Real Estate: For the Strong Stomached, Commercial Real Estate Looking More Attractive

• Morningstar's real estate sector looked expensive earlier in the year, but following recent market weakness, it now appears to trade at a 10% discount to our estimates of value, roughly in line with the discount on Morningstar's aggregate coverage universe.
• Recent trends in commercial real estate persist, including investor fears over the potentially negative impact of rising interest rates, REITs' preference for developments over acquisitions, and increased international capital flows for real estate investments.

Over the course of 2015, Morningstar's real estate sector coverage has moved from one we viewed as largely overvalued to one that looks more reasonably priced. The sector trades at a 10% or so aggregate discount to our estimates of value, roughly in line with the discount associated with our overall coverage universe. Investors should continue to be selective in the space, however, as plenty of real estate firms continue to trade above our estimates of value.

We expect REIT prices generally to move inversely with changes in long-term government bond yields. Higher interest rates would take some time to show up in REIT financial metrics. But 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.

Although 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. Although 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 low-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 and 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. For the first time in years, the commercial real estate services and data firms under Morningstar coverage (including

With the abundance of institutional capital chasing high-quality assets (especially in gateway markets), transaction 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 in 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 somewhat undervalued, thanks to the recent market swoon. Health-care REITs are our favorite sector currently, while pockets of opportunity also exist among the retail and specialty REITs, including the cell tower and document storage sectors.

After a recent pullback, value is emerging in Australian property, with the best opportunities being global industrial specialist Goodman Group and diversified REIT Stockland, with its focus on retail and affordable housing.

As with other major markets, Asia-Pacific property appears undervalued and offers attractive yields relative to conventional income products such as bonds. A pullback in the equity markets in the region has provided new opportunities in the property space. We prefer developers such as

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) with geographical diversification across greater China and Asia, and steady earnings underpinned by recurring investment income. We also continue to favor office property over retail property in Singapore. The limited new supply of office space in the Singapore 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

With its narrow moat and exemplary stewardship, Tanger is one of Morningstar's favorite REITs, and its low-priced stock makes it one of our favorite potential investments among our REIT coverage. With an expected 2016 cash-flow yield of 6%-plus at recent prices (using our 2016 normalized AFFO estimate) combined with at least mid-single-digit growth prospects, we think Tanger offers investors an attractive total return opportunity. Tanger's outlet stores weathered the last economic downturn better than other retail property types, and we think both consumer and retailer interest in the outlet concept remains strong, driving inflation-plus internal growth plus additional growth from incremental development opportunities.

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--with its narrow moat and exemplary stewardship--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.

Goodman Group

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Goodman is one of the top three global industrial specialists. Income comes from owning, developing, and managing premium warehouses and business parks. Recent share price weakness is most likely due to concerns around its exposures to China and Brazil. We think these concerns are misplaced as the balance sheet exposure to these regions is small (China is 7% of assets, Brazil is 1% of assets), and the firm's development exposures to these markets are modest as most have been presold and tenant demand remains robust for its higher-quality assets.

More Quarter-End Insights

• Stock Market Outlook: Minor Correction Not Enough to Make Stocks Cheap
• Economic Outlook: As World Growth Falters, the U.S. Consumer Rolls Along
• Credit Markets: Plummeting Commodity Prices Take Their Toll
• Basic Materials: U.S. Construction Activity Provides Shelter From the Storm
• Consumer Cyclical: Near-Term Concerns Over China Create Buying Opportunities
• Consumer Defensive: Upside in Staples Companies With Long-Term Cost-Cutting Opportunities
• Energy: No Rapid Rebound for Oil Prices
• Financial Services: Re-Analyzing Banking Systems and Bank Moats
• Health Care: Recent Pullback Opens Door to More Compelling Valuations
• Industrials: High-Quality Industrials Are on Sale
• Tech and Telecom: Still Watching Foreign Exchange Headwinds and the Cloud
• Utilities: Low Rates Keep the Sector's Lovefest Raging