REIT Rankings: Apartments
In our "REIT Rankings" series, we introduce readers to one of the thirteen REIT sectors. We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We update these rankings every quarter with new developments for existing readers.
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Apartment REIT Sector Overview
Apartment REITs comprise roughly 15% of the REIT Index (IYR and VNQ). Within our market value-weighted apartment index, we track the seven largest REITs within the sector, which account for over $105 billion in market value and 500,000 total housing units: Apartment Investment (AIV), AvalonBay (AVB), Camden (CPT), Equity Residential (EQR), Essex (ESS), Mid-America (MAA), and UDR, Inc. (UDR).
The performance of apartment REITs is largely dependent upon their ability to maintain or raise effective rents and keep vacancy low. REITs and other real estate asset owners benefit from "tight" rental space markets where there is limited supply and healthy demand. Demand for multifamily units is primarily a function of jobs growth, wage growth, and the availability/affordability of single family housing. While overall job growth has slowed in recent quarters, higher-wage job growth has been impressive.
The post-recession period between 2010 and 2014 saw very little new supply of multifamily units (or single family housing units) at a time when rental demand was growing quickly. Multifamily building has seen robust growth in recent years. Since 2014, multifamily construction has surged off these low levels and has returned to pre-recession levels. The boom in multifamily supply has resulted in soft rental conditions, particularly in the luxury segment.
Elevated levels of supply growth in the multifamily sector has been a major topic of discussion over the past few years. 2017 was supposed to be the year that we saw a spike in new supply, but construction delays have pushed back many of the completions into the second half of 2017 and into 2018. In Q2, completions finally ‘caught-up’ with starts, as seen below. We expect completions to remain in the 350-400k/year range through 2018, which will continue to put downward pressure on rent growth, all else equal.
Axiometrics publishes a monthly rent growth tracker. They noted that rent growth increased to 2.5% in June, showing signs of stabilization (or even acceleration) after the decline from 2015-2016. Axiometrics noted that YTD rent growth is roughly in line with the post-recession average at this point in the year. We estimate that rent growth will average 2-2.5% YoY growth for 2017 and 2018, which is roughly in line or slightly below consensus. We believe that this recent period of reacceleration may simply be the result of delays in deliveries that will hit in Q3 and Q4 2017.
The National Multifamily Housing Council also presents a survey-based analysis of conditions in the residential rental space markets. The primary metric, Market Tightness Index, has recovered in recent months but remains below breakeven 50, indicating that the majority of survey participants continue to see downward pressure on rent growth. All four metrics have improved since bottoming in late 2016/early 2017.
‘Real’ rent growth can also be estimated from BLS inflation data. We note below that ‘real’ rent growth (inflation adjusted) has slowed to just 1.5% in recent months, down from the 3% level in 2015. Interestingly, rising housing costs are one of the few components keeping overall inflation positive.
Housing supply growth is still at fairly low levels based on historical averages. During the single family construction boom, total housing supply growth reached 2% of existing housing stock per year. Right now, supply growth is roughly 1% of existing stock per year, and the net supply growth (accounting for obsolesce) is even lower. We can roughly estimate that housing supply appears to be nearing equilibrium, as shown in the chart below.
As we often point out, it's important to remember that demographics over the next ten years are highly favorable to apartment demand. The 14-year generation of 20-34 year olds, currently in prime renting age, has roughly 3 million more people than the prior 14-year generation.
Over the next five years, rental values will be a battle between high levels of supply and high levels of demand. Change at the margins, particularly in the propensity to rent versus own, single family housing affordability, and the availability of mortgage credit for this demographic, will determine whether we are currently over-building or under-building in the multifamily space.
Recent Developments and Performance
Apartment REITs have gained 3% over the past 13-week quarter, outperforming the broader REIT index, which has gained 2%. Camden has been the best performer while AvalonBay has been the weakest.
2Q17 earnings were generally quite good. Of the six apartment REITs that have reported earnings, 3 beat expectations (AIV, ESS, CPT) and 3 met expectations (MAA, EQR, UDR). AVB reports later this week. Forward guidance was similarly strong.
Occupancy has retreated slightly over recent quarters, but remains near peak levels at 96%. Year-over-year average revenue growth was 2.8% in 2Q17, down from the peak of 5.5% in 2Q15. NOI grew an average 3.3%, down from the peak of 7% in 1Q16. Demand remains solid. While overall job growth is slowing, high-wage job growth has actually accelerated in recent quarters, and overall real wage growth has been very strong over the past three years.
On a market-by-market level, the west coast and sunbelt markets (with the exception of Houston) remain the top performers. Houston has performed roughly as expected given the supply overhang and weak oil-related demand. San Francisco and New York City appear to have stabilized after a period of lower rent growth, a function of peaking levels of supply. DC has been weaker than expected as federal government job growth has slowed under the new administration. Boston and Northeast suburbs have been surprisingly strong.
