REITs: Playing Defense in an Uncertain Market
Look to retail for opportunity within a fairly valued REIT sector.
- Morningstar's real estate coverage is trading at a 3% 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 pressuring property stocks globally by double-digit percentages. 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 3% aggregate discount to our fair value estimate. Investors should continue to be particularly discriminating, 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. Following the recent widely expected rate hike in March, it's clear that the market anticipates more hikes in store this year for the Federal Reserve.
As the new administration settles in, details surrounding proposed policy changes are still vague. 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 also sending 10-year U.S. Treasury yields beyond 2.6% by mid-March.
Upward movement in Treasury yields, often used as a benchmark for real estate valuation, and interest-rate expectations have thus hurt 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 recent rise, 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 next 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 progressively railroading many capable U.S. REITs into allocating more capital toward value-creation opportunities such as the redevelopment of existing assets or the development of new properties to further increase and achieve required returns. 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.
At current pricing, the most attractive investment opportunities focus on retail REITs within our coverage. We still like owners of high-quality regional malls and retail properties such as Simon Property Group and GGP, in addition to shopping center REIT Kimco Realty.
Retail property firms have been negatively pressured from news of store closures, bankruptcies, and overall disappointing retailer performance amid continued growth in online retailing and changing consumer behavior. However, we believe physical retail strategies will remain critical marketing, service, and distribution points for retailers, with demand consolidating into well-located and ultimately profitable store locations, such as those owned by these firms. With all three REITs trading at roughly 20% discounts to our respective fair value estimates, we think the market is presently overly cautious toward class A regional malls and grocery-anchored shopping centers, which should maintain relatively steady demand.
In the office space, we see some opportunity for owners of Class A office and retail properties. Exciting developments related to the $25 billion Hudson Yards project in Manhattan are bringing much change to the area and opportunities for investors to capitalize on the shift away from midtown and into a new frontier. Management of firms focused there are hopeful that the newly popularized area will increase rent and bring added traffic to retail locations--current estimates expect an additional 65,000 people per day will frequent the area surrounding the project. Additionally, we view the new administration as an additional catalyst for growth in this asset class. Financial-sector jobs make up a large portion of Class A office space, so we think deregulation and lower taxes will help drive this market.
Self-storage names have decelerated from explosive growth in recent years, and we see this as the new normal for the asset class. In terms of strategy, we view development as the safer play compared with acquisition. We've seen cap rates at all-time lows in recent years, and yields are tight for purchased facilities. Additionally, we fear that a pullback in asset prices will have a meaningful impact on acquisitive firms relative to their development-focused counterparts.
Australian Real Estate Outlook Contributed by Tony Sherlock
Within our Australian regional coverage, few stocks screen as undervalued, with our best picks being
). Westfield's portfolio comprises premium shopping malls in the USA and London, in highly affluent areas. We expect these assets to outperform the broader retail sector, reflecting their focus on a demographic with high disposable income. Aveo owns and develops retirement villages and stands to benefit from a material increase in the number of Australians reaching 75, the age at which they typically enter a retirement village. The immediate challenge for the Australian market is the upward trajectory in U.S. interest rates, which will trigger portfolio reallocations by many yield-focused investors. We see this, along with higher levels of short interest in the sector, as weighing on prices over the near term at least.
Singapore Property Outlook Contributed by Michael Wu
For the Singapore property sector, our preference for developers over REITs, as noted last quarter, saw the developers outperform the REITs in the first quarter of 2017. The outperformance for the developers was boosted in March as the Singapore government and regulator Monetary Authority of Singapore jointly announced adjustments to the restrictive measures on residential properties. The timing of the move was a surprise, and we saw the announcement as a positive signal that the authorities are proactive in easing restrictive measures in a weak residential property market. However, the measures should have a limited impact on residential transaction volume, as the additional buyer stamp duties and loan/value limits remain in place. While there is less value after the share price rally in the first quarter, we maintain our view that the developers will fare better in a rising interest-rate environment.
We have raised our fair value estimates for
), two developers under our coverage, after their respective fiscal 2016 results last month. At the time, we remained positive, as we believe concerns over a slowdown in the residential property market were priced into their share prices. Both developers were trading below their respective book value, and we did not anticipate their equity book value to track backward. CapitaLand's earnings are supported by recurring income from its mall and serviced-residence business, while hotels and investment properties underpin earnings for City Development.
Still, the REIT sector reported resilient fourth-quarter results despite weakening economic conditions. Our preference remains for high-quality REITs such as
), which are trading at discounts of 10% and 16%, respectively, to our fair value estimates. With high-quality assets in the office and retail space, we expect rents to soften but occupancy levels to remain high, as they did in previous business cycles. Both trusts are also supported by strong balance sheets, with a large majority of their debt fixed.
We reaffirm our view that medium-term concerns over the pace of rising U.S. interest rates will continue to pressure the sector. The REITs took advantage of the low-interest-rate environment by fixing their debt in the near term and remained conservative in their asset valuation. Capitalization rates generally compressed between 15 and 30 basis points from 2010 to 2015. We see an expansion of capitalization rates to have a limited impact on the net asset value for the trusts.
