Idea of the Week: Apartment REITs Offer Yield – and Upside Potential
For some investors, the temptation to respond to the three-and-a-half year long rally in REIT stocks by taking some profits off the table may be too strong to resist, but the potential for further gains in apartment/residential REITs in particular offer some powerful incentive to stay put.
Released: August 22 2012
Length: 3 Minutes
Ever since the stock market hit bottom in March 2009, returns on real estate investment trusts – more commonly known as REITs – have soundly beaten those on the S&P 500 index. In part, investors have been drawn to this group as a conservative way to gain access to securities that have equity-like characteristics, but some of the buying activity in REITs has come as those living on fixed incomes and other yield-hungry investors have been driven out of Treasuries. The yield on the two-year Treasury has plunged to unprecedented lows, sending these investors in quest of investors generating something more than a nominal yield.
For many, the answer has been REITs. Now, the question of whether the three and a half year-long rally is a reason to take profits off the table presents itself; it’s a logical question to ask after such a lengthy period of outperformance, the kind displayed in the chart below. (The chart plots the performance of one of the most popular REIT exchange-trade funds, the Vanguard REIT ETF (VNQ.N), in yellow, against the return on the S&P 500, plotted in black: the ETF’s total return, including dividend reinvestment, is an eye-popping 260%, while that of the S&P is only 120%.)
In light of that kind of track record, are REITS still an attractive investment? We believe that there’s a secular case to be made in favor of REIT securities, which continue to offer investors almost twice the yield than the 10-year Treasury note. That kind of yield is particularly attractive to those living on pensions, who need to take on more risk to generate higher income. Even in the wake of the gains in REITs, there remains a significant case for investors to hang on to REITs in general, which appear to be fairly priced and likely to continue beating the broader market. Within the REIT universe, it is possible to make a particularly compelling argument in favor of apartment/residential REITs, according to valuation analyses.
It is residential REITS – portrayed in blue in the chart below – for generating a healthy proportion of the returns on the VNQ REIT ETF. The housing crisis has helped to trigger a surge in the number of apartment rentals. The red line in the chart below shows that non-residential REITs have done well also, though somewhat less than residential REITs. Since mid-July, however, as the broader stock market began to rally amidst hopes for a third round of quantitative easing by the Federal Reserve. To some extent, that has made investors somewhat more interested in more aggressive asset classes. In recent weeks, apartment REITs have actually lagged; with the apartment vacancy rate standing at only 4.7% nationwide – the lowest level seen since 2001 – investors may be worried that momentum in the sector will falter, and that future growth will prove harder to come by.
The outperformance of this part of the REIT market may also be a concern for wary investors, fearful that big gains will be followed by declines. Adding the performance of REIT stocks like that of high-end apartment operator Avalon Bay Communities (AVB.N), displayed in green below, to the equation, has to beg the question of whether outperformers like this are now ready to take a back seat to some other part of the market. We argue that the reverse is true – for reasons that go well beyond the group’s attractive dividend yields.
At the heart of the bullish case for residential/apartment REITs is the plain fact that continued unemployment and under-employment of millions of Americans – combined in many cases with credit scores damaged either by the housing crisis or by prolonged joblessness – is forcing many former and would-be homeowners to continue to rent rather than buy a new property. Repairing damaged credit will take them years to complete, and, barring significant changes in newly-tightened lending standards, will prevent them from making a quick transition back to home ownership from renting.
Another factor contributing to the likelihood of apartment REITs continuing to outperform is Americans’ recently discovered desire for mobility. Many unemployed and underemployed homeowners are realizing that if they can’t sell their homes in a depressed market, they won’t be able to accept a job in another city. It’s likely that many of them – and others who have witnessed their plight – will be less willing to own homes (even if they qualify for mortgages) for this reason, as job uncertainty lingers. This is an unintended consequence of the financial crisis that may well fade, but not until several years of prosperity help people block out the experience of being on the wrong end of a troubled housing market. Flexibility and mobility, however, involve risks for tenants. T. Rowe Price calculated last year that the average lease term for an apartment stands at nine months – rather than the years often outstanding on a typical mortgage. That means if inflation rears its head, landlords will be able to raise their rents fairly quickly – more good news for owners of residential REITS, and a reason not to be concerned about the fact that the vacancy rate for residential apartments is at the lowest level in more than a decade. Even if there is less room for the vacancy rate to contract, there’s still room for investors to profit from those higher rents.
In that context, the rental market remains strong. The Market Tightness Index (published by the National Multi Housing Council) remains in territory that looks bullish for landlords and for apartment REIT investors, having remained above the level of 50 that indicates apartments are becoming harder for prospective tenants to find since April of 2010. Some consider this index a more reliable gauge of what is happening in the rental market than is the sometimes-criticized Housing Affordability Index, issued by the Bureau of Labor Statistics.
There is a final reason that apartment REITs seem to have staying power and that it may be too early to walk away from them, and that is valuation. Thomson Reuters StarMine looks at analyst estimates for apartment REIT stocks five years out and, separating the group’s funds from operations (or FFO, the equivalent of earnings for a REIT) from the FFO of all other REITs. We found analysts expect residential REITs to see five-year FFO growth of 8.2%, handily beating the 4.3% growth in forecast FFO in the same period for all non-residential REITs. More importantly, the market is currently pricing that five-year FFO growth for residential REITs as if it were only expected to be around 3%, five percentage points below analyst projections. Meanwhile, the market is pricing non-residential REITs at around 6%, above the analysts’ 4.3% estimate. If the analysts have it right, then residential REITs are underpriced and non-residential REITs are slightly overpriced – and that spells opportunity.
The bottom line? REITs may still be a reasonable investment when measured against the S&P 500. That means that owning or continuing to hold a play on the entire universe of REITs in the form of something like the Vanguard REIT ETF appears to be a decent play – especially once you compare its current yield (3.3%) to what you can earn from Treasuries. But if you want to go one step beyond owning a passive index, it’s clear that owning residential REITs likely will provide you with an edge, given their compelling valuations and even their ability to adjust for inflation in a short time frame.
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