The premise of this article is the relationship between the recent decline in multi-family REIT prices and the massive influx of U.S. residential building permits driven by QE3. As the supply of new homes increases, it is important for investors to determine markets that will remain rental friendly.
The FTSE NAREIT US Residential Real Estate Index (REZ) and the Dow Jones U.S. Residential REIT Index (DJUSRN^) showed that equity REITs were down 4.18 percent and 5.32 percent, respectively, from September 13 through October 26. The sharp decline in residential REITs followed the announcement of a third round of quantitative easing (QE3) by the Federal Reserve on September 13. In an 11-to-1 vote, the Federal Reserve launched an open-ended, $40 billion a month bond purchasing program of agency mortgage-backed securities.
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I believe that forward-looking estimates of new home construction, driven by QE3, are driving down the prices of multi-family REITS. Following QE3, there has been a sharp increase in the number of housing permits over the U.S. Census Bureau's estimates.
Permits (Seasonally Adjusted)
Increase Over Estimate
I believe this is a major fundamental driver behind multi-family REITs' recent decline in price.
In order to allocate wisely, multi-family REIT investors should seek markets where renters will remain priced out of the housing market despite an increase in inventory driven by new construction. Taking a look at the September increase of U.S. residential building permits over the U.S. Census Bureau's estimates, a logical conclusion is that home builders are ramping up inventory to meet dwindling supply.
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This is a source of worry for multi-family investors, as an increase in supply could begin to draw renters into the housing market.
Comparing the multi-family REIT index prices' (^DJUSR) and (REZ) decline with the increase in U.S. Housing Permits, we can see a diverging pattern.
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As new homes are constructed, it will have a positive impact on supply. With increased supply, housing prices will inevitably go down, an indication that renters may begin to enter the housing market. However, the effect of increased supply on multi-family fundamentals is going to depend on the geographic market, and whether it remains cheaper for people in those areas to rent or buy.
Defining Optimal Rental Markets
With the impending increase of housing inventory driven by new home construction, it will be harder for investors to find markets that remain friendly to renters after QE3. In order to determine optimal markets, we need to seek locations where it will remain more expensive to buy than rent. A great resource to use is Trulia.com's "Rent vs. Buy Index." The index identifies rental friendly markets by weighing the following criteria:
- Low Foreclosure Rates
- High Unemployment Rate
- Low Job Growth
- High Home Prices (as an average monthly mortgage) vs. average rents
- Constrained housing supply and stagnated new home construction.
Although the Dow Jones U.S. Residential REIT Index does not disclose its composition, I have created a price-based index that closely parallels the (DJUSR^) index. The equities listed in the table below represent the largest U.S. multi-family REITS:
Apartment Investment & Management Co. (AIMCO)
Mid-American Apartment Communities
Camden Property Trust
Colonial Property Trust
The market weighted FTSE NAREIT U.S. Residential Real Estate Index is composed of pure multi-family REITS, college housing and senior care REITs. I believe this composition makes it difficult to measure multi-family performance due to the fact that senior care and college housing have less of a fundamental relationship to housing compared to pure multi-family REITs. So for all intents and purposes, I believe the Dow Jones Residential REIT Index is a better barometer of performance.
Putting It All Together
Now that we have determined the components of the index we are measuring against forward-looking estimates of new home construction, we can use this information to select REITs with a high concentration of apartments in the markets where renters will remain priced out of the housing market. Part 2 of this series will present my investment picks for 2013 based on their concentration in optimal rental markets, and a fundamental analysis of those investments for maximum potential.