REIT Rankings: Apartments
In our REIT Rankings quarterly series, we analyze one of the fifteen real estate 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 nine largest REITs within the sector, which account for roughly $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), UDR, Inc. (UDR), Preferred Apartments (APTS), and Independence Realty (IRT).
Above we show the size and strategy focus of these nine REITs. "Quality" is determined by the average rent per unit of the apartment portfolio. As a whole, REITs tend to own "A" quality assets in major "job hub" cities, though several REITs focus more on suburban and "B" quality assets. We note that the two small-cap REITs have higher leverage ratios than the seven larger REITs.
Recent Developments and Performance
Apartment REITs have gained 2% over the past 13-week quarter, underperforming the 4% rise in the broader REIT index. The sector, however, has been strong on a YTD basis, gaining 10% so far in 2017. Camden, Essex, and Independence, and Preferred Apartments have been the strongest performers, while Aimco has been the weakest.
3Q17 earnings were generally solid, but most REITs struck a cautious tone on earnings calls about 2018. Of the nine apartment REITs we track, six beat earnings estimates while the other three were inline. Four raised full-year 2017 guidance while five maintained guidance. New lease rates were slightly weaker than expected, however, particularly in markets seeing the highest supply growth.
Across the sector, revenue and NOI growth averaged 2.5% and 2.3%, respectively. Full-year 2017 revenue growth is projected to be roughly 3%, a solid rate of growth considering the low expectations heading into this year and well above initial analyst estimates. That said, however, the “boom-times” appear to be well behind us. Rent growth peaked in 2015 at 5.5% which spurred a flurry of new development. Multifamily completions are expected to peak in 2017 at nearly 2% of existing supply and remain above 1.5% per year through 2019, well above the <1% average from 2009-2014.
Below we show the revenue growth trends of all nine REITs including estimates for 2018. It’s clear that the significant disequilibrium between supply and demand from 2013-2015 has been erased, but we continue to see rents rising slightly higher than inflation for the next several years, driven by strong demographics, rising home prices, and rising construction costs.
Over the past quarter and during earnings calls, several key themes and recent developments are being discussed.
1) Rent Growth Trends
Axiometrics publishes a monthly rent growth tracker. They noted that rents rose 2.1% YoY in October, showing continued signs of stabilization after the decline from 2015 to 2016. Axiometrics noted that YTD rent growth is below the post-recession average of 4.4% in October. It’s clear that the hurricanes have had a positive effect on rental rates, though perhaps not as large as we initially projected. Houston, one of the weakest apartment markets, saw a 250 bps improvement in rent growth from 2016. We expect November and December to be above-trend and that full-year 2017 will see 2.5% growth from the previous year.
Zillow also publishes a monthly rent growth index, the Zillow Rent Index (ZRI) which tracks both single-family rental and multifamily. Zillow’s index shows more pronounced trends, with multifamily peaking in 2015 above 6% and bottoming this summer at 0.2%. Rent growth has been strong since May and is now higher by 1.5% YoY. Single-family rent growth has outpaced multifamily this year as supply growth has been most significant in the multifamily category.
Rent growth can also be measured by CPI data. We track the rent growth spread over core inflation below. Real rent growth has seen steady acceleration since 2012 and remains around the 2% level. After pausing in early 2017, the inflation data suggest that real rent growth has accelerated in the second half of 2017 even as the nominal rate has declined. Elevated levels of new apartment deliveries, though, should keep a lid on further upward pressure on that metric.
2) West Coast, Sunbelt Continue to Outperform
Overall, while rent growth has continued to slow since peaking in 2015, there are certainly signs of stabilization in the major REIT markets and a convergence towards supply/demand equilibrium. Markets that were once red-hot have seen the most supply growth and hence, the most downward pressure on rent growth.
On a market-by-market level, the west coast (except San Francisco, which grew 0-2%) and Sunbelt markets (exception Houston, which declined 1-3%) remain the top performers as job growth has remained solid and construction delays have pushed some completions into 2H17 and 1H18. These REITs reported 4-6% rent growth in Seattle and 2-5% in Southern California. The west coast focused ESS, however, raised caution for the end of 2017 and 2018, citing expectations of slowing job growth and continued oversupply issues.
