Real Estate: Only a Few Opportunities in Fairly-Valued Sector

In aggregate, global real estate stocks outperformed in 2018, with the Morningstar Global Real Estate Index slipping 6% year to date through Dec. 20 versus a 10% drop for the broader market (Exhibit 1).

Exhibit 1: Real estate is down slightly but outperforming the global equity index

Real estate is one of the most fairly valued sectors. The median stock we cover trades at a 6% discount to our estimate of intrinsic value compared with a 2% discount at the end of the third quarter. With most of our coverage trading in 3-star range, we see only a few attractively priced real estate companies: 2% trade in 5-star territory (Exhibit 2).

Exhibit 2:  Mostly 3-star names, but there are some bargains in services

The average dividend for real estate firms is higher than the rest of our coverage (Exhibit 3). To receive tax-free status, REITs are required to pay out most of their net income as dividends to shareholders. Non-U.S. REITs on average have higher dividend yields than U.S. REITs, but both offer regular income payments higher than most equities. These companies are frequently included in portfolios of income-oriented investors. As a result, the yields of REITs are often compared to government bond yields.

Exhibit 3:  Real estate firms have higher dividend yields than other sectors

The high dividend payouts make REITs sensitive to changes in interest rates. When the yields of risk-free government bonds rise, REITs' yield spread falls as many income portfolios move from holding REIT positions to holding government bonds.

This leads to real estate companies, REITs in particular, underperforming the broader equity market when interest rates rise. The 10-year U.S. government bond rose twice in the last year—in January/February and in September (Exhibit 4). The global real estate index underperformed the global equity index during both of these periods as investors moved out of REITs into risk-free, income-producing investments.

Exhibit 4:  Firms underperform when interest rates rise, but just in the short term

However, following both 2018 periods of rising interest rates, real estate companies bounced back to perform in line with the global equity index. This has been fairly common historically: underperformance during the period of rising rates followed by outperformance over the next one to six months as the market corrects itself. The opposite is true for falling interest rates. Therefore, interest-rate movements can create an opportunity to be contrarian and buy or sell as they stabilize.

Top Picks
 AVEO Group (AOG)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: AUD 2.30
Fair Value Uncertainty: Medium
5-Star Price: AUD 1.61

We remain positive on the Aveo and the Aus retirement living sector, as operators stand to benefit from a spike in demand as the number of elderly Australians exploring retirement living options surges over the next five years. A series of catalysts ahead could narrow the gap between our AUD 2.30 fair value estimate and the current AUD 1.55 share price. First, the board has appointed bankers to introduce capital partners, which could result in a takeover offer or acceleration in  buybacks. Second, the acquisition of RVG presents the opportunity to capture significant resale gains by upgrading the older units to contemporary standards.

 CK Asset Holdings (1113)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: HKD 81
Fair Value Uncertainty: Medium
5-Star Price: HKD 56.70

A potential decline in the Hong Kong residential market has weighed on the stock price, but with Hong Kong residential sales only projected to be around 30% of the company's earnings we believe it is well-diversified, with earnings coming from investment properties, interests in REITs, hotels, and non-real-estate activities accounting for the rest. The company also holds a large agriculture land bank that can be used for development. Proceeds from noncore asset disposals in Hong Kong and its strong balance sheet have been tapped to acquire higher-yielding infrastructure and utility businesses as well as real estate assets overseas.

 Sun Hung Kai Properties (00016)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: HKD 153
Fair Value Uncertainty: Medium
5-Star Price: HKD 107.10

We believe concerns about a potential decline in the Hong Kong residential market are priced into the stock, and we project SHKP’s exposure to the Hong Kong residential market will decrease over time. Earnings from investment properties account for 60% of the total, with this portfolio underpinned by quality office and retail assets in Hong Kong. The office market in Hong Kong remains robust, due to strong demand from mainland firms setting up a presence in the city. The city’s retail sales are recovering, and we expect the company’s well-managed retail assets to see faster-than-average growth rates in retail sales.

Exhibit Sources: Morningstar. Data as of Dec. 20, 2018.