While the struggles of mall REITs are no secret given Amazon’s increased dominance of the retail sector, real estate investors may also contemplate putting apartment REITs on their warning lists.
That’s because although apartment real estate investment trusts have done well this year — and since the end of the housing crisis, in general — rent growth is starting to slow.
To understand the current situation of multifamily rental housing, some recent history is necessary. In the lead-up to the housing crisis, homeownership in the U.S. rose from 64% to 69% at its peak in 2005 and 2006. But then, after the crisis, it started to collapse, and 5 million or so households that once owned homes (however briefly and tenuously) went back to renting. Homeownership is below 64% now.
To be sure, many single-family homes were converted to rentals, but many individuals and families who could no longer afford to own homes rented apartments. So the housing crash turned out to be a once-in-a-lifetime boon to apartment landlords.
Just as demand for rentals skyrocketed, the credit crisis caused residential building, including building multifamily structures, to collapse. At its nadir in 2009, housing starts for five-unit or more structures plummeted to 53,000. The average since 1959 is around 360,000, and, prior to the financial crisis, no downturn in housing had ever caused multifamily starts to run at an annual rate below 90,000. This combination of increased demand for apartments and lack of new supply caused rents to skyrocket from around 2011 to the present.
Increased demand and limited supply allowed apartment REITs AvalonBay Communities Inc. AVB, -1.31% Equity Residential EQR, -0.73% Camden Properties Trust CPT, -0.38% and Mid-America Apartment Communities Inc. MAA, -0.98% to raise rents 4% annually on so-called existing properties — that is, properties that had been in the portfolio the same quarter the year before. During this period the Consumer Price Index (CPI) and gross domestic product (GDP) ran at around 2%, while median household income stagnated. Our graphic shows Equity Residential’s results, and they’re similar to those of its competitors.
Rent increases slowing
The problem is for the past four or five quarters, the year-over-year rent increases have declined from the quarter before. Moreover, the first quarter showed that all the companies, except AvalonBay, raised rents over the first quarter of 2013 by less than 3%, the first time that’s happened for all of them since 2010. It’s likely that all the households squeezed out of owning during the crisis are back to renting, so apartment demand isn’t growing. Moreover, multifamily housing starts are up to their 55-year average, so supply is increasing.
Only AvalonBay managed to increase same-property rents by over 3% (3.1%, to be exact) in the first quarter of 2017. But a press release from June 6 shows the firm increased year-over-year rents in April and May by 2.6% and 2.5%, respectively. So now AvalonBay’s year-over-year same-property rent growth has dropped below the 3% line.
There’s nothing necessarily wrong with increasing rents at 2.5%, but it’s unclear the downward trend in rent increases will stop here. Rent increases, of course, could accelerate again. That’s what happened in mid- to late-2013 after increases slowed for a few quarters. But that was a time when new supply was lower than it is now.
Increased supply and decelerating rent increases mean investors in multifamily REITs have to contend with expensive valuations that may have depended on more prodigious rent increases. The big apartment REITs trade at an average of 21 times funds from operations (FFO), a REIT cash flow metric that adjusts net income for properties sold and depreciation. That’s a 5% cash flow yield before depreciation — not much if big rent growth is finished and if that yield doesn’t account for property upkeep.
|REIT||Ticker||Price/ FFO||Dividend yield|
|Equity Residential||EQR, -0.73%||21.4||2.94%|
|AvalonBay Communities Inc.||AVB, -1.31%||23.8||2.79%|
|Camden Property Trust||CPT, -0.38%||19.7||3.37%|
|Mid-America Apartment Communities Inc.||MAA, -0.98%||19.7||3.07%|
|Sources: Company filings, Morningstar|
I’ve skeptically watched apartment REITs raise rents at rates that outstrip inflation and GDP growth for more than seven years, and I’ve been wrong in warning investors away from them. But it finally looks like landlords can’t push rents much higher. Increasingly, it appears tenants have reached the limits of what they can pay.
It’s true that balance sheets are healthier than they were during the financial crisis, and companies can cover their dividends with current cash flow. Also, low bond yields, particularly on the 10-year Treasury, mean apartment REIT stock prices may have some support. But without such strong rent growth, it’s hard to imagine them surging higher. Apartment landlords may have enjoyed the run of a lifetime.