3 Residential REITs to Consider Despite Industry Challenges

·9 min read

The REIT And Equity Trust - Residential Industry constituents are expected to bear the brunt of macroeconomic uncertainties in the near term. Elevated deliveries, the lack of rental relief payments and regulatory issues are expected to add to the woes. High real estate taxes and insurance costs are likely to add to cost pressures. A hike in interest rates to counter inflation poses a risk to the flow of capital for this asset category. Also, interest expenses are expected to climb with rate hikes.

Nevertheless, residential REITs like AvalonBay Communities, Inc. AVB, Mid-America Apartment Communities, Inc. MAA and Elme Communities ELME are poised to benefit. Renting apartment units is a viable option as mortgage rates are high and the transition from renter to homeowner is difficult with the high costs of homeownership. Also, residential REITs are banking on technology and organizational capabilities to drive innovation, rent growth and improve the efficiency of their operating platforms.

About the Industry

The Zacks REIT And Equity Trust - Residential category is engaged in owning, developing and managing a variety of residences. The types of residences include apartment buildings, student housing, manufactured homes and single-family homes. Residential REITs rent spaces in these properties to tenants and earn rental income in return. Markedly, some residential REITs focus on specific classes or types of residences, or a particular geographical region. Moreover, unlike apartment buildings, manufactured homes and single-family homes that are open for leasing to all, the student housing units are leased only to students. Such real estates are, therefore, generally required to be set up within or in places closer to colleges and universities. Furthermore, the enrolment growth of educational institutes is a major driver of student housing assets.

What's Shaping the REIT and Equity Trust - Residential Industry's Future?

Macroeconomic Uncertainties: The residential REIT industry constituents face headwinds from a softening of the economy in the current year. A slowing economy is likely to cast a pall on leasing activity, and affect rental rate growth and occupancy level. The impacts of the slowdown are likely to be more profound in case of a slowing economy during the peak leasing season than later in the year.

Elevated Deliveries of New Units: While supply-chain issues and labor challenges have impacted construction activity to some extent in the past quarters, deliveries of new units are likely to accelerate in a number of markets in the upcoming quarters, as the ongoing construction activity remains high, resulting in a struggle on the part of landlords to lure renters. The elevated new supply is likely to weigh on rental rates and the occupancy level of residential REITs’ properties.

Lack of Rental Relief Payments and Cost Pressure: Growth in revenues of residential REITs is likely to be affected by bad debt, given the lack of rental relief payments in 2023. Moreover, amid an inflationary environment, residential REITs are facing higher cost pressure, with utilities, payroll, and repair and maintenance costs remaining elevated. Adding to the woes are property taxes and insurance, which are not only high but also volatile. Given the frequency and severity of several disasters over the past couple of years, there is greater pressure on insurance rates. Also, for real estate taxes, municipal fiscal pressures are driving the growth rate.

Complicated Regulatory Environment: With growing focus by state and local, and in certain cases federal and governmental authorities, the regulatory environment for rental housing continues to be complex. Particularly, the rent-control regulations in some of the major markets might curb the growth tempo. In recent years, there has been an increase in states and municipalities implementing or considering rent-control or rent-stabilization laws and regulations. This is limiting the residential REITs’ power to raise rents or charge non-rent fees.

Higher Interest Rates: The hike in interest rates to counter inflation poses a risk to the flow of capital for this asset category. This is likely to lead to volatility in asset prices. Also, interest expenses are expected to climb with rate hikes. However, mortgage rates are high, and with the high cost of homeownership, the transition from renter to homeowner is difficult, making renting apartment units a viable option.

Technology Adoption: Technological adoption gathered steam amid the social-distancing trend. Residential REITs are combining technology with sales and service expertise, aiming at driving revenues, trimming costs, improving operating margins, and enhancing customer experience. The REITs are focusing on virtual leasing assistance, virtual and self-guided tours, digital move-in processes, and process enhancements. Improvements in search and tour bookings, as well as smart home access, have gained much attention, and residential REITs are focusing on the same. Such efforts aim to generate incremental net operating income in the years ahead.

Rebound in Demand for Student Housing Properties: There has been a significant rebound in demand for student housing properties on the reopening of campuses and in-person classes, as well as extracurricular activities, driving leasing activity and rent growth. Rent growth hit another high in the Fall 2023 pre-leasing season, per a RealPage report.

