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Morningstar
Quarter-End Insights

Still Some Opportunities in REITs

U.S. REITs appear somewhat overvalued as a group, but we see some opportunities in the health-care, retail, and cell tower sectors.

Todd Lukasik
  • U.S. REITs appear slightly overvalued as a group, with pockets of opportunity in the health-care, retail, and cell tower property sectors. Most Australian property stocks appear fully valued, but we see some value in the retail sector, while the office and industrial sectors appear the most overpriced.
  • Capital is increasingly flowing across borders for property investments, and property values are high.
  • With acquisition prices high, more REITs are expanding their development pipelines, with initial yields projected to be 200 basis points or more above acquisition cap rates.
  • We generally expect REIT prices to move inversely with changes in long-term government bond yields, and we would expect REITs to generally underperform in a rising interest-rate environment.

U.S. REITs appear somewhat overvalued as a group, with pockets of opportunity in the health-care, retail, and cell tower 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 for the developers, with the market likely underestimating risk in what is inherently a deeply cyclical activity. Australian office faces medium-term 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 intraregion, 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, put pressure on traditional after-interest expense measures of REIT cash flow (such as FFO, AFFO, and FAD), and lead to 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, 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 100- to 150-basis-point 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. Many property sectors with shorter lease durations (of a year or less) that REIT pundits traditionally favor during rising interest-rate environments look to offer investors an insufficient margin of safety today. In the U.S., we are generally cautious on multifamily and self-storage REITs, while we see relatively attractive valuations among health-care REITs and cell tower REITs, with pockets of opportunity in other property sectors.

Top Real Estate Sector Picks
Star Rating Fair Value
Estimate 		Economic
Moat 		Fair Value
Uncertainty 		Consider
Buying
HCP $51.00 Narrow Medium $35.70
American Tower $111.00 Narrow Medium $77.70
CapitaMall Trust SGD 2.20 Narrow Medium SGD 1.54
Data as of 09-24-2017

 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 in North America and leased to tenant operators on a long-term basis--is attractive currently. 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 the insured 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 the 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 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 (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 year over the next five years. The stock is slightly undervalued, with a price/fair value ratio of 0.89, and it offers an attractive forecast dividend yield of 5.6%.

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