The Mid-Atlantic and New England regions remain slow but steady. The NYC metro saw 0-2% rent growth, DC saw 1-3%, and New England saw 1-3% growth. Last month, we wrote “Quantifying The Impact of The Hurricanes on Apartment REITs” where we forecasted that rent growth would improve in the Houston and Florida markets in the aftermath of the hurricane. Houston remains the weakest major market, lower by 1-3% YoY, but this quarter showed initial signs of recovery. Camden reported a 150 bps rise in QoQ occupancy and private data providers continue to see signs of significantly improved rent growth in Houston.
3) Construction Delays Have Pushed Supply Growth Into 2018
A shortage of skilled workers and regulation-related issues have extended the typical construction time period and delayed the completion of many multifamily projects. Starts and completions data suggests that the average 5+ unit project takes roughly 24 months from start to completion, up from prior assumptions of 18-22 months. Completions were expected to peak in the middle of 2017, but these delays have pushed this peak into 2H17 or 1H18. Many REIT executives expressed caution heading into 2018 related to this potential oversupply hitting the market during the slow winter leasing season.
4) Lower Development Yields, Steady Cap Rates
AvalonBay revised down development yield projections from 6.0% to 5.8%. Higher construction costs, moderating asset price appreciation, and weaker fundamentals have made new development less attractive over the past several years. Development yields are an important indicator of future new supply, and low yields should be expected to prevent marginal projects from breaking ground. With such a small spread between development yields and cap rates, and considering the risk of new construction, it makes less economic sense to put new money into development.
Meanwhile, private market valuations for apartment assets are essentially flat YoY after rising at a steady 7% per year rate from 2008 through 2015. Few buyers or sellers expect further cap rate compression. As private developers can no longer project significant rent growth or asset price appreciation, we expect new development to continue to tail off in 2018 and into 2019.
Below is our REIT Heatmap, showing the YTD performance in relation to other sectors.
3 Reasons to Be Bullish on Apartment REITs
1) Labor Market Continues to Exceed Expectations
Historically, there has been a strong correlation between job growth, wage growth, and apartment demand. Nearly 2 million jobs have been added since last November and more than 17 million jobs have been added since the beginning of 2010. The overall health of the labor markets continues to be impressive across nearly all metrics. ADP private employment data continues to show job growth averaging more than 2% YoY. According to BLS data, job growth has slowed from a 2% rate in 2015 to a 1.5% rate in 2017, however, as labor markets have tightened.
Average hourly earnings took a mild step higher and continue along an upward trend around 3% YoY growth, while CPI inflation remains low, a good development for financial markets. We have continued to point out that the “wage growth is stagnant” narrative is simply wrong. The data actually shows that real wages have seen one of the best periods of growth in forty years. Real wages have increased 7.3% since 2014.
2) Demographics Remain Highly Favorable
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. High student loan debt burdens, moderate wage growth, and a “rent-by-choice” preference also makes this demographic more likely to rent apartments further along into their family and career paths.
3) Renting Continues to Make More Economic Sense for Most Households
We continue to discuss home price affordability (or lack thereof) and how we believe that rental demand will continue to surprise to the upside as potential homebuyers remain in the rental markets for longer than expected. If labor markets continue to be strong, demand for multifamily units may be able to keep pace with this elevated supply growth and rental growth could remain firm or even re-accelerate after this wave of new supply gets absorbed. Home prices are up more than 40% since 2012 while rents are higher by roughly 20%. Meanwhile, median household income is higher by roughly 15%.
In our ‘Buy vs. Rent’ index, we continue view renting as the more affordable option for the average household.
2 Reasons To Be Bearish on Apartment REITs
1) Oversupply Issues Will Linger
Elevated levels of supply growth in the multifamily sector have been a major topic of discussion over the past several 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. Completions have finally ‘caught-up’ with starts, as seen below. We expect completions to remain in the 350-400k/year range through 2018, which would continue to put downward pressure on rent growth, all else equal. After peaking at 35% in 2015, multifamily starts are now 30% of total starts, which remains at the upper-end of the 50-year data set.
