How To Play The Affordable Housing Bottleneck

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Includes: AIV, AMH, APTS, AVB, CPT, ELS, EPS, EQR, ESS, EXT, FMCC, FNMA, FREL, FRI, ICF, INVH, IRET, IRT, IYR, MAA, NXRT, REK, REZ, SCHH, SUI, UDR, UMH, VNQ, WREI
by: Cashflow Capitalist
Summary

Demand for affordable housing is greater than supply and will remain so for quite some time.

Local zoning laws and housing regulations has constricted supply growth of affordable housing.

Homeownership will likely remain suppressed for years to come.

Class B and C apartments are already performing better than Class A apartments in many markets and will likely continue to do so for the foreseeable future.

Here are some ways investors can play the affordable housing shortage.

What if I told you that today's average American worker with a full-time job is only making $20 more per week (in inflation-adjusted terms) than a similar worker did in 1979? Would you believe me?

It doesn't seem right, but according to Fed data, it is:

In a previous article about How the American Consumer is Worse Off Today Than in Previous Decades, I discussed seven ways that today's consumer is actually worse off than in decades past. Those seven points are worth summarizing here for the purpose of the present discussion:

  1. Total civilian labor force participation is hovering around where it was in 1978, largely due to Boomers remaining in the workforce longer and men slowly dropping out.
  2. Single-parenthood, which puts financial strain on families, has risen from under 10% in 1950 to over 30% today.
  3. There is much more auto debt today than decades ago, and much of that debt is subprime.
  4. Student debt has risen rapidly, while graduation rates are lackluster and a substantial minority of graduates are underemployed.
  5. Only a little more than a third of Millennials over 30 are homeowners, whereas almost half of Baby Boomers were homeowners by age 30.
  6. Almost half of US households carry a credit card balance, and total credit card debt has risen much faster than disposable income in the last 5 years.
  7. Most Americans have very little in savings, and the savings rate for the bottom 90% of income earners hasn't risen above 5% in decades.

All of these issues have either stayed roughly the same or gotten worse during the economic boom of the last decade. This, then, paints a dreary picture for the future of consumer spending growth, the driver of the US economy.

In the midst of all this doom and gloom, is there any upside for investors? Initially, one might think that there's not. If consumers have less money to spend in the future, then that will show in corporate earnings (EPS, EXT) and GDP. However, there are some companies that will scarcely be harmed by, and may even benefit from, a weaker consumer. The market is well aware, for instance, of the likelihood that demand will remain elevated for dollar stores (DG, DLTR) and discount retail (ROST).

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Data by YCharts

But I'd like to discuss the case for a less frequently covered type of asset that should benefit from a weaker consumer, and that is affordable housing.

The Case for Affordable Housing

Technically, "affordable housing" refers to homes that cost (in the monthly rent or mortgage payment) a third or less of one's gross income. But here, I'm using the term to refer to Class B and C apartments.

It might be useful to quickly cover the difference between the “class” designations of apartments. Class A apartments are the highest quality and best located in their area, generally in newer buildings, and in turn command the highest rents. Class C apartments, on the other end of the spectrum, are among the lowest quality due to poor location and outdated (or lack of) amenities, and as such, have much lower rents. Class B apartments are in the middle — not the highest quality, but not the lowest; not the best location, but not the worst; not the highest rent, but not the lowest.

Cinnamon Ridge Apartments in Eagan, MN — a typical Class B apartment community

To give an idea of the range in rent rates, Class A apartments in the nation's one-hundred largest metros rented for $1,663 on average in January 2017, while rent for the average Class C ran $850. (Of course, these are averages. In some cities, rents are much higher, and in others, they're lower.)

Given that a little over 40% of US households make less than $50,000 per year already, four in ten American households are already looking to spend less than $1,390 per month in rent, and most of those far less than that. Throw in a potential recession and that number would only rise. Let's cover some of the data that backs this up.

1. Homeownership Will Likely Remain Weak for the Foreseeable Future

The Dodd-Frank Act tightened mortgage-lending standards and, in turn, decreased the number of households that qualify for homeownership. Moreover, during the Great Recession, the nationwide rise in foreclosures gave investors (many of them institutional) an opportunity to snatch up a large number of houses and turn them into rentals, which reduced the supply of moderately priced homes. This has not helped home price affordability.

Nor has the nearly decade-long streak of ultra-low interest rates, which contributed to home prices being bid up to their highest level ever. Given these challenges, a fall in the national homeownership rate to 60% or lower is not far-fetched.

One might think that the lack of home price affordability mainly affects Class A apartments, but one would be wrong. In my experience working in residential real estate, many renters who could afford a Class A apartment choose a Class B apartment anyway in order to save up for a down payment. Many of those who occupy Class A units are long-term renters who rent by choice.

