Increase In Housing Starts Might Signal Headwinds For Residential REITs

Includes: ELS, EQR, IRT, SUI, UMH
by: Arturo Neto, CFA

If more people buy homes, then rental rate growth will likely slow, which could have an impact on residential REITs.

The recent permits and housing starts data was positive but could signal a shift in buyer sentiment if it continues.

In the short term, we are still bullish on residential REITs, but are cautious about an uptick in home ownership.

When housing starts and building permits were reported earlier this week it was good news for the housing market and overall economy in general, but might not be such good news for REITs focused on residential housing. That includes apartment REITs, single-family home REITs, and manufactured housing REITs as well.

New building permits were reported at an annualized rate of 1.296M permits, which was slightly above the consensus forecast of 1.29M. Housing starts were reported at 1.235M – above the consensus of 1.205M. Both are still below the recent high but have stabilized after a steady decline since early 2018

For two consecutive months, we've seen an uptick in both building permits and housing starts, which should lead to an increase in supply and higher sales. That is, if the new supply coming on line is priced affordably.

If a recovery in home sales renews, we would expect rental rate growth to slow, putting the brakes on the growth rates of some of thea apartment and single family home REITs. Both are likely to be able to continue to raise rents, but in Class A Apartments for example, rental rates are tilting the rent vs. buy preference to the latter and an increase in supply – especially if its in the $200K to $400K range – would likely lead to some of those tenants to buy.

Rental Rates

For 10 years now, rents have been climbing faster than wages while rental vacancy rates have steadily declined from over 10% to around 7%, where they have remained for the last few years. The median asking rent in the data provided is $1,000 per month, but in many Class A apartments, rents can reach $3K.

The challenge for many renters interested in buying is that despite the increase in rents, the rise in home prices has made it more economically feasible to continue to rent. Mortgage rates rising didn't ease the burden of homeownership, and while they were partly to blame for the affordability issue, they have since retreated back down to around 4.25%.

Unfortunately, the lack of supply of homes for sale has caused the market to be in a state of disequilibrium. With so few homes to choose from, consumers that can afford to buy are bidding up the price of these homes, causing prices to increase more than the current level of sales would normally dictate.

As the chart below shows, the months supply of homes for sale is hovering around the six-month level. If you look at the data before the financial crisis, a six-month supply of homes for sale usually coincides with annualized sales of roughly 800 units and rising. We are nowhere near that, although the latest figures did show a slight uptick.

Housing Starts by Units

While single family home starts usually dominate the overall housing starts data, it has surpassed the 80,000 unit level several times over the last couple of years only to pull back down to the 60K range. With 5-plus unit housing starts remaining relatively steady throughout, I believe it will take a prolonged period of 80K-plus housing starts of single family homes to put housing back on a sustainable growth path.

I'm still bullish on the residential REIT sectors, particularly single family in secondary cities, as well as Class B and C Apartments, whose rental rate growth has lagged those of Class A – and while they are now accelerating, they are still well below Class A levels.

The challenge for us as investors is trying to figure out who the winners and losers are in each sub-sector based on economic data, geographic specific drivers, and demographic trends, not to mention, dividend yields, payout ratios, and debt levels.

Within the apartment REIT sector, I'm invested in both the Class A space and the Class B & C space, with Equity Residential (EQR) and Independence Realty Trust (IRT). I'm a bit cautious on some of the West Coast focused REITs. While concentration on the West Coast was positive for some time, the recently passed rent control bill in Washington could be a sign of things to come in other high-rent jurisdictions.

We don't have as many choices in the single family homes space but all seemed to do quite well year-to-date with the worst performing REIT generating 20.5%. Yields in the sector are not attractive for many income investors and there isn't enough history to gauge each company's dividend policies going forward.

There are even fewer options in the manufactured home sector but this could be an interesting theme for investing in the aging baby boomer generation, the changing tastes of millennials, and the more positive stigma of manufactured homes.

In the past, most residents of manufactured homes might have been thought to be older consumers with a fixed income or low income families that couldn't afford a more traditional home. Today, whether because of affordability challenges or because manufactured homes are just nicer than they used to be, the demographics of manufactured home buyers has changed – including interest by people aged 18 to 29, which makes up the largest group of mobile home residents, according to data compiled by Curbed.

It's a big reason why manufactured home REITs have been one of the best performing REIT sectors over the last five years, with an average total return of 22% and a three-year annualized return of 20%. Same-store NOI continues to be strong at 5.6% - leading all other REIT sectors.

The two largest Manufactured Home REITs are Sun Communities (SUI) and Equity Lifestyle Properties (ELS). Neither pays a dividend above 2.5%. Income investors might be more inclined to look at UMH Properties (UMH) with a dividend yield of 5.5%.

Takeaway from Permits and Housing Starts

If the trend we have seen over the last couple of months gains traction, we would be cautious about the long-term potential of apartment REITs and single family home REITs to continue to raise rents. However, It will take some time for permits to make their way through the pipeline and become final sales, while leases are renewed annually. We remain bullish on residential REITs, at least over the short term, but believe that the runway for manufactured homes is much longer.

Disclosure: I am/we are long IRT. 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: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances. Furthermore, none of the ideas presented here are necessarily related to NFG Wealth Advisors or any portfolio managed by NFG.