Student Housing Flunked In 2017

Summary

• Student Housing REITs have struggled immensely so far 2017, falling 15% YTD. Costly construction delays and oversupply in several key markets overshadowed an otherwise decent year.
• 3Q17 earnings results were weaker than expected and guidance was lowered for full-year 2017. Final leasing results came up short of estimates for this current school year.
• Both EDR and ACC noted similar trends of oversupply coupled with weaker enrollment growth, a trend that has continued over the past half-decade. Lower supply growth is expected in 2018.
• Development remains the modus operandi and growth engine as both REITs have expanded their portfolio by roughly 10% per year. Institutional demand for student housing assets remains strong.
• Investors have begun to question the “defensive” nature of the asset class given the choppy results in 2017. Purpose-built student housing faces risks that are distinct from typical multifamily assets.

REIT Rankings: Student Housing

In our REIT Rankings series, we introduce readers to one of the fifteen 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.

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Student Housing Sector Overview

Student housing REITs comprise 1% of the REIT Indexes (VNQ and IYR). Within our Student Housing Index, we track the two student housing REITs, which account for roughly $8 billion in market value: American Campus Communities (ACC) and EdR (NYSE:EDR-OLD).

For student housing, "quality" is a function of several factors including the proximity to campus, the quality of the academic institution, and the barriers-to-entry characteristics of the markets each REIT targets. These firms own a mix of on-campus, near-campus, and off-campus facilities, oftentimes in partnership with the University. While real estate ownership is the primary revenue source, these REITs also offer development, consulting, and management services to University partners.

Generally, these REITs target large flagship state universities. While both REITs are diversified across the country, American Campus Communities has more of a west coast "PAC-12" presence, while EDR has a more "SEC" presence, particularly at the University of Kentucky, where EDR has built six projects for the university. EDR has a slightly higher percentage of on-campus units. While both REITs are highly active developers compared to other REIT sectors, historically ACC has been relatively more acquisition-focused while EDR has been more development-focused. As development is considered "riskier," EDR reduces this risk by having a well-capitalized balance sheet.

These REITs utilize several different models to create value. The most profitable of these models is the public-private-partnership. A university, in need of new dorms but without the capital to build one, leases land to the REIT, who then builds, owns, and manages the facility. The University gets an annual ground-lease rent check (without deploying any capital) and the students get a new dorm. The university, in turn, guarantees a steady flow of renters. For EDR, this is called the ONE Plan and for ACC, it's called the ACE Plan. Revenue from these models comprises roughly one-third of total revenue.

The other two-thirds of revenue typically comes from a traditional private off-campus ownership model (sometimes in partnership with a university) which is generally more exposed to supply/demand imbalances and changes in university housing policies. Generally, facilities closer to campus are believed to have higher barriers-to-entry and are less exposed to oversupply or other idiosyncratic risks. These REITs have undergone a multi-year capital-redeployment towards these higher quality on-campus and near-campus assets.

Recent Developments And Performance

After a strong 2016, Student Housing REITs have been among the weakest performing real estate sectors since the start of 2017. The sector has declined 15% YTD and 10% since the prior quarterly earnings results in the second quarter. Only the mall and shopping center REIT sectors have had a worse 2017.

3Q17 earnings were below expectations and guidance was revised lower. Leasing results were disappointing, coming up shy of the '16/'17 school year, surprising investors after both REITs reported relatively strong pre-leasing results just two months earlier.

Across the sector, same-store occupancy averaged 96%, down from 97% achieved in the prior year. Hurricanes Irma and Harvey resulted in one-time expense impacts at ACC. Excluding the impact of the hurricane, same-store NOI grew 1.7% YoY for ACC and 2.0% for EDR, both well below initial guidance. Expense growth continues to surprise to the upside, largely a result of higher property taxes and construction costs, a troubling trend that has put downward pressure on NOI growth.

Over the past quarter and during earnings calls, several key themes and recent developments are being discussed. Overall, there is confidence that the macro tailwind of student housing modernization will continue over the next decade and that tight state budgets will continue to push universities to utilize the public-private-partnership model. On the micro-level, there is uneasiness about oversupply and choppy leasing metrics.

1) Near-Term Oversupply Is To Blame for Weak 2017

Neither ACC or EDR hid from the fact that 2017 has been a rough year for these REITs. While there were some missteps with delays in development projects earlier in 2017, the primary issue over the past quarter has been weak leasing trends. Both ACC and EDR cited similar issues with market-specific oversupply issues. For ACC, the oversupply was in the Florida State, Texas A&M, and Arizona State markets. For EDR, the oversupply was in the Mississippi, Texas Tech, and Syracuse markets. In earnings calls, both companies expressed confidence that, outside of these particular markets, the overall student housing market has been quite strong and that once these markets are balanced, these issues should subside in 2018 as supply growth slows. From the EDR earnings call:

"We believe 2017 was not the start of a new trend. Our same-store rate increase for 2017 was 3% above the 2.75% average that we've had over the last five years, and 68% of our properties achieved a 3% or greater rate growth. So by and large, it's still a very positive environment…Our belief is that the new supply in 2018 is going to have an impact but we don't think the impact is going to be what just incurred in 2017."

