Housing Weakness Good for REITs?

Includes: ASN, AVB, EQR
by: The Stalwart

The Stalwart submits: While homebuilder stocks such as Toll Brothers (NYSE:TOL), DR Horton (NYSE:DHI), and Pulte Homes (NYSE:PHM) are all at least 30% off their 52-week highs, another part of the property sector has actually been rallying hard- REITs.

Large apartment REITs such as Equity Residential (NYSE:EQR), Avalonbay Communities (NYSE:AVB), and Archstone-Smith (NYSE:ASN), are at all time highs. Housing worries seem to have skipped these shares entirely and in fact Wall Street has spun housing weakness into a positive argument for these guys.

What’s the bullish case being passed around? Well as the housing market falls, people will buy fewer houses and instead rent more apartments. And wallah. Increased demand will mean higher rents and the earnings of these REITs will soar. That’s all it took for most REITs to rise to levels whereby they are now paying the lowest dividend yields in the last 10 years. Their spread vs. treasuries is also the lowest in ten years, and they even have a negative spread vs. treasuries which means you get more yield by parking money in your local bank’s risk-free CD. So please, throw out the strong yield argument for these guys.

If indeed these REITs are a great value despite trading at 10-year yield lows, then there must be a huge dividend growth story ahead, larger than we’ve seen in the last 10 years. But... if it turns out that there isn’t such a massive dividend growth story, then investors could suddenly decide risk-bearing yields below the risk-free rate don't make much sense. If massive growth doesn't pan out, REITs would have to go back to paying their more historical yields- which means we’d see a reversion to the mean.

A reversion to the mean would be ugly for REIT share prices. For example, in the past:

  • EQR used to pay yields of 5.4-6.9% from 1996 - 2004, vs. only 3.5% now.
  • AVB shares used to pay 5.2% - 7% from 1996 – 2003 vs. only 2.6% now.
  • ASN shares used to pay 6-7% from 1998 – 2003 vs. only 3.2% now.
  • If dividend growth ended up being below expectations, it would take quite a correction for these shares to move back to historical yields. In general it would take a 30% share price correction to get many REITs just in-line with treasury yields. Vice versa, this shows that investors must be expecting massive dividend growth if they are happy buying these REITs, since if share prices stayed where they are now, it would take roughly a 30% increase in dividends to bring many REITs in line with treasuries. Furthermore, we’d guess that investors are actually looking to make gains beyond the risk-free rate, thus dividends would have to increase by more than 30% for most REIT investments to make sense.

    Thus the main question is what kind of dividend growth might we see from most REITs:

  • EQR requires a 27% higher dividend, up from its already increased dividend of $1.77, just to offer 4.5% yield.
  • AVB requires a 73% higher dividend from its already increased $3.12 payout. Fair enough, AVB is less leveraged than most REITs, thus has more room to simply add assets.
  • ASN needs to hike its dividend 40% just to hit a 4.5% yield.
  • Also, one would hope that this growth comes in the next 2 years; else we’d be waiting an awful long time just to match treasury yields. I mean for how long can rental yields get pushed up at historically aberrant rates?

    If one listens to 2Q06 conference calls, most rental increases are forecast in the mid to high single digit range, which with operating leverage gives us maybe 10% per year. But please do your own due diligence on this one. Obviously many in the market have much higher dividend growth expectations. We could be wrong. If you see something we missed, please leave a comment.

    Insider selling. In the latest (2Q06) conference calls, managements at most REITs were bullish on rental rates and poo-poohed the condo/home sales business. (Even though if you go back to the 4Q05 conference calls the story then was all about strong condo sales by the REITs.) But it's unsettling to see insider selling at these REITs in recent months. If apartment rentals are so surely about to boom, why would the key people at these REITs be selling now? EQR insiders have net-sold (excluding purchases due to options exercise) over US$15.5m of stock since August 1st, AVB insiders have similarly net-sold US$16.5m of stock since August. ASN hasn’t shown such strong insider selling signals, with a net-sell of US$2.2m since August 1st. (Data taken from the insider section for each stock at Yahoo Finance.)

    Yes, perhaps they are just cashing out options for cash flow, but for EQR especially, there was heavy selling in September. Might the outlook given during 3Q06 results disappoint?

    Supply/demand issues. Looking more at the general housing situation, this week’s September 30th issue of The Economist in its article “Going down?” states that the supply of existing homes for sale is currently up 60% year on year. The level of supply is also at a 13-year high, and rising. In contrast, sales of existing homes are down 12% year on year, and those of new homes down 17% year on year. Also, we expect that as further news of price declines hits, the pool of home buyers could suddenly shrink drastically. Supply up sharply, demand down sharply.

    Also, in Barron’s magazine this week Alan Ableson also tells us that the recent uptick in sales of new single-family homes was only due to the fact that the previous month’s numbers were revised down. Had they not been, August would have come in down 2.1%. Let’s also not forget that August could get revised down as well, like the previous month. Year on year he says new home sales are down 19.4% if we use a 3-month average. Nevertheless, inventory of unsold new homes is up 40% year on year, from 4.7m homes to 6.6m homes.

    In the end, renting and buying are fungible. One thing to remember regarding the falling housing market -- whether you rent or buy a home the two different options are relatively fungible. This means we could see a lot of condos and homes for sale suddenly entering the rental space. Thus the supply of rental units isn't a fixed figure. As home prices fall, supply of rental units will rise. As renting is somewhat fungible with buying a home, we expect that weak housing sales would flow throw to rental weakness as well. But again, many on Wall Street with Outperforms on REITs would disagree. "Um... housing sales weakness... means... switch to rental exposure..." Buy/sell combos can mean double business.

    From the horse's mouth.
    As our final argument against rental prices somehow being immune to housing weakness, or even on the verge of a massive boom due to it, we will leave you with part of the 2Q06 conference call transcript from EQR:

    CRAIG MELCHER [Analyst, Citigroup]: And specifically on South Florida. Can you talk a little bit about that market, occupancy dipped sequentially in the second quarter, [inaudible], can you talk about what you're seeing in that market and what's attractive to that market?

    GERRY SPECTOR [COO, Equity Residential]: Well, primarily, historically we've seen seasonal issues in the summer, Florida typically softens in the summer. One of the major changes that's occurred down there is a lot of the Condo product coming back into the rental market. Just in south Florida alone, Miami area, there have been 50 projects that we've identified coming back into the rental market that were ear marked, in some cases in the process of being sold. So, what you've had is, all of a sudden a significant increase in supply, all of a sudden, along with some seasonal factors, there's still strong job growth and we think demand will recover, but I think the new product going in there is creating a little more softness than we would have expected. We're not seeing the same impact in Orlando at that degree. We're seeing some impact there. It's off about a point and a half in occupancy. We think that's primarily seasonal, some of it with new product coming back into that market and we're seeing the same kind of issues in Tampa, I would say. So overall decline due to seasonal factors, but a lot of supply coming into the, due to the Condo bust.

    Our charts above are based on data from www.federalreserve.gov and Value Line.

    [Disclosure: The author opened short positions in EQR and AVB last week]

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