Real estate: Rising interest rates wreak havoc on REITs

We prefer REITs with reasonable leverage, moaty assets, demonstrated historical success across economic cycles, identifiable growth drivers and reasonable margins of safety.

Todd Lukasik, CFA 9 July, 2015 | 5:00PM

We expect REIT prices to generally move inversely with changes in long-term government bond yields. Although higher interest rates would take some time to show up in REIT financial metrics, eventually higher rates could cause higher debt financing costs, put pressure on traditional after-interest expense measures of REIT cash flow (such as funds from operations, adjusted funds from operations and funds available for distribution) and lead to higher cap rates, which could pressure investment spreads. Also, to the extent that low interest rates have diverted investor funds to REITs searching for higher yield, funds could flow out of REITs if interest rates rise, pressuring commercial real estate and REIT valuations.

Although rising interest rates might signal a strengthening economy, which could benefit real estate fundamentals, we do not expect the macro environment to improve enough to offset what could be another 200-basis-point rise in U.S. government bond yields to levels nearer historical norms.

While the potential negative impact of rising interest rates remains a key concern for REIT investors, U.S. REIT management teams seem less concerned. The majority of U.S. REITs have improved their balance sheets since the last downturn and appear as a group to remain more conservatively leveraged than the last boom in the mid-2000s. Moreover, upcoming maturities for many U.S. REITs over the next few years still carry interest rates that far exceed current borrowing costs, so even a 100-basis-point rise in rates from here would have a negligible impact on cash flow, at least over the medium term.

Nonetheless, recent trading activity suggests that investor expectations about actual or expected future interest rates can have an immediate impact on U.S. REIT stock prices. While we still view the potential for higher interest rates as a valuation risk for U.S. REITs, we would expect higher interest rates to have a negligible impact on our estimates of value. We already embed a mid-4s yield on the 10-year U.S. Treasury bond into our weighted average costs of capital, relative to the mid-2s level observed in the Treasury market recently.

While property remains a business that requires local market knowledge, global capabilities are becoming increasingly important, as capital seeks diversification and opportunity across borders. This global flow of capital is not just cross-border but increasingly cross-continent as well. This, combined with the generally low interest-rate environment, is keeping cap rates low (and property values high), especially for the highest-quality assets in global gateway markets, where global investment flows are especially strong. Global capital flows typically introduce increased competition for property acquisitions, a slight negative for REITs. But global capital flows generally require specialized local-market knowledge for deployment, a boon for the largest global commercial real estate services firms.

With the abundance of institutional capital chasing high-quality assets (especially in gateway markets), pricing for existing commercial real estate stock appears aggressive. U.S. REITs with development capabilities are allocating more capital to ground-up developments and redevelopment of existing, productive assets. We think this makes sense, with expected initial yields on development projects generally at least 200 basis points higher than current cap rates on sales transactions. If such yields are realized, REITs can theoretically create immediate value upon stabilization of these developments, as the market recognizes the earnings power of the developments in light of lower cap rates for stabilized, operational properties.

Despite the focus on developments at many U.S. REITs, overall development across the U.S. commercial property landscape continues to remain at reasonable levels, in our opinion. Oversupply of incremental square footage generally corresponds with commercial real estate downturns. But some developers from prior cycles did not survive the last downturn, and financiers remain less aggressive providing development capital in many instances. As such, we are not overly concerned with current U.S. construction levels, but this is an area that bears watching.

Given the potential for rising rates, however, we think it makes sense to focus on REIT investment opportunities that can do well in either a rising interest-rate environment or a future in which the slow-growth, low-rate environment continues. We prefer firms with reasonable leverage, moaty assets, demonstrated historical success across economic cycles, identifiable internal and external growth drivers and reasonable margins of safety to our estimates of value. Moreover, we think it makes sense to focus on firms with these attributes that also have well-covered dividends with strong prospects for growth over time.

Generally, our U.S. real estate sector appears fairly valued. Health-care REITs are our favourite sector currently, while pockets of opportunity also exist among the retail and cell tower sectors.

Top Real Estate Sector Picks

Star Rating
Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Tanger Factory Outlet Centers
$42
Narrow
Medium $29.40
Ventas
$90
Narrow
High $54.00
HCP
$53
Narrow
Medium $37.10
Data as of June 22, 2015. All figures are in U.S. dollars.

Tanger Factory Outlet Centers  (SKT)
Tanger is the only publicly traded U.S. REIT focusing exclusively on outlet centres in the U.S. and Canada. We like its outlet strategy as this is an area of retail that has held up well across economic cycles, and we think retailer demand for outlet distribution remains high. Occupancy at Tanger's centers was recently near 98%, among the highest of retail REITs in general. Strong consumer and retailer interest in the outlet channel is driving incremental outlet center development, which we think has another five to 10 years left to run, providing plenty of external growth opportunities for Tanger. Furthermore, we estimate Tanger's in-place rents are 5%-10% below current market rents, supporting inflation-plus rates of internal growth as leases expire and tenants' rents increase to market levels. To us, the combination of Tanger's 6%-plus cash-flow yield with mid-single-digit growth prospects appears attractive in the current environment.

Ventas  (VTR)
Health-care REITs in general are one of the most attractive property sectors in our U.S. real estate coverage on a relative valuation basis, and Ventas is currently our favourite among the bunch. In general, U.S.-based health-care REITs should benefit from some favourable tailwinds, including an expanding and aging population and potentially tens of millions of people added to the ranks of the insured because of the Affordable Care Act -- all of which should drive incremental demand for health-care real estate relative to historical levels. Plus, health care is a property sector in which the vast majority of assets remain in private hands, so Ventas should have opportunities to further consolidate ownership. We think the combination of Ventas' 7%-plus cash-flow yield with growth prospects in the low- to mid-single-digit range (if not higher, depending on external growth opportunities) provides investors with a compelling total-return prospect in the current environment.

HCP HCP
The advent of the Affordable Care Act in the United States has brought a renewed focus on health-care spending, the bulk of which is nondiscretionary and often requires physical space, creating favourable conditions for health-care landlords. We think HCP will continue to benefit from in-place, long-term leases, gain incremental exposure to potentially faster-growing operating assets, and find opportunities for profitable external growth, both with existing partners and by further consolidating ownership of health-care real estate. We expect HCP's 2015 dividend to represent 87% of our forecast adjusted funds from operations, which we view as a reasonable level. So HCP's current dividend and its future inflation-plus growth prospects appear to remain intact under our base case assumptions. HCP has also recently been more active on the acquisition front, and we expect it to have plenty of future acquisition opportunities to further consolidate its industry.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
HCP Inc34.95 USD-0.46

About Author

Todd Lukasik, CFA

Todd Lukasik, CFA  Todd Lukasik, CFA, is a senior equity analyst for Morningstar.