Real Estate: Strong Fundamentals Persist--As Do Opportunities

• Morningstar's real estate coverage appears fairly valued at current levels. It is currently trading at a market-cap weighted, price/fair value estimate of 0.98, only a 2% discount to what we believe the stocks in the sector are worth.
• We view themes in commercial real estate as generally defensive in nature, with lingering concerns about increasing bond yields associated with future rate hikes.
• Despite these concerns, 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, though supply may have peaked in many markets and sectors. Rising construction costs may lead to slowing supply growth over the next few years.
• At current price levels, we see attractive investment opportunities scattered across various asset classes within our REIT coverage.
  
  

U.S. Real Estate Outlook
Contributed by Kevin Brown

After falling in the first quarter due to pressure from rising interest rates, the U.S. real estate market performed in line with the broader U.S. market in the second quarter. The 10-year U.S. Treasury yield increased rapidly at the start of the year but has stayed near the 2.85% rate since mid-February, bringing relative stability to real estate stocks. Given the circumstances, many investors wonder whether we are near the peak of the commercial real estate cycle--higher interest rates could pressure growth rates, cap rates, return expectations, and ultimately asset prices. Also, to the extent that low interest rates have steered investors searching for higher yield and capital preservation toward REITs, the same funds could flow out of REITs if interest rates rise, further pressuring commercial real estate valuations.

However, rising interest rates also signal that the economy is healthy enough to support a rising interest rate environment. Continued economic growth will support the fundamentals of all commercial real estate. Real estate companies will benefit from the continued stabilization and growth of the acquisitions and developments they completed this cycle. Higher interest rates will make financing more expensive, not only reducing the return potential on new acquisitions and developments but also reducing the number of construction starts. REITs strengthened their balance sheets during the low interest rate environment, reducing near-term maturities and locking in low rates on long-term debt. There is still a shrinking but significant spread between real estate cap rates and interest rates, which combined with growing net operating income supports current real estate prices. Future interest rate increases should be more gradual, and the growth of the underlying fundamentals should support current valuations.

The Trump administration could have an impact on several real estate sectors. Policies such as infrastructure spending, tax reform, general deregulation, and many other matters have extended the length of the current economic cycle. Additionally, several economic signals, including unemployment levels, wage growth, and GDP growth, support the case for positive momentum as we enter the back half of the year. However, the potential for a trade war with China could have an impact on several real estate sectors, particularly retail and industrials. Rising prices on steel and lumber would increase construction costs, making accretive development more difficult and reduce the number of construction starts for all sectors. Finally, increased immigration enforcement could increase labor costs, increasing expenses for industries that rely on immigrant labor, such as the lodging industry.

Much of our U.S. REIT coverage still enjoys healthy underlying operating performance. Historically high levels of occupancy and durable balance sheets characterize most portfolios. Although 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. Supply has peaked and started to decelerate for sectors like apartments, industrials, and senior housing. Higher construction costs and tighter construction lending should reduce supply growth further even as demand continues to support fundamental growth through the cycle. 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. 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. Given that our real estate coverage is fairly valued as a whole, investors should enter the sector with caution. Our preferred investment vehicles are reasonably leveraged companies with solid prospects for long-term growth that can weather the natural cyclicality of the real estate markets.

Australian and New Zealand Property Outlook
Contributed by Tony Sherlock

Among our Australian and New Zealand property coverage, only retirement village operator  AVEO Group screens as attractive, with a 4-star rating. We see numerous attractions and potential earnings catalysts ahead for vertically integrated industrial heavyweight  Goodman Group (GMG) and  Ryman Healthcare (RYM), but they are fairly valued at current levels. The lack of attractively priced Australasian property stocks is a combination of property of all classes trading at record low yields and an outlook for bond yields to rise. Higher bond yields will weigh on the value of listed property because of a range of factors. First, yield-focused investors will rotate out of asset class to bonds, causing selling pressure. Second, valuers will reduce their assessment of property values as they increase the discount rates implicit in their valuations. Third, higher borrowing costs will weigh on cash flows hence REITs' long-term distributions. Our central scenario is for bond yields to rise over a protracted period, but the sector and property values are particularly susceptible to a sharp rise, which could be triggered by dislocation in credit markets.

Negative media attention in June 2017 had a negative impact on Australian retirement village operator and developer Aveo, and we think the firm has been oversold. The retirement living industry has very favorable underpinnings of limited supply and sharply increasing demand over the next five years. Aveo also stands to generate solid redevelopment gains as it upgrades and then resells units in older villages. The firm is not without risks as its reputation has not yet fully recovered from the negative coverage and the firm looks likely to have to trim prices if Australian dwelling prices retrace further.

