A Place to Stay

As a potential recession looms, investors may seek safe haven in REITs. However, the Morningstar US REIT Index has been among the top-performing indexes in the Morningstar lineup for the year to date through September— and over the past decade. After such a strong run, is there value to be had? And with interest-rate increases a possibility on the horizon, are REITs the best retreat?

I sat down with Kevin Brown, who follows apartment, healthcare, and retail REITs, and Yousuf Hafuda, who covers office REITs, to explore opportunities for long-term investors. Our conversation took place on Sept. 11, and valuation data is as of that date. The transcript has been edited for length and clarity.

Laura Lallos: Where are we in the real estate cycle?

Kevin Brown is an equity analyst with Morningstar Research Services.

Kevin Brown: I believe we are generally close to the end of the ballgame, though it's hard to say specifically what inning we're in for all of real estate. For most sectors, fundamentals have peaked and we are starting to see a downward trend. For example, hotel occupancies reached an all-time high point in 2017, which carried into 2018, and year-to-date numbers in 2019 so far show that year-over-year growth in occupancy for hotels is declining. Overall revenue growth is still positive, but it's in the zero to 1% range, a clear sign that we are past any sort of point of being able to have pricing power and are likely to see the situation get worse in the future than get better. So that's one clear example that we're probably at the end of the cycle.

In healthcare, however, we’re probably at a low point right now in terms of fundamental growth. This is largely due to some issues affecting occupancy and demand that were specific to 2018, but it’s also due to very high current supply growth. But we’ve seen demand picking up, and supply is falling off. There’s evidence that supply is going to continue to fall off, and the longterm trend for healthcare is that demand’s only going to increase over the next decade. So for healthcare we may be now into the next overall cycle.

Yousuf Hafuda is an equity analyst with Morningstar Research Services.

Yousuf Hafuda: It seems pretty clear that we're toward the latter stages of the real estate cycle. This cycle has been long-lasting but there's been a lot of hesitancy to call the top because we're not where we were back before the 2007–08 crash. I would highlight that.

Within the office REIT space, most of the companies that I cover are not acquiring too many assets, and that’s a reflection of the fact that real estate prices are really elevated. Consequently, they’re focusing on disposing assets, particularly noncore assets. They’re also pursuing growth by focusing on ground-up development to take advantage of healthy demand fundamentals.

That said, there are long-term demographic and macroeconomic factors that have impacts. For instance, within the office REIT space, we’re seeing a migration of higher-end white-collar labor into city centers like Lower Manhattan and Midtown in New York City, the Loop in Chicago, and downtown Boston. That’s an enduring secular trend that isn’t necessarily a cyclical factor. One of the reasons why some of these companies are pursuing ground-up development is because they think that the fundamental demand will remain even through an economic downturn. Look at the number of multinational corporations that have relocated from suburban locations into more downtown central business districts. Look at migration patterns: The prevalence of individuals living in a city who have a bachelor’s degree or earn a higher income is increasing dramatically. These long-term secular trends are creating a tailwind for some of the office REITs that I cover that are primarily focused within the elite coastal markets.

Lallos: In last issue's Sector Rap on housing, we talked about a parallel trend, of millennials wanting townhomes in cities instead of single-family homes in the suburbs.

Brown: Over the past 15 years, we've seen an expansion of high-end apartments in downtown areas. As the cities have gentrified, the millennial workforce has shown a preference for wanting to be downtown within walking distance or within public transportation distance of where they work. The vast majority of the companies that I cover in the apartment sector have built in downtown, dense markets, trying to capitalize on this trend. That's probably something that is independent of any economic cycle, so we may see that play out for a few more years. But are millennials going to become homeowners over the next decade or two? That may change this trend.

Lallos: Yousuf, you still see some value in certain office REITs that are capitalizing on these trends.

