The U.S. residential REIT industry’s growth in rent is slowing and there is no near-term respite in sight.
Per the latest report from the real estate technology and analytics firm RealPage, with several markets experiencing flat rents, U.S. apartment rents increased at an annual pace of just 2.3% as of mid-2018, denoting its slowest pace in eight years. While a mid-2018 occupancy level of 95.0% is still healthy, the deceleration in rent growth suggests that a competitive leasing environment is fast building up, and curbing landlords’ pricing power.
Even though solid job growth in recent months indicates more household formations and raises expectations of a revival of the U.S. residential real estate market fundamentals, the struggle to lure renters will quite obviously continue in the upcoming quarters, when much of new supply is likely to come on course.
According to the RealPage report, the “annual pace of completions” has climbed above the 300,000-unit level for four consecutive quarters. Further, through mid-2019, annual deliveries will keep adding on to the flow with around 300,000 units. So the stressed environment is anticipated to continue in the near term and curtail residential landlords' ability to command more rents and affect concession levels.
Moreover, the student housing sector, which is part of the residential REIT industry, is lately experiencing a slowdown in leasing velocity and compression in rent growth amid demand supply imbalances. Specifically, properties away from campus are feeling the brunt.
Industry Lags in Terms of Shareholder Returns
Looking at shareholder returns over the past year, it appears that the broader economic recovery wasn’t enough for enhancing investors’ confidence in the industry’s growth prospect. Elevated supply affected the performance of residential REITs over the past several quarters.
The REIT and Equity Trust - Residential Industry, which is a group within the broader Zacks Finance Sector, has underperformed both the S&P 500 and its own sector over the past year.
While the stocks in this industry have collectively lost 3.9%, the Zacks S&P 500 Composite and Zacks Finance Sector have rallied 12.1% and 4.0%, respectively.
One-Year Price Performance
Residential REIT Stocks Trading Cheap
For REITs, price-to-FFO (funds from operations) multiple is a common measure for valuation. This is because 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. This is done because although per GAAP accounting norms, REITs are required to depreciate their investment properties over time, in reality many properties experience value appreciation over time.
So, to offset that impact, depreciation and amortization are added back. Moreover, gains on sales of property are subtracted since such sales are considered nonrecurring in nature.
Thanks to the underperformance of the industry over the past year, the valuation looks really cheap. The industry currently has a trailing 12-month P/FFO of 18.31. When compared with the highest level of 20.63 and median level of 19.18 over the past year, there is plenty of upside left.
The space also looks inexpensive when compared with the market at large as the trailing 12-month P/E ratio for the S&P 500 is 20.08 and the median level is 20.17.
Underperformance May Continue Due to Bleak FFO per Share Outlook
Solid job growth in recent months indicates more household formations and raises expectations of still-healthy apartment market occupancy despite high deliveries in the near term. Also, shortage in construction labor and rising expenses might somewhat impede the growth momentum of supply.
But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. While the earlier valuation discussion shows that there is a solid value-oriented path ahead, one should not really consider the current price levels as good entry points unless there are convincing reasons to predict a rebound in the near term.
One reliable measure that can help investors understand the industry’s prospects for a solid price performance going forward is the industry's FFO per share outlook. FFO per share revisions trend for the constituent companies usually influences their stock market performance.
The Price & Consensus chart for the industry shows the market's evolving bottom-up FFO per share expectations and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus FFO per share expectations for 2019, while the light blue line represents the same for 2018.
Price and Consensus: Zacks REIT-Equity Trust – Residential industry
This becomes even clearer if we focus on the aggregate bottom-up FFO per share revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.
Please note that the $2.71 FFO per share estimate for the industry for 2018 is not the actual bottom-up dollar FFO per share estimate for every company in the REIT - Equity Trust - Residential industry, but rather an illustrative aggregate created by our proprietary analytics model. The key factor to keep in mind is not the FFO per share of the industry for 2018, but how this value has evolved recently.
Current Fiscal Year FFO Per Share Estimate Revisions
As you can see here, the $2.71 FFO per share estimate for 2018 is down from $2.73 at the end of May and $2.75 at the end of the month prior to that and $2.94 this time last year. Looking at the aggregate FFO per share estimate revisions, it appears that analysts are losing confidence in this group’s FFO per share potential.
Zacks Industry Rank Indicates Cloudy Prospects
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.
The Zacks REIT and Equity Trust – Residential industry currently carries a Zacks Industry Rank #183, which places it at the bottom 28% of more than 250 Zacks industries. 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.
Revenue Trend of Residential REITs Shows Some Promise
While the near-term prospects look unwelcoming for investors, the uptrend in revenues over the past years appears promising. This might support long-term growth in FFO per share.
Finally, in the present demand-supply scenario, a deceleration of fundamentals is anticipated. Therefore, pressure on new lease rates, occupancy as well as retention would persist, while concession activity to lure renters is expected to remain high.
Moreover, for REITs, rate hike remains the biggest near-term challenge as the use of leverage for REIT business makes the returns from this industry susceptible to interest rate movements. Also, the dividend payout itself might become less attractive than the yields on fixed income and money-market accounts. Although, the short-term nature of lease for residential REITs usually helps in adjusting rents quickly to any rate hike, the current lower pricing power is likely to erode some of that benefit.
Now it’s time for investors to consider portfolio reshuffling and stay away from some stocks from the said industry, which are unlikely to bounce back in the near term. Among these are:
(You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.)
Apartment Investment & Management Co. (AIV): The stock of this Denver, CO-based residential REIT, which is better known as Aimco, has lost 4.2% of its value over the past six months. The Zacks Consensus Estimate for the current-year FFO per share has been revised 1.6% downward over the last 60 days.
Price and Consensus: AIV
American Campus Communities Inc. (ACC): The consensus FFO per share estimate for this Austin, TX-based student housing REIT has moved 1.7% lower for the current year, over the last 90 days. The stock has declined 11% over the past year.
Price and Consensus: ACC
American Homes 4 Rent (AMH): The stock of this Agoura Hills, CA-residential REIT has declined 1.2% over the past year. The consensus FFO per share estimate for the current year has been revised 3.5% downward over the last 90 days.
Price and Consensus: AMH
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