Stop Hating Housing REITs

Summary

• 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.

Residential REITs

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.

Accounting

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.

Housing REITs

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.

The other two apartment REITs that qualified for a 2% increase in targets are Mid-America Apartment Communities (MAA) and UDR (UDR).

Manufactured Home Park REITs

We have a larger increase for (SUI) (+3%) compared to (ELS) (+1%) due to SUI’s effective use of marinas to stimulate further growth in FFO per share and NAV per share.

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.

Four REITs

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.

Conclusion

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.

Ratings:

• Bullish on AVB, ESS, ELS, SUI

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.

Comments

[madbeachman]

Curious if rising home prices is really boon for the housing REITs. Yes, it increases NAV, but since they are not liquidating that will has little impact. On the other hand:
1) Prices are up because more renters are buying in this ultra low rate environment. Leaving fewer renters in the market.
2) Taxes will go up with property values and since the homes not homestead, the annual increases are not capped.
3) Prices are too high for them to buy additional properties and rent them at a reasonable cap rate. This is their main path to growth - mostly cut off.

I would be curious on your take on these points.

[Colorado Wealth Management Fund]

@madbeachman
Great points for discussion.
1. This played out significantly over the prior quarters. The result of the prices rising is that it is more difficult for additional renters to switch, especially as mortgage rates increase.
2. Increases in property values are a headwind, but outside of the sunbelt markets, the value of apartment buildings hasn't rallied. It's been relatively flat. The quality of property tax assessors could certainly be suspect.
3. A large portion of revenue growth simply comes from gradual rent growth, rather than the addition of new properties. If the REITs are trading at a material discount to NAV and development is not wildly profitable (a good assessment of the last several months), then many of those REITs could simply use cash flows in excess of dividends to repurchase a few shares.

[btwulkan]

Thank you for the article. Following your recommendations I got into AVB and ESS last Fall in steps when they were ridiculously discounted. Obviously, I'm very happy with the buys. There's still a decent amount of negativity towards ESS due to its Cali and Seattle locations which I continue to believe is very offbase, and AVB just continues to rebound as reopening play. Long ESS and AVB.

[Colorado Wealth Management Fund]

@btwulkan Great choices. Those are two of our larger positions.

[Screen for Value]

Those AFFO multiples are a bit rich, aren’t they?

[Colorado Wealth Management Fund]

@Modern Value Investor Not bad. AFFO this year should still be depressed by the pandemic. Leases were prepared at lower rates. We should see some improvement in the second half of the year.

The MH parks were solid throughout, so that really applies to the apartments.

[Medusa's Head]

As a guy who probably does not have the personality type to deal with tenants, Housing REITs are definitely for me. Got in low on some names AVB, ESS, EQR, and UDR, but of course wishing I had bought more and added a few other names as well. Did get in on ELS and SUI last week as the values seemed reasonable, though I'll add more if given an opportunity. Thanks for the article.

[Signup22]

I picked up AVB last fall when it was heavily discounted, given the situation I thought it was back to full value with the price run-up.

This article and price target update were helpful, I will have to give thought to adding more.

[NJ Publish]

Amy thoughts on REZ ETF? I like it vs the risk of individual REITS.

[Hunt4cheapREITs]

good article - With markets getting shaky stable income REITs in the housing space look like very good choices. better inflation protection than in net lease. much less risky than office or malls.

[ikswo123]

Good choices, I picked up most of these at 4% yields late last year but lightened up after they all shot up in the reopening trade. A great way to enter into these positions now is through selling cash secured puts at prices you would not mind owning them at. Current example, with AVB at 177.65, write a Dec 2021 170 put option for approx. $15, securing it with 155 in cash as well as the $15 in premium.

If they stock stays above 170, you have made 15/155= 9.67% in 9 months. If it goes below 170, you own it but your net cost is $155. Not bad for 9 months work. You can also roll over the put to a later date and get more premium, etc etc. I'm keeping it simple just for discussion purposes, please learn a lot more about options mathematics before trying any options trade...be careful out there!

[A Serious Man]

What worries me most about the housing reits is never ending eviction moratorium. At least in CA, there are plans to extend it into 2022.

[Colorado Wealth Management Fund]

@A Serious Man Rent collections for ESS (83% of NOI from California) remain very strong.

[Dividend Sleuth]

From CPT's 2/23/21 statement: "...the Company expects to incur less than $1.0 million in expenses during the first quarter of 2021 related to the recent winter storms and freeze damage in Texas."

