Apartment REITs: Don't Look Now, But Rents Are Surging Again

Summary

• Renters enjoyed a brief reprieve from rising rents over the past two years as landlords competed to fill a record number of newly completed high-end apartment units.
• A “perfect storm” of factors - led by rising wages and continued robust job growth - has rejuvenated the rental markets, even as high-end multifamily supply growth remains historically elevated.
• Landlords are now back in control as rent growth has surged to the strongest rate since 2016, powered by the best year for household formation growth since 1985.
• Softness in the single family markets has been more than offset by strength in the apartment markets. Record-low turnover rates has helped keep expense growth under control for apartment REITs.
• Outside of the high-end apartment category, new home construction has significantly lagged housing demand, leading to a persistent rise in housing costs that will likely linger through the next decade.

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 largest apartment REITs, which account for roughly $120 billion in market value and more than 500,000 total housing units: Apartment Investment and Management Company (AIV) ("Aimco"), AvalonBay Communities (AVB), Camden Property Trust (CPT), Equity Residential (EQR), Essex Property Trust (ESS), Mid-America Apartment Communities (MAA), UDR, Inc. (UDR), Preferred Apartment Communities (APTS), and Independence Realty Trust (IRT).

Apartments - also called "multifamily rentals" - are one of the major commercial real estate sectors. The $3-4 trillion US apartment market remains highly fragmented, with REITs owning roughly 500,000 of the estimated 21 million multifamily rental units across the US, which is less than 3% of all apartment units. Even more than other real estate sectors, apartment markets tend to exhibit commodity-like characteristics over time as rental fundamentals respond in a rather efficient and predictable way to supply and demand conditions, highlighted by the minimal differentials in operating performance exhibited by the seven major REITs, which we analyze below. Over time, markets seeing well-above-trend rental growth experience a subsequent period of elevated new development, and vice-versa. On average, REITs tend to own more high-quality assets in major "job hub" cities, though several REITs focus more on suburban and more affordable assets.

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. Housing is the single-largest annual expenditure category for the average American at roughly 33% as measured by the Bureau of Labor Statistics. Because of the high percentage of housing assets held in the private markets, indexes weighted based on market capitalization like the S&P 500 (SPY) are significantly underweight the residential housing industry relative to their importance to overall spending at the GDP level.

The Bull and Bear Thesis for Apartment REITs

Residential real estate tends to be one of the most polarizing investment sectors, made worse by the dramatic dislocations before and after the Great Recession. We find that investors tend to overweight local market conditions and anecdotal evidence of particularly weak or strong real estate conditions, while often overlooking the wealth of available national data, perhaps explaining some of the persistent performance trends enjoyed by the sector over the last quarter century. 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 and as a share of GDP. On a rolling ten-year average, residential fixed investment as a share of GDP reached the lowest since the end of WWII in 2017.

This period of substantial underbuilding has corresponded with an acceleration in household formation growth, powered by the strongest labor market in at least four decades. On the demographic 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 (25-34) 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.

The US has seen a development "boom" in multifamily building - concentrated in the higher-end segments of the market - over the last four years following a period of very limited new construction immediately following the recession. When there's a demand imbalance, it is typically never too long for developers to swoop in and add new supply to the market, though impediments to supply growth in recent decades have weakened this market response. 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 330-360k/year range through 2020, which amounts to roughly 1.5% per year of supply growth.

Back in 1960, housing accounted for less than 20% of average annual spending. For the following three decades until the 1990s, "real" rent growth (in excess of inflation) was essentially zero as ample supply growth rusted in commodity-like returns for apartment assets. Since the mid-1990s, however, regulations such as restrictive zoning laws, rent control, and overly burdensome building codes have constrained supply growth and have resulted in a demand imbalance, producing "real" rent growth in excess of 1% per year. Housing now accounts for roughly a third of the weight of the CPI index.

While demand growth has more than offset supply growth over the last half-decade, those trends could flip soon if supply growth remains elevated. While demographic trends have been very favorable over the last decade, they will become a headwind by the end of the next decade. A generation that we dub the "Rocket Power" generation - those born between 1989 and 1993 - is the largest 5-year age cohort in the United States. This abnormally large age cohort, now entering their 30s, is likely to transition towards the single-family ownership markets with greater frequency over the decade.

Apartment REIT Fundamentals

Don't look now, but rents are climbing again and apartment landlords are partying like it's 2016. Renters enjoyed a brief reprieve from rising rents over the past two years as landlords competed to fill a record number of newly completed high-end apartment units. A “perfect storm” of factors - led by rising wages and continued robust job growth - has rejuvenated the residential rental markets, even as multifamily supply growth remains historically elevated. The Zillow ZRI Rent Index shows that rent growth in both the single-family and multifamily category jumped to the highest rate since 2016 despite moderating home price appreciation.

Apartment REITs are seeing this resurgence, as earnings results were generally above expectations in 1Q19. Same-store revenue growth accelerated to the strongest rate since 2016. Leasing metrics - arguably the most important of the statistics reported - were better-than-expected, with blended lease rates seeing a 3.0% bump, a roughly 110 basis point improvement over the same period in 2018. Occupancy remains near record highs at 96.3%, as millennials have shown few signs of rushing back into the single-family ownership markets.

