difficult and reduce the number of construction starts for all sectors. Finally, intensified immigration enforcement could raise labor costs, increasing expenses for industries that rely on immigrant labor, such as the lodging industry.
Much of our U.S. REIT coverage still enjoys healthy underlying operating performance. Historically high levels of occupancy and durable balance sheets characterize most portfolios. 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. Supply has peaked and started to decelerate for sectors like apartments, industrials, and senior housing. Higher construction costs and tighter construction lending should reduce supply growth further even as demand continues to support fundamental growth through the cycle. 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 volume, private-market asset values have largely stayed intact and should continue to serve as an anchor for public-market valuations. Given that our real estate coverage is fairly valued as a whole, investors should enter the sector with caution. Our preferred investment vehicles are reasonably leveraged companies with solid prospects for long-term growth that can weather the natural cyclicality of the real estate markets.
Australian and New Zealand Property Outlook
By Tony Sherlock
Australian and New Zealand property stocks mostly screen as overvalued. The two that trade at meaningful discounts to fair value are retirement village operator Aveo Group (AOG) with a 4-star rating and Stockland (SGP) with a 3-star rating. Outside these, we see numerous attractions and potential earnings catalysts ahead for vertically integrated industrial heavyweight Goodman Group (GMG), but the company screens as fairly valued at current levels.
Aveo's reputation took a hit following negative media attention in June 2017, and the company still has work ahead to fully recover from the reputational damage. Management is taking action, implementing more flexible contracts and permitting residents to exit after six months at negligible cost. It is also progressing a stock buyback and in August engaged an investment bank to develop capital-management strategies to narrow the gap between the AUD 2.10 stock price and the net tangible asset per security of AUD 3.92. The Australian retirement living industry has very favorable underpinnings of limited supply and sharply increasing demand over the next five years. Aveo is well positioned to benefit from this trend as it has a geographically diverse portfolio of villages, with upside from building additional units in existing villages. Aveo stands to benefit from high redevelopment gains as it upgrades and then resells units in older villages. Both of these development activities generate very high returns on equity. Aveo is not without risks, as the costs to stay at its villages are higher than most peers and the company and broader industry may be forced to trim prices if Australian dwelling prices retrace further.
Stockland is a diversified Australian property group with earnings derived from passive rental income from retail malls and warehouses and active income from residential land subdivision and development. The stock trades around AUD 4.20 versus our fair value estimate of AUD 4.45 and offers a dividend yield of 6.5%. The stock price has fallen from a high of AUD 4.80 in February, triggered by slowing retail sales and a small decline in Australian dwelling prices following five years of very strong gains. Stockland seems oversold, as it has substantial land inventory acquired well below market rates, and this embedded value in the residential division will be released over the next five years. We are not forecasting a major rebound in retail sales, but the mall division continues to generate rental growth, with long-term upside from redevelopment.
Global demand for industrial property exposure is perhaps the strongest it has ever been as wholesale investors clamor to increase weightings to this previously out-of-favor subsector. The escalation in demand for industrial property is being driven by institutions' rotation away from Internet-affected retail shopping centers toward modern logistics facilities serving high-growth Internet retailers like Amazon and JD.com.
Goodman Group is particularly well placed to benefit from the heightened interest in industrial property assets as it focuses on owning high-quality warehouses in strategically important locations. Demand for these is robust as they enable logistics companies to steal a lead on competitors in speed of delivery and cost. Goodman is already reaping rewards from its focus on premium logistics assets, with the portfolio having very low vacancy and superior rent growth. Goodman also has a series of potential earnings catalysts ahead, which include an acceleration in the volume of development work as it becomes more active in North America and Brazil. As most of the company's developed assets will be acquired by Goodman-managed funds, we foresee strong uplift in fund management earnings from an expanding asset base and also an acceleration in performance fees. The company's property management platform has a total balance of undrawn debt and equity in excess of AUD 11 billion, providing ample capacity to fund new developments or acquire quality assets should there be a retracement in property values.
Singapore Real Estate Outlook
By Michael Wu, CAIA, and Ken Foong, CFA
Office rental rates troughed in the first half of 2017 and continued to recover into the second quarter of 2018, with average monthly rental for Grade A office space increasing 13% to SGD 10.10 per square foot in the second quarter of 2018 compared with SGD 8.95 per square foot in the first half of 2017. We expect the worst to be over for office rentals as new office supply is slowly digested by the market and there is limited new office supply from 2018 to 2021. We expect the office rental recovery to continue for the next few years. However, this will not flow through to the rental reversions for CapitaLand Commercial Trust (C61U), the main office REIT under our coverage, and negative rental reversion is expected this year as average expiring rents in 2018 are above the current average market rent for Grade A office space. 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. There could be some downside risks to rental rates in 2022 as a huge supply of 1.8 million square feet is expected to be completed then.
The trusts under our coverage have been actively managing their portfolios, and some of them have made acquisitions recently in Singapore and foreign markets. CapitaLand Commercial Trust made its first foray into overseas markets by acquiring a 94.9% stake in Gallileo, a Grade A freehold commercial property in Germany, while Ascendas Real Estate Investment Trust (A17U) made its first venture into Europe by acquiring a portfolio of 12 logistics properties in the United Kingdom, and there could be more to come. CapitaLand Mall Trust (C38U) has also acquired the remaining 70% stake it does not own in Westgate, a retail mall at Jurong East. We view all of these transactions positively and think the trusts’ active portfolio management and overseas diversification are the right strategies as they will help to drive growth for the trusts.
