Residential real estate can be an excellent way to generate both income and long-term growth, but being a landlord isn't for everyone.
Fortunately, there are several ways you can get exposure to housing without actually buying a property thanks to the stock market. Here's an overview of the different types of housing stocks you can invest in and what you should know about each one.
Why not invest in housing by buying property?
To be clear, investing in rental housing can be a great way to generate income and build wealth. In full disclosure, I own a few investment properties myself.
Having said that, buying investment properties isn't for everyone, and there are some good reasons you might want to invest in housing through stocks instead. Just to name a few of the most compelling reasons:
It takes a lot of money to buy a rental property. While it isn't required in every single case, the majority of lenders want at least 20% down when buying an investment property. And costs like origination fees tend to be higher. If you're buying a $200,000 investment property, you should plan on needing at least $50,000 to close.
Investment properties are time-consuming. You can hire a property manager to deal with the day-to-day operations, but looking for, evaluating, and actually buying a property can be a big drain on your time.
Rental housing is an illiquid type of investment. It can take months to sell a home unless you want to accept a low price.
As a rental property owner, you have to deal with vacancy risk, maintenance costs, and other uncertain expenses.
Why choose housing stocks instead?
In simple terms, investing in housing through stocks eliminates the major pain points of owning rental properties. Going through the four downsides to property ownership I mentioned in the last section:
With housing stocks, you can invest with far less capital than you'd need to buy a property. You can technically buy just one share of a stock, and with a few thousand dollars you could put your money to work in a few different housing stocks of your choosing.
There's a bit of research required to invest in stocks, but it's likely to be far less time-consuming than buying an investment property. I've done both and can tell you firsthand that there's no comparison -- investment properties involve a ton of work, and for an extended period of time. For example, last time I bought a rental property, I exchanged no less than 70 emails with my lender, had to drive to the property at least a dozen times before closing, and spent several hours in my real estate agent's office.
Stocks are perhaps the most liquid type of investment you can make. If you choose to sell a stock, you can typically do so with a simple click of the mouse. The sale will take a second or two (if that long), and it will take place at full market value.
You won't have to worry about the inner workings of the business if you buy a stock. If a property has maintenance issues, there's someone employed to deal with it.
Furthermore, investing in housing through stocks also helps diversify your investment strategy. Let's say that you buy a duplex as an investment property. If one of those units sits vacant for a few months, that's 50% of your potential income that you aren't collecting. On the other hand, if you buy a real estate investment trust that owns 50,000 apartment units, the effects of any specific vacancies are negligible.
The same concept applies to homebuilders -- if a homebuilder runs into a problem selling one of its homes, it's an issue. However, it's a far smaller issue than if you built one house with the intention of selling it and were unable to do so.
In other words, investing in housing stocks allows you to spread your money out among a collection of assets, not just a single property.
Types of "housing stocks" you can invest in
When it comes to investing in housing through stocks, there are three main ways you could go:
Homebuilders: The most obvious way to invest in housing is through the companies that build homes.
Residential REITs: There are many real estate investment trusts, or REITs, whose primary business function is acquiring or developing apartment buildings or single-family homes for the purpose of renting them out to generate income.
Housing-adjacent businesses: There are publicly traded companies with businesses that are related to housing, but aren't direct investments into housing. We'll get into these later, but examples include companies that sell construction supplies, as well as companies that help facilitate real estate transactions.
Investing in homebuilder stocks
As I mentioned, homebuilders are the most obvious way to invest in housing, so although it isn't my favorite way (that would be REITs, as you'll see in the next section), we'll briefly discuss it first. As the name implies, these are companies whose primary business activity involves building new homes and selling them for a profit.
There are a few factors that determine how well homebuilders perform. Most obviously, if the housing market is strong, it is a generally positive catalyst for homebuilders. And, it's important to mention that one area of the housing market can be stronger than others. For example, there could be a ton of demand for lower-priced housing at the same time that luxury home sales are lagging.
In addition, material costs are another factor. If the price of lumber spikes, for example, it could dramatically cut into homebuilders' profit margins.
Homebuilding is a capital-intensive business with relatively low profit margins, and it can be quite cyclical. So, as my colleague Tyler Crowe discussed in a recent article about homebuilder stocks, it's extremely important to identify homebuilders with significant advantages over the competition such as scale or strong management.