[Colorado Wealth Management Fund]

@Dividend Sleuth A good sign, though we still can't be certain about the impacts to the local economy. The wording can be a bit tricky as well, since cap-ex is technically not an "expense" (it is a capitalized investment on the balance sheet which later flows through depreciation). I don't think the management of CPT would play those words games, as they seem to appreciate clarity and transparency. However, I remain concerned about the impact this storm is having on many consumers (including renters and potential renters) utility bills. An impact to renters leads to an impact to rent.

[Dividend Sleuth]

@Colorado Wealth Management Fund, yes, vigilance is in order. In their Q4 2020 earnings call, CPT said natural disasters globally in the past year would drive insurance costs up for everyone.

[Buyside Guy, CFA]

@Dividend Sleuth Respectfully, I don't see insurance rates as a big driver for the sector.
From properties that I look at, insurance costs are a low % of rents. I doubt it will meaningfully impact the bottom line but i guess its possible and all depends on level of coverage/location (in risk area)/etc. If we think that insurance is 3% of rents, then a 20% increase in rents might impact NOI by 60bps on a 50% NOI margin (?). These are all ballpark #'s and I think my estimate above for insurance is high. Vacancy and progression of rents in $ are what mostly matters.

Finally, no REIT that I know of has a competitive advantage in insurance, so over the next two years, this increase will be felt by all REITS and eventually be recaptured by rents.

[Russell A]

Isn't another great point about these picks is that they should do well in an inflationary environment (especially compared to all other REITs)?

[Colorado Wealth Management Fund]

@Russella1221 Potentially, it depends on which areas really have "inflation". If rent is enjoying inflation, then it is great for landlords.

[Buyside Guy, CFA]

Rents roll over every year (in general) vs other areas of CRE where rents can be longer term in nature.

[Allocation Alpha]

that's not how power bills work in Texas... should be no impact to CPT from that

[Colorado Wealth Management Fund]

@Allocation Alpha Perhaps I'm wrong. It's happened before in my life. Would you like to highlight precisely where you see a flaw?

I was under the impression that Texans still had utility expenses. Google confirms that Texans have high utility bills following the storms. Perhaps you would specify precisely where you see a mistake?

[Allocation Alpha]

@Colorado Wealth Management Fund CPT has a mandatory technology package that includes TV/internet, but not power or water. Renters contract their own power in most of the state (hence the small subset of variable rate plans with extremely high bills you may have read about), or use the local utility in the remainder (Austin). So tenants are not charged a flat rate for power by CPT nor are costs are passed through to renters by CPT: it is option C, none of the above, renters pay power company directly. A call to a CPT property in Texas should confirm this.

finance.yahoo.com/...

[Colorado Wealth Management Fund]

@Allocation Alpha That sounds clear. No issues with that explanation, thank you. As you say, the renters pay the power company directly. So if the renters were impacted by enormous power bills, it would reduce their savings on hand (potentially negative) reducing their ability to afford rent increases.

This is a general "macro" level impact of wealth being drained out of some tenants and potential tenants. The impact wouldn't be huge from only a portion of the population being impacted, yet it would still drain resources out of the local economy that could have been used for rent. That could lead to leasing spreads being weaker than they otherwise would be for that city, though it would be hard to determine the precise level of the impact.

This is clearly less of a concern than if CPT were required to be a middle man, where they would be exposed to a far more significant potential loss, as opposed to simply facing a weaker leasing market (compared to a no-storm scenario).

[The Rutledge Group]

Didn't I just read this article last month, and the month before, and before then?

[Colorado Wealth Management Fund]

@The Rutledge Group Couldn't have been. The latest developments in this piece had not occurred at that point.

[User 9072361]

I sold my CPT, Dec 2020. I still hold EQR and buying little as it comes to support or trend lines. I liked EQR fundamentals better.

[ski2nite]

My theory is we are going into rapidly increasing period of inflation, similar to 1974 to 1979. It seems to me that companies with allot of debt will not perform well

[Announcer]

@ski2nite In inflationary times, borrowers benefit by paying back loans with dollars that have less real value. It is lenders who lose out, because they get repaid in depreciated money.

[sbally4]

Do you think we've already seen the bottom for apartment REITS (ESS) or we'll see it later this year after the eviction moratoriums expire?

[Colorado Wealth Management Fund]

@sbally4 My view is strongly that the bottom is behind us. At least for all the high quality ones (not over leveraged). I think they are unlikely to set and prices below their pandemic lows in at least the next several years. Granted, the are substantially higher than those lows already.

