Apartments - A Contrarian View

by: Jan Brzeski

Recently in the Wall Street Journal an article appeared including the following graphic based on data from Moody's Investor Services:

Moody's projects apartment values increasing by about 33% over the next four years. In this article, we will analyze what that would mean about underlying apartment operations and capitalization rates (the ratio between cash flow before debt service and a property's value). We conclude that this projection by Moody's is highly optimistic and that, to the extent apartment REITs have these sorts of projections baked into their value, they are probably overvalued.
What Would Happen if Moody’s Proved Right
For apartment values to increase by 33% over the next four years, they would need to climb 7.4% per year. Apartment values are based on two things: the cash flow from operations (before debt service), and the capitalization rate (“cap rate”), which is the yield that investors require. The cap rate is like the inverse of the price earnings ratio.
Typically, apartments are financed with debt. A typically loan-to-value ratio is 65-70%. Suppose an apartment owner purchased a property for $10 million today with a down payment of $3.5 million and a loan of $6.5 million. Over the next four years, the value rose to $13.3 million, in line with the Moody’s projections. The owner’s equity has increased from $3.5 million to $6.8 million—a 94% increase, or 18% per year. Add this to the current income (cash-on-cash return) of about 5% per year, and the apartment owner would enjoy something like a 23% annualized return over the next four years.
Common sense tells us that this is extremely unlikely to happen, especially with an asset class that is already highly favored by real estate investors. In other words, the Moody’s projections are highly unrealistic and naïve.
Capitalization Rates Cannot Go Any Lower
Cap rates on apartments are currently at historically very low levels—typically in the 5-6% range in Southern California, and a bit higher elsewhere. In part this reflects the extremely low cost financing available for apartment from Fannie Mae and Freddie Mac—in the 4% range for 10-year financing with 30-year amortization. This rate is likely to go up in coming years, which means cap rates are very unlikely to decline. More likely, they will move higher in the coming years.
If we just assume that cap rates remain constant at their current, historically low levels, then the entire increase in value projected by Moody’s would need to come from increased operating income. For operating income to increase 7.4% per year, rents would need to increase by a similar amount. It is true that if occupancy rose, operating income could rise more quickly than rental income, because costs do not increase much with one incremental unit rented in a property. However, this is very unlikely to happen. Vacancy rates are already at a 5-year low of 5.6% (reference a Bloomberg article with details by clicking here). While rental rates will likely rise, costs will rise as well—probably at an equal rate.
Apartment Rent Growth is Limited by a Shadow Inventory of Homes
The likelihood of apartment rents growing by 7.4% per year, every year for the next four years, is close to zero, even in a healthy economy. It is true that apartments are benefiting from the fact that first time home buyers find it difficult to qualify for a loan. Many families now have a default or short sale impairing their credit. However, this simple explanation for the strong performance of apartments recently overlooks a huge drag that will limit the growth in apartment rents, namely, an increase in the supply of rental homes.
As I wrote in another Seeking Alpha article, home ownership in the U.S. is likely to drop by at least 2 million homes (about 2%) and could drop by 6 million or more before reaching equilibrium, given young people’s reduced desire to own a home today.
Apartment rent increases will be limited by the supply of vacant homes that will end up as rental properties. We can estimate the number of such properties by referencing data in a recent CBS MoneyWatch article. At the time of the article, there were 3.7 million homes on the market, or nine months’ supply. If this came down to a more normal supply of six months, the number would be 1.2 million fewer homes. Of this 1.2 million, it is likely that half or more will end up as rental homes, because there are not enough first time home buyers to absorb such a large number.
In addition, there are now 1.6 million homes in the “shadow inventory,” according to Corelogic. These homes are seriously delinquent, in foreclosure, or bank owned but not yet on the market. Many of these homes are vacant currently, and many will become rental properties, for the same reason that many homes for sale will be purchased by investors and rented out. Putting together our estimate of 600,000 homes on the market that will likely become rentals, plus another 800,000+ from the shadow inventory, we might have an increase in supply of rental properties of 1.4 million or more from current levels. This is about 1.3 homes for every 100 families in the U.S. As this supply comes on the market, apartment rents are unlikely to grow rapidly.
Apartments have been everyone’s favorite asset class among investment properties. Moody’s is feeding the frenzy over apartments with projections of rapidly increasing apartment values in the coming years. However, if we look under the surface of their projections, we can see that they are highly unlikely to materialize, especially given a supply of vacant homes that will be coming on stream as rental properties as lenders work through their bad loans. As Warren Buffett says, “be fearful when others are greedy.” Today, people are being greedy when they chase apartment properties with rosy projections in their heads.

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