Real Estate: Through the Noise, Opportunities Exist
To navigate the choppy waters ahead, keep it simple and focus on the fundamentals.
Morningstar's real estate coverage looks marginally undervalued, trading at a 7% aggregate discount to our fair value estimate. Investors should continue to be particularly discriminating as we expect mixed economic outlooks, including the potential for increased central bank interest rate activity throughout the next 12 months, to continue to affect property and capital markets activity, asset pricing, and overall volatility in the near term.
The unexpected results of the U.S. presidential election have had a tremendous impact on the markets even though proposed policy details behind the incoming administration's agenda are still largely unknown. Speculation regarding potential trade policy, healthcare reform, infrastructure spending, and general deregulation, among many other matters, had the markets hitting all-time highs on the increased expectation for overall economic growth, while also sending 10-year U.S. Treasury yields up nearly 100 basis points over the quarter. In addition, economic data supported the Fed announcing an increase of the federal-funds rate by 25 basis points in December, as widely anticipated, along with prospects for three similar increases in 2017.
Upward movement in Treasury yields, often used as a benchmark for real estate valuation, and interest rate expectations have consequently negatively affected REIT share prices over the quarter. Given the circumstance, many investors continue to wonder whether we are near a peak of the commercial real estate cycle; higher interest rates could put pressure on growth rates, cap rates, return expectations, and ultimately asset prices. Also, to the extent that low interest rates have diverted investor funds to REITs searching for higher yield and capital preservation, the same funds could flow out of REITs if interest rates rise, further pressuring commercial real estate valuations.
In context, however, we still expect U.S. interest rates to remain historically low in the near term, solidifying a path toward measured growth. Additionally, several economic signals, including unemployment levels, wage growth, and GDP growth, support the case for positive momentum going into the next administration. While we now expect increased near-term volatility as market speculation and expectation eventually converges with economic reality over the next several months (or years), the same perceived positive catalysts for the market that have affected interest rates should only help to support fundamental demand for real estate and offset pressure on relative valuations.
That said, much of our U.S. REIT coverage still enjoys healthy underlying operating performance. Most portfolios are characterized by historically high levels of occupancy and durable balance sheets, and benefit from in-place leases that can potentially be re-leased at higher current market rents, giving these firms embedded cash flow growth if not a safety cushion for future economic weakness. Many firms have also continue to significantly reposition and refine their portfolios, trading out of weaker, more vulnerable assets into stronger assets with better long-term growth prospects and risk profiles. Although near-term uncertainty has affected leasing and transaction volumes, private-market asset values have largely stayed intact and should continue to serve as an anchor for public market valuations.
However, as we get deeper into the cycle, increased new supply in localized markets, such as New York and San Francisco, and asset classes, including office, multifamily, and senior housing, have become a greater concern. Furthermore, a wave of legacy, peak-market property debt maturing over the next 12 months may cause significant disruption in real estate property and capital markets. And if effective debt yields ultimately rise relative to overall performance, we would expect asset values and performance to be increasingly challenged. As investors and businesses become wary and return expectations decrease, a reduction in overall investment will slow demand and reinforce negative outlooks.
Given prolonged uncertainty for demand, attractive investment opportunities are harder and harder to source. Historically high asset prices for existing, stabilized institutional real estate are progressively railroading many capable U.S. REITs into allocating more capital toward value-creation opportunities such as the redevelopment of existing assets or the development of new properties to further grow and achieve required returns. While we continue to acknowledge the opportunity for prudent capital allocation to achieve excess returns, we are cautious of firms overextending themselves into riskier investments. Reasonably leveraged companies with solid prospects for long-term growth that can weather the natural cyclicality of the real estate markets are our preferred investment vehicles.
That said, we believe there are opportunities within our U.S. REIT coverage. We currently like Simon Property Group, owner/operator of high-quality regional malls and retail properties and the largest REIT by market capitalization. Trading approximately 20% below our fair value estimate, we think Simon's high-quality, productive assets and exemplary stewardship will continue to support solid performance despite online retailing headwinds. We also think health-care REITs--including Welltower, Ventas, and HCP--represent a noteworthy, reasonably priced opportunity due to a robust, relatively noncyclical demand outlook and positive industry trends that should help maintain strong cash flow generation and insulate these firms from economic volatility. Current dividend yields approximately 5% or more don't hurt, either.
Likewise within our Australian regional coverage, we see the most value in sub-sectors with robust demand fundamentals and discipline in adding new supply. Our best picks are Goodman Group, Westfield Corporation, and Aveo Group. In our view, returns for investors in property stocks for the past few years have been driven more by falling interest rates than market fundamentals. However, central bank policies to stimulate growth by reducing borrowing costs have not delivered the desired results and now appear to be out-of-favor. Based on the assumption that bond yields will gradually increase going forward, we see Australian property as fairly valued, with rents growing 2% to 3% and an average distribution yield of 5.6%.
The rally in the Singapore property companies from a flight to safety post the U.K. referendum in the third quarter has faded, and the sector's share price has declined steadily in the fourth quarter. While the Singapore property index has recovered its losses since the U.S election, medium-term concerns over the pace of rising U.S. interest rates will continue to pressure the sector. The REITs took advantage of the low interest rate environment by fixing their debt in the near term and remained conservative in their asset valuation. Capitalization rates generally compressed between 15 basis points to 30 basis points from 2010 to 2015. However, we maintain our preference for developers over the REITs, as we believe the developers will fare better in a rising interest rate environment.
