A perfect storm of rising interest rates, inflation, remote working and an oversupply of commercial properties is rattling the U.S. real estate market like never before.
A sobering reflection of the excess office space in the U.S. is the fact that about 18% of U.S. office space remained unoccupied, as of October. This percentage is predicted to increase as more leases come to an end and a growing number of companies reduce their real estate footprint.
The trend could have significant implications for companies that offer a wide range of real estate services to owners, occupiers, and investors globally. A potential decline in their stock prices could present an appealing opportunity for those seeking to increase their exposure to the real estate sector.
Jones Lang LaSalle JLL provides a plethora of real estate-related services. Its rich array of offerings includes property management, project development, advisory, maintainability, digital real estate management solutions, and consulting.
“Jones Lang LaSalle has benefited from the secular trends in the real estate services industry and has experienced explosive growth over the past decade as it recovered from the global financial crisis in 2007,” says a Morningstar equity report.
The company has evolved into a more robust generator of cash flow throughout the business cycle by expanding its range of services and capturing a larger portion of real estate spending.
JLL’s continued healthy growth is predicated on the company continuing to take share from its smaller rivals and from rising capital flows into real estate and growth in urbanization.
Further, the firm has been investing in modern technologies that give the company a unique insight into potentially disruptive solutions and emerging trends.
“We are confident that JLL will be able to outearn its cost of capital over the next 10 years particularly because its product mix has become more contractual and less cyclical as compared with the previous downturn,” says Morningstar equity analyst, Suryansh Sharma.
Given its significant business growth lately, “JLL is poised to better withstand future downturns,” says Sharma, who recently lowered the stock’s fair value to US$203 from US$205, prompted by the fact that “rapidly increasing interest rates and a slowing economy have weighed on the company's recent results.”
Kilroy KRC is a premier owner and landlord that develops, acquires, and manages office, life science, and mixed-use real estate properties in Los Angeles, San Diego, San Francisco Bay Area, Seattle, and Austin. The company operates as a real estate investment trust.
“The company’s strategy is to achieve long-term maintainable growth by developing and owning the highest quality real estate in technology and life science market clusters,” says a Morningstar equity report.
The company has faced some choppy waters in some of its key markets in recent times due to economic uncertainty resulting from pandemic recovery and the remote work dynamic.
Employees are still hesitant at returning to the office as office utilization remains around 50% of the pre-pandemic level, the report states. The current vacancy rates in both LA (22.4% in Q4 2022) and San Fransisco (24.1%) are substantially higher than the vacancy rates during the height of the global financial crisis.
However, “we are seeing an increasing number of companies requiring their employees to return to the office,” observes Sharma, noting that while remote work and hybrid remote work solutions will gain increasing acceptance over time, “offices will continue to be the centerpiece of workplace strategy and will play an essential role in facilitating collaboration, harnessing innovation, and maintaining the company culture.”
Kilroy lacks an economic moat, though, due to “the uncertainty in demand associated with the remote work dynamic, and the ease with which competitors can lure tenants away with concessions,” says Sharma, who pegs the stock’s fair value at US$63.
Realty Income O owns roughly 13,100 freestanding, single-tenant, triple-net-leased retail properties across 49 states and Puerto Rico. Recent acquisitions have added industrial, gaming, office, manufacturing, and distribution properties (roughly 17% of revenue).
Realty Income describes itself as ‘The Monthly Dividend Company,’ and its line of business and operating metrics make “its dividend one of the most stable sources of income for investors,” says a Morningstar equity report.
The steady, stable stream of revenue has allowed Realty Income the rare distinction of being one of only two REITs to feature in the S&P High-Yield Dividend Aristocrats Index.
Its lease agreements are often long term (frequently 15 years), which affords the company a steady stream of rental income. “This makes Realty Income one of the most dependable investments for income-oriented investors,” says Morningstar equity analyst, Kevin Brown.
That being said, stability often comes at the cost of economic profit. Since the lease terms include very low annual rent increases (around 1%), it severely limits internal growth for the company. Therefore, to grow, Realty Income must rely on acquisitions.
“The company has executed nearly US$35 billion in acquisitions over the past decade at average cap rates around 6%,” points out Brown, who puts the stock’s fair value at US$76, but cautions that “the recent rise in interest rates has started to squeeze the company's spread and its ability to create value.”
:quality(80)/cloudfront-us-east-1.images.arcpublishing.com/morningstar/7WLK3HWLZBFR7NKI45PXWUD6OI.jpg)
