Real Estate: Enter With Caution

• 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 as firms look for higher returns, putting into question levels of new supply as economic uncertainty remains.

America's Real Estate Outlook Contributed by Brad Schwer

Investors should continue to be skeptical of opportunities across different industries, as we expect actions by the new 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. Volatility levels have been low as of late, but that could change if some key initiatives from the Trump campaign continue to fall by the wayside.

As the new administration looks to the fourth quarter, details surrounding proposed tax reform remain murky and could push any action into 2018. Another headwind to timely reform is the budget approval, which itself is enough to provide doubt that anything will pass in 2017 on the tax front. Continued speculation regarding potential trade policy, 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-September.

Relatively little movement in Treasury yields, often used as a benchmark for real estate valuation, has equated to a stable performance in 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 the June hike, 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, support the case for positive momentum going into the end of the new administration's first year in office. 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. While 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 Contributed by Tony Sherlock

We see few compelling opportunities among Australian REITs, with

) and

) remaining our two best ideas.

Firms with substantial property management platforms have been the strongest performers in 2017 to date, but we see these firms as overvalued, particularly given an outlook for rising interest rates that will exert downward pressure on property values and the earnings base of these firms. After enjoying a strong run during 2016, the office REITs of

(

) and

(

) have both retraced during 2017, with reported growth in effective rents not as strong as we anticipated, with landlords still having to offer significant incentives to lease vacant space. Overall, we think valuations of office REITs remain lofty, with investors encouraged to wait for a more attractive entry point.

Westfield's share price has declined over the past year on concerns of slowing retail sales and an escalation in the number of retailers encountering financial difficulties as a higher proportion of discretionary spending switches to online retailers. These concerns are valid as the lower cost structures of online retailers mean an increasing proportion of sales will occur through digital channels.

However, our fair value estimate accounts for this sales leakage by forecasting annual rent growth across the portfolio trends down from 3.5% to around 2.6% over the coming decade as less relevant retailers are replaced by tenants with a marginally lower rent-paying capacity. In essence, we see rents in outer years growing marginally above inflation as malls also benefit from increased housing density in their catchment areas.

Our thesis is for Westfield's malls operating as de-facto town centers, with rich offerings in entertainment, dining, and services, but also extended trading hours. The portfolio is already well aligned to catchment areas with higher household income but will become more focused on the affluent demographic following planned development capital expenditure. The combination of a premium rental roll and the higher household income of inner city locations is forecast to result in rent growth for Westfield's larger centrally located malls outperforming the broader market.

Singapore Real Estate Outlook Contributed by Michael Wu

Most Singapore developers and REITs maintained their outperformance of the Strait Times Index in the third quarter. Given the appreciation of the REITs' unit price, we continue to see little value in REITs under our coverage as their respective discount to fair values continue to narrow.

This is similar for the two developers, with

(

) the better performer in the quarter, underpinned by better performance for its hotel operation and the more accommodating environment as the United Kingdom continues its exit from the European Union. We continue to see its peer, narrow-moat rated CapitaLand as better quality, as its earnings and cash flow are supported by its mall and serviced-residence business.

Hong Kong and China Real Estate Outlook Contributed by Phillip Zhong

In Hong Kong, the physical property market moved slightly higher during the quarter, albeit at a much slower pace than that seen during the first half of the year. The physical property market is now at a very elevated level, especially considering higher interest rates, lower liquidity, and increasing supplies ahead. After multiple rounds of prudential measures, including higher risk weighting and lower loan-to-value for new mortgages, the government is now turning to supply-side measures to tame a stubbornly high housing market. A new government task force has been formed to find ways to increase land supplies for residential housing development in the city. The government is also expected to announce a new affordable housing scheme.

During the third quarter,

(

) shares rallied 18% versus the Hang Seng Index of 12%. The shares are currently trading at 15 times earnings and 0.8 times book, still below our fair value estimate. Recently, the company successfully converted a large plot of farmland for residential development, dovetailing with the new government initiatives to identify new sources of land supplies. Further, the company's interim results showed the resiliency of its Hong Kong retail assets, signaling the end of the city's retail downtown.

In China, the property sector as a whole saw contract sales rise 12% year on year. Large developers continued to report very strong contract sales growth, far exceeding the sector average, likely benefiting from the consolidation trend sweeping the sector. However, we expect growth rates to slow for the remainder of the year, both for the sector as well as the major developers, under the weight of the gradually tightening government policies. We observed that some higher tier cities have already experienced falling sales volume and slowing or negative price growth in recent months.

