In a rising interest rate environment, which is generally tough on REITs, we'd prefer exposure to reasonably priced, narrow-moat firms with attractive internal and external growth prospects, conservative capital structures, and well-laddered debt maturity schedules.
U.S. REITs appear slightly overvalued as a group, with pockets of opportunity in the health-care and retail property sectors. Most Australian property stocks appear fully valued, but we see some value in the retail sector, while the office and residential sectors appear the most overpriced.
In Australia, there is unquestionably a strong near-term earnings outlook for residential development, driven by record-low borrowing costs boosting affordability. But valuations appear too high, with the market likely underestimating risk in what is inherently a deeply cyclical activity. Australian office faces structural headwinds of oversupply and slower absorption rates for new stock. However, against this weak outlook, office values are rising, driven by the global search for yield.
While property remains a business that requires local market knowledge, global capabilities are becoming increasingly important, as capital seeks diversification and opportunity across borders. This global flow of capital is not just intra-region, cross-border, but increasingly cross-continent as well. This, combined with the generally low interest rate environment, is keeping cap rates low (and property values high), especially for the highest-quality assets in global gateway markets, where global investment flows are especially strong. Global capital flows typically introduce increased competition for property acquisitions, a slight negative for REITs. But global capital flows generally require specialized local-market knowledge for deployment, a boon for the largest global commercial real estate services firms.
With acquisition prices high, more REITs are expanding their development pipelines, targeting initial yields that exceed acquisition cap rates by 200 basis points or more. If such yields are realized, REITs can theoretically create immediate value upon stabilization of these developments, as the market recognizes the earnings power of the developments in light of lower cap rates for stabilized, operational properties. Although construction levels seem reasonable currently, oversupply of incremental square footage generally corresponds with commercial real estate downturns. While we are not overly concerned with current construction levels, this is an area that bears watching.
We expect REIT prices to generally move inversely with changes in long-term government bond yields. Although higher interest rates would take some time to show up in REIT financial metrics, eventually, higher rates could cause higher debt financing costs, pressure on traditional after-interest expense measures of REIT cash flow (such as FFO, AFFO, and FAD), and 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 might signal a strengthening economy, which could benefit real estate fundamentals, we do not expect the macro environment to improve enough to offset what could be another 150-basis-point (or more) rise in rates to levels nearer historical norms.
In a rising interest rate environment, we'd prefer REIT investment exposure weighted toward reasonably priced, narrow-moat firms with attractive internal and external growth prospects, conservative capital structures, and well-laddered debt maturity schedules.
| Top Real Estate Sector Picks | |||||
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| | Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying |
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| HCP |  | $51.00 | Narrow | Medium | $35.70 |
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| American Tower | | $100.00 | Narrow | Medium | $70.00 |
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| CapitaMall Trust | | SGD 2.20 | Narrow | Medium | SGD 1.54 |
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| Data as of 06-23-2014 |
HCP (HCP)
Health-care REITs in general are the most attractive property sector among our U.S. real estate coverage, and HCP--which owns senior housing facilities, skilled nursing facilities, life science properties, medical office buildings, and hospitals, mainly located in North America and leased to tenant operators on a long-term basis--is our favorite among the bunch. In general, U.S.-based health-care REITs should benefit from some favorable tailwinds, including an expanding population, an aging population, and potentially tens of millions of people added to the ranks of insureds because of the Affordable Care Act--all of which should drive incremental demand for health-care real estate relative to historical levels. Plus, health care is a property sector in which the vast majority of assets remain in private hands, so HCP should have opportunities to further consolidate ownership. We think HCP's current yield of greater than 5%, combined with growth prospects in the low- to mid-single-digit range (if not higher, depending on external growth opportunities), provides investors with a compelling total return prospect in the current environment.
American Tower (AMT)
American Tower owns wireless communication towers, on which it leases network capacity to the Verizons and AT&Ts of the world. It is essentially a play on increased mobile data usage, both in the United States and around the world. Once a tower is in place, adding a new customer to a tower or expanding capacity of an existing customer on a tower generates high-margin incremental revenue. Plus, American Tower's leases with tenants generally call for 3% to 5% annual rate increases. The combination of these annual rent escalators with wireless provider demand for additional capacity to meet the needs of their subscribers' demand for premium unlimited data plans as well as next-generation networks should result in rapidly escalating cash flow for American Tower.
Capitamall Trust (C38U) (Singapore)
CapitaMall Trust, or CMT, owns a portfolio of quality malls in Singapore, and boasts the city-state's greatest market share. Its malls are well-managed, situated in densely populated areas, and are close to mass-transport hubs with high foot traffic. These attributes are attractive for its diverse tenant base, resulting in high retention rates and near-full occupancy across its properties. The competitive position (and hence, moat) is also supported by the ongoing expansion and revitalization of CMT's malls, which strengthens the retail offering and discourages competitors from entering the market. This is achieved through better utilization of floor space, increasing net leasable area by expanding existing properties, and improving tenant and trade mix. We expect redevelopment activities to continue to feature as part of CMT's operations over the long term, supporting net rental income growth increasing to 4% per annum over the next five years. The stock is slightly undervalued with a price/fair value ratio of 0.90, and it offers an attractive forecast dividend yield of 5.5%.
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