- Investors show remarkably little interest in housing REITs.
- Housing REITs offer some material advantages over direct investment in the real estate.
- Currently, many housing REITs still trade at a discount to the net value of their assets.
- The REITs also benefit from strong economies of scale. We have fewer picks today than we did a few months ago, but some good options remain.
- The recent rally didn't take us by surprise here. We frequently highlighted the residential REITs over the last year.
- I do much more than just articles at The REIT Forum: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »
This research report was produced with assistance from Hoya Capital Real Estate.
We recently went through some price target updates for the housing REITs. The adjustments were pretty small. Generally, 1% to 3%. We didn't need to swing targets, because we didn't undervalue the housing REITs in prior months.
Apartment REITs have generally provided very reasonable returns for investors and manufactured home parks have been outstanding. The premise for reasonable returns for apartment REITs is quite simple. Over a long time period, the performance should be roughly correlated with the performance of the underlying real estate.
Some investors simply don't like housing REITs because they prefer to own individual properties with mortgages running around 70% to 80% of the total property value. If everything works out, those mortgage properties provide modest cash flow (after recurring capital expenditures) and provide intense capital appreciation due to the leverage.
You won't find that in many of the housing REITs. There are a few that run high on leverage, but many of them are much more conservative. That's positive in our view, because we don't want to take on that high level of risk. We would prefer to see the debt being equal to less than 30% of the fair market value of the assets.
When we talk about the fair market value of assets, we often have a reader ask about the high level of debt relative to "equity" under GAAP. When we are dealing with equity REITs, properties don't "appreciate" under GAAP. If you owned a building with a historical cost of $100 million and have accumulated depreciation of $30 million, it will show up as $70 million for the "asset." Consequently, if you had $40 million of debt on that property, investors would see $70 million of "assets" tied to $40 million of debt and leaving only $30 million of "equity."
That's the rule even if the property is worth $200 million today. In that case, you might have a property worth $200 million and $40 million in debt, so the debt would only be equal to 20% of the fair market value of the property.
Consequently, investors often misunderstand leverage in this area.
If we are dealing with mortgage REITs, the book value of the assets (recorded under GAAP) is usually going to be a very good estimate for the value as of the end of the last period. However, for equity REITs, the book value under GAAP may dramatically understate the fair value of the assets.
We’re happy with the overall range for relative price targets on the apartment REITs. However, the positive leasing momentum referenced on earnings calls encourages us to lift targets slightly. We’re going with 2% across the apartment REIT sector. For most analysts, the gateway apartment REITs like (AVB), (EQR), and (ESS) may get the biggest gains. Why? Because they rallied further over the last few months.
We correctly predicted that they were severely undervalued several months ago, so the earnings calls were confirming our thesis. Turning to Camden Property Trust (CPT), we think the storm in Texas (CPT’s largest market) may be underrated by many analysts.
If tenants are charged a flat rate for utilities, the spiking utility bills would hurt AFFO per share. If costs are passed through to renters throughout the market, it would weaken consumer spending in other areas (like rent). Further, the unusual storm may drive elevated recurring capital expenditures for CPT. Since our targets for CPT on some metrics (like price to NAV) are already lower than peers, we included them in the 2% increase to targets. However, we would remain cautious about the potential for a terrible Q1 2021 earnings call.
Manufactured Home Park REITs
We don't cover UMH Properties (UMH) on a regular basis. It offers a higher yield than SUI and ELS, but investors miss out on superior growth. We find the difference in growth (reflected in Analyst AFFO per share and share price) to be more than worth the difference in dividend yields.
Single-Family Rental REITs
Targets are going up for (AMH) (+3%) and (INVH) (+2%) to reflect appreciation in single-family homes. Appreciation for single-family homes over the last year surpassed our expectations. While the reopening of the economy matters more for the apartment REITs than the single-family rental REITs, we need to adjust for the appreciation in the underlying property.
Throughout the housing REITs, rising mortgage rates are a substantial positive factor for rental rates. We believe the market often underestimates this impact. Rising Treasury yields can cause investors to believe REITs should decline and that cap rates on properties should increase. In practice, we find the spread between cap rates on properties and Treasuries can change significantly. Consequently, we see the increasing mortgage costs for buyers as a significant positive factor for housing REIT rental rates.
We're going to condense this into sharing our top 4 picks for the housing REITs today:
Source: The REIT Forum
Source: The REIT Forum
We see each of these REITs remaining attractive. AFFO per share multiples generally remain reasonable while the apartment REIT values for AFFO per share are still suffering from the weaker leasing spreads seen over the prior few quarters.
Commentary on the earnings call indicates that the situation is improving substantially for gateway apartment REITs like AVB and ESS. Leasing momentum is improving (Q1 looking better than Q4 2020) and the results could turn positive over the next few quarters. That is in line with our initial estimates, potentially slightly ahead, as we called for the results (metrics like AFFO per share and Same Property Net Operating Income) to bottom out by the end of 2021.
While apartment REITs are getting through the bottom and should begin trending positive on comparisons again, the manufactured home park REITs simply continued to deliver strong performance.
Even throughout the pandemic, they put in a pretty solid performance and they are looking for another year of healthy growth in AFFO per share.
Apartment REITs offer investors an efficient way to gain exposure to residential real estate. Our preferred picks are a combination of apartment REITs and manufactured home parks.
The MH parks trade at higher multiples of AFFO per share, but also performed much better during the pandemic. They should be seen as high-quality choices that tend to deliver growth year after year.
The apartment REITs trade at slightly lower multiples of AFFO per share, though still significant. The AFFO per share values should hit a bottom in 2021 (for some it may have been 2020). From there we should expect significant growth as improvements in the leasing environment translate into higher revenue, improved same-property NOI, and growth in AFFO per share.
- Bullish on AVB, ESS, ELS, SUI
This article was written by
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Analyst’s Disclosure: I am/we are long ELS, SUI, AVB, ESS, EQR. 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.
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