[Aiki Investor]

Thank you. I just learned about housing REITs. A new investment area to explore.

[Colorado Wealth Management Fund]

@Aiki Investor You're welcome. Happy to share.

[oldBUTcool4]

Solid article - these are intriguing here and I used last weeks interest rate panic to start positions in these names.

Honestly though with interest rates still so low, why the heck don't they use more leverage? maybe not 80% but come on 30% is just so low.

I don't see what the downside is for AMH/INVH. Prices are cheap vs. house value and trend is our friend. How do you lose?

[Colorado Wealth Management Fund]

@oldBUTcool4 If rates jump higher, asset values fall. That's one risk. It would benefit their income on a cash flow basis, but they would need to lock up that financing for 10 to 30 years.

Look at the way prices plunged in March. I want my REITs to be in a position to repurchase shares when that happens.

Those highly leveraged REITs may end up issuing equity instead. Not to mention cutting dividends to zero. Have to seen the way investors rage when the dividend is suspended?

Is it really worth taking on so much leverage when it creates the chance for those severe negative events? For me, such risk just isn't worth it.

[drdsch]

There is some repetition in these articles, and for me that's helpful and valuable. Examples are discussion of "net" leverage analysis in residential REITs;
FMV ratio analysis of debt/equity in eREITs and BV metrics in mREITS;
and perhaps most importantly the concept of relative spread and relationship between T-yields vs. cap rates.
Repetition is not a bad thing. This stuff does not get boring. It's hard to get the concepts into your head but it's important to keep trying.

[Colorado Wealth Management Fund]

@drdsch Thank you. It took me time to learn about the value of repeating these aspects. They are so central to the process that we need to ensure readers remember them. Especially when so many other sources are providing bad information.

[Medusa's Head]

@drdsch Agreed, I like the repetition as well. It can take a while before certain concepts "click" and if you already understand it, you can skip sections easily.

[SeriousGoldBUG]

Very timely piece - I agree with basically everything you have said here Colorado - really enjoy your thoughtful pieces. I've lightened up on my EQR/AVB shares because they have run so hard since the vaccine announcement. I bought some INVH this past week as it sold off. Most people don't think of REITs like gold (I like gold!!) but I like apartment REITs and housing REITs as dividend paying protection from inflation.

My old co-worker sent me this piece on INVH - the writer thinks it is worth $35 or more. www.privateeyecapital.com/... IDK if it is worth that much tbh but I don't see how you lose at this price and like I said there should be inflation protection.

Here are my nitpicks of INVH/AMH:

- i wish they disclosed NAV - unlike the apartment REITs, it is harder to work out what NAV is for these companies - i mean there are 80 thousand homes! They could help investors by publishing NAV estimates - NXRT does this.
- Frankly 30% LTV is ridiculously low for this type of company. I benefit from inflation if I have fixed rate debt and my asset appreciates. But these guys don't seem to understand it.

Despite these small criticisms I will be buying a few more shares of INVH and ELS too. Maybe SUI - IDK.

[private market guy]

@SeriousGoldBUG Kudos to Colorado for pretty much crushing it on the apartment REITs. That blog also has been spot on - takes a private market approach (as opposed to equity market metrics like P/FFO, P/AFFO, etc).

@colorado how do you think about what the right level of debt is for a given REIT?
Thanks!

[Colorado Wealth Management Fund]

@private market guy I like really low debt levels for equity REITs. I like to see debt to total asset value (using fair market value) at 30% or below (even going as low as 15% in some cases). By 50% I consider the REIT severely over leveraged.

With higher debt levels the interest rate on debt is higher to compensate the debt holder for additional risk. Further, in those scenarios we are more likely to see them issuing equity near a bottom rather than buying it back. Consequently, there are multiple long term factors that enhance the low-leverage approach, particularly in the public markets.

Research shows that REITs which regularly trade at a premium to NAV (which is also more common with lower leverage) tend to deliver higher levels of long-term returns. That's not surprising since they can issue equity at a premium, further driving AFFO per share growth.

[Colorado Wealth Management Fund]

@SeriousGoldBUG I like that site also. Author does good work. I think his NAV estimates tend to be higher than mine. Nothing wrong with that though. Good research won't always come to the exact same numbers.

I would like to see the apartment REITs and single family REITs disclose NAV also. I think it is often a good move.