This REIT Sector Could Benefit From Ongoing Higher Interest Rates
Nothing lasts forever on Wall Street. Today's champion stocks are tomorrow's bums and vice versa. For investors, the conundrum is determining when the downtrodden stocks will turn around. Buying after a long price decline is risky because investors must distinguish between the proverbial "falling knife" that may continue to drop versus an opportunity to buy a quality stock that will appreciate nicely over time.
Sometimes it pays to watch for trends and gauge what should be the future direction of a sector. Real estate investment trusts (REITs) have been hammered since 2022 with interest rate increases. At the last Federal Open Markets Committee (FOMC) meeting, the Federal Reserve promised another hike in 2023 and spooked the markets by stating that higher rates may have to continue for a longer time. REITs sold off heavily after those comments.
But there is one REIT subsector — residential REITs — that could benefit from a prolonged higher interest rate cycle. Take a look at three residential REITs that could see strong earnings for some time to come.
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Mid-America Apartment Communities Inc. (NYSE:MAA) is a self-administered residential REIT that specializes in purchasing and leasing apartment complexes. It owns just under 102,000 units in 300 communities across 16 states and Washington, D.C. Most of Mid-America Apartment Communities' properties are in the Southeast, Southwest and Mid-Atlantic states.
Mid-America Apartment Communities is a member of the S&P 500 and has been a public company for 28 years. The Atlanta and Dallas areas comprise over 22% of its same-store net operating income.
American Homes 4 Rent (NYSE:AMH) is a Calabasas, California-based residential REIT that purchases, develops, renovates and leases existing and build-to-rent single-family homes. American Homes 4 Rent was created in 2012 and in 11 years has built a portfolio of more than 60,000 single-family units across 21 states. Its largest concentration of homes is in the Southeastern U.S., where population growth has been explosive. Its most recent occupancy rate was 96.5%.
Equity LifeStyle Properties Inc. (NYSE:ELS) is a Chicago-based residential REIT with a focus on manufactured home communities, RV resorts, marinas and campgrounds in North America. Equity LifeStyle owns 450 communities across 35 states and British Columbia. It was founded in 1992 and had its initial public offering (IPO) in 1993.
With single-family homes so expensive, manufactured homes remain an alternative for people who would love to buy a home but have a limited budget or down payment funds.
The following charts are from the National Association of Realtors' (NAR) August housing report. The first shows the total existing home sales in two-month intervals between August 2019 to August 2023. Note the downward trend since February 2022, when interest rates began climbing higher in anticipation of the Federal Reserve raising interest rates:
The next chart shows the median price of existing home sales over the same four-year time frame. Note that the general trend of prices has been higher, and despite a downturn last fall and winter, prices have risen again during 2023. This is surprising given that 30-year mortgage interest rates have been climbing and were recently at 7.48%, which is the highest interest rate since 2000.
Higher interest rates make pricier housing even more unaffordable and increase the likelihood that homeowners with 3% to 4% mortgage rates will remain in their homes rather than move into another home with a 7% mortgage rate. This keeps the housing supply levels tight and has contributed to the higher prices, despite the slowdown in sales.
So, when Fed Chairman Jerome Powell said there are more rate hikes to come and that high-interest rates would be of longer duration, the markets sold off, and REITs were especially hard hit. But the REITs cited above and other similar REITs could actually benefit as rental demand continues to be strong.
Single-family homes are particularly attractive to renters who prefer the space and privacy of a home but lack the down payment or cannot afford the principal, interest, taxes and insurance (PITI) needed to buy a home right now.
The two reasons the market has punished these residential REITs are:
A fear that increased construction of rental units will create too much supply.
Concerns that rents may now have peaked.
The same fears were in the market during the 2008-2011 period when many new construction rental units were being built because people were too afraid to buy homes, and yet demand and rents increased heavily over the next decade.
Another factor being overlooked by Wall Street is that the higher costs of new construction will necessitate higher rents in new apartments or single-family homes than rents in existing residential units. Materials and labor are much more expensive now than before 2020. Higher prices in newly constructed properties will keep demand high in the existing units and may even pull prices up in older units.
Rather than inflation, the greater risk to the residential REITs is another recession like the one that began in 2007. During recessions, many younger renters lose their jobs or are downsized, so they return to living with their parents or give up their leases to move in with roommates. The Fed maintains it is determined to have a soft landing rather than a tough recession from its policies.
Mid-America Apartments' second-quarter earnings were positive, with both funds from operations (FFO) and revenue increasing year-over-year and beating analysts' estimates. American Homes 4 Rent also beat estimates, improved earnings from the second quarter of 2022 and raised its full-year 2023 guidance. Equity Lifestyles' second-quarter FFO was in line with estimates, but revenue beat the estimates and was up year over year.
Investors may want to forget the noise coming out of Wall Street about rents having peaked and an over-supply of rental units. Residential REITs could prove to be one of the strongest REIT subsectors when the next round of earnings reports comes out in October.
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