Supply has been, and will continue to be, the primary focus on conference calls, particularly for coastal (especially New York City) and west-coast REITs: AVB, EQR, and ESS. Rent growth, especially in the luxury segment, continues to slow as supply has increased significantly in coastal markets. REITs own a disproportionate amount of high-end units relative to the national average. The average monthly rent per unit across all seven REITs exceeds $2,100, up from $1,250 in 3Q11.
Below is our REIT Heat Map, showing the YTD performance in relation to other sectors.
Valuation of Apartment REITs
Compared to the twelve other REIT sectors, apartment REITs appear fairly valued or perhaps slightly expensive. At 23x Forward FCF and 7x FCFG, apartment REITs trade at a slight premium to the REIT averages.
(Hoya Capital Real Estate estimates, Company Filings)
Within the sector, MAA appears to be the most attractive across the three metrics.
Dividend Yield and Payout Ratio
Based on dividend yield, apartment REITs rank towards the bottom, paying an average yield of 3.0%. Apartment REITs payout just 72% of their available cash flow, the fifth lowest payout ratio sector, giving these companies quite a bit of flexibility to take advantage of development opportunities or to increase distributions through higher dividends or share buybacks.
More so than other sectors, the dividend and payout strategies of the seven apartment REITs are quite similar. CPT and MAA are the highest yielders at 3.4%. ESS is the lowest yielder at 2.7%.
Sensitivities to Equities and Interest Rates
Using our factor calculations, we show that apartment REITs are the sixth least interest rate sensitive sector, which is near the average across all REIT sectors. The short lease terms of apartment REITs provide investors protection against inflation as rents are able to re-price more often than other REIT sectors with longer average lease maturities. Interestingly, apartment REITs show little sensitivity to movements in the broader equity markets. Rental apartments have some counter-cyclical properties: when incomes fall, it encourages potential home buyers to hold-off on the home purchase, putting a floor on the demand for apartment units.
As a whole, the sector is firmly in the Hybrid REIT category, which is ideal for investors seeking a blend of income and growth. Within the sector, EQR and MAA are categorized as Yield REITs, while the other 5 names are Hybrid REITs.
Apartment REITs have been among the strongest performing real estate sectors in 2017. The sector is up 8% YTD compared to a 2% gain in the broader REIT index. Strong demand and lower than expected supply growth, partially a function of delays in new deliveries, has resulted in firming rent growth after several consecutive quarters of slowing.
Apartment REITs enjoyed robust rent growth between 2013 and 2015 resulting from the post-recession period of under-building. The recent surge in high-end apartment construction, however, continues to moderate apartment rents. Completions of multifamily units will peak this year near record levels before gradually declining through 2018.
2Q17 earnings and guidance were generally better than expected. Demand remains solid. While overall job growth is slowing, high-wage job growth has actually accelerated in recent quarters. Occupancy has retreated slightly over recent quarters, but remains near peak levels at 96%. Year-over-year average revenue growth was 2.8% in 2Q17, down from the peak of 5.5% in 2Q15. NOI grew an average 3.3%, down from the peak of 7% in 1Q16.
We caution that this optimism may be short-lived as there is a heavy pipeline of projects that will be completed in 2H17 and through 2018. Demand remains the wild card. Over the next five years, rental values will be a battle between high levels of supply and high levels of demand. Change at the margins, particularly in the propensity to rent versus own, single family housing affordability, and the availability of mortgage credit for this demographic, will determine whether we are currently over-building or under-building in the multifamily space.
We aggregate our rankings into a single metric below, the Hoya Capital REIT Rank. We assume that the investor is seeking to maximize total return (rather than income yield) and has a medium- to long-term time horizon. Valuation, growth, NAV discounts/premiums, leverage, and long-term operating performance are all considered within the ranking.
We currently view UDR as the most attractive REIT within the sector, followed by Mid-America Apartments and AvalonBay.
Please add your comments if you have additional insight or opinions. Again, we encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.
Be sure to check out our prior sector updates leading up to Q2 earnings season: Data Center, Manufactured Housing, Single Family Rentals, Healthcare, Industrial, Student Housing, Net Lease, Mall, Self-Storage, Shopping Center, Hotels, and Office.
Disclosure: I am/we are long VNQ, SPY, MAA, CPT, CCP, OHI, PLD, GGP, TCO, PEI, STOR, SHO, SUI, ELS, ACC, EDR, DLR, COR, REG, CUBE, PSA, EXR, BXP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: All of our research is for educational purpose only, always provided free of charge exclusively on Seeking Alpha. Recommendations and commentary are purely theoretical and not intended as investment advice. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. For investment advice, consult your financial advisor.