ACC noted that supply growth was not unusually high on a national level, but that some of ACC's particular markets were disproportionally exposed to high supply levels. From the ACC earnings call:

"We have four communities with cumulative three-year supply including 2018 deliveries that is in excess of 10% of enrollment. They include Texas Tech and Old and Ole Miss, as discussed previously as well as Arizona State Phoenix downtown campus and Florida State…. [But on the national level], this year is really not any differentiation in terms of overall supply. It's going to be about 1.3% of enrollment, which has averaged for the last decade. Also, when you look at the amount of supply coming into each individual market, nothing out of the norm."

Supply growth is expected to cool in 2018, consistent with a pullback in a nation-wide pullback in multifamily development. High construction costs, a tougher financing environment, and moderating rent growth are all putting downward pressure on new development.

2) Strategy Focus Continuing To Evolve Towards Higher-Quality On-Campus Portfolio

ACC and EDR are both nearing the conclusion of a multi-year phase of "capital recycling" whereby these REITs have sold lower-quality assets far from campus and redeploying those funds into near-campus and on-campus facilities. Further, these REITs have increased their focus on flagship public 4-year universities where enrollment trends have been more positive.

These public universities are more likely to utilize the public-private-partnership model to modernize their existing on-campus facilities, which these REITs note is the most profitable use of capital. From the EDR earnings call:

"The P3 on-campus market continues to be vibrant with EdR winning five deals this year. This recent win along with the 30-plus opportunities we're accurately pursuing are clear indications that the on-campus market is robust and EdR is well-positioned to win our fair share… Modernization of on and off-campus housing [has been] taking palace across the country and provides a positive macro environment."

3) Enrollment Growth Steady, Including International Students

Finally, in terms of enrollment growth, besides the demographic weakness that will continue to put downward pressure on domestic enrollment, there are still lingering concerns over the impact of President Trump's immigration policies. International students account for roughly 5% of the total enrollment in US Universities, but as much as 15-25% at some major state universities. A new study published by the IIE suggests that international enrollment has been unaffected. "Despite widespread concerns that international student interest in the United States might be flagging, the evidence from this survey, albeit based on a small sample of responding institutions, suggests that this is not the case." ACC and EDR see flat or even slightly higher international enrollment trends over the past year. From the ACC earnings call:

"From some of other data that I've read what we're seeing, in some of the larger universities which are what we typically serve, they're showing that they believe international student population to be essentially flat. So, yes, the environment is changing but to the extent that it's a large impact, I don't think so."

Below is our REIT Heatmap, showing the YTD performance in relation to other sectors. As we mentioned, student housing REITs have underperformed the broader REIT index YTD.

3 Reasons To Be Bullish on Student Housing REITs

1) Modernization Will Fuel Growth As State Funding is Squeezed

A significant percentage of the current housing stock at universities is physically and operationally outdated. The average age of dorm facilities at many universities exceeds 40 years, built for the boomer generation in an era where privacy, connectivity, and amenities in dormitories were afterthoughts. State or endowment funding for student housing is generally a tough sell when budgets are tight and it comes at the expense of other academic programs. According to a Center on Budget and Policy Priorities study, 46 of the 50 states still have tighter education budgets than before the recession. Widening pension deficits in most states make it unlikely that education budgets will be expanded until the funding shortfall closes. The slide below from ACC outlines the potential secular tailwind from modernization.

2) Predictable Demand and Defensive Attributes

The choppy leasing results this quarter is particularly surprising given the historically "defensive" and predictable nature of student housing assets. Over the past decade, same-store rents have never decreased on a YoY basis, rising for 49 consecutive quarters, albeit at a lower average rate than the broader apartment market. Investors have typically been able to "bank" on the idea that rents will rise 2-3% per year, in-line or slightly higher than inflation. In theory, student housing REITs should outperform during downturns as enrollment increases during recessions as job seekers return to school to improve their resume and future employment opportunities. Ideally, these REITs exhibit investment characteristics that add countercyclical balance to a portfolio while still being growth-oriented.

3) Development and Capital Recycling Will Continue to Be Drive Value-Creation

Student Housing REITs remain very active developers. ACC's development pipeline is roughly 10% of enterprise value, while EDR is even more active at 15% of enterprise value. Development yields are estimated to be 6.5-7%, down from 9%+ yields experienced several years ago. This modest premium should help keep supply in-check while also allowing these two skilled developers to plow ahead with NAV-accreting projects. These two REITs have established themselves as the go-to developers and equity financiers within the industry. Institutional demand for student housing REIT assets has driven cap rates below 5% in most major markets, providing a healthy spread for developers. Below, EDR outlines the value creation opportunity from development.

2 Reasons To Be Bearish on Student Housing REITs

1) Weaker Demographics Over Next Decade

A significant lingering concern for student housing REITs is a negative demographic trend that will continue to put downward pressure on enrollment. The 15-year generation of 5 to 20-year-olds has 3 million fewer people than the 15-year generation of 20 to 35-year-olds that have recently completed college or are in their final years. The effects of this demographic shift have already been felt in higher education. Total college enrollment has been declining since the end of the recession. It's important to note, however, that the decline is concentrated in the "lower-quality" institutions including for-profit schools and community colleges. Rising tuition costs and a strong labor market have also contributed to the downward pressure on college enrollment. Below, we see the enrollment trends from the last several years from the National Student Clearinghouse Research Center.