Global demand for industrial property exposure is perhaps the strongest it has ever been, as wholesale investors clamor to increase their weighting to this previously out-of-favor subsector. The escalation in demand for industrial property is being driven by institutions' rotation away from Internet-impacted retail shopping centers, toward modern logistics facilities serving high growth Internet retailers like  Amazon (AMZN) and  JD.com (JD).

Goodman Group is particularly well placed to benefit from the heightened interest in industrial as it focuses on owning warehouses in strategically important locations. Demand for these is robust as they enable logistics firms to steal a lead on competitors in speed of delivery and cost. Goodman is already reaping rewards from its focus on premium logistics assets, with the portfolio having very low vacancy and superior rent growth. Goodman also has a series of potential earnings catalysts ahead, which include an acceleration in the volume of development work as it become more active in North America and Brazil. As most of the developed assets, will be acquired by Goodman managed funds, we foresee strong uplift in fund management earnings from an expanding asset base and also an acceleration in performance fees. The firm has negligible gearing and undrawn debt and equity of AUD 10 billion, providing ample capacity to acquire quality assets should there be a retracement in property values.

Singapore Real Estate Outlook
Contributed by Michael Wu and Ken Foong

Office rental rates have troughed in first-half 2017 and continued to recover into first-quarter 2018, with average monthly rental for Grade A office space increasing by 8.4% to SGD 9.70 per square foot in first-quarter 2018 compared with SGD 8.95 per square foot in first-half 2017. We expect the worst to be over for office rentals as new office supply is slowly digested by the market and there is limited new office supply from 2018 onward. We expect the office rental recovery to continue for the next few years. However, this will not flow through to the rental reversions for  CapitaLand Commercial Trust , the main office REIT under our coverage, and negative rental reversion is expected this year as average expiring rents in 2018 are above the current average market rent for Grade A office space. We remain positive on the Singapore office property sector in the long term and we expect strong regional growth to underpin office demand from multinational corporations, absorbing the new office supply, which we view largely as a timing issue, as highlighted in our previous notes.

In view of limited investment opportunities in the Singapore Grade A office space market, CapitaLand Commercial Trust made its first foray into overseas markets by acquiring a 94.9% stake in Gallileo, a Grade A freehold commercial property in Germany. We view this transaction positively as it provides the trust with an opportunity to diversify into foreign markets and acquire a freehold asset. The trust also managed to take advantage of the current low interest rate environment in Germany. In the industrial property space, Ascendas Real Estate Investment Trust has also stated it is looking at investment opportunities in the U.S. and Europe. We think that the trusts' active portfolio management and overseas diversification are the right strategies going forward as these will help to drive growth for the trusts.

Within our Singapore REIT coverage, we continue to prefer  CapitaLand Mall Trust (C38U) given the trust is trading on the largest discount to our fair value estimate with a price/fair value estimate ratio of 0.87 times. We believe that active portfolio management, ongoing asset enhancement initiatives, adaptive to technology advancement and redevelopment of its properties will continue to generate long-term growth for its unitholders. In the medium term, growth will be supported by the redevelopment of Funan.

Of the two developers under our coverage, there is no change in our view  City Developments (C09) will benefit more from a recovery in the residential property market in Singapore. For CapitaLand, the group has prudently participated in land auctions in Singapore, but a more geographically diversified operation sees capital allocation considered across all divisions. While the group has lower exposure to Singapore residential development, it benefits from a greater number of opportunities across the region. This is most prominent in its exposure in China, with a large portfolio of investment properties including malls and serviced residence, and a residential property development business. With a strong rally in City Developments' share price late last year, we see CapitaLand as better valued. Trading at a 20% discount to our fair value estimate of SGD 4.20, we believe the upside from CapitaLand's more diversified business and upside from its China operation is not factored into current share price.

Hong Kong and China Real Estate Outlook
Contributed by Phillip Zhong

In Hong Kong, the physical property market continued to trend higher, with the Centaline Leading Index up 10.7% through beginning of June. This is on top of a double-digit rise last year. However, the torrid pace of activity seen at the beginning of the year has slowed; total number of transactions are up 4% through May, compared with 60% in January. In particular, primary market sales are down 25% compared with a year ago.

Mirroring the U.S. Federal Reserve's rate hike, the Hong Kong Monetary Authority, or HKMA, lifted the base rate by another 25 basis points to 2.25% in mid-June. The impact of the rate hikes are gradually spreading throughout the system. The Hong Kong Interbank Offer Rate, or Hibor, continues to edge higher in the second quarter as liquidity exited Hong Kong, with the one-month rate hitting a 10-year high. The latter saw the HKMA intervening in the foreign currency market to maintain the Hong Kong dollar peg. We maintain our view that stronger U.S. economic conditions underpin the normalization of interest rates, translating into higher interbank rates for Hong Kong. We expect the tightening liquidity will be a headwind to the Hong Kong property market.

