Real Estate: Rising Rates Won’t Derail Strong Fundamentals

• Morningstar's real estate coverage appears fairly valued at current levels.
• We view themes in commercial real estate as generally defensive in nature, with lingering concerns about increasing bond yields associated with future rate hikes.
• Despite these concerns, 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; however, this raises questions about oversupply as economic uncertainty remains.
• At current price levels, we see attractive investment opportunities scattered across various asset classes within our REIT coverage. Vornado is trading at a noteworthy discount to our fair value estimate.

U.S. Real Estate Outlook Contributed by Brad Schwer

Investors should continue to be skeptical of opportunities across different industries, as we expect actions by the Trump 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 expect the tax plan will have significant effects on the overall sector, we do think elements of the plan could affect certain asset classes such as multifamily REITs given the curtailment of the mortgage interest deduction.

As the Trump 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 due to the increased expectation for overall economic growth.

In addition, the 10-year U.S. Treasury yield had increased to 2.85% by late March. Increasing Treasury yields, often used as a benchmark for real estate valuation, has equated to dismal performance in REIT share prices over the quarter. 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.

Even though the Fed raised rates in March, 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 as we enter the Trump administration's second year in office.

Although we expect increased near-term volatility as market 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.

As we get deeper into the cycle, however, increased 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, investors should enter the sector with caution. Historically high asset prices for existing, stabilized institutional real estate is forcing 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 with riskier investments. 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 Contributed by Tony Sherlock

Attractive ideas among Australian and New Zealand property stocks are limited. The few that screen as attractive include global vertically integrated industrial heavyweight

and retirement village operator

. Commercial property of all classes continues to trade of record low yields, a reason most listed firms are deploying surplus capital to share buy-backs and shunning acquisitions.

The sell down of the retail focused property stocks during 2017 has continued into 2018 and this seems well founded, with sales for the high-margin specialty retailers slowing and online retail still in its infancy compared with the U.S. and Europe. Having cut our rental growth projections and fair value estimates for retail property stocks now screen as attractive. Our concerns in retail lie not just in future growth in online retail, but the fact that spending by households and governments are buoyed by debt. It’s only a matter of time before households will need to spend within their means, which will inflict more pain on retailers the quantum of rents they can afford to pay.

While roughly 40% of Goodman’s earnings is composed of low risk rental income, we see significant upside in the development and fund management divisions. We expect an acceleration in the value of newly completed logistics facilities with the catalyst being an upgrade cycle by logistics toward modern heavily automated facilities. The firm has ample means to accelerate development, being the leading developer in Europe, U.K., Australia, and New Zealand, and also with a meaningful presence in the logistics markets of China, Japan, and the Americas. The net cash position of the firm means Goodman has plenty of dry powder to acquire quality assets should there be a dislocation in property or credit markets.

Australian retirement village operator and developer Aveo was sold down heavily following negative media in June 2017, and there remains a risk of tighter regulatory controls in the future. We think the firm has been oversold, with Aveo well placed to benefit from a shortage of supply and future redevelopment gains as it upgrades older villages to contemporary standards and captures the valuation uplift.

Singapore Real Estate Outlook Contributed by Michael Wu and Ken Foong

With the recovery of the residential property market in Singapore looking more sustainable after two consecutive quarters of price increases, developers have turned more aggressive in land auctions in recent months. The two developers narrow-moat

The recovery of office rental rates that started in third-quarter 2017 continued into fourth-quarter 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 onward. We expect the office rental recovery to continue for the next few years. However, this will not flow through to the rental revisions for the office REITs 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. 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.

Within our Singapore REITs coverage, we continue to prefer CapitaLand Mall Trust given the trust is trading on the largest discount to our fair value estimate with price-to-fair value estimate ratio at 0.88 times. We believe that ongoing asset enhancement initiatives, focusing on 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.

During the latest budget announcement, the Singapore government plans to raise the goods and services tax, or GST by 2% to 9% sometime in the period from 2021 to 2025 from 7% currently. We think that retail sales could grow before the GST hike takes place as consumers would want to purchase goods and spend in advance. We only expect some short-term weakness in retail sales after the GST hike takes place as consumers would have spent in advance. Food and beverage and supermarket, which makes up around 36% of gross rental income for CapitaLand Mall Trust should be largely immune to the GST hike as these spending remains a necessity to consumers. Hence, we think that the impact on retail properties would be minimal.

Hong Kong and China Real Estate Outlook Contributed by Phillip Zhong

In Hong Kong, the physical property market trended even higher during the first quarter of 2018, up 3.5% on top of a double-digit rise last year. For the first month of the year, transactions are up 46% year on year, but with most activities concentrated in the secondary market. Transaction data for March should provide better clarity as the Chinese New Year fell in mid-February this year. HKMA followed the lead of the Fed with another hike in the base rate in late March. While the interbank rate remained low given the ample liquidity in the system, signs of receding liquidity are emerging. The city’s currency has weakened against the U.S. dollar in recent months, hovering near the weak side of convertibility band, prompting the chief executive of HKMA to pen a blog piece to calm the market. PBOC raised interest rates for its open market operation, signalling tighter liquidity ahead for the country. We maintain our view stronger U.S. economic conditions underpin the normalization of interest rates, translating into higher interbank rate for Hong Kong. We expect the tightening liquidity will be a headwind to the Hong Kong property market.