Hafuda: The New York-focused office REITs have a compelling story. We think the market has fundamentally overreacted to an uptick in supply, notably from the Hudson Yards megadevelopment, which is supposed to add around 10-million-plus square feet of office space to Manhattan once it's complete. The overall Manhattan market contains around 450 million square feet, so it does represent a decent amount of incremental supply, and there is additional construction in Midtown and Lower Manhattan.

But structurally, the ease with which construction can be brought on line in Manhattan hasn’t changed. What we’re seeing now are a few one-off events. The Hudson Yards neighborhood is an area that used to be industrial that had the zoning and the whole infrastructure completely changed with support from the local government. That’s not necessarily indicative of an area that is becoming easier to build in overall. Therefore, when we look at the New York City metropolitan area, we think that the fundamentals remain relatively quite strong, as reflected by the number of corporations that are relocating to the Manhattan area or are adding square footage there. New York is going to remain a hub for talent and for the corporations that employ that talent.

As evidence, we’ve seen some of the premier submarkets that had a bit of a dip due to a perceived supply glut bounce back, most notably Midtown. That’s why we like SL Green Realty SLG in particular. It historically has focused mostly on the Midtown submarket within Manhattan, and as a result, it’s been beaten up more than some of the other companies, because of the perception that premier office space might relocate to Hudson Yards. Our assertion is that there is enough demand to ultimately satisfy both of these premier submarkets, and leasing numbers are beginning to show this.

Lallos: Kevin, are there pockets of value on your coverage list?

Brown: It's the riskier names that are undervalued, because as fear of a potential recession has grown over the last six months, investors have moved into the more defensive names. Our models go out 10 years, rather than two to three years as is common with most other sell-side shops. While we are worried that there is going to be a correction coming to the hotel names and the mall names, we also recognize that after a recession, there is typically a recovery when you have higher growth.

Fear of a recession creates an opportunity. We’re not trying to call the bottom of a recession. The next 12 months may be rocky for these names, but over the next three to four years we think they are going to outperform the more defensive healthcare and triple-net names. These safer names have very stable cash flows, and the fundamentals look very solid, but the market has moved too much money into those sectors and at some point the money will shift back to malls and hotels. That’s where I’m seeing the greatest values at the moment for investors with longer investment horizons.

Many of these stocks have very high dividend yields, so you can collect significant income during your investment period. One of my top picks in the mall sector is Macerich MAC, which is currently paying between a 9% and 10% dividend yield right now, well above not only the U.S. equity but also the U.S. REIT average.

Lallos: You mentioned healthcare as a stable area, but what about political risks?

Brown: The major cuts that were made to the Affordable Care Act over the past several years really scared off the big three healthcare REITs from owning the type of healthcare that would be subject to such cuts, such as skilled nursing and hospitals. The big three now mostly own senior housing, which is mainly funded by private sources out of retirement savings; medical offices, which is less affected by the spending cuts; and life science, which is research- and pharmaceutical-driven.

Lallos: Yousuf, what are some of the less obvious risks that you think should be factored in?

Hafuda: One of the big ones is the affordability crisis playing out in high-cost areas such as San Francisco. This represents a risk for companies like Kilroy Realty KRC, which mostly operates on the West Coast in some of the most highcost areas in the United States. This dynamic is increasingly driving what we call domestic immigration: Some larger and higher-cost cities are bleeding residents. Meanwhile, the so-called second-tier metropolitan areas, such as Denver, Austin, and Phoenix, have been capturing many of these residents. So far, there hasn't been much of an impact in terms of white-collar migration, but if these cities don't address the affordability crisis, people may have to move— and not just people on the lower end of the income spectrum.

Another risk to consider is coworking. In certain cities like New York and Chicago, WeWork is now the largest occupier of office space. Previously, the main driver of incremental demand was what’s called TAMI—technology, advertising, media, and information services. Today, a larger percentage of new office demand is driven by coworking.

That represents a risk if the business model proves unviable, or if it turns out that some of the coworking companies have taken on too much risk by subleasing space to financially unreliable tenants. Boston Properties BXP has been proactive about drawing in coworking companies: It’s made a concerted bet on shifting away some occupancy risk to companies like WeWork or Regus. An economic downturn that affects short-term leasing could represent a pretty significant risk for a company like Boston Properties.

