REITs: Some Scattered Opportunities in a Fairly Valued Sector

• Morningstar's real estate coverage is trading at a 2% discount to our fair value estimates.
• We view themes in commercial real estate as generally defensive in nature, with lingering concerns about increasing bond yields associated with future rate hikes. However, we continue to focus on underlying performance, which has remained healthy overall, as REITs have been focused on repositioning and strengthening their portfolios, deleveraging, and capital recycling.
• Construction of new property continues, however, as firms look for higher returns, putting into question levels of new supply as economic uncertainty remains.

Morningstar's real estate coverage looks fairly valued, trading at a 2% aggregate discount to our fair value estimate. Investors should continue to be particularly discriminating, as we expect actions by the new presidential administration, as well as potential for increased central bank interest-rate activity throughout the remainder of the year, to continue to affect property and capital markets activity, asset pricing, and overall volatility in the near term. Continued tension in Washington, along with the potential inability to pass tax reform, could make for a rocky rest of the year.

As the new administration approaches its half-year mark, details surrounding proposed tax reform remain murky, yet House Speaker Rep. Paul Ryan, R-Wis., remains confident that fundamental tax reform affecting corporations, small businesses, and individuals will be completed in 2017. Continued 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 the 10-Year U.S. Treasury yield had retreated to 2.2% by mid-June.

Downward movement in Treasury yields, often used as a benchmark for real estate valuation, have supported REIT share prices over the quarter. Given the circumstances, many investors continue to wonder whether we are near the 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.

Despite recent hikes, U.S. interest rates are expected to remain historically low in the near term, which we view as a plus for real estate in general. Additionally, several economic signals, including unemployment levels, wage growth, and GDP growth, supported the case for positive momentum going into the current administration. While we now expect increased near-term volatility as market speculation and expectations eventually converge 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 they 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. While growth has slowed from elevated levels seen in recent years, we believe the market has been expecting this slowdown and has priced it into the sector. Many firms have also continued to recycle capital, trading out of weaker, more vulnerable assets into stronger assets with better long-term growth prospects and risk profiles. While 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 greater concerns. Furthermore, a wave of legacy, peak-market property debt maturing over the remainder of the year 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 weary and return expectations decrease, a reduction in overall investment will slow demand and reinforce negative outlooks.

Given that our real estate coverage is nearly fairly valued as a whole, it's important that investors enter the sector with caution. Historically high asset prices for existing, stabilized institutional real estate is forcing the hand of many U.S. REITs to focus on new development and redevelopment opportunities. Although we still 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.

Australian and New Zealand Real Estate Outlook

Australian REITs have now been tracking sideways since December 2016, but there has been a divergence in performance between sub-categories, with industrial and office in favor and retail out of favor. The decline in the share price of the retail REITs reflects a confluence of factors, the most significant being weakening investor sentiment due to slowing sales performance and a lift in the number of retailers in financial distress. There are also heightened concerns about the impact that the forthcoming arrival of

On average the 26 Australian and New Zealand REITs under coverage screen as 2% over-valued, with just

) rated 4 stars, both of which are best ideas. The whole property sector remains beholden to interest rates, but we have not reduced fair value estimates as our central thesis remains that interest rates will rise very slowly over the foreseeable future.

Westfield was put on our best ideas list in June as we view the stock as being oversold on concerns around struggling USA apparel brands. The risk is real, as brick-and-mortar retailers will face further challenges from a higher proportion of sales occurring through online channels. However, Westfield has the option to reallocate space that is currently occupied by struggling fashion brands to alternative uses such as dining and services. We expect the incoming tenants to have marginally lower rent-paying capacity and account for this in our forecasts for the annual growth trajectory to systematically trend down to 3%. We see Westfield's retail malls evolving to become de facto town centers, rich with entertainment, dining, and essential services, but also extended trading hours. The combination of an attractive tenant mix and the higher household income of inner city locations is forecast to result in the sales and rental performance of Westfield's larger centrally located malls outperforming the broader market. Contributed by Tony Sherlock

Singapore Property Outlook

Most developers and REITs under our coverage outperformed the Strait Times Index in the second quarter. Moderate increase in REITs' unit prices have seen most REITs trading close to our fair value; however, we continue to see value in two developers: CapitaLand and

).