While the Singaporean economy grew 1.1% year on year in the third quarter, economic growth remains weak and consumer prices have maintained a negative trajectory, declining 10 basis points year on year in October, or 24 consecutive months. We continue to see mall REITs as more defensive in the current slowdown, but the recent decline in unit prices have seen value emerging for the commercial REITs. Both CapitaLand Commercial Trust and CapitaLand Mall Trust are trading at a 15% discount to our fair value. Commercial rentals will be pressured in the near term due to new office supply concentrated in 2017 and softer demand, but we reiterate there is little new supply after 2018. Combined with a recovery in net office demand in line with the economy, office rental should steady in 2018 before growing thereafter. Several Grade A office projects in the Central Business District have been announced in the quarter with completion likely after 2020, painting a more positive outlook in the office space over the long term. And the first piece of land auctioned off by the Singapore government at Marina Bay in nine years saw a winning bid at SGD 2.6 billion, significantly higher than market expectations.
In Japan, we similarly maintain our preference for major developers over the J-REITs. Major property developers continue to benefit from a low rate environment supporting financial leverage, strong office demand supported by limited land supply, and the Bank of Japan's accommodative policy stance, leading us to believe the developers will fare better in a rising interest rate environment. We also like that major developers took advantage of the low interest rate environment by fixing their debt in longer duration and remaining conservative with asset valuations.
While medium-term concerns exist over the pace of U.S. interest rate increases, Tokyo's prime office investments maintain an attractive value proposition over the near-zero 10-year government bond rate with the latest average expected total returns tracking above 7.8%.
In the near term, we expect Tokyo Grade A office property to exhibit strong rental income growth as low new office supply offsets softer demand and keeps prime office vacancy rates low, most recently at 4.8% for the last two consecutive quarters. However, longer-term concern over new supply emerges only after 2018 leading up to the 2020 Tokyo Olympics. And central bank liquidity infusions, with annual repurchases of JPY 90 billion targeted at J-REITs, continues to distort market fundamentals, with larger downside risks extending to the years beyond our forecast horizon. We currently prefer Mitsubishi Estate, having the most conservative balance sheet management among its peers.
In Hong Kong, developers' shares weakened throughout 2015 as a result of concerns over a federal rate hike and reached a trough level at the beginning of 2016. Aggressive marketing and financing offers lured back the buyers in the third quarter, allowing developers to de-stock their inventories as housing prices rebounded. However, this led to another round of government austerity measures imposed in early November, in the form of an additional 15% stamp duty applicable to all except for Hong Kong residents buying their first properties. This sent developers’ shares lower, erasing half of the gains accrued during the year.
As the best name among Hong Kong developers, in our opinion, Cheung Kong Property's shares are currently trading near 11 times earnings and 0.7 times of book, attractive compared to historical averages. We also like China Overseas Land & Investment (00688), currently trading at a P/E and P/B of approximately 7 times and 0.9 times, respectively.
Simon Property Group (SPG)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $213.00
Fair Value Uncertainty: Low
Five-Star Price: $170.40
Simon owns and operates a diversified portfolio of regional mall, outlet, and other retail properties throughout North America, Europe, and Asia. These high-quality assets tend to be dominant hubs for retail, entertainment, and dining offerings and have proven highly productive in terms of tenant sales, allowing the properties to maintain high demand, occupancies, and consistent rent growth. This, in turn, has generated greater cash flow for Simon to reinvest into its properties, allowing the company to adapt and insulate its portfolio from e-commerce headwinds. Along with a solid management team and a history of exemplary stewardship, we think shares of Simon are attractive at a roughly 15% discount to our fair value estimate.
Cheung Kong Property Holdings (01113)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: 70.00 HKD
Fair Value Uncertainty: Medium
Five-Star Price: 49.00 HKD
Cheung Kong Property employs a flexible pricing strategy and full-cycle view, allowing it to achieve good sell-through regardless of physical market conditions. The firm focuses on quickly turning assets and maintaining a strong balance sheet, leaving ample opportunities for countercyclical land acquisitions. However, since a reorganization in early 2015, coupled with the recent aggressive market to offload inventories, the company has reduced its exposure to residential trading; currently, 45% of its income now comes from rentals, hotels and REITs. After retreating 17% since the implementation of the stamp duty, the company's shares are currently attractive compared to historical averages, in our view.
China Overseas Land & Investment (00688)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: 33.00 HKD
Fair Value Uncertainty: High
Five-Star Price: 19.80 HKD
We prefer China Overseas Land & Investment for its strong operational capability and access to M&A opportunities to acquire a large-scale project portfolio and landbank. Shares of Chinese developers declined more than 30% as the government began to introduce administrative measures to rein in a heated property market. The sector has seen a significant amount of destocking in 2016 while land sales and new starts have remained subdued. Hence going into 2017, we believe the property market should see declining sales volume, but prices holding firm with a possible surprise on the upside due to constrained supply. Further, we do not believe liquidity will tighten significantly as the economy remains weak.
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Edward Mui does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.