What would have to change to precipitate a renewed escalation of homeownership? If interest rates rose and remained elevated even as the economy remained healthy, that could gradually lower home prices while leaving plenty of Americans financially capable of buying. But it doesn't appear as if we will have both higher interest rates and a healthy economy going forward. It may be one or the other, or neither.

Relaxing or getting rid of local zoning restrictions, as in the cases of Houston and Victoria, Texas, would also result in lower home prices, as developers would have greater ability to build.

And this would have a corresponding effect on rents. Average rent for an apartment in Houston, for instance, is $1,083 per month, which is significantly lower than the average rents for the next largest American city, Chicago ($1,893 per month), as well as the next smallest city of Philadelphia ($1,576 per month). And it’s not as if workers are compensated proportionately higher in these higher rent cities. Houston’s average salary of $59,508 is roughly equal to Philadelphia’s $59,730 and only a little under Chicago’s $62,884.

Houston’s average rent is even lower than that of Dallas, TX ($1,190 per month), despite being home to over a million more people. The difference between the two? Zoning. In the coastal markets of San Jose, San Francisco, and Manhattan, zoning accounts for approximately half of a house’s value.

Unfortunately, entrenched NIMBYism (the acronym standing for "not in my backyard") makes any widespread relaxation of zoning laws unlikely. The movement has acted as molasses poured over the gears of many areas' real estate landscapes, slowing or halting development that is needed to address the housing shortage.

2. Demographics are Destiny

The total number of US households is projected to increase by 12.2 million in the next decade, and 11.2 million of those are headed by a person 65 or older. Considering that the median savings of Americans aged 50-55 is a whopping $8,000, and, for those between 56 and 61, $17,000, it’s safe to assume that much of this new demand will be going toward the lower end of the rental market. According to Gallup, 43% of near-retirees plan to rely heavily on social security for income. Given that the maximum monthly social security benefit for retirees is $2,687, increased demand for housing under $900 per month would seem inevitable as Boomers retire.

Add to this the point that 9.3 million of the total new households are projected to be minorities, mainly blacks and Hispanics, whose median income is only about 60% that of whites, and the conclusion is only compounded. What other effect could this have besides heightened demand for affordable rentals?

3. Supply of Affordable Housing is Growing Much Slower Than Demand and Will Likely Continue to Do So

Indeed, going forward, overall rental demand will remain strong, despite the surge of new supply over the past 6 years. Between 2006 and 2016, rental-occupied housing grew by 7 million units, while owner-occupied housing remained relatively flat. The most imbalanced demand-to-supply segment of the rental market, though, is affordable housing, with the number of available units falling 0.5% from 2006 to 2016, while households in that income bracket rose 1.8%. According to the American Consumer Institute,

In Dallas, during that same period, the number of low-income households grew by 40,000, while the number of affordable rentals declined by 70,000 units. In DC, the number of low-income households grew by 45,000, but affordable rentals did not grow. In high income areas like New York City, affordable units declined by 75,000.

Total units renting for $800 or less fell by over 260,000 from 2005 to 2015, despite the overall rental stock increasing by over 6.7 million units.

(Higher end housing [rent of $2,000 and above] has also been in high demand in recent years, but it also experiences the most volatility in demand. During recessions, its rents come down the most, but they also rise the most in the beginning stages of a new economic cycle.)

As a result of this demand on the lower end, Class B and C apartments enjoy a lower vacancy rate as well as higher rent growth. Affordable housing vacancy, according to Reis, sits around 2% and is forecasted to remain at that level for the next five years as the recent tax reform has decreased the incentive to build affordable housing. Compare that to a 5.6% vacancy in class A apartments as of Q1 2018. Reis expects a 40% reduction in affordable housing investment from 2019 to 2022. This translates into higher rent growth. In 2018, Class B buildings in top 70 metros averaged 3.4% rent growth and even reached 7% growth in the top metro markets.

In fact, in all but a few high-construction markets, Class B and C apartment rent growth outpaced that of Class A units in the first half of 2018.

There will be proposed solutions from politicians, but few, if any, would actually lower rents. For instance, a recent study on rent control from Stanford Graduate School professors found that initial renters in a rent controlled environment benefit greatly from frozen rent rates, but the longer the rent control scheme lasts, the more newer renters are hurt by it. As landlords redevelop their properties or switch them to condos or AirBnb units in order to achieve higher returns, the total stock of affordable housing diminishes. In the rent-controlled environment of San Francisco, for example, the number of affordable units declined by 25% between 1994 and 2010, and all the money saved by initial renters was paid by later renters who had less choice of housing.

