Renter Nation Is Alive And Well

Summary

• "Renter Nation" is alive and well. Apartment REITs reported reaccelerating rent growth in 2019, as robust employment and wage gains have powered growth in both renter and owner household formations.
• Millennial-led gains in the homeownership rate did not come at the expense of the rental markets. Apartment occupancy rates remain near record highs, while turnover rates dipped to new record lows.
• Jobs, jobs, jobs. Apartment REITs returned 26% in 2019 and are off to a hot start in 2020, as the employment outlook remains resilient. Sunbelt markets performed particularly well last year.
• Renters actually enjoyed a brief reprieve from rising rents over the prior two years as landlords competed to fill a record number of newly completed high-end apartment units.
• The 2010s will be remembered as a decade of historic underbuilding. Despite a US population nearly double the size of the 1960s, the US produced 30% fewer housing units.
• This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

REIT Rankings: Apartments

In our REIT Rankings series, we introduce and update readers to each of the residential and commercial real estate sectors. We focus on sector-level fundamentals, analyzing supply and demand conditions and macroeconomic factors driving underlying performance. We update these reports quarterly with a breakdown and analysis of the most recent earnings results.

(Hoya Capital, Co-produced with Brad Thomas through iREIT on Alpha)

Apartment REIT Sector Overview

Within the Hoya Capital Apartment REIT Index, we track the twelve largest apartment REITs, which account for roughly $140 billion in market value and more than 500,000 total housing units: Equity Residential (EQR), AvalonBay Communities (AVB), Essex Property Trust (ESS), Mid-America Apartment Communities (MAA), UDR, Inc. (UDR), Camden Property Trust (CPT), AIMCO (AIV), Independence Realty Trust (IRT), NexPoint Residential Trust (NXRT), Investors Real Estate Trust (IRET), Preferred Apartment Communities (APTS), and Bluerock Residential Growth REIT (BRG). Apartment REITs comprise 10-14% of the broad-based "Core" REIT ETFs.

Apartment REITs also comprise 10% of the Hoya Capital Housing Index, the housing industry benchmark that tracks the GDP-weighted performance of the US housing sector. 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 U.S. Bureau of Labor Statistics.

The $4-5 trillion US multifamily apartment market is highly fragmented, with REITs owning roughly 500,000 of the estimated 25 million multifamily rental units across the US, which is roughly 2% of the existing rental apartment stock. Multifamily rentals comprise roughly 15% of the total housing stock in the US - in aggregate valued at $30 trillion - but have accounted for a greater share of new home construction activity in the post-recession period. Apartment REIT portfolios are skewed towards the upper end of the rent spectrum, but many of the larger REITs focus on coastal markets that are more at risk of an unfriendly regulatory environment for real estate owners.

The 2010s will be remembered as a decade of historic underbuilding. Despite a US population nearly double the size of the 1960s, the US produced 30% fewer housing units. Undersupply of housing has been the driving force behind rising housing costs, and overregulation at the local, state, and national levels have been at the root of the growing housing shortage, which has led to persistent housing inflation. The regulatory cost and timeline of constructing new housing units have substantially increased over the last two decades, and we continue to believe that easing impediments to supply growth is the optimal policy method to reduce housing cost burdens over time.

From an investment perspective, apartment demand is driven primarily by demographics, employment growth, and wage gains. Apartment REITs tend to pay relatively modest dividend yields compared to other REIT sectors but are seen as somewhat counter-cyclical, while also providing inflation protection due to the short lease terms of multifamily rental units. Over the last decade, apartment REITs have become far more active developers and have been able to create significant shareholder value through "capital recycling," a strategy of selling assets of lesser strategic value to fund development and acquisitions of higher-value properties.

A common feature among residential real estate sectors, apartment REITs are among the most operationally "efficient" real estate sectors, commanding a relatively low operating and overhead expense profile and requiring fairly minimal ongoing capital expenditures. Property tax is the largest single expense item for apartment owners and is one of the few line items expected to see consistent above-inflation growth over the next decade. As we'll discuss more below, apartment REITs have benefited from extremely favorable millennial-led demographic trends over the last decade, but we anticipate that demographics will become a mild headwind in the 2020s.

Apartment REIT Stock Performance

As discussed in our Real Estate Decade in Review, at the real estate sector level, three themes dominated the 2010s: 1) The Housing Shortage, 2) The Retail Apocalypse, and 3) The Internet Revolution. Four of the five best-performing real estate sectors over the decade were on the residential side, as the positive tailwinds of the affordable housing shortage continue to provide a favorable macroeconomic backdrop for rental operators and homebuilders alike. Apartment REITs returned more than 26% in 2019, which slightly trailed the FTSE NAREIT All Equity REIT Index, which gained 29%, which was the second-best year of the decade.

Apartment REITs are off to a hot start so far in 2020, as the employment outlook remains resilient. The US economy recorded positive employment growth for a record-extending 112th consecutive month in January, precipitated by a return of previously discouraged workers back into the labor force. As we'll discuss below, strong 4Q19 earnings have helped to push the sector to gains of 6.5% through the first month and a half of 2020, outperforming the 5.8% gains from the Vanguard Real Estate ETF (VNQ) and the 4.8% gains from the S&P 500 (SPY).

