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.
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. 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. In the office space, we see some opportunity for owners of Class A office and retail properties. 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.
The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation.