The Hong Kong office market is still robust, while the retail sector continues to recover. We continue to see high valued transactions in the private market at very low capitalization rates. We prefer those with effective capital management by recycling proceeds from asset disposals into higher-yield assets outside of Hong Kong or returning capital to investors through share buybacks or special dividends.

The Chinese property sector continued to slow under the weight of government policy, with year-to-February sales up 2.3% year on year, compared with 24% a year ago. The 70-city price index from Bureau of Statistics showed slower price growth with Tier 1 cities showing monthly price declines.

Listed developers are still seeing strong sales growth due to continuing consolidation trend, albeit at a slow rate than before. 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 that typically have more constrained supplies, lending some support to the current price level. Major Chinese developer shares spiked higher in January along with the market before retreating. However, share prices have also been supported by good earnings results being released. On average, Chinese developer shares have gained 15% year to date, outperforming the market.

Japanese Real Estate Outlook Contributed by Mari Kumagai

We see the Japanese property sector as fairly valued with no major industry catalyst during the quarter. Our long-term preference for major developers over J-REITs remains the same. Fading signs of near-term interest rate increases is adding some comfort to J-REITs, maintaining the distribution yields around 4.1%. In our view, J-REITs will need to be more selective on their pipeline as the overall cap rate is expected to edge down 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 even after the Governor Kuroda has secured another five-year term to continue the same quantitative and qualitative easing program. Investors should still be aware that domestic banks are already taking a cautious stance to the real estate sector.

Since the year-end, major property developers’ shares under our coverage trended sideways, reflecting heightened risk aversion among most investors. In our coverage universe, Mitsubishi Estate (8802JP) are priced attractively, at price-to-fair value ratio of 0.85 times. Investor remains frustrated with its plan of capital deployment for the future, yet the quality of its leasing portfolio remains resilient with unparalleled ability to provide the comprehensive real estate services. Mitsui Fudosan (8801JP) is also expected to see some strong earnings with Tokyo Midtown Hibiya’s official opening during March 2018. We also like ongoing trend of industry consolidation in condominium sales over the past five years, as three majors are steadily expanding the aggregate market share in the greater Tokyo area from 26.7% to 31.4%.

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 logistic due to temporary oversupply. The mainstay Grade A office leasing markets remain steady as limited supply within the Tokyo’s central business districts still supports steady rent levels with vacancy rate tracking steady around 2.7%.

Top Picks

Vornado Realty Trust

VNO

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $84

Fair Value Uncertainty: Medium

5-Star Price: $58.80

We still like high-end Class A office providers such as Vornado Realty Trust, which is currently trading at a 13% discount to our $84 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.

Quarter-End Insights

Stock Market Outlook: Stocks Look Slightly Overvalued Today 4- and 5-star stocks are harder to come by in today's market, but a few values are still out there.

Credit Market Insights: A Decidedly Negative Quarter for Fixed-Income Markets Rising rates and widening credit spreads took their tool in the first quarter of 2018.

Basic Materials: Still Overvalued Despite Protective Tariffs Our bearish view on the mining and metals sector means the basic materials coverage universe trades at a market-cap-weighted 30% premium to our fair value estimates.

Communication Services: The Most Undervalued Sector We Cover We see value in several firms as consumers migrate away from traditional TV bundles and Europe invests in fiber and 4G.

Consumer Cyclical: Confidence, Demographics Support Consumption Gains E-commerce market share gains present challenges for some, but trends continue to support healthy profitability for many companies.

Consumer Defensive: Looking to M&A, Online Sales for Growth We see a few values for long-term investors amid intense competition.

Energy: Looming U.S. Shale Supply Should Temper Optimism Huge output decline boosts near-term fundamentals, but lofty prices likely to trigger dangerous shale growth later.

Financial Services: Regulations and Interest Rates Remain in the Spotlight for 2018 We see financial services stocks across the globe as fairly valued today.

Healthcare: Values Among Drug, Biotech, and Supply Chain Firms Innovation, consolidation, and a mixed regulatory picture for healthcare stocks in the first- quarter.

Industrials: Healthy Demand, But Few Values Among a mostly fairly valued industrials sector, some good values remain.

Technology: Shift to Cloud Computing Most Important Story The sector looks modestly overvalued as a whole, but there are some attractive firms in enterprise software and IT services.

Utilities: Under Pressure in Early 2018 Utilities sell-off presents opportunities for long-term investors.

Venture Capital Outlook: Despite Slow Volume, Liquidity Prospects Remain We expect ample opportunity in the VC-backed IPO market as alternative liquidity routes gain popularity.

Private Equity Outlook: Carveouts on the Rise as Fundraising Slows As dealmakers look to innovate their origination process, we anticipate a continued rise in take-privates and corporate divestitures.