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Quarter-End Insights

Real Estate Sector Outlook

REIT prices reset with rising interest rates.

  • Although interest rates have risen, they remain well below historical averages.
  • Just as falling interest rates provided REITs a strong tailwind through early 2013, we would expect a rising interest rate environment to be a major headwind for REITs. 
  • Slow but steady macroeconomic improvement generally translates into slow and steady increases in demand for commercial real estate space without spurring too much construction or incremental supply, a favorable condition for REITs.

Aside from higher interest rates (and the fear of potentially even higher rates), the environment for equity REITs remains favorable, driving continued improvement in REIT fundamentals. The operating environment couldn't be much better for REITs. Slow and steady economic and job growth translates into incremental demand for commercial real estate, yet the macro economy is not improving enough for developers to aggressively add incremental supply to commercial real estate stock. As such, existing landlords should continue experiencing improved occupancy rates, greater bargaining power relative to tenants, and nice increases in same-store net operating income. In fact, we think a number of REITs, especially those with shorter-term lease structures, are performing at peak or near-peak levels of performance, and there is risk that deviation from the slow-and-steady macro improvement--either to the upside or downside--could alter the supply/demand picture and introduce weaker, but still positive, fundamental performance. 

However, the biggest risk to REITs may remain the prospect of rising interest rates. As rates on the U.S. 10-year Treasury rapidly rose roughly 100 basis points in the second quarter, REIT stock prices fell. Hardest hit among REIT stocks were some of our favorite firms that use long-term lease structures, as their rental streams generally cannot quickly reset higher in an inflationary environment. 

Although there has been a meaningful increase in interest rates, they remain well below historical averages, and there is risk that they will increase further, which we would view as a major headwind for REIT performance and valuations, due to potentially higher debt financing costs, potential pressure on traditional after-interest expense measures of REIT cash flow (such as FFO, AFFO, and FAD), and potentially higher cap rates, which could pressure investment spreads. Also, to the extent that low interest rates have diverted investor funds to REITs searching for higher yield, funds could flow out of REITs if interest rates rise further, pressuring commercial real estate and REIT valuations. Although rising interest rates may signal a strengthening economy, which could benefit real estate fundamentals, we do not expect the macro environment to improve enough to offset what may be another 150-200-basis-point potential rise in rates to levels nearer historical norms. 

Given the second-quarter correction in asset prices, our Real Estate Sector coverage universe has gone from roughly 15% overvalued relative to our estimates of fair value near the end of April to roughly fairly valued recently.

Our Top Real Estate Picks

Data as of 07-08-13.
Top Real Estate Sector Picks
  Star Rating Fair Value
Fair Value
American Tower Corp. $100.00 Narrow Medium $70.00
HCP, Inc. $55.00 Narrow Medium $38.50
Vornado Realty Trust $94.00 Narrow Medium $65.80

Although we currently have no 5-star rated stocks among our Real Estate Sector coverage, one of our Best Ideas is American Tower Corporation (AMT), currently benefiting from outsize demand for space on its cell phone towers, as wireless providers rush to upgrade communications systems to meet incremental demand as adoption and utilization of wireless devices push higher.  

Among office REITs, we favor Vornado Realty Trust (VNO) and Corporate Office Properties Trust (OFC) from a valuation perspective. Neither lacks uncertainty, however. Vornado recently embarked on a process to divest noncore holdings (including some unconventional REIT holdings such as its investments in retailers Toys R Us and J.C. Penney ), and both Vornado and COPT are exposed (COPT nearly exclusively so) to a weak leasing market around Washington, D.C. Of these two office REITs, we prefer Vornado for its quality assets and narrow moat. 

Although many other REITs we cover now trade closer to our fair value estimates, investors may want to keep an eye on the moatworthy landlords with good growth prospects and solid management, potentially adding exposure if stock prices drop and reasonable margins of safety materialize. Two REITs we think fit this profile are Realty Income (O) and Tanger Factory Outlet Centers (SKT), both of which receive narrow moat ratings and exemplary stewardship ratings from Morningstar. Realty Income's growth prospects stem from one of the most attractive acquisition environments in the firm's history, while Tanger's outlet mall model faces a very long runway of potential growth, in our opinion. 

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