These REITs, however, target major flagship state universities. A premium is placed on schools that rank towards the top of the academic rankings, where enrollment trends are more predictable. Enrollment at these highly ranked schools is expected to grow at roughly 1-2% per year.

2) Idiosyncratic Risk of Student Housing Oversupply

Purpose-built student housing has unique idiosyncratic risks compared to traditional multifamily properties. We identify three risks. First, a university could change housing policies that drastically lower demand for a particular asset. Universities frequently change policies related to freshman and sophomores living on-campus, for instance. Second, the leasing window for student housing assets is limited, and if the facility isn't leased by the beginning of the school year, it will likely sit vacant for a year. Third, like senior housing facilities, the impacts of oversupply can linger for longer than usual as demand responds slowly to imbalances because of a limited set of potential renters. We note that the same-store metrics may overstate the stability of student housing assets as these REITs quickly remove underperforming assets via dispositions.

Both ACC and EDR cited face issues related to market-specific oversupply issues. As a defensive-oriented sector that prides itself on predictability, these choppy leasing results have not sat well with investors. EDR saw more than 2% growth in new supply in 2017 as a percent of enrollment, one of the most active years of new development. Below is the current supply outlook for EDR in key markets. 16% of their NOI comes from markets with 5%+ supply growth.

Valuation Of Student Housing REITs

Compared to the other REIT sectors, student housing REITs now appear cheap. Trading at 20x current free cash flow, these REITs now trade at a discount to the multifamily average and are one of the cheapest ways to play the residential sector. When we factor in near-term growth expectations, the sector appears even more attractive. Based on FCF/G, which considers the expected 5-year growth rate, student housing REITs are the fourth most attractive REIT sector.

Within the sector, both EDR and ACC trade at similar multiples and have similar expected growth rates.

Sensitivities To Equities And Interest Rates

Student housing REITs are more "bond-like" than the typical REIT, exhibiting the third highest interest rate sensitivity among REIT sectors. The sector exhibits very little correlation with the S&P 500 and is generally seen as a "defensive" sector that generally outperforms when economic data disappoints.

We separate REITs into three categories: Yield REITs, Growth REITs, and Hybrid REITs. (Click to read more information about our methodology.)

Within the sector, we see that both REITs are classified as "Yield REITs" and are generally more bond-like and defensive. Of the two, ACC is more bond-like and exhibits very high sensitivity to interest rates.

Dividend Yield And Payout Ratio

Based on dividend yield, student housing REITs rank in the middle of the pack, paying an average yield of 4.3%. Student Housing REITs pay out 87% of their available cash flow, one of the highest payout ratios of any REIT sector.

Within the sector, EDR pays slightly higher dividend yield by paying out more of their available free cash flow, so future dividend increases will rely on the realization of growth expectations. ACC appears to be in a better position to raise distributions over the next several years.

Bottom Line: An 'F' For 2017, But Sell-off Overdone

Student Housing REITs have struggled immensely so far 2017, falling 15% YTD. Costly construction delays and oversupply in several key markets overshadowed an otherwise decent year. 3Q17 earnings results were weaker than expected and guidance was lowered for full-year 2017. Final leasing results came up short of estimates for this current school year.

Both EDR and ACC noted similar trends of oversupply coupled with weaker enrollment growth, a trend that has continued over the past half-decade. Lower supply growth is expected in 2018. Declining college enrollment is a lingering concern. College enrollment has declined 5% over the past 3 years, but that decline is concentrated in lower-quality institutions. Negative demographic trends and high tuition costs will continue to pressure enrollment.

Development remains the modus operandi and growth engine as both REITs have expanded their portfolio by roughly 10% per year. Institutional demand for student housing assets remains strong. Investors, however, have begun to question the "defensive" nature of the asset class given the choppy results in 2017. Purpose-built student housing faces risks that are distinct from typical multifamily assets.

We believe that the sell-off in the student housing sector is overdone and may be poised to outperform heading into 2018. Currently, valuations appear attractive based on historical averages.

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 view EDR as the better pick within the sector at these valuation levels, but note that both of these REITs perform roughly in-line over the long-term To see where student housing REITs fit into a diversified REIT portfolio, be sure to check out our other REIT Rankings for all fifteen REIT sectors: Data Centers, Apartments, Malls, Self-Storage, Manufactured Housing, Healthcare, Net Lease, Single Family Rentals, Hotels, Cell Towers, and Office, and Shopping Centers, and International.

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.

Analyst’s Disclosure: I am/we are long VNQ, SPY, MAA, CPT, OHI, PLD, GGP, STOR, SHO, SUI, ELS, ACC, EDR, DLR, COR, REG, CUBE, PSA, EXR, BXP, EQR, INVH, SPG, HST, TCO. 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.

All of our research is for educational purposes 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.