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As we mentioned in a previous article about Sun Belt REITs and the rise of the 18-hour city, the increase in prices in so-called 24-hour cities has resulted in cap rate compression and a renewed focus on opportunities in secondary or tertiary markets – particularly in the Sun Belt, where there are still good supply-demand dynamics, high occupancy, and rent growth. Lower cap rate compression in these markets also means potentially higher yields for investors.
In the previous article we talked about REITs in general and touched on some of the specific sub-sectors that looked most promising in light of some of the demographic factors in these markets. We focused some of our analysis on Apartment REITs and Office REITs and how demographic trends should be a tailwind for some of the apartment and office landlords in the area.
In this article, we will take a closer look at apartment REITs and some of the specific drivers to watch for that we believe will drive future price and dividend increases within the sector.
The outlook for apartment REITs
Demographic forces and household formation are key drivers in the demand for both apartments and single-family homes, and the demographics are driving a need for higher levels of construction of a new supply of inventory.
Multifamily construction may be high, but total residential construction is not. In fact, the pace of single-family construction has continued to lag, more than offsetting the modest strength in the apartment sector, leaving total residential construction below the level needed to house a growing population.
Exhibit 1: Population trends and housing starts
Total residential construction over the past decade has lagged population growth by a wide margin, resulting in housing shortages and affordability crunches in markets across the country. One result, however, has been solid demand for apartments, including those owned by REITs. In fact, the occupancy rate at apartment REITs has continued to move to new record highs even during this building boom, reaching 96.1% in early 2019.
Exhibit 2: Apartment REIT occupancy rate
Current strong demographic trends should continue to buoy the apartment market and apartment REITs too. The drivers of apartment investment returns remain favorable, and occupancies tend to be more resilient in a downturn than other commercial sectors.
Another supporting factor is the widening gap between rents and home payments. Higher loan rates combined with rising home prices has resulted in affordability issues – although the recent decline in mortgage rates could offer a short-term reprieve. The monthly payment on a median-priced home increased by $175 last year to nearly $1,700 per month, dramatically widening the disparity between a mortgage payment and the average monthly rent – even as rent rates have increased. This widening payment gap has slowed young adults’ migration into homeownership, reducing the under-35 homeownership rate to 37 percent, down from the peak of 43 percent in 2007. This confluence of factors will likely carry on, sustaining young adults’ preference for rental housing.
Exhibit 3: Rising propensity to rent
Population demographics have largely been influenced by the millennial generation, which has surpassed the baby boomers as the nation’s largest living generation and are spurning the suburbs for urban living in these 18‐hour cities.
Many 18-hour cities have a wide spread between the cost of renting and homeownership, which helps ensure a continuous, large pool of quality renters. More companies are relocating to these lower cost locations, which often exhibit strong multifamily demand as the skilled workforce prefers to live in close proximity to employers.
Just as millennials are attracted to 18-hour cities because of the lower cost of living relative to major markets, investors also are attracted to the lower pricing for assets in such markets relative to major cities such as San Francisco and Washington. Compared to the traditional gateway cities, these 18-hour cities offer a wider range of investment opportunities and better yields.
Sun Belt apartment sector
The above average population growth in the Sun Belt cities should spur demand for housing in the next 10 to 15 years – both apartments and single family homes. Population growth is clearly higher in Sun Belt cities compared to the big cities like New York and San Francisco.
Exhibit 4: Sun Belt population growth
This higher population growth also is reflected in higher apartment rent growth.
Exhibit 5: Sun Belt apartment rent growth
Sun Belt apartment REITs
There are five REITs that have a major focus on Sun Belt apartments. Two of them, Mid-America Apartment Communities (MAA) and Camden Property (CPT), are large caps. Both have an investment grade rating and Mid-America Apartment Communities is part of the S&P 500.
Mid-America Apartment Communities focuses on quality apartment communities in the Southeast, Southwest, and Mid-Atlantic regions of the United States. As of June 30, 2019, MAA had ownership interest in 101,954 apartment units.
Camden Property Trust, an S&P 400 Company, is primarily engaged in multifamily apartment communities. Camden owns 165 properties containing 56,271 apartment homes.
