Student Housing: Fundamentals Remain Challenged

Summary

• Student Housing REITs were among of the worst-performing real estate sectors in 2017. Supply growth has outpaced enrollment growth in each of the past five years, which has weakened fundamentals.
• The demographic boom of college-aged Americans peaked in 2011. A strong economy, rising wages, and increasingly negative attitudes towards traditional liberal arts college curriculum have resulted in declining 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.
• While development is highly accretive when trading at a NAV-premium, the opposite is true when trading at a discount. Wide NAV discounts have forced these REITs to scale back development plans.
• Despite the short-term valuation dislocations, the long-term secular growth story appears intact. Cash-strapped universities will increasingly utilize private-public-partnerships to modernize their aging stock of dormitories to remain competitive.

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.

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.

Student Housing Sector Overview

Student housing REITs comprise 1% of the REIT Indexes (NYSEARCA:VNQ and NYSEARCA:IYR). Within our Hoya Capital Student Housing Index, we track the two student housing REITs, which account for roughly $7 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.

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 Performance

2017 was a brutal year for student housing REITs. These REITs were punished by investors and analysts after a series of operational missteps including costly construction delays, a streak of disappointing earnings results, and several downward revisions to guidance and supply/demand fundamentals. The sector returned negative -12% in 2017 compared to a 5% total return in the REIT index.

So far, 2018 hasn’t been too kind to the sector, either. Dragged down by a broader REIT sell-off related to fears of rising interest rates, student housing REITs have dipped another 13% so far this year compared to a 10% decline in the REIT index. ACC and EDR have essentially traded in synchrony over the past two years, but EDR has slightly outperformed over the past 52 weeks.

4Q17 Recap & New Developments

Expectations were low heading into fourth-quarter earnings season after a disappointing miss on the critical third-quarter results that showed sluggish final leasing performance for the ‘17/’18 academic year. Downward revisions to full-year guidance last quarter lowered the bar for this quarter’s mid-academic-year update. ACC reported results that were at the top-end of analyst estimates and their prior guidance while EDR reported results that were in-line with analyst estimates and at the mid-point of their prior guidance. ACC reported 2018 guidance that topped estimates, forecasting 2% NOI growth for the year. EDR painted a dimmer outlook and sees NOI growth potentially dipping into negative territory. As we’ll discuss below, both REITs plan to step-up their disposition plans in 2018 in response to the deep NAV discounts that have made funding new development more difficult.

The story continues to be about rising supply and slowing enrollment growth in key university markets. For full-year 2017, same-store revenues rose an average of just 2.1%, continuing a trend of deceleration after peaking in 2014 at 4.4%. The culprit to slowing revenue growth has been weakening occupancy, which is lower by roughly 100 bps over last year. Rental rates have remained consistent and firm, rising an average of 3% over last year.

Core FFO growth has also disappointed in recent years. The robust growth in 2013 and 2014 was powered by external growth funded by equity sold at a NAV premium. Amid broader pressure on REITs since mid-2016, this NAV premium has become a steep NAV discount, making it more difficult for external-growth-focused REITs to grow accretively. ACC grew Core FFO by 2% in 2017 and sees 3% growth in 2018. EDR grew Core FFO by a more robust 7% in 2017 but sees a decline of 2% in 2018.

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) Supply/Demand Fundamentals Remain Challenged

Neither ACC or EDR hid from the fact that 2017 was 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 six months has been weak leasing trends resulting from unfavorable supply/demand fundamentals. Both ACC and EDR cited similar issues with market-specific oversupply issues with EDR appearing to have more significant issues with supply growth. EDR revised up their estimate for 2018 supply growth while revising down their estimate for enrollment growth.

ACC’s supply issues have been less significant and 2018 is expected to see improvement. ACC expects 1.3% supply growth in their markets compared to 1.9% growth in EDR markets. Over the last decade, supply growth has averaged roughly 1.3% of enrollment per year. 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) Private Market Values Remain Firm

Based on recent transactions in the private market, capitalization rates for student housing assets has remained steady despite this 30% sell-off in student housing REITs over the past two years. According to National Real Estate Investor, private-market sales of student housing assets totaled roughly $8 billion in 2017, the second-best year ever after $10 billion in 2016. EDR sees a wide discount between private and public-market valuations of student housing assets. From the 4Q17 EDR earnings call:

“Today, there is a substantial discount between public and private market valuations, with EdR trading at an implied cap rate of around 6.5%, which doesn't include any value for our platform. And the private market is valuing similar assets at a cap rate of 5% or less. In early January 2018, over $1 billion of student housing assets trade at these cap rates, giving no evidence that the private market valuations are changing at this time.”