Major Chinese developer shares rallied strongly during the third quarter. Two large private developers,

(

) and

(

) saw their shares up 115% and 62% during the period, while SOE affiliated developers saw their shares rising 20% to 30%. While we believe some developers' shares are overvalued now, we remain positive on

(

), currently trading at a P/E and P/B of approximately 8.7 times and 1.2 times, respectively. Despite a runup of 27% during the third quarter, the share price is still below our fair value estimate. We expect the company to maintain its track record of earnings growth through fast asset turn and portfolio acquisitions.

Japanese Real Estate Outlook Contributed by Mari Kumagai

Our preference for developers over REITs remains the same as we saw some non-speculative demand returning to markets while the net fund outflow still continued from regulatory tightening on excessive income distribution. After hitting the peak around the year-end, major developers under coverage suffered from weak stock performance encumbered with a sharp rise in geopolitical tensions from multiple missiles launched directly over Japan's Northern island of Hokkaido.

The property sector remains sensitive to interest rate increases, but interest rates in Japan remain near zero with persistent deflationary pressures. We do not expect 10-year risk-free rates to rise meaningfully above zero during our forecast horizon in a political attempt to control a large debt burden of the government. In the next month, we expect strong quarterly earnings as major firms are on track to set records, with the average net profits increasing 5% year on year. Current tailwinds from higher pricing power under a low interest rate environment and longer-term relationship with a larger affluent client base can only accelerate with an inevitable industry consolidation in favor of major developers as domestic markets remain highly fragmented unlike other developed markets in our view.

Market performance across asset categories remains mixed, with logistics and low-grade office turning in favor and residential sales turning 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 rate tracking below 2.5%.

Top Picks

Vornado Realty Trust

VNO

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $92.00

Fair Value Uncertainty: Medium

5-Star Price: 64.40

We still like high-end Class A office providers such as Vornado, which is currently trading at an 17% discount to our $92 fair value estimate. As its competitors continue development of 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 continued to climb this year. 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: $243.00

Fair Value Uncertainty: Low

5-Star Price: $194.40

Within self-storage, we note that Public Storage is trading at a 12% discount to our $243 fair value estimate. The company should benefit from management's continuous price increases passed along to its sticky customer base every 8-10 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%-5% to yields compared with its acquisitive competitors who 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

(SGX:

)

Star Rating: 3 Stars

Economic Moat: Narrow

Fair Value Estimate: SGD 2.30

Fair Value Uncertainty: Medium

5-Star Price: SGD 1.61

Within our REITs coverage in Singapore, we continue to prefer CapitaLand Mall Trust given the trust is trading at the largest discount to our fair value estimate, at a price-to-fair value ratio of 0.91, despite a 5% appreciation in its unit price. The trust posted another weak second-quarter result as retailers and consumer spending remain challenged in the current economic environment, leading to another quarter of negative revision. While we expect this to continue to near term, we maintain our view that softer rental is cyclical and the focus should be on the underlying fundamentals of its mall portfolio, which we rate as high quality at favorable locations.

Encouragingly, year-to-June tenant sales per square feet and foot traffic improved in the second quarter. More importantly during the quarter, the trust will partner with its parent CapitaLand's service residence unit in its Funan redevelopment project. The intention of a partnership and a divestment was there at the beginning of the project as the various components in the Funan project was originally structured into separate trusts. For the trust, it will receive SGD 101.8 million in the sale of the hotel component with capital expenditure also declining in proportion. In our view, the redevelopment will strengthen the quality of trust's mall portfolio.

More Market Outlooks

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Credit Market Insights: A Solid Quarter for the Bond Markets

Basic Materials: Valuations Propped Up by Shaky China Fundamentals

Communication Services: Smaller Rivals Call the Shots in U.S. Wireless

Consumer Cyclical: Tepid Mall Traffic Could Constrain the All-Important Holiday Season

Consumer Defensive: Valuations More Reasonable After Third-Quarter Retreat

Energy: All Roads Point to Oversupply in 2018

Financial Services: Banks Can't Rest Easy

Healthcare: Stock Selection Key as Valuations Rise

Industrials: Worldwide Growth Is Resilient, But Valuations Look Full

Technology: Valuations Painting Overly Rosy Scenarios

Utilities: Valuations Still Running Out of Control

M&A Outlook: High Prices Impede Dealmaking in the U.S.

Private Equity Outlook: Larger Funds, Larger Deals

Venture Capital Outlook: Exits Come Into Focus as Valuations Continue to Climb

U.S. Stock Funds: Steady as She Goes

International-Stock Funds: The Beat Goes on

Bond Funds: A Period of Relative Calm