Housing data, however, has surprised to the downside in six of the past seven months after a relatively strong start to 2017 and end of 2016. The long-awaited pullback in multifamily construction, which had driven the housing recovery, has finally arrived and it has been rather dramatic. On a rolling 12-month basis, total housing starts are higher by less than 5%, a slight recovery in September due to weak comparisons in last September’s data. The comparisons get harder into the end of the year, and we expect the TTM growth rate to decline back below 3% if the recent trends hold as the total starts over the past six months are just 1% higher than the same six-month period in 2016. Multifamily starts are lower by 4.2% TTM while single-family starts are higher by 9.8%
2) The Homeownership Rate Seems To Have Bottomed
The modest tick higher in the homeownership rate in the third quarter has gotten a lot of media attention, notably in a Wall Street Journal article titled “Millennial Home Buyers Send a Chill Through Rental Markets.” The article raised questions about the health of the rental markets if younger households suddenly acquire a taste and ability to own rather than rent. Below we show that the homeownership rate has nearly returned to the pre-bubble average of 64%.
Digging deeper into the data, however, we can see that the recent modest climb in homeownership is not because of millennials re-entering the market in great numbers, as the Journal’s title suggests. The homeownership rate among households less than 44 years old has fallen considerably more than the overall rate since the recession and has been moving sideways since bottoming in 2015. The largest climb in homeownership rate in the third quarter, interestingly, was among the 65+ demographic. That being said, the data does indicate that homeownership rate among millennials has indeed bottomed in this cycle and there is an argument to be made that a “reversion to the mean” would entail a larger upward percentage move in this millennial demographic. This, of course, would mean incrementally less demand for apartments.
Valuation of Apartment REITs
Compared to the fourteen other REIT sectors, apartment REITs appear fairly valued. At 23x Forward FCF and 8x FCFG, apartment REITs trade roughly in line with the index averages.
(Hoya Capital Real Estate estimates, Company Filings)
Within the sector, we see how the small-cap REITs, APTS and IRT, trade at sizable discounts to the established players, in part due to their high leverage ratios. We believe that 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 pay out 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 large apartment REITs are quite similar. The two small-cap REITs pay a higher dividend yield but also tend to pay a higher percentage of FCF towards the dividend.
Sensitivities to Equities and Interest Rates
Using our factor calculations, we show that apartment REITs are not particularly interest rate-sensitive sector, nor are they sensitive to movements in the equity markets. 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. 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.
We separate REITs into three categories: Yield REITs, Growth REITs and Hybrid REITs. (Click on each link to read more information about our methodology). As a sector, apartment REITs fall into the Hybrid REIT category.
Within the sector, EQR and MAA are categorized as Yield REITs and IRT is a Growth REIT, while the other 6 names are Hybrid REITs.
Expectations were low for Apartment REITs heading into 2017 as oversupply issues were expected to pressure rent growth. These REITs have surpassed expectations but raised caution for 2018. Robust rent growth from 2013-2015 prompted a wave of new development. Multifamily completions are expected to peak in 2017 at nearly 2% of existing supply and remain elevated through 2019. Multifamily starts have pulled back sharply in 2017, however, as lending markets have tightened and construction costs continue to rise above inflation. AvalonBay now sees development yields under 6%.
Strong job growth, a “rent-by-choice” attitude among a large demographic of millennials, and homeownership unaffordability have kept demand growth firmly above expectations. Strong demand has kept rents solid in 2017. The homeownership rate has show a modest uptick in recent quarters back to the pre-bubble average. The economics of renting, however, remain highly favorable relative to owning for most households.
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 AIV as the most attractive REIT within the sector, followed by MAA, UDR, and CPT. To see where apartment REITs fit into a diversified REIT portfolio, be sure to check out our other REIT Rankings for all fifteen REIT sectors: Data Center, Mall, Manufactured Housing, Student Housing, Storage, Healthcare, Net Lease, Single Family Rentals, Hotels, Cell Towers, Office, 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.
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 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.