Diving deeper into the company-level performance, the Sunbelt-focused REITs were solid outperformers in 2019, led by 42% gains from Mid-America and strong returns from small-cap REITs Independence Realty Trust and Investors Real Estate Trust. Ten of the twelve apartment REITs are higher by at least 5% so far this year. Preferred Apartment Communities, however, is down by nearly 12% after the externally managed REIT detailed a plan to internalize the functions performed by its manager and submanager by acquiring the entities that own the manager and the submanager for $154 million, a price that many shareholders viewed as excessive.

Apartment REIT Fundamentals

"Renter Nation" is alive and well. Apartment REITs reported reaccelerating rent growth and steady occupancy in 2019 as robust employment and wage gains offset record levels of supply growth in the high-end multifamily category. As we've been forecasting since late 2018, following a slowdown in rent growth over the preceding two years, apartment REITs delivered impressive performance in 2019 that came in far above initial guidance. Same-store operating metrics were stellar across the board, as NOI growth jumped 3.9% in 4Q19, the strongest rate of growth since 2016. Record-low turnover - which fell another 100 basis points in 2019 - has been an unexpected, but much-welcomed, tailwind which has kept expense growth in check.

Leasing metrics - arguably the most important of the statistics reported - were generally in line with expectations. The seasonally slow winter quarter saw blended lease rates rise 2.4%, which was roughly in line with last year. As we tell our renter friends, if you're willing to move around, you're bound to get a good deal. Rent growth continues to be powered by strong renewal rates, while rents on new leases remain flat as many REIT markets continue to deal with elevated levels of supply growth. While we expect to see a similarly solid year of rent growth in 2020 powered by real income growth, we think that the recent upward reacceleration to rent growth is moderating.

Full-year NOI growth averaged 3.6% for these seven REITs, a nice uptick from the 2.5% rate in 2019 and above initial guidance of below 3.0%. It's all about job growth and wage gains, and the Sunbelt continues to deliver with growth above the national averages. Sunbelt apartment outperformance was the theme in 2019, and we expect more of the same in 2020. Four of the seven apartment REITs - ESS, MAA, CPT, and AIV - reported same-store revenue and NOI growth that came in above prior guidance. The larger coastal REITs - EQR, AVB, and UDR - reported slightly softer-than-expected core results, however.

Guidance for 2020 calls for a slight deceleration in revenue and NOI growth to 3.0% and 3.1%, respectively, but we see these forecasts as being on the conservative side. Considering the recent trends in rental rates, we project 2020 will see growth rates matching that of 2019, with same-store NOI rising 3.5%. Looking at the sector on a more granular level, as we get later into the current economic cycle, the variance in fundamentals between markets has become less pronounced, as there has been a convergence towards supply/demand equilibrium. All seven REITs are projecting same-store revenue growth within a 120-basis point spread of 2.7-3.8%.

Diving even deeper, we note the rent growth of the top 60 markets, according to the Zillow ZRI data below. While Zillow's data is prone to large revisions and volatility, it has historically been a decent leading indicator of directional trends in national and regional rent growth. Essentially, every city in the US is reporting positive rent growth as of December 2019, which was certainly not the case at this time last year. Milwaukee, San Diego, Phoenix, Cincinnati, and Riverside topped the charts in September, while Omaha, Buffalo, Oklahoma City, Cleveland, and San Jose lagged. The top-8 REIT markets by asset value are San Francisco, Los Angeles, Washington, D.C., New York, Seattle, Boston, San Diego, and Houston.

Capital Markets and External Growth

Apartment REITs are beginning to get back to doing what they do best: utilizing their access to equity capital markets - one of their primary competitive advantages over private market peers - to accretively grow via external acquisitions. The "REIT Rejuvenation" of 2019 - through the positive impact on REIT's cost of capital - allowed these apartment REITs to kick-start the acquisition channel which had sat idle since the end of 2016. While we're still waiting on the final numbers for NAREIT, 2019 will almost surely go down as the biggest year for net acquisitions since 2014.

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 and recycle assets that are less strategically valuable. Acquisitions have historically accounted for a sizable percentage of total FFO growth per share across the REIT sector. In part because of the improved cost of capital conditions, along with the reacceleration in core same-store fundamentals, six of the seven REITs reported an acceleration in Core FFO growth in 2019. After rising 5.1% in 2019 - the best since 2016 - these REITs are projecting 5.5% FFO growth in 2020, which is towards the top of the REIT sector.

As it has for much of the past half-decade, supply growth remains a headwind for the apartment REIT sector. Before this year, renters enjoyed a brief reprieve from rising rents over the prior two years as landlords competed to fill a record number of newly completed apartment units, particularly in the high-end luxury category. The relative "boom" in multifamily construction that began in 2014 continued into 2019, but deliveries appeared to have peaked for this cycle during the summer of 2018 at a TTM rate of roughly 365k units. Deliveries will likely remain elevated, however, hovering around a range of 330k-350k through the end of 2020, which amounts to roughly 1.5% per year annual supply growth.

