Real estate is one corner of the market that investors are moving into , as expectations of interest rate cuts grow. Markets are betting that this month’s inflation data will give the U.S. Federal Reserve justification to cut rates, as it has repeatedly said consumer prices need to come down for that to happen. It’s commonly believed that assets related to real estate, such as REITs, benefit from lower interest rates. That’s because many investments in this asset class involve leverage and borrowing, and the lower the interest rate, the lower the cost of holding the investment. A lower interest rate environment also increases the attractiveness of this investment in terms of the higher rental income yield offered by real estate. But there’s no guarantee — and such real estate assets may also do well when rates are higher. For example, the extent of borrowing costs depends on debt loads and type of industry, among other variables. For those interested in REITs, Morningstar is bullish on a name that it says is “cheap” and offers a high yield. ‘Catalysts for future gains’ That’s U.S.-listed Kilroy Realty , said Suryansh Sharma, an equity analyst at Morningstar, in a July report. The firm owns, develops and acquires premier offices, mixed-use real estate and those related to the tech and life sciences industries in U.S. cities. Also in July, Morningstar’s chief U.S. market strategist Dave Sekera named Kilroy as one of his four new stocks to buy “with catalysts for future gains.” Sharma said “the REIT has positioned itself to benefit from the burgeoning life sciences sector with material exposure in its portfolio and development pipeline,” adding that “We believe that although remote and hybrid work solutions will gain increasing acceptance, offices will continue to be the centerpiece of workplace strategy.” He gives a Morningstar fair value estimate of $59 to the REIT, which translates to it being undervalued by 46%, according to him. The rate of office use is set to increase over time , which will in turn lead to a recovery in office real estate demand, he said. Over the next decade, Sharma expects a 0.9% compound annual growth rate in average rent per square foot for Kilroy’s portfolio. “We think Kilroy’s significant development pipeline will provide yields around 6.50% through 2033, adding incremental net operating income and contributing significantly to the company’s valuation,” he said. Currently, Kilroy’s dividend yield is around 6%, according to FactSet data. “A focus on technology and life sciences market clusters should benefit Kilroy in the long run as we expect buoyant growth in these areas. The company’s high-quality office buildings with good amenities should benefit from the flight-to-quality trend,” Sharma said. Sekera pointed out that Kilroy is “one of the most undervalued” REITs under Morningstar’s coverage, but one positive is the firm is skewed toward the tech sector. “When we look at employment in the tech sector, that has been growing,” he said. “When we look at a measurement of job tech postings within their specific market areas, some of the largest tech companies like Apple, Alphabet, Amazon, Meta, they’re all requiring employees to go back into the office, go back to that hybrid work schedule of at least three days a week.” He also noted that the buildings in Kilroy’s life sciences portfolio are only 11 years old — significantly younger than many of their peers. That means it should lead to better occupancy rates, Sekera said. But, according to Sharma, investors should note that on the whole, the remote work dynamic persisting in various industries is still going to be a major risk. “The remote work dynamic is probably the biggest source of uncertainty for the office real estate industry. The pandemic showed us that technology can help employees collaborate and maintain productivity as they work remotely,” he said. “Hybrid workplace policies are now increasingly becoming the norm and present a significant challenge to future office demand.”
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