With that in mind, here are a couple of my favorite homebuilders you may want to consider:
NVR (NYSE: NVR) operates in some key metropolitan areas and has the unique aspect of not being a land developer, which is one of the most capital-intensive parts of homebuilding. The company obtains lot purchase agreements, which give it the right (but not the obligation) to buy a buildable lot -- only purchasing the land after a homebuyer agrees to purchase a home. This is an especially good quality to have during market downturns and allowed NVR to actually increase its market share during the 2008-09 housing crisis.
LGI Homes (NYSE: LGI) focuses on the "starter homes" portion of the market. It aims to capitalize on the need for lower-priced homes by building homes quickly and efficiently, and without much customization or upgrade choices.
Bigger players in the space that you may also want to take a look at include D.R. Horton (NYSE: DHI), KB Home (NYSE: KB), and Lennar (NYSE: LEN), just to name a few.
Residential REITs could be the best alternative to buying rental property
Another way to invest in housing is with real estate investment trusts, or REITs. This is a fundamentally different approach to investing in housing as compared with homebuilders, who are in the business of building a house, selling it, and moving on. Residential REITs are in the business of developing or acquiring properties, renting them out to generate income, and holding for long periods of time.
If you aren't familiar with REITs, here's a quick overview. As mentioned earlier, REITs own income-producing real estate assets. In order to be legally classified as a REIT, a company (among other requirements) must pay out at least 90% of its taxable income to shareholders. This is why REITs tend to have above-average dividend yields.
By paying out substantially all of its income, REITs avoid taxation on the corporate level, which can be a major benefit for investors. Most dividend stocks are effectively taxed twice on their profits -- once on the corporate level, and then again on the individual level when profits are paid out as dividends. This is an especially good benefit if you own REITs in tax-advantaged retirement accounts, as by doing so it's possible to defer or even avoid taxes on REIT profits entirely. If you're looking for stocks to buy in your IRA, REITs can be a great way to invest in housing.
In addition to income, REITs can have tremendous long-term growth potential as the value of the underlying properties increases over time. As you'll see by some of the long-term performance statistics I'll give in the coming sections, REITs have the ability to generate some pretty impressive total returns.
5 great residential REITs you can buy
There are a bunch of publicly traded residential REITs available to invest in. To give you a good idea of what's out there, here are five of the biggest and best-run residential REITs in a variety of specializations.
Type of Residential Properties
Equity Residential (NYSE: EQR)
Urban apartment communities
AvalonBay Communities (NYSE: AVB)
Urban apartment communities
Mid-America Apartments (NYSE: MAA)
Mid-range apartments in growing areas
American Campus Communities (NYSE: ACC)
Student-focused apartment communities
American Homes 4 Rent (NYSE: AMH)
Single-family rental properties
Equity Residential and AvalonBay: Two massive urban apartment REITs
The majority of residential REITs focus on apartment properties, including the largest residential REITs in the market. The two largest players in the space are Equity Residential and AvalonBay Communities, and they have rather similar strategies. Both focus on building larger apartment communities in high-barrier urban markets, and both prefer developing properties from the ground up as opposed to acquiring existing properties.
Equity Residential owns a little more than 300 apartment communities consisting of about 79,000 rentable units. The company focuses its efforts on six core markets -- Boston, New York City, D.C., Seattle, San Francisco, and Southern California. Not only are these high-cost markets, but they have limited supplies of rental housing and it's difficult for new competitors to enter these markets to compete. There are also strong demographics, such as a high concentration of millennial households, that favor renters over homeowners. The company also has an excellent track record of efficiently recycling capital -- that is, strategically selling assets with limited growth potential and reinvesting the proceeds in higher-growth opportunities.
AvalonBay Communities, as I mentioned, is quite similar to Equity Residential. It focuses on most of the same markets and is similar in size. One key difference is that AvalonBay has been far more active when it comes to developing new properties. During 2016 and 2017, for example, AvalonBay invested $2.4 billion in development -- roughly 12 times that of Equity. And AvalonBay sees lots of future opportunities in markets that it hasn't yet tapped into to a large extent, particularly Denver and South Florida.