Independence Realty Trust owns and operates 58 multifamily apartment properties, totaling 15,734 units, across non-gateway U.S. markets.
NexPoint Residential Trust is focused on well-located, middle-income multifamily properties with "value-add" potential in large cities and suburban submarkets of large cities, primarily in the Southeastern and Southwestern United States. As of June 30, 2019, NexPoint Residential Trust owned 13,407 units.
BRT Apartments is an owner and operator of Class B value-add and select Class A multi-family assets primarily in superior Sun Belt locations. BRT Apartments owns 35 properties containing 10,008 units.
Growth In The Sun Belt
What growth figures can we expect in the future for the Sun Belt apartment REITs? The premium or discount at which REITs trade can give us an indication of expected growth. The concept is similar to value vs. growth stocks.
The equity markets have a strong preference for higher levels of NAV growth, and at times when this exists, price REITs at premiums to NAV - just like growth stocks are expected to generate higher EPS growth and therefore trade at higher multiples than their value counterparts. When real estate value growth is more muted, short-term focused equity investors look elsewhere - leading to REITs trading at a discount.
Over the long term, U.S. REITs have, on average, traded at the value of their underlying real estate.
A premium to NAV does not mean a sector is overpriced, however. Over the long term, the REIT premiums and discounts to NAV by sector are predictive of future changes in private market values.
If REIT stocks trade at big discounts to the value of their assets, private market asset values tend to fall. This may sound counterintuitive because stocks trading at big discounts might be thought to be cheap. And while this may be the case, and the stock might actually be cheap, valuations in the public markets tend to lead the change in property values being held by these companies.
If REITs trade at large premiums, private market asset values tend to rise, which has a positive impact on the NAV growth of REITs.
Exhibit 6: NAV Premium/Discount
On average Sun Belt apartment REITs trade at a 9% premium to NAV compared to an average 1% discount for US apartment REITs. This suggests investor expectations of higher growth from Sun Belt apartment REIT relative to all apartment REITs.
It’s not enough to forecast a rise in NAV growth, although that's an important factor to consider for investing. Investors also might want to ensure a certain level of dividend safety when in investing in REITs. A low payout ratio and low debt ratios tend to lead to higher dividend safety. When we compare apartment REITs that focus on the Sun Belt with the average US apartment REITs, we can argue that the Sun Belt apartment REITs have stronger balance sheets and lower payout ratios and hence should have a lower risk of a dividend cut.
Exhibit 7: Balance sheet strength
We should mention NexPoint Residential Trust’s high debt load that's an exception compared to the other Sun Belt apartment REITs. However, NexPoint Residential Trust’s low payout ratio makes a dividend cut unlikely, as is the case for most of the other Sun Belt apartment REITs.
Is the higher historic and expected growth of Sun Belt apartment REITs reflected in a higher valuation? Is the higher balance sheet strength of Sun Belt apartment REITs reflected in a higher valuation?
The answer is no!
The Sun Belt apartment REITs trade at a cheaper valuations than the average US apartment REITs.
The most expensive one is NexPoint Residential Trust.
The cheapest ones are Independence Realty Trust and BRT Apartments. The last one could be cheap for a reason - Low growth and a high payout ratio combined with quite high debt levels point to lower dividend safety.
Independence Realty Trust is one of our favorite apartment REITs, but is currently rated Reduce/Neutral – meaning we still like the long-term prospects, but the stock is up 28% over the last 12 months and we think it might take a pause here.
The safest ones are Mid-America Apartment Communities and Camden Property based on (dividend) safety with nice growth and reasonable valuation. For the moment, however, we don’t have an active rating in either of them.
In a late-cycle environment, in which growth opportunities are scarcer, a focus on markets with stronger demographic trends can help identify opportunities with attractive total return potential. The Sun Belt is such a market as we have mentioned in this and previous articles.
We also particularly like Sun Belt-focused REITs in the apartment sector, which combine high growth, modest to cheap valuations, balance sheet strength, and high dividend safety.
If you haven’t added any Sun Belt exposure to your portfolio, consider the recent stock market pullback and higher volatility an opportunity to phase in to a long-term position either in one or several of the Apartment REITs mentioned.
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