CHICAGO—Morningstar's near-term forecast for REITs' stock performance starts off partly sunny and then clouds over. "We expect REIT prices generally to move inversely with changes in long-term government bond yields," according to Stephen Ellis, director of financial services equity research at Chicago-based Morningstar. He notes that while higher interest rates would take some time to show up in REIT financial metrics, those effects will be felt eventually.

Those effects range from higher debt financing costs, pressure on traditional measures of REIT cash flow such as funds from operations and lead to higher cap rates, putting pressure on 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," Ellis writes as part of Morningstar's end-of-quarter outlook.

A number of industry economists have pointed out that rising interest rates provide evidence of a strengthening economy, which provides its own benefits for real estate fundamentals. Nonetheless, Ellis notes that Morningstar doesn't expect the macro environment to improve enough to offset what could be another 200-basis-point rise in US government bond yields to "levels nearer historical norms."

He notes that management teams at US REITs appear to be more sanguine about rising interest rates than investors have been. "The majority of US 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," writes Ellis. "Moreover, upcoming maturities for many US REITs over the next few years still carry interest rates that far exceed current borrowing costs." As a result, even a rate increase of 100 bps would have a negligible impact on the companies' cash flow, at least in the medium term.

Nonetheless, Ellis notes that recent trading activity points to "an immediate impact" on stock prices from investor expectations. "Although we still view the potential for higher interest rates as a valuation risk for US 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 Treasury into our weighted average costs of capital, relative to the low-2s level recently observed in the Treasury market."

That being said, Ellis also cites one REIT in particular, Ventas Inc., among Morningstar's current stock favorites. "Healthcare REITs in general are one of the most attractive property sectors in our US real estate coverage on a relative valuation basis, and Ventas—with its narrow moat and exemplary stewardship—is currently our favorite among the bunch," he observes.

In general, Ellis sees favorable tailwinds for US-based healthcare REITs, 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. "Plus, healthcare is a property sector in which the vast majority of assets remain in private hands, so Ventas should have opportunities to further consolidate ownership," he writes. "We think the combination of Ventas' 7%-plus cash flow yield (using our 2016 normalized AFFO estimate) 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."