Both companies have delivered fantastic returns for shareholders. AvalonBay has delivered annualized returns of nearly 14% in the 26 years since its 1993 IPO through July 2019, and Equity Residential produced 11.7% annualized returns during the same time period. Both were well ahead of the S&P 500.
Mid-America Apartments: A focus on higher-growth, lower-cost markets
Mid-America Apartments is another residential REIT, but unlike the two we've already discussed, Mid-America focuses on other areas of the U.S. with lots of growth potential. Most of the company's properties are concentrated in the Southeast, Southwest, and Mid-Atlantic regions, with large presences in Atlanta, Dallas, Charlotte, and Tampa, just to name a few major markets.
Because it specifically chooses to avoid the highest-cost markets, Mid-America's properties are at a lower price point than Equity or AvalonBay, a feature that the company believes gives it more growth potential as well as more downside protection during recessions and other difficult economic times. Like the first two REITs we discussed, Mid-America generated impressive performance through mid-2019, with 15.1% annualized total returns over the past two decades.
American Campus Communities: A play on the evolution of college housing
If you're looking for more of a niche play on housing, American Campus Communities could be a good one to consider. The company is a pioneer in student housing and is currently the only pure-play publicly traded REIT that focuses on it. In full disclosure, American Campus Communities is one of the largest stock positions in my own portfolio.
American Campus Communities has two main strategies -- off-campus housing communities it develops, owns, and manages, and on-campus communities that it develops in partnership with universities. The company targets markets where the average on-campus housing facility is more than 50 years old, which translates to a huge demand for student-focused communities with modern technology infrastructure, student-focused amenities, and desirable housing units.
The company's strategy has been quite successful so far. Same-store rents had grown for 58 consecutive quarters as of mid-2019, and the company's average fall occupancy rate was 97.5% -- higher than the overall U.S. apartment average. From its 2004 IPO to mid-2019, American Campus Communities produced a 427% total return for its investors, handily beating the S&P 500's 280% return during the same time period.
American Homes 4 Rent: Invest in single-family housing
As I mentioned, most residential REITs focus on various types of apartment communities, but there is one major REIT focused on single-family homes. As of mid-2019, American Homes 4 Rent owned about 53,000 homes in 22 states, and it aims to capitalize on the robust demand for single-family rental properties. The millennial generation is more inclined to rent than previous generations, and is currently entering the peak family forming years -- in other words, this group as a whole is starting to need more space than an apartment can offer, but isn't quite ready to take the leap into homeownership.
The youngest REIT in this discussion (IPO in 2013), American Homes 4 Rent has a big efficiency advantage over its competition, which mostly consists of small property management companies and independent landlords. In the company's target market, employment is growing faster than the national average, and as a result, so are market rental rates.
Third, there are some businesses that can benefit from a strong housing market, but don't directly build or own homes.
Real estate website businesses like Zillow (NASDAQ: Z) (NASDAQ: ZG) are good examples of this. Zillow makes its money through selling premium services to real estate agents as well as from ad sales to mortgage lenders, property managers, and other businesses. In 2017, Zillow added house buying and flipping to its business model, but this isn't nearly a primary business function.
Home supply businesses like Home Depot (NYSE: HD) and Lowe's (NYSE: LOW) are other housing-adjacent businesses, since they are a source of construction materials and can see a surge in business when home construction and renovation activities are strong.
Realogy (NYSE: RLGY) is another good example. This is the company that is behind many popular real estate sales brands, including Century 21, Coldwell Banker, Sotheby's International Realty, among others. Obviously, Realogy benefits from an active housing market.
Lots of passive ways to invest in housing
As you can see, there are several different ways to invest in housing through the stock market. Investors who want income would probably be well suited for residential REITs, while growth-oriented investors may want to consider homebuilders or some of the housing-adjacent businesses instead. When it comes to investing in housing stocks, there is truly something for everyone.
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Matthew Frankel, CFP owns shares of American Campus Communities. The Motley Fool owns shares of and recommends Zillow Group (A shares) and Zillow Group (C shares). The Motley Fool owns shares of American Campus Communities and NVR. The Motley Fool recommends Home Depot and Lowe's. The Motley Fool has a disclosure policy.