Zacks Industry Rank Indicates Bleak Prospects

The REIT And Equity Trust - Residential industry is housed within the broader Finance sector. It carries a Zacks Industry Rank #161, which places it at the bottom 35% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates dull near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of the downward funds from operations (FFO) per share outlook for the constituent companies in aggregate. Looking at the aggregate FFO per share estimate revisions, it appears that analysts are losing confidence in this group’s growth potential. Over the past year, the industry’s FFO per share estimates for 2023 and 2024 have moved down 6.1% and 1.5%, respectively.

However, before we present a few stocks that you might want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Industry Lags on Stock Market Performance

The Zacks REIT And Equity Trust - Residential industry has underperformed the broader Zacks Finance sector and the S&P 500 composite over the past year.

The industry has declined 28.5% during this period compared with the S&P 500’s fall of 12.6% and the broader Finance sector’s dip of 15.4%.

One-Year Price Performance

Industry's Current Valuation

On the basis of the forward 12-month price-to-FFO (funds from operations) ratio, which is a commonly-used multiple for valuing Residential REITs, we see that the industry is currently trading at 15.94X compared with the S&P 500’s forward 12-month price-to-earnings (P/E) of 15.99X. The industry is trading above the Finance sector’s forward 12-month P/E of 12.88X. This is shown in the chart below.

Forward 12-Month Price-to-FFO (P/FFO) Ratio

Over the last five years, the industry has traded as high as 25.48X and as low as 15.15X, with a median of 18.96X.

3 Residential REIT Stocks Trying to Survive Industry Challenges

Elme Communities is a multi-family real estate investment trust that owns and operates apartment homes principally in the Washington, DC, metro and the Sunbelt regions.

The REIT’s portfolio allocation to the Washington metro offers insulation from employment loss. Also, its mid-level rents offer protection from new supply woes.

Elme Communities currently carries a Zacks Rank of 2 (Buy). The Zacks Consensus Estimate for the current-year FFO per share of 99 cents suggests a 12.5% year-over-year increase, backed by 11.4% growth in revenues. The company’s shares have gained 0.8% in the past three months.

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

AvalonBay Communities primarily focuses on developing, redeveloping, acquiring and managing apartment communities in the leading metropolitan areas in New England, the New York/New Jersey Metro area, the Mid-Atlantic, the Pacific Northwest, and Northern and Southern California, as well as in its expansion markets of Raleigh-Durham and Charlotte, NC; Southeast Florida; Dallas and Austin, TX; and Denver, CO.

AvalonBay Communities is poised to benefit from high-quality assets in the premium markets, and portfolio diversification among the urban and suburban markets. In its first-quarter 2023 operating update, AvalonBay Communities reported a 10.5% increase in same-store residential rental revenues for the two months ended Feb 28, 2023, compared with the prior-year period. This is in sync with the company’s initial expectation, which was published on Feb 8, 2023.

AVB reported that the economic occupancy for its same-store residential communities improved to 96.2% in February from 95.8% in January 2023. The like-term effective rent change for same-store residential communities improved to 4.2% in February from 3.7% in January.

AvalonBay Communities currently carries a Zacks Rank #3 (Hold). The Zacks Consensus Estimate for its ongoing-year FFO per share has been revised marginally upward in the past week. The company’s shares have appreciated 4.8% in the past three months.

Mid-America Apartment Communities is headquartered in Germantown, TN, and is commonly known as MAA. This residential REIT is engaged in owning, managing, acquiring, developing and redeveloping quality apartment communities, mainly in the Southeast, Southwest and Mid-Atlantic regions of the United States.

Mid-America Apartment Communities’ well-diversified Sunbelt-focused portfolio is set to gain from healthy operating fundamentals and a strong development pipeline. The favorable in-migration trends of jobs and households in SunBelt submarkets are likely to fuel demand. We expect strong rent growth and stable occupancy to drive revenues, going forward. The prospects of its redevelopment program and progress in technology measures are likely to expand margins. Its solid balance sheet acts as a tailwind.

MAA currently has a Zacks Rank #3. The recent trend in estimate revision indicates a favorable outlook for MAA. Particularly, the Zacks Consensus Estimate for 2023 FFO per share has been revised marginally upward over the past month to $9.17. The company’s shares have declined 2.9% in the past three months.

Note: Funds from operations (FFO) is a widely used metric to gauge the performance of REITs rather than net income as it indicates cash flow from their operations. FFO is obtained after adding depreciation and amortization to earnings and subtracting the gains on sales.

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