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The apartment sector has entered the recovery phase of the commercial real estate property cycle. Declining vacancies and rising rents highlight the recovery phase and point to higher total returns for investors. The mid-term prospects for apartments are further strengthened by powerful demographic trends that will fuel demand for apartments creating strong growth in apartment rents and strong returns for investors.

The recent economic downturn triggered a commercial real estate recessionary phase that is highlighted by increasing vacancies, declining rents, and limited new construction. The other sectors of commercial real estate (retail, office, and industrial) are still in the transition from a recessionary to recovery phase. Apartments, however, are firmly established in their recovery phase.

Apartment vacancies have been declining since their peak at 8% in late 2009. According to REIS, the 3Q 2011 national apartment vacancy dropped to 5.6%, which is the lowest vacancy level since late 2006. The rising demand for apartments has led to the vacancy declines and has put landlords in the position to raise rents. REIS reported the 3Q 2011 rents increased by 2.4% over the past year nationally. As a result, apartment investors will see higher returns.

The apartment recovery is heavily market-dependent. Strong gateway markets, such as San Francisco and New York, have experienced the strongest growth. Other markets, such as Las Vegas and Phoenix, continue to struggle with a rental market flooded with foreclosed homes available for rent. These market differentials point to a need to find an apartment REIT with an experienced investment and management team.

According to REIS, 3Q 2011 apartment construction was the lowest quarterly new supply in over ten years. The limited supply of new apartments over the past two years will allow vacancies to decline further until new apartment construction can be completed to meet the growing demand. REIS also reported that developers are racing to develop the hundreds of thousands of apartment units needed to meet expected demand.

The strong demand for apartments will come from these powerful demographic trends. The first trend is the significant population surge among Generation Y (people ages 15-29). The core apartment renters are people in their 20s that are mobile, transient, and not ready or qualified to make an investment in a home. This demographic trend is projected to raise apartment demand by over 3.2 million renters over the next five years.

The second demographic trend is a significant increase in household formation. Household formation has a historical average of 1.3 million new households per year, but recessions push down new household formations, as young people move back home or seek out roommates. When the economy recovers, household formations rise significantly. Economists project that pent-up demand for new households is 4.8 million.

The third and final demographic trend is the decline in homeownership. The average historical homeownership rate was 63.1%. In the last decade, through government initiatives and a subsidized housing market, homeownership spiked at 69% in 2006. The rate of homeownership has already been in decline and is projected to reach 62% due to tighter lending standards and housing affordability. This decline results in more apartment renters.

These demographic trends, combined with a commercial real estate sector already in recovery, position apartments to provide strong growth and higher total returns for investors. Investors can capture this growth by investing in publicly-traded apartment REITs or non-listed apartment REITs. Below are a few well established, strong performing publicly-traded apartment REITs and a few non-listed apartment REITs that have recently opened in a favorable market.

Publicly-Traded Apartment REITs

Share Price

Dividend

Avalon Bay Communities (NYSE:AVB)

$23

2.10%

Equity Residential (NYSE:EQR)

$59

2.40%

UDR, Inc. (NYSE:UDR)

$25

3.30%

*Share price and dividend are effective as of 11/3/11 with data from Yahoo! Finance.

Non-Listed Apartment REITs

Effective Date

Dividend

Bluerock Enhanced Multifamily Trust

10/15/09

7.00%

KBS Legacy Partners Apartment REIT

3/12/10

6.50%

Steadfast Income REIT

7/9/10

7.00%

As with any investment, investors should understand the structure, risks, and expected returns for both publicly-traded apartment REITs and non-listed apartment REITs. But, these REITs focusing on apartments should benefit from strong growth over the next couple years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Apartment REITs Should Benefit From Rising Demand