Despite reporting a positive first quarter result, CapitaLand's share price eased off slightly after a strong rally early in the year, while City Development maintained its positive trajectory as concerns over a hard exit for the United Kingdom from the European Union alleviates, in our opinion. With both developers trading close to a 10% discount to our fair value estimates, our preference is for the narrow-moat rated CapitaLand, as we believe its earnings and cash flow are better quality, supported by its mall and serviced-residence business.

In the REIT space, the strongest performer was

) post-acquisition of a hotel in the United Kingdom. The acquisition of a high-quality asset, as one of two five-star hotels in Manchester, was in line with the trust's strategy in diversifying away from its core market of Singapore, which has seen room rates pressured from weaker corporate travels and increased room supply. The latter continues to make up 59% of its earnings, and we believe the trust is fairly valued.

CapitaLand Commercial Trust, one of two REITs we favored last quarter, is also fairly valued, as it posted a resilient first-quarter result and more importantly, monetized its asset by divesting a 50% stake in One George Street for SGD 591.6 million to FWD Group. In our view, the valuation was favorable and represented a transactional net property yield of 3.2%, compared with a valuation capitalization rate of 3.75% to 4.25% for the rest of its portfolio. Contributed by Michael Wu

Japanese Property Outlook Our preference for developers over REITs, as noted in the last quarter, remains the same after cap rates fell closer to a historical low of 3.8% with the net REIT fund outflow continuing into the quarter-end.

Similar to other geographies under our coverage, Japanese property markets have been tracking sideways after hitting the peak around the end of last year. Major Japanese developers under coverage are now fairly priced with limited upsides after we have adjusted our fair value estimates incorporating their year-end results. The property sector remains sensitive to interest rate increases, but interest rates in Japan remain low. We also do not expect that 10-year risk-free rates would rise meaningfully above 0.1% during our forecast horizon in a political attempt to control the large debt burden of the government.

Market performance across asset categories saw more mixed trends, with logistics and hotels falling into favor and residential sales falling out of favor. The mainstay office leasing markets remain steady, as limited supply within the central business districts still supports a reasonable annual rent increase of 2% and vacancy rates tracking below 2.5%. Over the next five years, we expect incoming tenants to have marginally higher pricing power given a slowly rising net building supply, and we have revised down our annual revenue growth forecast to 4% against industry growth of 1.5%.

For major developers, the unique combination of attractive locations, long-term relationships with an affluent client base, and higher pricing power under a low interest rate environment will remain the same, keeping sales and rental performance tracking substantially above the broader markets. Contributed by Mari Kumagai

Hong Kong and China Property Outlook In Hong Kong, the physical property market moved higher during the quarter, promoting additional prudential measures from HKMA, including higher risk weighing and lower LTV for new mortgages. The regulator also tightened lending to developers by limiting construction financing.

Year to date,

) shares rallied 27% versus HIS up 17%. The shares are currently trading at 13 times earnings and 0.8 times book, only slightly below our fair value estimate. The company has entered into several yield-focused businesses outside the property sectors as well as continued share buybacks to deploy its excess cash.

) shares are trading at 14 times earnings and 0.7 times book, still attractive relative to our fair value estimate. However, the overheated physical market is likely to be very volatile ahead, affected by higher interest rates, lower liquidity, and increasing supply. As the bellwether of the Hong Kong real estate sector, Sun Hung Kai Properties' shares will be volatile as well.

In China, major developers' shares moved sideways after the rally during the first few months of the year. Government policies are gradually tightening with regard to the real estate sector. While sales volume will be down relative to a year ago, prices will likely stay firm on account of successful destocking in 2016 and a possible supply shortage in certain upper-tier cities.