The Hong Kong office market is still robust while the retail sector continues to recover. We continue to see highly valued transactions in the private market at very low capitalization rates, with Chinese corporates being the sole buyers. We prefer those with effective capital management by recycling proceeds from asset disposals into higher-yield assets outside of Hong Kong or returning capital to investors through share buybacks or special dividends.

The Chinese property sector continued to slow under the weight of government policy, with year-to-April sales volume up 0.4% year on year, compared with 13% a year ago. Sales by values are up 10%, indicating continued growth in average selling price. The 70-city price index from Bureau of Statistics showed a faster and broader price growth in May, with second-tier cities gaining the most.

Listed developers are still seeing strong sales growth due to continuing consolidation trend, albeit at a slower rate than before. We expect the tightening policy to persist, capping volume and price growth, maintaining the current headwind for the sector. Growth is likely to be modest compared with a year ago, especially for mass residential developers. We favor the quality names with operational focus in higher-tier cities that typically have more constrained supplies and solid demand. Major Chinese developer shares spiked higher in January along with the market before retreating. Some quality names are reasonably priced including  China Vanke (02202) and  China Overseas Land & Investment (00688).

Top Picks

 Welltower (WELL)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $74
Fair Value Uncertainty: High
5-Star Price: $44.40

Welltower currently trades at roughly a 23% discount to our $74 fair value estimate. We think that the shares have traded down over the past six months on issues that are short-term in nature and are already baked into our estimates. Longer term, we believe the top healthcare real estate stands to disproportionately benefit from the Affordable Care Act, as there is an increased focus on higher-quality care in lower-cost settings. The best owners and operators in the industry, which can provide better outcomes while driving greater efficiencies, should see demand funneled to them from the best healthcare systems. Additionally, the baby boomer generation is starting to enter its senior years and the 80-and-older population, which spends more than 4 times on healthcare per capita than the national average, should almost double over the next 10 years. While shares of healthcare REITs have underperformed due to expectations of lower senior housing growth in 2018 from high supply and a severe flu season, growth should pick up in the next few years as supply growth falls off and demand picks up significantly. Additionally, first quarter fundamentals came in above expectations, suggesting that the near-term weakness may not be as bad as previously feared.

 Boston Properties (BXP)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $143
Fair Value Uncertainty: Medium
5-Star Price: $100.10

We still like high-end Class A office providers such as Boston Properties, which is currently trading at a 17% discount to our $143 fair value estimate. The company operates its portfolio of office buildings across five key geographic markets (Boston, Washington, D.C., New York, San Francisco, Los Angeles). The company has a large, multi-billion dollar development pipeline that are creating new office properties and spaces that are attractive to young, professional talent and should be increasingly filled by technology and life science firms. While the company's portfolio has become increasingly suburban-focused where there are fewer barriers to entry and new supply can easily enter the market, we think the life science and healthcare industries are attractive industries to partner with from a leasing perspective. Management has been prudent in recycling capital over the years, maintaining a modern portfolio of assets that continue to meet tenant demand in an evolving labor market.

Quarter-End Insights

Stock Market Outlook: Some Values to Be Found in Defensive Sectors
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Energy: Despite Geopolitical Wildcards, the Reckoning Is Still Coming for U.S. Shale Producers
The longer the delay, the worse the supply onslaught becomes.

Real Estate: Strong Fundamentals Persist--As Do Opportunities
REITs should have several more years of solid growth in property fundamentals as the economic cycle continues and many sectors have the peak in supply growth behind them.

Utilities: Back to Fair Value With Some Emerging Opportunities
Utilities investors have buying opportunities but should pick carefully.

Healthcare: Drug Pricing Concerns Weigh on Valuations, Creating Opportunities 
Innovation, consolidation, and a mixed regulatory picture for healthcare stocks in the first quarter.

Consumer Cyclical: The Themes Driving Retail's Rebound 
Amazon continues to linger as a disruptive threat, but the market is coming around to those retailers offering specialization, convenience, and experience.

Consumer Defensive: Attractive Opportunities in Competitively Advantaged Stocks
Lackluster fundamentals and competitive pressures persist, but fail to warrant the recent retreat in shares.

Industrials: Despite Bullish CEO Talk, Few Values
Lackluster fundamentals and competitive pressures persist, but fail to warrant the recent retreat in shares.