We estimate that student housing REITs currently trade at a 20-30% discount to private market values. As we'll discuss below, this has important implications for capital financing.

3) NAV Discount Forces Change in Strategy

Ground-up development has historically been the modus operandi and growth engine for the student housing sector. Like other sectors that focus on external growth, such as net lease and data center REITs, these REITs require “cheap” equity capital to be able to accretively fund the pipeline. Equity is “cheap” when REIT shares are trading at a premium to the private-market value of their assets and equity is similarly “expensive” when trading at a discount to NAV. NAV premiums and discounts tend to be self-perpetuating, which can be a serious issue for external-growth-focused REITs that now trade at deep discounts to NAV.

We saw early signs this quarter that ACC and EDR have been forced to scale-back and become more selective in development plans. We noted above that ACC plans to dispose of $400 million in assets in 2018 which amounts to a sizable 5% of their total assets. EDR plans to sell up to $225 million in 2018 which amounts to 7% of their assets. While the 2017 and 2018 development pipleines remain robust, it appears that both REITs have scaled back the pipeline for new development. Last quarter we noted that 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. It appears that these REITs will again ramp up the disposition activity after a quiet 2016 and 2017.

2 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) Student Housing REITs Have A Competitive Advantage

Over the past decade, student housing REITs have built a stellar reputation as the leaders in student housing development and the stalwarts of the public-private-partnership model. This reputational advantage serves as a defensible "moat" that gives these REITs a competitive advantage over private market competitors. For elected officials that have the final say in awarding development contracts, the relative political safety of using a "brand-name" publically-traded REIT cannot be overlooked.

Despite the deep NAV discounts, student housing REITs are expected to remain very active developers and should re-expand the pipeline once the NAV discount dissipates. Development yields are estimated to be 6.5-7%, down from 9%+ yields from 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) Demographic Boom Has Come and Passed

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 and it has been readily apparent in the fundamentals of student housing REITs. After several years of negative growth in the 18-22 demographic, however, we should see modest growth over the next decade.

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.

A strong economy, rising wages, and increasingly negative attitudes towards traditional liberal arts college curriculum have also contributed to declining enrollment. While college enrollment tends to decline during economic expansions, the trend in attitudes towards college is perhaps the most surprising development over the past decade. Nearly 40% of Americans now believe that colleges and universities have a negative effect on the country, up sharply from 27% in 2010. Critics cite the politicization of the college curriculum and question the relative value of a four-year degree compared to pre-professional programs and trade schools.

2) Oversupply Remains A Key Idiosyncratic Risk

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.

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 across all three metrics. Student housing REITs trade at an FCF (AFFO) discount to the REIT average and appear attractive in the FCF/G metric. As we stated above, the sector trades at an estimated 20-30% discount to NAV.

ACC trades at cheaper valuations compared to EDR, but is expected to grow more slowly over the intermediate-term.

Sensitivities To Equities And Interest Rates

Student housing REITs are more "bond-like" than the typical REIT, exhibiting the second highest interest rate sensitivity among REIT sectors. Rising interest rates over the past several months have put considerable downward pressure on valuations. 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 towards the top, paying an average yield of 4.9%. Student Housing REITs pay out 83% of their available cash flow, one of the highest payout ratios of any REIT sector.

EDR and ACC have identical dividend yields, but EDR pays out nearly 90% of its free cash flow while ACC pays out a more modest 80%.

Bottom Line: Fundamentals Remain Challenged

Student Housing REITs were among of the worst-performing real estate sectors in 2017. Supply growth has outpaced enrollment growth in each of the past five years, which has weakened fundamentals. The demographic boom of college-aged Americans peaked in 2011. A strong economy, rising wages, and increasingly negative attitudes towards traditional liberal arts college curriculum have resulted in declining 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. While development is highly accretive when trading at a NAV-premium, the opposite is true when trading at a discount. Wide NAV discounts have forced these REITs to scale back development plans. Despite the short-term valuation dislocations, the long-term secular growth story appears in-tact. Cash-strapped universities will increasingly utilize private-public-partnerships to modernize their aging stock of dormitories to remain competitive.

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 ACC as the better pick within the sector due to their superior results in 4Q17 and their more positive supply/demand outlook. We note, however, that both of these REITs have historically moved roughly in tandem over time and we would expect similar performance over the long-run. For further analysis on all fifteen real estate sectors and how they all stack up, be sure to check out all of our quarterly updates: Malls, Hotel, Cell Tower, Single Family Rental, Industrial, Healthcare, Apartment, Mall, Net Lease, Data Center, Shopping Center, Manufactured Housing, Office, and Storage.

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, ACC, EDR. 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.