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Real Estate Stock Outlook: AvalonBay Is High-Profile in This Undervalued Sector

Park Hotels and Ventas are recovering well from pandemic’s effects on occupancy levels.

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The Morningstar U.S. Real Estate Index is down 18.9% over the trailing 12 months, which is worse than the 9.6% decline seen by the broader U.S. equity market over the same period. The real estate sector fell 4.07% quarter to date through March 27, underperforming the broader U.S. equities market that was up 3.83% in the quarter. While the real estate sector has seen negative stock performance over the past 12 months, same-store net operating income growth was strong in 2022 with many sectors reporting historic levels of growth and we anticipate that 2023 will be another year of solid same-store NOI growth for real estate.

Real Estate Has Trailed Broader Market Since October

The real estate sector is currently trading significantly below our fair value estimates. Our real estate coverage currently trades at a 22% discount to our estimate of fair value, which is more undervalued than most other North American sectors. Currently, 84% of the real estate sector is trading in either the 5-star or 4-star range, 12% is trading in the 3-star range, and only 4% is trading in the 2-star range while no company is currently trading in the 1-star range.

Since 2000, the relative performance of REITs compared with the broader equity market has shown a significant negative relationship to interest rate movements for the 10-year U.S. Treasury. While many income-oriented investors favor REIT investments for their dividend payments during periods of low interest rates, rising rates cause income-oriented incomes to rotate money out of the sector and into lower-risk investments. Additionally, rising interest rates increase the debt costs many REITs rely upon to fund acquisitions and development projects, so external growth becomes less accretive to REIT cash flows as interest rates rise.

Due to the strong, negative correlation, rising interest rates in 2022 directly led to the negative performance of the real estate sector over the past 12 months. While interest rates have flattened out since October, REIT management teams have guided to significantly lower external growth and higher interest expense as they refinance debt. However, most real estate subsectors also guided to rate, revenue, and net operating income growth above the historical average for the sector in 2023. Rising interest rates have limited long-term impact on REIT cashflows, so we believe many companies in the sector are trading at a discount due to short-term disruption caused by higher interest rates.

Consumers Shift Spending Patterns From Goods To Services

Top Real Estate Sector Stock Picks

AvalonBay Communities AVB

  • Fair Value Estimate: $241.00
  • Star Rating: 5 stars
  • Uncertainty Rating: Medium
  • Economic Moat Rating: None

AvalonBay Communities owns and operates high-quality multifamily buildings in urban and suburban coastal markets with demographics that allow the company to maintain high occupancies and drive strong rent growth. High inflation drove double-digit rate growth across the company’s portfolio in 2022. The company should continue to benefit from high inflation driving rental rate growth above the company’s historical average for a few more quarters and derive additional cash flow growth by completing projects in its development pipeline.

Park Hotels & Resorts PK

  • Fair Value Estimate: $26.50
  • Star Rating: 5 stars
  • Uncertainty Rating: High
  • Economic Moat Rating: None

While the coronavirus significantly affected Park’s operating results with high-double-digit revPAR declines and negative hotel EBITDA in 2020, the company’s portfolio has significantly improved operations over the past several quarters. Leisure travel rebounded to prepandemic levels in 2021 with group travel returning to prepandemic levels in 2022. Additionally, business travel also saw signs of improvement in 2022. We think business demand will eventually return close to prepandemic levels by the end of 2024, leading to years of strong growth for Park.

Ventas VTR

  • Fair Value Estimate: $68.00
  • Star Rating: 5 stars
  • Uncertainty Rating: Medium
  • Economic Moat Rating: None

Ventas owns high-quality assets in the senior housing, medical office, and life science fields. While the company’s medical office and life science portfolios should be relatively unaffected by either the pandemic or a potential recession, the senior housing portfolio saw a large drop in occupancy in the first year of the pandemic as the coronavirus has the highest lethality rate among senior citizens. However, occupancies slowly recovered in 2021 and 2022 and the industry should see strong long-term growth from the coming demographic wave of baby boomers aging into senior housing facilities.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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