“Upward movement in Treasury yields, often used as a benchmark for real estate valuation, and interest rate expectations have consequently negatively affected REIT share prices over the quarter, writes Mui. He adds that 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,” thereby putting additional pressure on commercial real estate values.

That said, much of Morningstar's US REIT coverage still enjoys strong fundamentals. “Most portfolios are characterized by historically high levels of occupancy and durable balance sheets, and 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. Many firms have also continued to significantly reposition and refine their portfolios, trading out of weaker, more vulnerable assets into stronger assets with better long-term growth prospects and risk profiles. Although near-term uncertainty has affected leasing and transaction volumes, private-market asset values have largely stayed intact,” and should continue serving as an anchor for public market valuations.

However, the Morningstar report cites increasing concerns about oversupply in localized markets, such as New York City and San Francisco, and in asset classes, including office, multifamily and senior housing. Furthermore, a wave of legacy, peak-market property debt maturing over the next 12 months may cause significant disruption in real estate property and capital markets, Mui writes. “And if effective debt yields ultimately rise relative to overall performance, we would expect asset values and performance to be increasingly challenged.”

Given prolonged uncertainty for demand, attractive investment opportunities are harder and harder to source for public companies, writes Mui in the Morningstar report. “Historically high asset prices for existing, stabilized institutional real estate are progressively railroading many capable US REITs into allocating more capital toward value-creation opportunities,” including redevelopment as well as new development.

“While we continue to acknowledge the opportunity for prudent capital allocation to achieve excess returns, we are cautious of firms overextending themselves into riskier investments,” he writes. “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.”

CHICAGO—Strong underlying performance helps to offset what Morningstar views as the “generally defensive” nature of commercial real estate themes, especially on a global scale. Publicly traded real estate companies within Morningstar's sphere of coverage are “marginally undervalued,” trading at a 7% discount to fair value estimates.

In its outlook report on real estate stocks, issued Thursday, Morningstar cites “lingering concerns about increasing bond yields pressuring property stocks globally by double-digit percentages.” That being the case, analyst Edward Mui notes that “we continue to focus on underlying performance, which has remained healthy overall, as REITs have been focused on repositioning and strengthening their portfolios, deleveraging, and capital recycling. Construction of new property continues, however, as firms look for higher returns, putting into question levels of new supply as economic uncertainty remains.”

Om a global basis, Morningstar is anticipating “mixed economic outlooks” over the next 12 months, including the potential for increased central bank interest rate activity, to continue affecting property and capital markets activity, asset pricing and overall volatility. “The unexpected results of the US presidential election have had a tremendous impact on the markets even though proposed policy details behind the incoming administration's agenda are still largely unknown,” Mui writes.

Among the other effects of that impact, yields on the 10-year Treasury rose by nearly 100 basis points over the fourth quarter. Q4 also saw the Federal Reserve increase the federal funds rate by 25 bps and announce that three more increases were possible next year.

“Upward movement in Treasury yields, often used as a benchmark for real estate valuation, and interest rate expectations have consequently negatively affected REIT share prices over the quarter, writes Mui. He adds that 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,” thereby putting additional pressure on commercial real estate values.

That said, much of Morningstar's US REIT coverage still enjoys strong fundamentals. “Most portfolios are characterized by historically high levels of occupancy and durable balance sheets, and 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. Many firms have also continued to significantly reposition and refine their portfolios, trading out of weaker, more vulnerable assets into stronger assets with better long-term growth prospects and risk profiles. Although near-term uncertainty has affected leasing and transaction volumes, private-market asset values have largely stayed intact,” and should continue serving as an anchor for public market valuations.

However, the Morningstar report cites increasing concerns about oversupply in localized markets, such as New York City and San Francisco, and in asset classes, including office, multifamily and senior housing. Furthermore, a wave of legacy, peak-market property debt maturing over the next 12 months may cause significant disruption in real estate property and capital markets, Mui writes. “And if effective debt yields ultimately rise relative to overall performance, we would expect asset values and performance to be increasingly challenged.”

Given prolonged uncertainty for demand, attractive investment opportunities are harder and harder to source for public companies, writes Mui in the Morningstar report. “Historically high asset prices for existing, stabilized institutional real estate are progressively railroading many capable US REITs into allocating more capital toward value-creation opportunities,” including redevelopment as well as new development.

“While we continue to acknowledge the opportunity for prudent capital allocation to achieve excess returns, we are cautious of firms overextending themselves into riskier investments,” he writes. “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.”