In our Singapore REIT coverage, we continue to prefer CapitaLand Mall Trust, given that it is trading at the largest discount to our fair value estimate with a price/fair value of 0.89 times. We believe that active portfolio management, ongoing asset-enhancement initiatives, adapting to technology advancement, and redevelopment of its properties will continue to generate long-term growth for its unitholders. In the medium term, growth will be supported by the redevelopment of Funan.
With residential property prices in Singapore appreciating strongly over the past year, the government has acted decisively in lifting Additional Buyer's Stamp Duty rates and lowering loan/value on residential property in July. Shares in the real estate sector reacted sharply lower to the unexpected announcement. While the cooling measures will dent short-term sentiment, resulting in a lower level of residential property transactions and prices and in turn limiting any share price performance in the near term, we believe the decline in the share prices of CapitaLand (C31), City Developments (C09), and Keppel (BN4) presents an opportunity for long-term investors to accumulate the stocks. City Developments benefited more from a recovery in the residential property market, and as such, its share price reacted more severely to the news and is trading at a 36% discount to our fair value estimate. While CapitaLand is trading at a narrower 21% discount, we believe is better quality, given its recurring income is supported by its portfolio of malls in Singapore and China, Grade A offices, and a more geographically diversified operation.
Hong Kong and China Real Estate Outlook
By Phillip Zhong
In Hong Kong, the physical property market edged higher during the third quarter, with the Centaline Leading Index up 3%. This is on top of a rise of 14% in 2017 and 10% in the first half of 2018. The number of transactions slowed during the half, especially in the primary market. However, the implementation of a vacancy tax in July resulted in more project launches and a small rebound in primary market transactions.
With the base rate hike in mid-June, the Hong Kong Interbank Offer Rate rose during the first half but remained steady during the quarter. However, continued liquidity outflow saw the Hong Kong Monetary Authority intervening in the foreign currency market several times in August to maintain the Hong Kong dollar peg, resulting in aggregate balance--a measure of interbank liquidity--falling below HKD 100 billion, a decade low. Further, many banks began to raise deposit rates. We maintain our view that stronger U.S. economic conditions underpin the normalization of interest rates, translating into higher interbank rates for Hong Kong. We expect the tightening liquidity will be a headwind to the Hong Kong property market.
Property developers continue to exercise prudence. During the quarter, we saw continued opportunistic asset disposals, investments in higher-yield non-real estate assets, and share buybacks. Limited land banking activities took place, but with clear preference for land conversions to minimize market risk, as well as greater emphasis for nonresidential projects.
The Chinese property sector remain subdued under the weight of government policy, with year-to-August sales volume up 4% year on year, compared with 10% a year ago. Sales by values are up 16%, compared with 14% a year ago, indicating continued price growth driven by a still declining inventory level. The 70-city price index from the National Bureau of Statistics showed faster and broader price growth in August, with smaller cities gaining the most. This is likely to lead to more tightening measures from the government. However, this risk is somewhat tempered by growing concern about an escalating trade war.
Listed developers are still seeing strong sales growth thanks to continuing consolidation trend, albeit at a slower rate than before. We expect the tightening policy to persist, capping volume and price growth, maintaining the current headwind for the sector. Growth is likely to be modest compared with a year ago, especially for mass residential developers. We favor the quality names with operational focus in higher-tier cities that typically have more constrained supplies and solid demand. Major Chinese developer shares spiked higher in January along with the market before retreating. Some quality names are reasonably priced, including China Vanke (000002), China Overseas Land & Investment (00688), and China Resources Land (01109).
Star Rating: 3 Stars
Economic Moat: None
Fair Value Estimate: $74
Fair Value Uncertainty: High
5-Star Price: $44.40
Welltower currently trades at roughly an 11% discount to our $74 fair value estimate. After trading off at the end of 2017 and the first quarter of 2018, the shares have somewhat recovered over the past six months, though we still think there is upside. Longer term, we believe the top healthcare real estate stands to disproportionately benefit from the Affordable Care Act, as there is an increased focus on higher-quality care in lower-cost settings. The best owners and operators in the industry, which can provide better outcomes while driving greater efficiencies, should see demand funneled to them from the best healthcare systems. Additionally, the baby boomer generation is starting to enter its senior years, and the 80-and-older population, which spends more than 4 times the national average on healthcare per capita, should almost double over the next 10 years. While shares of healthcare REITs have underperformed due to expectations of lower senior housing growth in 2018 from high supply and a severe flu season, growth should pick up in the next few years as supply growth falls off and demand picks up significantly. Additionally, fundamentals in the first half of 2018 came in above expectations, suggesting that the near-term weakness may not be as bad as previously feared.
Boston Properties (BXP)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $143
Fair Value Uncertainty: Medium
5-Star Price: $100.10
We still like high-end Class A office providers such as Boston Properties, which is currently trading at a 13% discount to our $143 fair value estimate. The company operates its portfolio of office buildings across five key geographic markets: Boston, Washington, D.C., New York, San Francisco, and Los Angeles. It has a large, multi-billion-dollar development pipeline that is creating new office properties and spaces that are attractive to young professional talent and should be increasingly filled by technology and life science companies. While Boston Properties' portfolio has become increasingly focused on the suburbs, where there are fewer barriers to entry and new supply can easily enter the market, we think the life science and healthcare industries are attractive industries to partner with from a leasing perspective. Management has been prudent in recycling capital over the years, maintaining a modern portfolio of assets that continue to meet tenant demand in an evolving labor market.
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