REIT Rankings: Apartments
In our REIT Rankings series, we introduce and update readers to each of the commercial and residential 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 the Hoya Capital Apartment REIT Index, we track the nine apartment REITs, which account for roughly $100 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 Apartment Communities (APTS), and Independence Realty (IRT).
One of the major commercial real estate sectors, the $3-4 trillion dollar US apartment market remains highly fragmented with REITs owning less than 5% of all apartment units. Even more than other real estate sectors, apartment markets tend to exhibit commodity-like characteristics as rental fundamentals respond in a rather efficient and predictable way to supply and demand conditions. On average, REITs tend to own more high-quality assets in major "job hub" cities, though several REITs focus more on suburban and lower-quality assets.
The Bull & Bear Thesis for Apartment REITs
The US has seen a development boom in multifamily building over the last four years following a period of very limited new construction immediately following the recession. Strong growth in apartment construction has helped to offset the weakest period on record for single-family construction, but total new housing construction remains historically low on a per-capita basis.
On the demand side, the US is right in the middle of the demographic boom that is most likely to prefer apartment living. The prime rental age population (25 to 34) will continue to grow until the mid-2020s, adding 1.0% to 1.5% per year. High student loan debt burdens, moderate wage growth, and a "rent-by choice" preference have made this demographic more likely to rent apartments further along into their family and career paths.
When there's a demand imbalance creating positive fundamentals, it is never for very long as developers swoop in and add new supply to the market. This reality is readily apparent when looking at the long-term rent growth data compared to inflation. Since 1960, "real" rent growth (in excess of inflation) is essentially zero, meaning that over the long run, supply and demand tend to balance, leaving a theoretical investor with a "commodity-like" investment that provides an inflation-hedge but not much else. Since the mid-1990s, however, regulations such as restrictive zoning laws, rent control, and overly-burdensome building codes have constrained supply and have resulted in a demand imbalance, producing 'real' rent growth in excess of 1% per year.
Robust rent growth from 2013 to 2015 prompted a wave of new development that is equalizing the supply/demand imbalance. 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. The question remains whether we will indeed see development activity tail off in 2019 and beyond or whether builders will continue to build until every bit of "real" economic value is sapped out of the apartment markets.
After producing sector-leading returns in 2014 and 2015, apartment REITs underperformed the REIT average in 2016 and 2017 amid lingering concerns regarding oversupply and moderating fundamentals. Since the Modern REIT era began in 1994, however, apartment REITs have produced an average annual total return of 13.3% per year compared to the 12.1% return on the REIT index.
Apartment REITs have outperformed the broader real estate index by roughly 5% through ten months of 2018. Climbing back from losses amid the early 2018 interest-rate-driven REIT selloff, the sector has turned positive on the year, bucking the trend of weakness felt across other housing sectors, particularly homebuilders (XHB). The Housing 100, an index that tracks the broad performance of the US housing market, has dipped 5% in 2018, but Residential REITs have been among the top performers.
Essex, Equity Residential, and UDR have been the best performers in 2018 while small-cap REITs Preferred Apartments and Independence have been the laggards. The sector has outperformed the broader REIT index by roughly 4% over the last quarter.
Apartment REIT Quarterly Fundamentals
Coming off a strong second quarter, 3Q18 earnings were similarly strong across the apartment sector. Seven of the nine REITs beat quarterly expectations while six of the nine raised full-year estimates. Same-store revenue and expense estimates were generally in line with last quarter, rising 2.5% and 2.4%, respectively, translating into 2.6% NOI growth. The positive surprise came from rent growth, which continues to show a significant reacceleration after years of slowing. Blended rent growth rose an average of 3.4%, ticking higher from the 3.3% rate last quarter, buoyed by a 4.9% jump in renewal rates.
In line with our calls earlier this year, apartment REITs have continued to revise up their full-year guidance in each subsequent quarter. In late 2017, when apartment REITs were guiding to just 2.0% revenue growth in 2018, we discussed that the combination of housing unaffordability and tax reform would create enough incremental demand to support revenue growth closer to 3.0%. With blended rent growth averaging close to 3.5% this year, we expect same-store revenue growth to climb to the 3.0-3.5% range in 2019.
Same-store NOI growth, which was impressive from 2014-2016, has stabilized in recent quarters after briefly dipping below the REIT average in early 2018. The REIT sector as a whole has seen an upward inflection in NOI growth this year amid a slowdown in supply growth and increased demand across most major sectors.
Interestingly, one of primary rent growth indexes that we track, the Zillow ZRI Rent Index, has been decidedly more bearish on rent growth than reports from apartment REITs or from data providers like REIS, which noted a 2.9% rise in rents in the third quarter, up from 2.6% in 2Q18. The ZRI notes that rents have actually decreased 1% over the last year.
As we get later into the cycle, the variance in fundamentals between markets has lessened as there is a convergence towards supply/demand equilibrium. The West Coast markets, which were once producing double-digit annual rent growth, have cooled but continue to outperform the national average. Northeast markets, particularly New York City, continue to underperform. Sunbelt markets have performed well, including a nice recovery in the Houston markets, in part attributable to the lingering effects of Hurricane Harvey last year.
Turnover continues to decline, a powerful tailwind that has helped fundamentals and helped to keep expenses under control despite rising property taxes, the largest source of expense growth. Turnover has dipped more than 160 bps YTD compared to the same period last year, at or near the lowest rate on record for apartment REITs. A recent Freddie Mac survey noted several key trends that are helping to support rental demand including an increase in renter satisfaction to near-record levels and an increasingly favorable view towards renting as the most affordable housing option. 78% of tenants believe that renting is more affordable than owning, up significantly this year.