Expense growth outpaced revenue growth in 2018 but showed improvement in the first quarter of 2019, helping to power same-store NOI growth to the best level in roughly three years. 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, which could eventually be shifted back onto renters. Ever-lower turnover rates continue to be an unexpected but much-welcomed tailwind which has kept expense growth in check.

"Underpromise and overdeliver" has become the credo for most of the REIT sector over the past several years. As we projected in our last report, full-year 2019 guidance appears to be quite conservative given the performance through the first quarter and the jump in leasing metrics. Camden boosted NOI projections, but the other six REITs maintained guidance, with a handful suggesting that they were waiting until 2Q19 to raise guidance. At 2.9% current guidance, we expect apartment REITs to surpass full-year NOI guidance and achieve growth closer to the 2017 average of 3.5-4.0% if recent trends in the labor market continue through the end of the year.

As we got later into the cycle, the variance in fundamentals between markets 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.

This convergence is seen in the apartment REITs themselves, with each of the seven major REITs displaying remarkably consistent operating metrics despite having portfolios in different regions and different rental price points. All seven REITs are projecting same-store revenue growth within an 80 basis point spread of 2.7-3.5%, with same-store NOI projections in a similarly tight spread between 2.3% and 3.8%.

Capital Markets and External Growth

Last quarter, we projected that apartment REITs would become net buyers in 2019 as the early effects of the REIT resurgence pushed equity valuations into territory more favorable for external growth. Currently, apartment REITs trade at roughly NAV parity, with several REITs in the sector trading at NAV premiums by our estimates, which has begun to grease the wheels for acquisition-fueled 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. Somewhat counterintuitively, elevated equity valuations (particularly in relation to private market valuations) can be beneficial for REITs, which can utilize this valuable equity as "currency" to accretively acquire new assets. Acquisitions have historically accounted for a sizable percentage of total FFO growth per share across the REIT sector.

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 Communities still sees roughly 6.1% stabilized yields, compared to capitalization rates around 4.6%. This 150 bps spread compares to the 300 bps+ spreads in 2014-2015.

Multifamily Supply and Demand Analysis

As discussed above, 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 340k-360k level through the end of 2020, which amounts to roughly 1.5% per year annual supply growth. Starts and permitting activity has pulled back since mid-2018, and as of April, multifamily starts have actually dipped 2.5% on a trailing twelve-month basis.

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.

The jobs market is powering the best growth in household formations in a generation, setting the stage for a housing market recovery in 2019 and also rising rents and likely home values. Last month, the US Census released data which showed that growth in household formations are growing at the strongest rate since 1985. Once thought to be a "new normal" of lower labor force participation, the strong US economy has pulled workers from off of the sidelines and into the housing markets.

Apartment REIT 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, apartment REITs have produced an average annual total return of 12.5% per year, compared to the 11.5% return on the REIT index through the end of 2018.

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 17% so far this year, slightly underperforming the 17% jump in the REIT index and the broader US housing industry, as measured by the Hoya Capital US Housing Index, an index designed to track total spending on housing and housing-related services.

UDR, Inc., Equity Residential, Essex Property Trust, and Aimco were the best performers in 2018, while the small-cap REITs Independence Realty Trust and Preferred Apartment Communities were the weakest performers. So far this year, Mid-America Apartment Communities and Independence Realty Trust have led the YTD gains at just shy of 20%, while UDR has lagged, returning roughly 13% on a price-only basis.

Valuation 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 essentially NAV parity.

Apartment REIT Dividend Yields

Based on dividend yield, apartment REITs rank in the middle of the sector, paying out an average yield of 3.0%. Apartment REITs pay out just around 70% of their available cash flow, towards the lower end of the REIT 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 Preferred Apartment Communities and Independence Realty Trust have payout ratios near 100%.

Apartment REITs and Interest Rates

Apartment REITs are not particularly an 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. Falling into the "Hybrid REIT" category, apartment REITs are suitable for both yield-oriented and growth-oriented investors.

Bottom Line: Don't Look Now, But Rents Are Rising

Renters enjoyed a brief reprieve from rising rents over the past two years as landlords competed to fill a record number of newly completed high-end apartment units. Landlords are now back in control as rent growth has surged to the strongest rate since 2016, powered by the best year for household formation growth since 1985. A “perfect storm” of factors - led by rising wages and continued robust job growth - has rejuvenated the residential rental markets, even as multifamily supply growth remains historically elevated. Softness in the single-family markets has been more than offset by strength in the apartment markets. Record-low turnover rates have helped keep expense growth under control for apartment REITs.

We continue to have a positive outlook for the broader residential REIT sector given favorable supply/demand conditions. Over the next decade, we expect supply growth to gradually equalize this demand imbalance from a combination of continued multifamily development and an uptick in single-family homebuilding, but believe that we will continue to see "real" rent growth in excess of inflation during this period. Outside of the high-end apartment category, new home construction has significantly lagged housing demand, leading to a persistent rise in housing costs that will likely linger through the next decade.

If you enjoyed this report, be sure to "Follow" our page to stay up-to-date on the latest developments in the housing and commercial real estate sectors. For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Storage, Student Housing, Manufactured Housing, Cell Towers, Healthcare, Industrial, Data Center, Malls, Net Lease, Student Housing, Single-Family Rentals, Apartments, Shopping Centers, Hotels, Office, and Homebuilders.

Disclosure: I am/we are long VNQ, EQR, MAA, UDR, CPT, AVB, ESS, AIV. 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.