Morningstar - Winter 2019 - 67

notably from the Hudson Yards megadevelopment,
which is supposed to add around 10-million-plus
square feet of office space to Manhattan
once it's complete. The overall Manhattan market
contains around 450 million square feet, so
it does represent a decent amount of incremental
supply, and there is additional construction in
Midtown and Lower Manhattan.
But structurally, the ease with which construction
can be brought on line in Manhattan hasn't
changed. What we're seeing now are a few
one-off events. The Hudson Yards neighborhood is
an area that used to be industrial that had the
zoning and the whole infrastructure completely
changed with support from the local government.
That's not necessarily indicative of an area that is
becoming easier to build in overall. Therefore,
when we look at the New York City metropolitan
area, we think that the fundamentals remain
relatively quite strong, as reflected by the number
of corporations that are relocating to the
Manhattan area or are adding square footage
there. New York is going to remain a hub for talent
and for the corporations that employ that talent.
As evidence, we've seen some of the premier
submarkets that had a bit of a dip due to a
perceived supply glut bounce back, most notably
Midtown. That's why we like SL Green Realty SLG
in particular. It historically has focused mostly on
the Midtown submarket within Manhattan,
and as a result, it's been beaten up more than
some of the other companies, because of
the perception that premier office space might
relocate to Hudson Yards. Our assertion is
that there is enough demand to ultimately satisfy
both of these premier submarkets, and leasing
numbers are beginning to show this.

there is typically a recovery when you have
higher growth.

Lallos: Yousuf, what are some of the less obvious risks
that you think should be factored in?

Fear of a recession creates an opportunity.
We're not trying to call the bottom of a recession.
The next 12 months may be rocky for these
names, but over the next three to four years we
think they are going to outperform the more
defensive healthcare and triple-net names. These
safer names have very stable cash flows,
and the fundamentals look very solid, but the
market has moved too much money into
those sectors and at some point the money will
shift back to malls and hotels. That's where
I'm seeing the greatest values at the moment for
investors with longer investment horizons.

Hafuda: One of the big ones is the affordability
crisis playing out in high-cost areas such as
San Francisco. This represents a risk for companies
like Kilroy Realty KRC, which mostly operates
on the West Coast in some of the most highcost areas in the United States. This dynamic is
increasingly driving what we call domestic
immigration: Some larger and higher-cost cities
are bleeding residents. Meanwhile, the so-called
second-tier metropolitan areas, such as Denver,
Austin, and Phoenix, have been capturing
many of these residents. So far, there hasn't been
much of an impact in terms of white-collar
migration, but if these cities don't address the

Fear of a recession creates an opportunity.

Kevin Brown

Many of these stocks have very high dividend
yields, so you can collect significant income
during your investment period. One of my top picks
in the mall sector is Macerich MAC, which is
currently paying between a 9% and 10% dividend
yield right now, well above not only the U.S.
equity but also the U.S. REIT average. (For more
on Macerich, see Best Ideas on Page 55.)
Lallos: You mentioned healthcare as a stable area,

but what about political risks?
Lallos: Kevin, are there pockets of value on your

coverage list?

Brown: It's the riskier names that are undervalued,
because as fear of a potential recession has grown
over the last six months, investors have moved
into the more defensive names. Our models go out
10 years, rather than two to three years as is
common with most other sell-side shops. While
we are worried that there is going to be a
correction coming to the hotel names and the mall
names, we also recognize that after a recession,

Brown: The major cuts that were made to the
Affordable Care Act over the past several
years really scared off the big three healthcare
REITs from owning the type of healthcare
that would be subject to such cuts, such as
skilled nursing and hospitals. The big three now
mostly own senior housing, which is mainly
funded by private sources out of retirement
savings; medical offices, which is less affected by
the spending cuts; and life science, which is
research- and pharmaceutical-driven.

affordability crisis, people may have to move-
and not just people on the lower end of the
income spectrum.
Another risk to consider is coworking. In certain
cities like New York and Chicago, WeWork is
now the largest occupier of office space. Previously,
the main driver of incremental demand was
what's called TAMI-technology, advertising,
media, and information services. Today, a
larger percentage of new office demand is driven
by coworking.
That represents a risk if the business model
proves unviable, or if it turns out that some of the
coworking companies have taken on too
much risk by subleasing space to financially
unreliable tenants. Boston Properties BXP
has been proactive about drawing in coworking
companies: It's made a concerted bet on
shifting away some occupancy risk to companies
like WeWork or Regus. An economic downturn

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Morningstar - Winter 2019

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