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 $115 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 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.
As we discussed in our ETF Spotlight, the iShares Residential Real Estate Capped ETF (REZ) is currently the ETF that offers the most direct exposure to apartment REITs. REZ tracks an index that includes not only classic residential REIT sectors like apartments, single family rentals, and manufactured housing, but also non-core and specialty residential sectors like self-storage, hospitals, skilled nursing facilities, and student housing REITs. Americans spend an estimated $1.3 trillion per year in direct and imputed rent, accounting for roughly 30% of the $3.5 trillion per year spent on an annual basis on housing, home construction, and housing-related services at the GDP level.
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 a rolling ten-year average, residential fixed investment as a share of GDP is the lowest since the end of WWII.
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, it is never for very long as developers swoop in and add new supply to the market. 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 330-370k/year range through 2019 before moderating in 2020, which would continue to put downward pressure on rent growth, all else equal. Robust demand growth over the past year, however, has more than offset the negative effects of supply growth.
Apartment REIT Fundamentals
Apartment REIT earnings were generally in line with expectations in 4Q18 as the trend of improving fundamentals continued into the end of the year, aided by rising mortgage rates and weakening sentiment in the single family ownership markets. Headline metrics in 4Q18 were mixed as expense growth was elevated at 3.5%, dragging down NOI growth to 2.5% from 2.6% last quarter. Same-store revenue growth ticked higher to 2.8% in 4Q18, the strongest since 2Q17.
Leasing metrics, arguably the most important of the statistics reported, were generally better than expected, highlighted by a roughly 150 basis point improvement in new lease rate growth from the same quarter last year. On average, REITs achieved 2.5% blended rent growth on new and renewed leases with all REITs in a tight range between 2-3%. Occupancy remains near record-highs at 96.3% as millennials have shown few signs of rushing back into the single family ownership markets.
"Underpromise and overdeliver" has become the credo for most of the REIT sector over the past several years. Full-year 2019 guidance appears to be quite conservative given recent strong leasing statistics and strong job growth at the end of 2018. At 2.6%, apartment REITs fairly easily surpassed initial 2018 revenue guidance which called for same-store revenue growth around 2%. REITs forecast revenue growth of 3% in 2019 which would be the strongest rate since 2016.
Expense growth outpaced revenue growth in 2018 and is expected to do the same in 2019. Rising property taxes, the largest single expense item for apartment REITs, continue to be a chief concern among investors, particularly in the wake of tax reform which shifted more tax burden onto homeowners in high-tax coastal markets. With decent visibility into revenue growth, variance in expense growth will be a key driver of potential upside in NOI growth.
One of the primary rent growth indexes that we track, the Zillow ZRI Rent Index, had been decidedly more bearish on rent growth through most of 2018, but recently jumped to the highest level since last summer. REIS, meanwhile, reported that the national average effective rent grew 4.6% in the fourth quarter from the same time last year, the strongest fourth quarter since 2015.
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, as well as Houston, have bounced back into positive territory after dipping into negative rent growth 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 260 bps on a TTM basis 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
After trading at sizable NAV discount for all of 2018, the resurgence this year has pushed valuations back towards NAV parity. Currently, apartment REITs trade at a modest 0-10% NAV discount which may begin to grease the wheels of external growth. Apartment REITs had responded to the persistent NAV discount 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 still sees roughly 6.4% stabilized yields compared to 4.7% capitalization rates. This 170 bps spread compares to the 300 bps+ spreads in 2014-2015.
Multifamily Supply & Demand Analysis
The relative "boom" in multifamily construction that began in 2014 has continued into 2019 with a near-record level of units still under construction. Deliveries appeared to have peaked for this cycle during the summer of 2018 at a TTM rate of roughly 365k units. Deliveries 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.
Demand for apartment units is a function of three primary factors: job growth, income growth, and the propensity to rent versus own. 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 3.2% 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.
Recent Stock Performance
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 but returned to their winning ways in 2018, producing a total return of 4%. Since the Modern REIT era began in 1994, however, apartment REITs have produced an average annual total return of 12.5% per year compared to the 11.5% return on the REIT index.
Coming off their worst year since the financial crisis, the real estate sector has roared back to life in 2019 with broad-based gains across nearly every residential and commercial real estate category. Apartment REITs have surged 12% so far this year, slightly underperforming the 14% jump in the broader REIT ETFs (VNQ and IYR).
Apartment REITs have actually been among the weaker segments of the Hoya Capital Housing Index, an index that tracks the broad performance of the US housing industry, which has climbed more than 16% this year. UDR, Equity Residential, Essex, and Aimco were the best performers in 2018 while the small-cap REITs Independence and Preferred Apartments were the weakest performers.
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/Growth metric, a metric similar to a PEG ratio. As discussed, apartment REITs now trade at rather modest Net Asset Value discounts.
Based on dividend yield, apartment REITs rank in the middle of the sector, paying out an average yield of 3.1%. Apartment REITs pay out just around 70% 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%.
Apartment REITs are not particularly interest rate-sensitive sector, nor are they particularly sensitive to movements in the equity markets. The short lease terms of apartment REITs provide investors with 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. As a whole, the sector generally falls into the "hybrid" category, exhibiting a blend of characteristics that may be well suited for either income or growth-oriented real estate investors.
Bottom Line: Rents Rise, Again
Apartment REITs delivered another solid year in 2018. Fundamentals inflected higher as strong rental demand more than offset peaking supply growth. '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 in 2018. For apartment renters, the modest relief from rising rents was short-lived. Leasing trends improved throughout 2018, particularly new leases, which were up nearly 150 bps from last year. Turnover rates remain near record-lows as renter satisfaction remains very high. Low turnover has kept expense growth in-check despite pressure from rising property taxes. Supply growth appears to have peaked last 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.
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Disclosure: I am/we are long AVB, CPT, EQR, MAA, VNQ. 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.