Development yields are an important indicator of future new supply, and low yields should be expected to prevent marginal projects from breaking ground. Contrary to a central contention of many rent control and "Not In My Backyard" advocates, real estate development isn't as lucrative as critics believe, confirmed by rather modest development yields achieved by these REITs - yields that are rather meager on a risk-adjusted basis. As we point out below, same-store NOI growth from these apartment REITs has been closely linked with a swelling development pipeline. Higher construction costs, moderating asset price appreciation, and moderating fundamentals made new incremental development less attractive over the past several years, but many developers continue to see positive value-creation spreads.

The Bull and Bear Thesis for Apartment REITs

Demand for apartment units is a function of four primary factors: household formations, job growth, income growth, and the propensity to rent versus own. Despite a global economic slowdown this year, the US labor markets have remained remarkably resilient. Wage growth has accelerated from a peak of around 2% in 2016 to more than 3% over the past two years, and real wage growth has been even more impressive, no doubt helped by the deflationary forces inherent with slowing growth outside the US. The strong jobs market powered the best two years for household formations in a generation in 2018 and 2019, with growth averaging nearly 2.0%.

This acceleration in household formations, a phenomenon that we expect to continue into the 2020s given the demographic wave of millennials entering their late 20s and early 30s, has come at a time of significant and lingering undersupply in the housing markets. Meanwhile, elevated student loan debt burdens, the effects of tax reform on reducing the incentives of homeownership, and a "rent-by choice" lifestyle preference have made this demographic more likely to rent apartments further along into their family and career paths. Below, we outline the five reasons that investors are bullish on apartment REITs.

While demographic trends have been very favorable over the last decade, they will become a headwind by the end of the next one. Almost 100% of the incremental growth in household formations has gone towards the ownership markets since 2017, but total household growth has kept the vacancy rate of rental households near historic lows. A generation that we dub the "HW Bush Babies" - those born between 1989 and 1993 - is the largest 5-year age cohort in the United States. This abnormally large age cohort, the oldest of which are now entering their 30s, is likely to transition towards the single-family markets with greater frequency over the decade.

Additionally, political risk has become an unavoidable potential headwind for the apartment REIT sector. The dirtiest words in real estate - "rent control" became a focus in 2019 after Oregon and California became the first states to enact state-wide rent control laws this year. Despite overwhelming economic evidence, including the consensus of 95% of economists, that rent control laws do more harm than good for renters, the policy that has been called the "bad idea that doesn't go away" has made a political comeback this decade, championed by several leading Democratic candidates. Below, we discuss the five reasons why investors are bearish on apartment REITs.

Valuation of Apartment REITs

Apartment REITs appear fairly valued across the metrics that we track. The sector trades at a slight Free Cash Flow premium (aka AFFO, FAD, CAD) to the REIT average, and after accounting for medium-term growth rates, apartment REITs trade at attractive valuations relative to the REIT average on the FCF/Growth metric, a metric similar to a PEG ratio. As discussed, apartment REITs now trade at a modest 5-10% NAV premium, which should help to fuel external growth this year following several years of challenging conditions.

Apartment REIT Dividend Yields

Based on dividend yield, apartment REITs rank towards the bottom of the sector, paying out an average yield of 2.8% compared to the REIT sector average of 3.4%. Apartment REITs pay out just around 60% 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.

Relatively expensive and lower-yielding may not be the worst qualities for a REIT sector, however. In our recent report, "The REIT Paradox: Cheap REITs Stay Cheap", we discussed our study that showed that lower-yielding REITs in faster-growing property sectors with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding counterparts. Three of the five small-cap REITs pay a dividend yield at or above 4%, but also tend to pay a higher percentage of free cash flows towards the dividend and have significantly higher debt burdens than the seven larger apartments REITs.

Conclusions: Renter Nation Is Alive And Well

Jobs, jobs, jobs. Apartment REITs returned 26% in 2019 and are off to a hot start in 2020, as the employment outlook remains resilient. Sunbelt markets performed particularly well last year. "Renter Nation" is alive and well, however. Apartment REITs reported reaccelerating rent growth in 2019, as robust employment and wage gains have powered growth in both renter and owner household formations. Millennial-led gains in the homeownership rate did not come at the expense of the rental markets. Apartment occupancy rates remain near record highs, while turnover rates dipped to new record lows, as illustrated in our chart below which was featured in the WSJ's Daily Shot.

We remain bullish on residential REITs, noting that the combination of historically low housing supply and solid demographics and employment-driven household formations continues to provide a compelling macroeconomic backdrop for companies involved across the US housing industry - both on the rental and the ownership side - over the next decade and beyond. While we like broad-based exposure across the entire housing industry, within the apartment REIT sector, we prefer the Sunbelt-focused REITs where jobs remain plentiful and demographics are an especially powerful tailwind.

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