There’s also downward pressure on lease terms. A driving force behind the strength of the coworking industry has been an increased desire from corporate tenants for flexibility. Traditionally, a company would lease space for five to 10 years. Now larger organizations are seeking the flexibility that smaller, nimbler companies demand. Maybe they’ll seek a longer lease term for their more stable operations, but then supplement that with shorter lease terms with coworking providers. This represents a potential change in the nature of the way that the business is structured.

Lallos: Kevin, how about the risk of e-commerce for retail REITs. This isn’t a new risk, but it’s persistent.

Brown: E-commerce is here to stay, and it's going to continue to grow at a much faster pace than brick-and-mortar retail for some time. That being said, people aren't going to shift 100% of their buying online. Even Amazon AMZN now has Amazon stores. Casper Sleep, Warby Parker, and apparel companies like Adore Me have found that having a physical presence benefits their online store. Does a Casper mattress really feel as good as a traditional? Some consumers need to come in and feel it in person. Studies have shown that customers are much more willing to purchase something online if they can drop off a return at a store. Studies have also shown that having a certain number of physical stores in an area will increase traffic to the company's website significantly. It's marketing. You drive by the store and the name is in your head. However, these e-tailers are only looking to place their stores in the top retail locations.

High-quality properties in dense markets with shoppers who have money to spend will stay open; these properties produce high sales per square foot. Low-quality retailers will struggle and decline. We’re going to see a continuation of the mall death spiral, where struggling sales lead to store closures, which leads to lower foot traffic, which leads to lower sales … eventually the property is forced to shut down.

The top 100 malls in America are doing really well, and another 300 to 400 malls will continue to produce decent growth, even if e-commerce continues to grow at double digits. The rest of America’s malls are going to have to find alternative tenants, such as medical offices, grocery stores, even churches. They’re going to have to get very creative to survive.

We give malls a narrow moat for two reasons. One is their very wide trade area. Two of the highest-productivity malls in America are in southern New Hampshire. They are 50 miles from Boston, but New Hampshire is a tax-free state so there are enough Bostonians willing to drive there to produce a very high sales per square foot number.

It would cost over $1 billion for somebody to buy the land and develop a mall in that trade area, and then they would have to find tenants in an environment where people are struggling to hold onto their tenants. Any existing Class A mall dominates its trade area. And there is an inverse of the mall death spiral: High-quality tenants attract additional shoppers, which raises sales numbers, which then makes your mall more attractive to additional high-quality tenants. The Class A malls are both able to dominate their trade areas and produce a network effect.

Lallos: Otherwise, moats are uncommon in this sector, right?

Hafuda: That's right. For a commodified business like real estate, there needs to be something very compelling to convince us that returns on invested capital are going to exceed the cost of capital over 10 years or more. One potential avenue for achieving a moat is intangible assets. This is a regulatory-based moat source, predicated on the notion that in a situation where it's extremely difficult to build, demand can get pent up and bid up prices and rents. For example, San Francisco has explicit limits on the square footage of office space that can be constructed within a given year. However, over the long run, we tend to see supply come on line commensurate with new demand, making us hesitant to award moats in this industry.

Lallos: Let’s wrap up with interest rates, with increases on people’s minds.

Brown: Interest rates have been shown to affect REITs in the short term given that REITs' dividend payment requirement makes them attractive to income-oriented investors. Any interest-rate increase is going to cause a decline in REITs' stock prices, and conversely, any period of falling rates is going to lead to REITs outperforming, which we have seen in 2019. That being said, much of that relative difference to the overall market is given back if rates remain stable over the next 12 to 18 months. Then the fundamentals reassert themselves as the driving factor for REITs. Rate movements do create short-term opportunities to buy and sell, but over the long run, they don't have a significant impact on REITs themselves.

This article originally appeared in the Winter 2019 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.