Japanese Property Outlook Contributed by Mari Kumagai
For the Japanese property sector, despite muted performance over the past three months, we maintain our preference for major developers over the J-REITs. Despite a rising interest-rate environment globally, we anticipate that the pace of the interest-rate increase will be considerably slower in Japan. Our long-term risk-free rate for Japan is unlikely to exceed 0.4% during our explicit forecast horizon.
We do not anticipate a material rise in the inflation rate, as aging demographics will become stronger headwinds when fighting against deflationary pressures. Several factors related to the aging demographic will likely contribute to structural deflationary pressures, including (1) a lower labor participation rate; (2) lower economic growth expectations; and (3) a lower propensity for consumption.
This structural disinflationary pressure of negative 0.25% can be temporarily offset by inflationary factors, mainly from the external environment, including (1) rising commodity prices; (2) a weaker Japanese yen from a wider yield gap among countries; and (3) higher demand for investment in overseas assets.
We agree that Japan's strong monetary policy remains in the liquidity trap, reducing the policy effectiveness to some extent. However, strong policy framework will likely keep low inflation stable during our explicit forecast horizon by pushing real rates to negative if necessary to rehabilitate the economy. The central bank's liquidity infusions, with annual repurchases of JPY 90 billion targeted at J-REITs, continues to inflate investor confidence, with larger downside risks extending into the years beyond our forecast horizon.
For the past three months, Tokyo's prime office investments have maintained an attractive value proposition, with the latest average expected total returns tracking above 7.5%, while softer capital returns are supported by stable income returns at around mid-4%. For the past three years, low new office supply offset softer demand, keeping prime office vacancy rates low, trailing below 3%. For the next three years, we still expect Tokyo Grade A office property to maintain a stable rental income trend.
Adjusting for larger loss from abolished buildings, the Tokyo central business district office market is likely to see only a modest increase in net leasable area of 1.2%/2.2%/1.9% for the next three years. For comparison, our forecast demand growth is 1.5% for the same period.
We still prefer
), although we have yet to confirm the level of additional investment appetite under the new management team from April 2017. This will mark the end of the firm's six-year leadership under Hirotaka Sugiyama, who has led the conservative balance sheet management ahead of its peers.
Hong Kong and China Property Outlook Contributed by Phillip Zhong
In Hong Kong, developers' shares have rallied during the first quarter of the year, along with the rest of the market. The physical property market has continued to move higher despite restrictive government measures. Developers are taking advantage of the positive sentiment and launching projects with higher asking prices. This will likely result in better margins when these projects are booked.
However, once the physical market begins to retreat under the weight of higher interest rates, lower liquidity, and increased supply, Hong Kong developers' shares will likely suffer as well.
As the best name among Hong Kong developers, in our opinion,
) shares are currently trading at 11 times earnings and 0.7 times book, which is attractive relative to historical averages. The company has entered into several yield-focused businesses outside the property sectors to deploy its excess cash. Thus, it will be less exposed than its peers to the Hong Kong property market, shielding it from the inevitable volatilities on the horizon.
In China, major developers' shares also rallied in the year to date. Concluding a successful 2016 with robust sales for many developers, government policies will gradually tighten with regard to the real estate sector. Yet, the successful destocking in 2016 means there will be supply constraints across many upper-tier cities. While sales volume will be down relative to a year ago, prices will likely stay firm.
The land market has also heated up in China, as many developers are looking to replenish their landbanks. Despite the policy headwind, we remain positive on large developers 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 times and 1 times, respectively. The CITIC acquisition a year ago should have bolstered the company's growth with a pipeline of projects at reasonable cost.
Simon Property Group
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $213.00
Fair Value Uncertainty: Low
5-Star Price: $170.40
Simon owns and operates a diversified portfolio of regional mall, outlet, and other retail properties throughout North America, Europe, and Asia. These high-quality assets tend to be dominant hubs for retail, entertainment, and dining offerings and have proven highly productive in terms of tenant sales, allowing the properties to maintain high demand, occupancies, and consistent rent growth. This, along with its fortress balance sheet, generates greater cash flow for Simon to reinvest into its properties, allowing the company to adapt and insulate its portfolio from e-commerce headwinds.
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $29.00
Fair Value Uncertainty: Medium
5-Star Price: $20.30
In the aftermath of the financial crisis, GGP has made significant progress in building and refining one of the largest portfolios of Class A regional malls throughout the United States. The firm's quality-focused strategy has helped largely insulate it from recent high-profile retailer store closures like those of
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $29.00
Fair Value Uncertainty: Medium
5-Star Price: $20.30
Since 2010, Kimco has refocused its strategy and portfolio toward higher-quality shopping-center assets and markets. Through billions of dollars of acquisitions, dispositions, and development projects, the firm has simplified its core business model while fortifying its balance sheet and freeing up liquidity. In addition, significant below-market leases should promote future performance and operational flexibility. Overall, we think Kimco's strategy will better support long-term demand and decrease risk for the company's portfolio, ultimately benefiting investors.
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