By Jason Ren
We recently had the opportunity to hear a panel of multifamily REIT CEOs--Camden Property's (CPT) Richard Campo, Equity Residential's (EQR) David Neithercut, UDR Inc.'s (UDR) Tom Toomey, and Essex Property's (ESS) Michael Schall--speak candidly about sector fundamentals. While we agree with these CEOs that near-term fundamentals are robust, our opinions differed on other matters. For instance, we disagree with the assertion that the millennial cohort is meaningfully different than others before it.
The panel discussion did not lead us to change our moat assessments or fair value estimates for the apartment market, and we continue to think that recent acquisition pricing offers no margin of safety. While there is upside to our current fair value estimates for apartment REITs, if present supply and demand tailwinds persist beyond the near term, or if boomers turn toward apartment renting en masse, we continue to think the benefits will ultimately prove ephemeral.
Tailwinds, But For How Long?
Much of the panel discussion centered on the presently attractive supply and demand drivers of the apartment space. For instance, on the supply side, single-family housing construction boomed during the last decade, while multifamily construction stalled. Because banks were badly burned by construction loans, they are not robustly building out construction books at this juncture. Also, most of the single-family overhang from the last decade isn't competitive with multifamily portfolios in structurally dense urban cores.
Central to the current demand tailwinds are the echo boomers, the second-largest demographic, who have decoupled from recessionary living conditions thanks to increased jobs and are forming households at a later stage in life. The fact that mortgage requirements remain high across the board provides an additional demand tailwind. It remains prohibitively expensive to buy in some areas, such as New York, Boston, and San Francisco.
The CEOs were more uniformly bullish on supply tailwinds than demand tailwinds. This led to variances in terms of assessments of tailwind duration, with Schall and Campo estimating a few years and Toomey suggesting a decade. Neithercut seemed to fall somewhere in between in terms of his assessment of tailwind potential.
There was quite a bit of disagreement over the pricing sensitivity of echo boomers. Neithercut was the most sanguine, remarking that the firm did not need job creation for the firm to prosper because the echo boomers have a decidedly different set of preferences than cohorts before them: Namely, they view renting as "financial freedom" and housing as a consumption good rather than an investment. Campo, though he believed that a healthy job market was necessary in order to maintain growth prospects, did offer several points that supported this "preference" assertion.
In Camden's markets, such as Dallas and Las Vegas, which aren't as well-situated in structurally dense locales as the others, his firm and others are nonetheless able to push rents in central business areas, despite much more affordable single-family housing in the suburbs. As an example, he noted that single-family rentals in Las Vegas have a 20% vacancy, while other multifamily vacancy rates in the city were just 8%, citing this as proof that the housing product is different and that people prefer to live in the city center instead of suburban-sprawl areas. Countering this positivity was Schall, who seems to believe that all housing ultimately competes with one another, and that there are clearing prices.
We don't think that the millennial generation will prove to be much different than cohorts that have come before. If presented with an attractive financing offer, a shift toward increased single-family home ownership is likely, in our view. Banks' balance sheets are healing from past credit ills, and in a compressing net interest margin environment, we doubt it would take more than a few years for credit to loosen. Moreover, while it's true that job prospects for echo boomers have noticeably improved, wage growth hasn't proven as robust. This is problematic as rent/income ratios climb to between 20% and 25%. We think pushing rents aggressively could be difficult in the absence of wage growth or replacement residents with higher incomes.
But the Acquisition Makes Sense Using the Right Metrics
Acquisition pricing was also briefly discussed. Generally, the CEOs remarked that cap rates did not reflect other measures of scarcity or profitability. Namely, they pointed to aspects such as discounts to replacement cost and the improved liquidity of higher class buildings than lower ones.
We disagree. To us, using replacement cost in the absence of obtaining a reasonable rental return on capital is speculative. If the company purchases a property at a 20% discount to replacement cost, but is only achieving a 4.5% net operating income yield, then to prevent value destruction the firm needs to find someone who's willing to accept a 3.6% yield at that replacement value if rents don't grow. Otherwise, the company needs to achieve near-term rent growth in excess of 10% in order to achieve a 4.5% yield at "replacement value."
As such, we think that recent acquisition prices are dependent upon strong future rent growth and reflect no margin of safety. Viewed differently, current cost of debt financing for well-positioned apartment REITs ranges from approximately 400-450 basis points. Since equityholders are in a more junior position, cost of equity should reasonably be higher than cost of debt financing for a given firm. Some recent acquisitions that have transacted in structurally dense coastal locales have been at capitalization rates of 450-500 basis points, or 4.5%-5.0%. The numerator of capitalization rates, net operating income, is property level income less property level expenses. This doesn't take into account financing costs or the consolidated firm's overhead. As such, by all reasonable estimates, the cash flows ultimately received for a property at recently low cap rates do not meet or exceed estimated costs of capital. At recent prices, executives would likely have to bake in at least several years of outsize growth for profitability to climb meaningfully above estimated costs of capital.
Not Just the Echo Boomers
One of the questions posed to the panel addressed elder boomers and the degree to which that cohort could meaningfully affect bottom lines moving forward. The panel members were generally positive on the development. Schall mentioned that there is a trend of empty nesters moving back to urban cores. Neithercut concurred, remarking that 15% of residents at his firm were over 55, and that this percentage had increased over the years. Toomey, however, offered the most insightful viewpoint, surmising that elder boomers will likely have to draw down assets to finance rising health-care costs moving forward. To him, the easiest way to finance health-care needs is by selling a single-family home and renting instead.
Our current fair value estimates do not bake in a sustained tailwind from the baby boomer cohort moving back to the urban core. If this couples with other supply and demand tailwinds, the multifamily space in sum, not just the moaty firms, could see net operating income growth above inflation for a sustained period of time. If this were to occur, benefits would not accrue to the apartment REITs in isolation. In all likelihood, operational improvement would be seen at storage facilities, as well, though not to the degree seen at multifamily, owing to the less favorable industry structure.
Under this scenario, we think the potential negative impact on health-care REITs would be fairly muted. Because amenities provided at independent and assisted-living facilities differ so greatly from multifamily offerings, we don't view them as directly competitive. At worst, it may persuade higher-income individuals to put off moving into an independent community for a few years until they absolutely require the incremental amenities and services.