Sector Outlook -- Real Estate

The environment for equity REITs remains favorable, driving continued improvement in REIT fundamentals and high valuation levels. The macro environment couldn't be much better for REITs. Slow and steady economic and job growth translates into incremental demand for commercial real estate, yet the macro economy is not improving enough for developers to aggressively add incremental supply to commercial real estate stock. As such, existing landlords should continue experiencing improved occupancy rates, greater bargaining power relative to tenants, and nice increases in same-store net operating income. In fact, we think a number of REITs, especially those with shorter-term lease structures, are performing at peak or near-peak levels of performance, and there is risk that deviation from the slow-and-steady macro improvement--either to the upside or downside--could alter the supply/demand picture and introduce weaker, but still positive, fundamental performance.? However, the biggest risk to REIT valuations may be the prospect of rising interest rates. REITs have benefited greatly from much lower debt financing costs recently. As the cost of debt financing has fallen, REITs have sent less cash to bond holders for interest payments, leaving more for dividends to equity investors and/or reinvestment in the business (once the 90% dividend distribution requirement has been met). Similarly, with less cash out the door for debt servicing, traditional measures of REIT cash flow, such as FFO, AFFO, and FAD have improved. We expect the tailwind that low (and falling) interest rates have provided to REITs in recent history to become a headwind if and when interest rates start to rise. ?? We think that another consequence of low interest rates has been investors' search for yield, driving demand for income-producing instruments, including REITs. To the extent that low interest rates have diverted investor funds to REITs searching for higher yield, funds could flow out of REITs if and when interest rates begin to rise, pressuring commercial real estate and REIT valuations.? Relative to our long-term expectations, REITs in general appear pricey, with our coverage trading at a 10% premium to our estimates of fair value and more than half of our coverage trading in 2-star or 1-star territory. Our Top Real Estate Picks
While fundamentals generally remain strong across our REIT coverage property sectors and valuations generally appear stretched, some pockets of opportunity remain.
One of our Best Ideas is American Tower Corporation AMT, currently benefiting from outsized demand for space on its cell phone towers, as wireless providers rush to upgrade communications systems to meet incremental demand as adoption and utilization of wireless devices push higher. ? Among office REITs, we favor Vornado Realty Trust VNO and Corporate Office Properties Trust OFC from a valuation perspective. In addition to American Tower, these are the only other U.S.-listed REITs among our coverage trading at slight discounts to our fair value estimates. Neither lacks uncertainty, however. Vornado recently embarked on a process to divest non-core holdings (including some unconventional REIT holdings such as its investments in retailers Toys R Us and J.C. Penney JCP) and both Vornado and COPT are exposed (COPT nearly exclusively so) to a weak leasing market around Washington, D.C. Of these two office REITs, we prefer Vornado, both for its quality assets, narrow moat, and relative valuation.? Although none of the other U.S. REITs we cover trade below our estimates of their fair values, investors may want to keep an eye on the moat-worthy landlords with good growth prospects and solid management, potentially adding exposure if stock prices drop and reasonable margins of safety materialize. Two REITs we think fit this profile are Realty Income O and Tanger Factory Outlet Centers SKT, both of which receive narrow moat ratings and exemplary stewardship ratings from Morningstar. Realty Income's growth prospects stem from one of the most attractive acquisition environments in the firm's history, while Tanger's outlet mall model faces a very long runway of potential growth, in our opinion.? If you'd like to track and analyze the stocks mentioned above, click here to create a Watchlist. Then simply click "continue," name your watch list, and click "done." (If this link does not work, please register with Morningstar.com--registration is free--or sign in if you're already a member, and try again.) This will allow you to save and monitor these holdings within our Portfolio Manager.

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Source: http://news.morningstar.com/articlenet/article.aspx?id=592067

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