Capital Markets & External Growth
Currently, apartment REITs trade for an estimated 10-20% discount to private market Net Asset Value. This NAV discount implies that REIT's cost of capital is unfavorable relative to the private markets. Apartment REITs have responded by slowing their pace of net acquisition, as these REITs have been net sellers since early 2016, and liquid transaction markets have helped these REITs reposition their portfolios and recognize the immediate value creation of asset sales into a NAV discount.
Development yields are an important indicator of future new supply, and low yields should be expected to prevent marginal projects from breaking ground. Higher construction costs, moderating asset price appreciation, and weaker fundamentals have made new development less attractive over the past several years, but many developers continue to see positive value-creation spreads. AvalonBay sees 6.2% stabilized yields compared to 4.4% capitalization rates. This 140 bps spread compares to the 300 bps+ spreads in 2014-2015.
Supply and Demand Dynamics
Supply Growth Peaking, Moderating Into 2020
The boom in multifamily construction that began in 2014 has continued into 2018 with a near-record level of units still under construction. 2017 was supposed to be the year that we saw a spike in new supply, but construction delays pushed 'peak completion' into the first half of 2018. On a trailing twelve month basis, completions appear to have peaked for this cycle in May 2018 at 362,800 units completed over that twelve-month period. We will likely hover around this 340-380k level until the second half of 2019 before tailing off towards 300k (the post-1960 average) in 2020.
While many analysts expect supply growth to linger well into 2020, rising construction costs and moderating private market valuations should keep developers contained. Construction costs have risen at a high-single-digit rate so far this year and construction labor markets remain historically tight, forcing some marginal projects to be tabled. Housing permits and starts data suggest that supply growth should indeed tail off beginning in 2019, but at rates that are above historical trends.
The above-trend growth in apartment supply, however, has corresponded with far below-trend growth in single-family supply. Growth in the total housing stock has significantly lagged broader economic and population growth over the last decade. We believe that, absent a significant economic slowdown, housing markets will remain tight for at least the next half-decade as a result of years of under-building. As a result, we expect housing costs to significantly outpace the broader rate of inflation for the foreseeable future.
Robust Demand, Fueled By 'Lower for Longer' For Homeownership
Demand for apartment units is a function of three primary factors: job growth, income growth, and the propensity to rent versus own (and live with roommates or family). Evidence of broad-based strength in the labor markets continued to show over the last quarter. Overall, the pace of hiring has actually accelerated in 2018, reversing a multi-year slowdown that many analysts attributed to tightening labor market conditions. Deregulation and corporate tax reform appear to have added another leg to the labor market recovery, which is already the longest on record. Further, for the first time in several years, income growth is outpacing rent growth with average hourly earnings rising by 3.1% over the past year.
While the positive outlook for job and income growth are visible tailwinds for apartment demand, the third factor of the demand equation, the propensity to rent, remains a key swing-factor. For years, many analysts have projected that millennials were poised to ditch the apartment lifestyle in droves to get a mortgage and buy houses in the suburbs. Despite the most favorable economic backdrop for homeownership in decades, the data has yet to indicate that younger demographics are entering into the ownership markets to the same degree as in past decades. The homeownership rate among the under-44 cohort saw the most pronounced declines after the financial crisis and has barely budged off the 2015 bottom.
Valuation & Characteristics of Apartment REITs
Apartment REITs appear attractively valued across the three metrics that we track. The sector trades at a slight Free Cash Flow premium (aka AFFO, FAD, CAD) to the REIT average, but after accounting for medium-term growth rates, apartment REITs appear attractively valued based on the FCF/G metric. Apartment REITs, however, trade at steep NAV discounts, largely a function of the strong private-market performance of apartment assets. As discussed, development-focused REIT sectors like apartments are less affected by the NAV discounts compared to acquisition-focused sectors, but the impaired cost of capital does make external growth less accretive.
Based on dividend yield, apartment REITs rank in the middle of the sector, paying out an average yield of 3.3%. 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.
The two small-cap REITs pay a higher dividend yield but also tend to pay a higher percentage of FCF towards the dividend. After accounting for CapEx, we estimate that APTS and IRT have payout ratios near 100%.
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. Within the sector, EQR, MAA, and APTS are categorized as Yield REITs. IRT is a Growth REIT, while the other five names are Hybrid REITs.
Bottom Line: Homeownership's Loss Is Apartments Gain
'Renter Nation' is alive and well. Rising mortgage rates and tax reform have led to softening demand at the margins for homeownership, offset by strengthening demand for rentals. The battle rages on between record levels of supply growth and robust demand growth. The economic reacceleration of 2018 has fueled positive surprises for apartment REITs.
After years of decelerating rent growth and moderating occupancy, fundamentals have inflected favorably this year. Blended renewal rates topped 3.6% in 3Q18, the strongest since 2015. Turnover continues to decrease, partially a function of record-high levels of renter satisfaction. 78% of tenants believe that renting is more affordable than owning, up significantly this year. Supply growth appears to have peaked earlier this year but will remain elevated in 2019 before pulling back in 2020. Rent growth is likely to rise above the rate of inflation well into the next decade.
With earnings season concluding this week, be sure to check out all of our quarterly updates: Data Center, Manufactured Housing, Student Housing, Single-Family Rentals, Cell Towers, Manufactured Housing, Net Lease, Malls, Shopping Centers, Hotels, Office, Healthcare, Industrial, Storage, and Homebuilders.
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Disclaimer: All of our research is for informational 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.
Disclosure: I am/we are long VNQ, XHB, EQR, MAA, CPT.
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.