2023-06-20 03:08:04 ET
Summary
- Housing supply constraints and high borrowing costs are pricing many potential buyers out of the single-family market, leading to increased demand for rental properties.
- Apartment REITs, particularly those exposed to growing markets, are well-positioned to benefit from this supply-demand imbalance and pass value along to investors.
- Investors can gain exposure to this opportunity through individual apartment REITs or ETFs focused on residential real estate, such as the Residential REIT ETF.
Housing supply is constrained and that is not likely to improve for the foreseeable future. In part, this is a function of evolving demographics colliding with monetary policy. The Millennial generation now outnumbers the Baby Boomers, and many are in the age range where they are ready to form new households, start families, etc. This trend is large and powerful and should not be underestimated.
Monetary policy has been tightening for nearly a year and a half as the Fed has raised interest rates and shrunk its balance sheet. The money supply in the U.S., measured by M2, has been declining, with recent months seeing the fastest declines ever recorded. Of course, this is counterbalanced by the spike in money supply growth experienced during the pandemic.
Typically, a shrinking money supply would have the opposite effect of a growing money supply. That is, falling consumer goods prices and inflation, falling equity prices and asset values in general. While this might end up being true for many parts of the economy, one area that might buck the trend is apartment REITs.
During the pandemic, the housing market took off, fueled by easy money/low interest rates, and a desire to leave city centers in exchange for more space. Great. The result of the increased demand for housing was an increase in price as housing supply failed to keep pace. The lack of new supply wasn’t only a pandemic issue, although volatile lumber availability and prices combined with labor shortages didn’t help. Supply has been constrained since the Global Financial Crisis of 2008-09. For more than a decade, the housing industry has not built enough housing to keep up with growing population, household formation, and scrappage. So, when demand spiked during the pandemic, so did prices.
Higher demand resulted in a much more competitive housing market for consumers. The average inventory in most markets plummeted. These dynamics caused some potential buyers to be priced out while others struggled to have a bid accepted by a seller. This created a strong sellers’ market, that despite rising mortgage rates, largely still exists now.
In a way, the Fed may be inadvertently painting housing into a corner – higher housing costs for consumers and higher capital costs for builders. In response to the broader inflation experienced in the economy the Fed raised its target for the Federal Funds rate, effectively pushing benchmark interest rates higher economy wide. However, despite higher interest rates and the resulting higher mortgage payments, house prices have not experienced any meaningful declines. This results in individuals and families facing a supply constrained market with high prices and high borrowing costs. For many, this is not feasible, making renting the only option. We see this growing rental demand in the form of falling vacancy rates since the GFC as many never fully recovered from that crisis or have changed their perspective on housing completely.
The rental market has not been immune from these distortions. Reduced money supply and higher interest rates means that borrowing costs are higher for builders as well. This has a direct impact on available supply for both single-family homes and multi-family apartment buildings. Fortunately, there has been above trend construction of multi-family real estate. The increase in this construction can also be traced back to the GFC.
Despite this increased supply in apartments, demand has grown quicker, resulting in upward pressure on rental rates. The chart below shows an estimate for the year-over-year change in rent in the U.S. Although it appears to have peaked, it remains at an elevated level, far above both overall inflation and wage growth.
Portfolio Strategy
There are many ways for investors to benefit from this supply-demand imbalance, but the direct path would be to own apartment REITs.
Investors can look to purchase individual companies that are focused on apartments while avoiding other property types. While some industrial and retail properties remain strong, avoiding office-heavy REITs, particularly those with a coastal geographic focus, is probably a good idea for now.
There are several ETFs dedicated to residential real estate, and a few that focus almost exclusively on apartment communities. Unfortunately, these ETFs are thinly traded.
For example, the Residential REIT ETF ( HAUS ), managed by Toroso Investments and Armada ETF Advisors, typically trades 500-5,000 shares daily, although the average is probably around 1,000. The fund has a very small AUM of only about $4.25 million. That said, the underlying portfolio is a concentrated mix of apartment-focused REITs that are more liquid. With about 27 holdings in the fund, the top 10 represent about 70% of total value. The top three holdings, AvalonBay Communities ( AVB ), Equity Residential ( EQR ), and American Homes 4 Rent ( AMH ) represent about 28% of the fund value and each trade hundreds of thousands or millions of shares daily. American Homes 4 Rent differs from the other in that it focuses on single-family houses as rental properties.
