Real estate investment trusts and related exchange traded funds have become overpriced as investors flocked to yield-generating assets in a low rate environment. However, after the recent selling pressure, the asset class may be more attractively valued.
“Over the course of 2015, Morningstar’s real estate sector coverage has moved from one we viewed as largely overvalued to one that looks more reasonably priced,” writes Todd Lukasik, senior equity analyst for Morningstar. “The sector trades at a 10% or so aggregate discount to our estimates of value, roughly in line with the discount associated with our overall coverage universe.”
Lukasik pointed to health care sector REITs as Morningstar’s favorite area, pointing to companies like HCP (NYSE: HCP), Health Care REIT (NYSE: HCN) and Ventas (NYSE: VTR), which are trading at discounts to estimates of value.
A number of broad REIT ETFs also include these stocks. For instance, the iShares Cohen & Steers Realty Majors (NYSEArca: ICF) holds 4.4% HCP, 4.6% VTR and 6.0% HCN. Health care REITs make up 15.1% of ICF’s sector weights. ICF has a 3.40% 12-month yield.
Additionally, the iShares Residential Real Estate Capped ETF (NYSEArca: REZ) includes a 4.4% HCP position, along with 6.7% VTR and 8.7% HCN. REZ has a 33.3% tilt toward health care REITs and 47.1% in residential REITs. REZ has a 3.39% 12-month yield.
The recently launched Guggenheim S&P 500 Equal Weight Real Estate ETF (NYSEArca: EWRE), which follows an equal-weight indexing methodology that leans toward smaller companies, has 4.2% in HCN, 4.1% in VTR and 4.0% in HCP.
The Morningstar analyst warned that REITs could eventually underperform in a rising rate environment as the higher rates would cause greater debt financing costs, put pressure on expenses of REIT cash flow, and lead to higher cap rates. Moreover, funds could flow out of REITs as interest rates rise and weigh on valuations.
Nevertheless, Lukasik argues the REITs are capable of withstanding shocks as the majority of U.S. REITs have improved their balance sheets since the last downturn and remain more conservatively leveraged than the last boom. Additionally, many U.S. REITs still carry interest rates that exceed borrowing costs over the next few years, which can help provide a cushion in the medium-term even if interest rates rose 1%
For more information on real estate investment trusts, visit our REITs category.
Max Chen contributed to this article.