As we get deeper into the current real estate cycle, many investors are wondering if the sector is nearing its peak. Meanwhile, interest-rate expectations are weighing on the sector’s valuations. Higher interest rates would put pressure on growth rates and return expectations. To get a better read on the real estate cycle, how a rise in interest rates would affect real estate markets, and the long-term risks to the sector, I sat down with analyst Edward Mui, who covers the sector for Morningstar. Our interview took place on Oct. 31, and his answers have been edited for clarity and length.
Let’s start by looking at the broad picture. Where are we in the real estate cycle? What’s your current outlook for the next 12 months?
Mui: Like the broader market, the real estate sector has been in prolonged recovery since the recession eight years ago. It feels like we’re currently in the later innings of the real estate cycle; many REITs are experiencing historically high occupancies, there is still robust rental growth, and peak valuations are driven by not only the underlying demand for this real estate but also by the lower interest-rate environment that we’ve been in for quite some time. With the potential of a U.S. Fed rate hike, there are a lot of questions right now in the market about where growth and valuations for real estate are going in the next 12 months.
Within the next year or so, I would still expect demand to be cyclically high. There’s not a catalyst that we see right now that would bring growth and demand screeching to a 2008–09 style halt, even though there are signs of deceleration from the cyclical or historical peaks of rental growth and occupancy.
If rates go up, what would be the short-term effects to the sector?
Mui: Interest rates matter to REITs and real estate mainly because real estate is a very capital-intensive business. REITs and real estate investors need ample liquidity and access to capital markets to keep the markets going, not only in terms of purchasing buildings but also for developing new supply, signing new tenants, and even just for working capital purposes.
The mental benchmark for real estate is the 10-year U.S. Treasury. As we know, the 10-year Treasury has been trading at historical lows for many years. So, there’s a worry that as interest rates increase, it places pressure on real estate valuations, which are somewhat benchmarked to the yield that real estate provides investors relative to the 10-year Treasury. That’s the short-term outlook. Right now, in my opinion, any increase in interest rates is more a sign of confidence in the economy in maintaining the Fed’s inflation targets, not necessarily due to the decrease in capital markets activity or the excess liquidity. An increase in interest rates in the near term, even though it may be a drag on performance due to the cost of debt, doesn’t necessarily indicate a negative outlook for the real estate market or the market overall.
So, higher interest rates wouldn’t necessarily spell the end of the real estate cycle?
Mui: The end of the real estate cycle could be caused by some type of negative, market-jarring surprise that shakes investor confidence, brings capital markets to a halt, and decreases overall demand. In 2009, oversupply, over-leverage, and bankruptcies within the financial markets led to a lack of liquidity and lower demand, affecting real estate performance and valuations. We don’t necessarily see similar risks today; since the recession, underwriting standards for real estate have been more conservative, which has kept levels of new supply relatively low in many cases and added to the relative outperformance of the current real estate market.
Is there anything else that you look at besides interest rates in the economy that are risks to the sector?
Mui: The adage for real estate is “all real estate is local.” You have to get down to the underlying portfolio that a REIT owns and what markets they’re in, the quality of their assets, how they’re performing, and the long-term supply-and-demand outlook for each market.
The real estate cycle is going to happen, but the sector has maintained cyclically high performance and demand amid an environment that has limited new supply for the most part. You see some supply pressures in very select markets and select asset classes, but overall, demand has supported the current level of supply that we have in the United States.
Where are the strongest areas of the market?
Mui: There are some parts of the real estate market that have been particularly strong over the past several years, mainly due to secular shifts of the marketplace. The effects of e-commerce on industrial real estate has driven demand for warehouses and distribution centers. At the same time, there’s been an increase in demand for apartments—for real estate driven by the millennial generation’s penchant for renting versus owning. Millennials are delaying major life decisions, such as marriage and having children, choosing to maintain flexibility and mobility. This has driven demand for apartments in the urban core of cities and, increasingly, suburban settings.
What are some other risks to the sector?
Mui: I think any long-term risks are technology-related. What is the potential of, say, improved distribution capabilities to shorten shipping times for e-commerce players, of self-driving cars to play into that, or drone delivery to lower the friction that exists between online purchases and physical store purchases, which is something that is clearly being explored.
It’s fun to dream about these very large, disruptive concepts playing out within our lifetimes, if not within the next 10 to 20 years. But I think there will always be this immediate demand, not only to buy products, but to have types of environments and real estate that connects people to their communities and gets people outside of their homes and out from in front of their computer screens. It gets down to creating that value proposition for consumers that drives demand for physical real estate.
Are there any buys valuation-wise?
Mui: The REIT sector has experienced a bit of a pullback, because of, again, concerns about the interest-rate environment and the deceleration in demand, which I think is more of cyclical factor than a structural factor. When we’re looking at long-term value, there still is value that you can find within our coverage.
One of our favorite real estate sectors right now is healthcare, a sector that has demonstrated a fairly inelastic or less volatile performance in all parts of the cycle. Talking about generational shifts and demographics, you have very large baby-boomer generation hitting Medicare eligibility and driving demand for healthcare services that will continue to benefit healthcare REITs. Along with that, even though there is this large growth in the baby-boomer demographic, you really have to get down to the companies that have the financial wherewithal and operating track records and management to not only take advantage of the opportunity, but to work with the best service providers and have the best capital allocation.
Mui: I would just say that even though there is uncertainty about where we’re headed to within the next 12 to 24 months, real estate is the type of investment for long-term, patient investors who don’t have kneejerk reactions to cycles or normal events that happen in the market. There is a lot of potential for pain, but there’s clearly potential to gain.
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