“Be fearful when others are greedy, and greedy when others are fearful” - Warren Buffet
To state the obvious, it has been an extremely challenging twelve-month period for the residential REIT sector of the market. Residential REITs, including apartments, manufactured housing and single-family rentals have returned -30.1% for the 1-year period through March 22, 2023.[1] This compares to a –23.2% return for the FTSE Nareit Equity REITs Index. The only sub-sector that has underperformed residential over this same period has been the office category, with a total return of -51.8%. While it is fair to ascertain that the apartment REIT sector had “gotten ahead of itself” going into the start of 2022 with much rental rate upside baked into the equation, we also believe that current valuations are reflective of an overly dour outlook for the group as most signs are leaning towards a reacceleration in demand and firming occupancy levels as we head into the critical spring/summer leasing season. Investors are rightfully cautious that pockets of excess multi-family deliveries could squelch momentum in several high beta markets in several sunbelt metros, however, much of this new supply is coming to market at rent levels well north of where many of our constituent landlords' price their product and in locations that are inferior to more established communities. We would also argue that while multifamily inventory levels are elevated and expected to peak in 2023, single-family construction is substantially below its historic trend and thus overall availability of housing units remains tight.
The recent upheaval in the banking sector has also added a layer of uncertainty to markets with some forecasters claiming that commercial real estate loans and commercial mortgage-backed securities (CMBS) with 2023 maturities are at a greater risk of default with borrowers struggling to refinance at higher interest rates and lenders being reluctant to extend maturities. We would concur that the rapid diminution in net operating income for several property sectors, primarily within the office and regional mall categories could cause market disruptions, we do not however believe that such an outcome will be rampant within rental housing given the solid underlying fundamentals of the industry and sustainable drivers of demand. We would anticipate that overly aggressive apartment developers may have trouble leasing up and stabilizing their properties at their projected rent levels, forcing them to align with well capitalized operators such as REITs to stave off creditors.
We recently published an analysis focused on the balance sheet strength of the top ten holdings of the Residential REIT Income ETF (HAUS), which constitute almost 68% of the fund. The constituent companies have a weighted average years to maturity on their debt of 8.1 years, a weighted average interest rate on all debt of 3.6% and average debt coverage to adjusted EBITDA of 5.2x. Also, only 20% of all debt is maturing through 2025, so these companies have minimal exposure to rolling over debt into a rising interest rate environment. Finally, 8 of the 10 constituents have investment grade credit ratings with a majority of their financing coming through the corporate bond market.
In recent weeks, we have received preliminary updates from many of our constituent companies and believe that in the aggregate, they provide a helpful roadmap for considering first quarter results and expectations for the upcoming leasing season which runs through late summer. One macro-economic perspective that rings true revolves around U.S. employment which has remained quite steady with only a modest uptick in unemployment over the past several quarters, a considerable victory given the sizeable layoff announcements that have been coming out of the technology sector. By way of example, initial unemployment claims edged down to 191,000 for the week ended March 18th from 192,000 in the prior week and continuing claims have been range bound since the start of the year. [2]
National apartment data from sources such as RealPage and Costar Group pointed to a flattening of demand for traditional apartments in the third and fourth quarters of 2022 as foot traffic and web searches moderated and this translated into a reduction in actual absorption for apartments. The moderation in fundamentals was most severe at the luxury end of the spectrum and where rental prices were the highest.[3] Several of our constituents reported occupancy declines of 50-100 basis points in 4Q22 but overall occupancy levels still ended the year above 95%, which can only be construed as healthy given leasing activity typically trends down heading into the yearend holiday season. Sunbelt apartment owner, Mid-America Apartments (MAA), announced an acceleration in rental rate growth for January and February which was above 4%, driven primarily by increases in renewal rates which approached 8%. The company is experiencing similar tailwinds for both new leases and renewals in the March/April period, which gives us a high degree of confidence that 1Q23 earnings will meet company and investor expectations.
UDR Inc. (UDR), which operates in both coastal and sunbelt markets is also noting an uptick in traffic since the start of the year and expects new lease growth to go from flat to the “mid-single digits” while renewal lease rates remain consistently high in the 7-8% range. UDR also believes that coastal markets including Boston and Washington D.C. will be standout performers in 2023 driven by a return of demand and only modest levels of new inventory being delivered.
For California centric companies, demand is finally on the upswing as the state has now recovered all the jobs that were lost during the pandemic. Essex Properties (ESS) reported that rent growth for January and February was 7.8% and they see good momentum going into the spring leasing season. As investors are aware, the California recovery has been impeded by eviction moratoriums in several important markets including Alameda County in the north and Los Angeles in southern California. While moratoriums in both locals have now come to an end, the damage has been severe as it relates to uncollected rent and delinquencies. By way of context, ESS reported delinquencies of 3.1% for January, and anticipates this number to be down to 2.0% for the full year 2023, higher in the first half of the year and trending down in the second half. Prior to the pandemic, ESS had a historic delinquency rate of 0.35 basis points, and they hope to get back to that level in the future.
Aside from supply, which we touched on earlier, the elephant in the room for the apartment sector and industry at large is operating expenses. The sector has done an admirable job of managing expenses through the course of the pandemic, but the added inflationary pressures in property taxes, insurance and wages has taken a toll over the past year and while 2023 levels will be elevated as well, there is evidence that these pressures will peak this year and begin to taper off into 2024. Several companies point out that property taxes, which have seen an exponential increase over the past two years, are “backward looking” and should hit a highwater mark in 2023. They also expect other large expense items to subside in the second half of 2023. One large item which unfortunately will not likely reverse in 2023 is property insurance. MAA is guiding to a 13% increase in 2023 with no anticipation of relief for 2024. Climate events such as floods, fires and hurricanes have made property insurance a major challenge and topic of discussion across the real estate industry.
While it is impossible to call a “bottom” in any market at any given time, we do observe that recent market commentary appears to be building towards a consensus view that the Federal Reserve’s aggressive stance on interest rates might be nearing completion and more prognosticators are now even speculating that the Federal Reserve could begin lowering the federal funds rate before the end of 2023. REITs have historically performed well during periods when Federal Reserve policy shifts from a more aggressive to less aggressive stance, so we will continue to watch this dynamic closely for [4] signs of an inflection point.
In terms of valuation metrics across the residential REIT universe, we would note that many of our constituents currently provide a dividend yield of approximately 4% and these dividends are well covered by operating cash flow. We would also point to earnings growth (funds from operations) expectations for the group that are in the 6-7% range for 2023. The sub-sector is also trading at an approximate –20% discount to net asset value (NAV) today and it has historically traded at a modest premium to NAV.[5]
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Footnotes:
[1] NAREIT: FTSE Nareit U.S. Real Estate Index Series Daily Returns (March 22, 2023)
[2] Evercore ISI: Another Low Reading For Unemployment Claims (March 23, 2023)
[3] Costar Group: Multifamily National Report (March 20, 2023)
[4] NAREIT: How Rising Interest Rates Have Effected REIT Performance (03/09/22) by Nicole Funari
[5] Citi Research: Weekly REIT and Lodging Strategy (March 16, 2023)
Definitions:
Weighted average years to maturity – the weighted average amount of time until the maturities on outstanding debt comes due. The higher the weighted average years until maturity, the longer it takes for debt to mature.
Operating cash flow - the amount of excess cash that a property or portfolio of properties generates after accounting for expenses. This is the money the business generates from its core operations.