We prefer developers with land bank exposure to growing metropolitan areas, and those with a track record of earnings growth through fast asset turn and portfolio acquisitions. We remain positive on

), currently trading at a P/E and P/B of approximately 8.5 times and 1 times, respectively. We expect the CITIC acquisition last year to bolster the company's growth with a pipeline of projects at reasonable cost.

Contributed by Phillip Zhong

Top Picks

Vornado

VNO

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $118.00

Fair Value Uncertainty: Medium

5-Star Price: $82.60

We still like high-end Class A office providers such as Vornado, which is currently trading at a 20% discount to our $118 fair value estimate. As its competitors pour concrete and cash into the upcoming Hudson Yards project, Vornado remains set to benefit from the improving neighborhood with 6.5 million square feet of office space and half a million square feet of retail property just east of the incoming development. We were pleased with rental rates surrounding Penn Plaza, which climbed into the upper-60s to end 2016. We see this trend continuing, as half of lease expirations for 2018 are concentrated in One Penn and Two Penn Plaza, so next year serves as a real opportunity to realize higher rental spreads given the greater appeal for that submarket.

Public Storage

PSA

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $237.00

Fair Value Uncertainty: Low

5-Star Price: $189.60

Within self-storage, we note that Public Storage is trading at an 11% discount to our $237 fair value estimate. The company should benefit from management's continuous price increases passed along to its sticky customer base every eight to 10 months. Its recognizable brand name and development focus should position the company to absorb growth driven by macro factors such as dislocation associated with a stronger jobs market, the strong number of renters versus buyers, and increasing popularity of urban living. Additionally, the company is development focused, which can add between 3% and 5% to yields compared with its acquisitive competitors that have been buying at peak prices. Public Storage's balance sheet is among the strongest in storage, which provides support for its ability to profitably expand its market-leading presence in a highly lucrative industry. Storage facilities can operate profitably with occupancy rates below 40%, so we view firms with easy access to capital to fund growth as the winners in this asset class.

CapitaLand Mall Trust

(

)

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: SGD 2.30

Fair Value Uncertainty: Medium

5-Star Price: SGD 1.61

Within retail, CapitaLand Mall Trust remains our preferred trust as its unit price weakened after a soft first-quarter result. Many of its assets saw negative rental reversions while foot traffic fell and tenant sales per square feet per month declined. At close to a 15% discount to our fair value, we believe the trust is undervalued, and we maintain our view that softer rental is cyclical and the trust will maintain high occupancy levels, which is underpinned by its high-quality malls at favorable locations.

More Quarter-End Reports

Market Stock Market Outlook: Equity Valuations Look Lofty

Economy Midyear Economic Forecast: Lower Inflation, Slow Growth

Credit Markets Credit Market Insights: Bond Indexes Perform Well in a Quiet Market

Equity Sectors Basic Materials Outlook: Propped Up and Too Expensive

Communication Services: AT&T and Verizon--A Duopoly No More

Consumer Cyclical: Amazon Reshapes Retail in Real Time

Consumer Defensive: Retailer Consolidation Sparks Concerns, but Opportunities Exist

Energy: Despite OPEC Cuts, a Crude Awakening Is Near at Hand

Financial Services: Our Take on U.S. Tax Reform and Bank Deregulation

Healthcare Outlook: ACA Repeal Efforts Unlikely to Yield Major Legislative Changes

Industrials: China Shows Signs of Softening, but the Sector Remains Healthy Overall

Tech: A Tectonic Shift Toward Enterprise Cloud Computing

Utilities: Tough to Stop This Sector's Powerful Performance

Mutual Funds First Half Winners and Losers for Funds

Second Quarter in U.S. Stock Funds: Growth on Fire

International-Stock Funds Continue to Prosper

Bonds in the Second Quarter: The Flattening

Portfolio Planning With Christine Benz Trends and Takeaways From 2017's First Half

PitchBook Reports Tapping the Brakes on M&A

Private Equity: Capital Deployment Remains a Challenge

Venture Capital: Less Is More?