Nor would the affordable housing shortage be helped by tax credits for those who are "rent-burdened" — paying more than 30% of their income toward housing. Without changing the supply of housing in a given area, landlords would easily be able to capture all or most of this tax credit.

Multifamily or Single Family?

One might think that a REIT specializing in single family rental houses would be a good way to play the affordable housing bottleneck, but I believe this is mistaken.

Having worked at a residential management company for many years (and being a landlord myself), I'm conscious of the many issues with mixed residential management. Margins are very thin. Profits are made by spending as little as possible and charging residents as much as possible. Cap rates for single family rentals are in the low single digits, resulting in dividend yields of 1-2% for their REIT owners. The two largest SFR REITS (AMH & INVH) have yields of 0.90% and 1.95%.

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Data by YCharts

And expenses for SFRs are less predictable than in apartment complexes. Garage doors can malfunction. Roofs can leak. Backyard fences can break. Subcontractors can overcharge. And, of course, tenants are generally more picky and demanding than for apartments.

Demand for SFRs will likely remain strong for the foreseeable future, but that doesn't necessarily mean their publicly traded landlords make for good investments.

Plus, according to Hoya Capital Real Estate, growth in single family houses has been faster than multifamily during this economic recovery.

Perhaps this is one reason why rent growth for apartments has consistently risen faster than inflation.

Source: A Student of the Real Estate Game

This is partly why, as Dane Bowler recently pointed out, the apartment sector’s performance has crushed that of the office and hotel sectors over the last 25 years. I may also point out that demand for hotels and office space is cyclical, whereas demand for a home is non-cyclical.

How to Tap Into the Affordable Housing Bottleneck

My preference to play the affordable housing bottleneck is to invest in multifamily REITs that have significant exposure to Class B and C apartments. By far my favorite of these is Mid-America Apartment Communities (MAA), a REIT with a market cap just shy of $12 billion, currently trading at ~16.6 P/FFO based on 2018 FFO of $6.06. It paid out only ~62% of its FY2018 core FFO in dividends, leaving plenty of room for future growth while yielding a decent 3.81% at the current price. The company's portfolio is made up of a little over half Class B apartments.

Source: Mid-America Apartments Presentation

My second favorite pick is Independence Realty Trust (IRT). The first reason that it comes in second place is the small market cap of ~$920 million. The second reason that it's inferior to MAA is that it paid out a little more than 96% of its FFO in the first three quarters of 2018, leaving little room for error. On the other hand, IRT investors are compensated by an almost 7% dividend yield and have access to a larger percentage of Class B apartments.

Source: Independence Realty Trust Presentation

My third choice to play the affordable housing shortage is NexPoint Residential Trust (NXRT), a REIT that is even smaller than IRT but boasts an impressive growth streak since its IPO in 2014. The company's strategy of acquiring value-add properties, performing rehabs, and raising rents has resulted in a handsome ROI of 21.2% and NAV compound annual growth rate of 19.7%. For the first three quarters of 2018, NXRT paid out only ~64% of its FFO, but it trades at a rather pricey ~23 P/FFO based on its estimated FY2018 core FFO. This gives the stock a paltry 2.96% yield.

While they don't give the percentages of each apartment class in their portfolio, one can deduce based on their average rents that the classes of their apartment buildings upon acquisition are almost all B or C. Average monthly rents across their markets in the first quarter of 2018 ranged from $774 in Phoenix to $1,135 in West Palm Beach, averaging $958 across all markets.

Source: NexPoint Residential Trust Presentation

Each of these REITs invest mainly or exclusively in non-coastal markets where lower and middle-income earners are fleeing to find affordable housing.

MAA is already a core holding in my portfolio and I'd only look to add more in the low $90s per share, while IRT and NXRT are on my watch list. I'd like to see IRT fall back to its Spring 2018 low and NXRT yield about the same as MAA currently does before I initiate positions.

Summary

The demand-to-supply ratio for affordable housing will remain imbalanced for quite some time due to the weakening homeownership rate, demographic trends of increasing retirees and minorities, and slow growth of the affordable housing stock. Local zoning laws and housing regulations are the primary cause of restricted supply growth, and as such, they are the main reason that occupancy and rent growth of Class B and C apartments will continue to outperform.

The multifamily REITs discussed above are likely to benefit from this demand-supply imbalance because their portfolios are weighted toward Class B and/or C units. At the same time, these companies are not slumlords. Through their value-add approaches, they are adding value to the lives of their residents by providing quality yet affordable housing.

What do you think? What other companies (REIT or otherwise) might benefit from the affordable housing bottleneck?

Disclosure: I am/we are long MAA. 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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.