The Nuveen Short-Term REIT ETF ( NURE ) also has a significant apartment exposure in its 37 position portfolio, but does hold REITs exposed to self-storage, hotels, and other rental properties. The objective of NURE is to focus on assets with short-term leases. The thesis here is that short-term leases turnover more frequently, allowing them to reset at current market rates and reducing overall sensitivity to changes in interest rates. Given that the bias at this time is likely toward neutral monetary policy, this approach may not be as advantageous if rates were to decline.
Considering the available options, I would suggest constructing a basket of individual apartment REITs or using HAUS. HAUS is more concentrated and more focused on apartments, making it more aligned with this investment thesis. Although the low AUM and trading volume are a consideration, it provides direct exposure to the target underlying companies.
To construct a basket of individual names, I would simply replicate what is held in HAUS by purchasing positions in the top five names. To make this approach more passive, I suggest purchasing the names in equal weight.
Recent Performance
Performance across the REIT space has been underwhelming over the last year as rising interest rates have created a headwind for the industry. Given the continued decline in inflation and the Fed’s recent pause, it is reasonable to expect the Fed to maintain a more neutral stance on rates. If the level of rates combined with shrinking money supply result in meaningful damage to the economy in the form of negative economic growth and/or rising unemployment, it is reasonable to expect a reversal in Fed policy toward easing. Regardless, monetary policy is unlikely to tighten much more from this point, eliminating the headwind recently faced by REITs.
On a total return basis, both REIT ETFs discussed above have significantly underperformed the S&P 500 over the last year. The largest holdings in HAUS have fared better, but still trailed the broader market meaningfully. Moving forward, however, long-term investors in any of these positions should benefit from the trends discussed above as well as the continued growth in distributions to shareholders. Many of these companies are growing dividends well above the rate of inflation, allowing long-term investors to increase their portfolio cash flow in real terms.
Risks
This thesis and the suggested strategies to capture its value have numerous risks. While it seems as though interest rates will level out where they are, that is not a guarantee. Despite leaving the Fed Funds rate unchanged at its most recent meeting, the Fed could change course and continue its tightening strategy.
If interest rates were to continue higher, or if there were some exogenous shock, it is not unreasonable to expect a possible economic slowdown in the foreseeable future. Many analysts and financial pundits have been warning about an impending recession for more than a year. While that has yet to come to fruition, there is a possibility of that happening this year or next.
While evolving demographics won’t change, preferences can and do change often. We are more mobile than at any other time in this country’s history, and this geographic mobility could result in people leaving currently popular and growing areas for new ones. While this seems like a remote possibility at this time, the future is unknown. Few would have predicted the spike in real estate demand in Idaho prior to the pandemic.
The real estate business uses a lot of leverage to generate returns. We have already mentioned the sensitivity to rates in terms of building new supply or consumers' ability to borrow. But the use of leverage creates an inherent risk in any business and exposes the business to potential financial mismanagement. The names listed above, and the others held in the funds are generally run by experienced and conservative management teams, mitigating this risk.
This list of potential risks is not exhaustive and should be considered a starting point in assessing this type of investment.
Final Thoughts
The rise in housing costs is unfortunate for many households. The constrained supply and high borrowing costs price many out of the single-family market, resulting in more renters overall. We have seen steady growth in household formation while single-family construction remains insufficient. Although multi-family construction picked up following the GFC, vacancy rates have fallen and rents have steadily increased. This creates an opportunity for property owners to benefit in both the short and long run. Large incumbent apartment REITs, particularly those exposed to growing markets, are well-positioned to capture this value and pass it along to investors. While some may argue that this isn’t “right”, it is our current reality and shouldn’t be ignored. No matter what the economic picture looks like there are always opportunities for those that are prepared and willing to risk their capital. I believe this to be one such opportunity. Like with any suggestions I make, this one should be considered within the broader context of strategic asset allocations as well as personal needs and constraints. Any overweight or underweight positions need to be considered carefully to understand the impact on long-term total returns. Thank you for reading. I look forward to seeing your feedback and comments below.
For further details see:
Apartment REITs: Gain From Housing Market Imbalances