Real Estate: Rising Interest Rates Wreak Havoc on REITs

• As investors' concerns about potentially higher interest rates increase, they should focus on moaty REITs with reasonable balance sheets, good growth prospects, and relatively attractive valuations. Overall, our U.S. real estate coverage appears roughly fairly valued. After a recent pullback, value is emerging in the Australian property sector. Asia-Pacific property still offers attractive yields relative to conventional income products such as bonds.
• Rising interest rates may be an immediate valuation risk to REIT share prices, but long-dated in-place debt maturity schedules mute the near-term impact on REIT cash flows.
• 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 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 funds from operations, adjusted funds from operations, and funds available for distribution), 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 200-basis-point rise in U.S. government bond yields to levels nearer historical norms.

While the potential negative impact of rising interest rates remains a key concern for REIT investors, U.S. REIT management teams seem less concerned. The majority of U.S. REITs have improved their balance sheets since the last downturn and appear as a group to remain more conservatively leveraged than the last boom in the mid-2000s. Moreover, upcoming maturities for many U.S. REITs over the next few years still carry interest rates that far exceed current borrowing costs, so even a 100-basis-point rise in rates from here would have a negligible impact on cash flow, at least over the medium term.

Nonetheless, recent trading activity suggests that investor expectations about actual or expected future interest rates can have an immediate impact on U.S. REIT stock prices. While we still view the potential for higher interest rates as a valuation risk for U.S. REITs, we would expect higher interest rates to have a negligible impact on our estimates of value. We already embed a mid-4s yield on the 10-year Treasury into our weighted average costs of capital, relative to the mid-2s level observed in the Treasury market recently.

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 the abundance of institutional capital chasing high-quality assets (especially in gateway markets), pricing for existing commercial real estate stock appears aggressive. U.S. REITs with development capabilities are allocating more capital to ground-up developments and redevelopment of existing, productive assets. We think this makes sense, with expected initial yields on development projects generally at least 200 basis points higher than current cap rates on sales transactions. 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.

Despite the focus on developments at many U.S. REITs, overall development across the U.S. commercial property landscape continues to remain at reasonable levels, in our opinion. Oversupply of incremental square footage generally corresponds with commercial real estate downturns. But some developers from prior cycles did not survive the last downturn, and financiers remain less aggressive providing development capital in many instances. As such, we are not overly concerned with current U.S. construction levels, but this is an area that bears watching.

Given the potential for rising rates, however, we think it makes sense to focus on REIT investment opportunities that can do well in either a rising interest-rate environment or a future in which the slow-growth, low-rate environment continues. We prefer firms with reasonable leverage, moaty assets, demonstrated historical success across economic cycles, identifiable internal and external growth drivers, and reasonable margins of safety to our estimates of value. Moreover, we think it makes sense to focus on firms with these attributes that also have well-covered dividends with strong prospects for growth over time.

Generally, our U.S. real estate sector appears fairly valued. Health-care REITs are our favorite sector currently, while pockets of opportunity also exist among the retail and cell tower sectors.

After a recent pullback, value is emerging in Australian property, with the best opportunities being in the retail and industrial sectors.

As with other major markets, Asia-Pacific property offers attractive yields relative to conventional income products such as bonds. Singaporean REITs are fairly valued, but we prefer office over retail. Limited new supply of office space in the central business district in 2015 is supportive of rental growth. Although office construction will add meaningful new supply in 2016, this should be absorbed by increased tenant demand as Singapore remains a premier location for multinationals' regional headquarters.

Tanger Factory Outlet Centers

SKT

Tanger is the only publicly traded U.S. REIT focusing exclusively on outlet centers in the U.S. and Canada. We like its outlet strategy as this is an area of retail that has held up well across economic cycles, and we think retailer demand for outlet distribution remains high. Occupancy at Tanger's centers was recently near 98%, among the highest of retail REITs in general. Strong consumer and retailer interest in the outlet channel is driving incremental outlet center development, which we think has another five to 10 years left to run, providing plenty of external growth opportunities for Tanger. Furthermore, we estimate Tanger's in-place rents are 5%-10% below current market rents, supporting inflation-plus rates of internal growth as leases expire and tenants' rents increase to market levels. To us, the combination of Tanger's 6%-plus cash-flow yield (using our 2016 normalized AFFO estimate) with mid-single-digit growth prospects appears attractive in the current environment.

Ventas

VTR

Health-care REITs in general are one of the most attractive property sectors in our U.S. real estate coverage on a relative valuation basis, and Ventas is currently our favorite among the bunch. In general, U.S.-based health-care REITs should benefit from some favorable tailwinds, including an expanding and 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 Ventas should have opportunities to further consolidate ownership. We think the combination of Ventas' 7%-plus cash-flow yield (using our 2016 normalized AFFO estimate) 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.

Westfield

(

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After the June 2014 restructuring, Westfield is a purely international retail REIT with rents coming from the United States (70%) and the United Kingdom (30%). With cap rates for finished products around 5% and development yields around 7%, we see significant value in the firm's USD 11.4 billion pipeline (AFD share USD 6.3 billion). In addition, the pipeline should step up further, with Westfield having recently obtained approval to develop 2,500 apartments above its two London sites. The strategy to divest more of the regional assets and redeploy capital on the destination-style super-regional assets is expected to result in a higher-quality income stream. The long-term trend toward greater urban density in major cities supports further redevelopment of existing sites and is expected to be a long-term earnings catalyst.

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• Consumer Cyclical: Assessing Disruptions in Restaurant, Retail, and Travel
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• Financial Services: A Favorable Outlook for Insurance
• Health Care: A Few Stocks Still Offer Upside
• Industrials: Stronger U.S. Dollar, Weaker Energy Activity Weigh
• Tech & Telecom: M&A Heats Up, and the Cloud Changes the Landscape
• Utilities: Starting to Look Attractive After a Woeful 2015 Start