I understand the attractiveness of high-yield stocks. However, sometimes investors are so blind to everything else that they miss incredible growth.
The apartment REIT sector carries lower than average dividend yields but much better than average dividend growth. Growth in dividends is driven primarily by rising rental rates, but several REITs also retain part of their AFFO (adjusted funds from operations) to develop new apartment buildings or enhance existing properties. They should be included in most dividend growth portfolios.
Apartment REITs combine with single-family rental REITs (known as SFRs) and Manufactured Housing Park REITs (known as MH Parks) to create the “Housing” REITs.
Suggested Sector Allocation Table
It is critical to point out that the sector allocation ranges for the entire subsector, not for an individual stock. Further, the chart above only pertains to equity REITs.
The Apartment REITs
The REITs in this sector are:
AvalonBay Communities, Inc.
Camden Property Trust
Essex Property Trust, Inc.
Mid-America Apartment Communities, Inc.
Apartment Investment and Management Company
NexPoint Residential Trust, Inc.
Independence Realty Trust, Inc.
American Campus Communities, Inc.
The “big 7” are the first 7 in the table: AVB, EQR, CPT, ESS, MAA, UDR, and AIV
Note: prices are from original publications to subscribers in December 2019
Below we have our ratings and several figures on each REIT in the sector. These tables come from the Common Shares Spreadsheet, also known as the REIT Industry Tracker. The first chart shows our ratings, dividend yields, growth expectations, and multiples:
The next table shows our price targets, suggested maximum allocations, and the dividend growth history:
Note: EQR appears to have a dividend cut in 2016. This is a technicality. EQR spun off a large chunk of their portfolio and paid a huge special dividend to shareholders. If shareholders reinvested that one special dividend, they would’ve seen significant growth in their total dividends from the position.
Equity REIT Terms
We use several terms when talking about equity REITs. It helps us communicate if we have the same definitions. Consequently, we put together charts to help investors understand several equity REIT terms:
To fit everything into one nice image, we had to use short terms with no definition. In the chart below, you’ll see definitions for each of those terms:
If you still have any questions about the terms, please feel free to ask in the comments (or in REIT Forum chat for subscribers).
The following table summarizes the risk ratings for REITs with an assigned risk rating:
Our risk ratings run from 1 to 6. However, 6 is very rarely used. You’ll mostly see ratings from 1 to 5. We believe buy-and-hold investors should focus on shares rated 1 or 2, with the occasional 3 or 3.5 for a small position if their risk tolerance allows. Shares rated 4 or above are seen as significantly riskier than their peers. We think high-risk shares should only be used for trading opportunities. The buy-and-hold portion of any portfolio should be built around the lower-risk securities.
Investors often look at the dividend yield. However, they should also care about the portion of FFO and AFFO that is retained. Using the yield table, you can easily compare those values:
You may notice that the difference in dividend yields doesn’t necessarily reflect a difference in FFO yields or AFFO yields.
The Payout Ratios chart gives investors another way to visualize the information from the prior chart. Now we are contrasting the dividend yield with the consensus analyst forecasts for FFO and AFFO:
Sometimes analysts can be wrong and occasionally the consensus estimate will be off. However, this is a fairly good predictor for where the values should land. We use the median estimate, rather than the average. Using the median removes the potential for one absurd estimate to push the average up or down.
Few investors talk in terms of an “Earnings Yield” or an “AFFO Yield”. Instead, investors are more familiar with using a P/E ratio. A P/E ratio divides the price by the expected earnings. For REITs, the equivalent is a P/FFO ratio or a P/AFFO ratio. We divide the share price by the estimated FFO or AFFO per share:
When investors chart returns on a stock, they are generally picking a starting date and an ending date. This is how all investors learn to read charts. We have a superior option. By using the $100k Chart, investors can have hundreds of potential starting dates to evaluate how shares have moved over time. In the chart below, you can see how much an investor needed to invest (with dividends reinvested) on any prior date to reach $100k today:
We prepared a full guide for the $100k chart. The full guide goes into much greater detail on how to read the tool.
The $100k chart supports our ratings here and is a useful metric for comparing similar REITs. We can see that ESS recently dipped and MAA outperformed significantly. Those two factors go hand in hand. MAA is unique for their lack of exposure to California. ESS, on the other hand, only invests on the west coast (mainly Seattle + California).
MAA’s lack of exposure to California is done by design. It was a deliberate move by management to make the REIT more appealing to investors who wanted to diversify their geography. Since all the major peers had California in their portfolio, MAA offers investors a unique way to modify their total exposure. That’s great, but the price is too high.
MAA trades at 20.4x normalized FFO forecasts for 2019. For years they traded at lower multiples than their peers because their portfolio is in lower-cost markets. We would expect that trend to resume at some point.
Since we purchased shares on 5/18/2018 they delivered a total return of 54%. Investors with huge taxable gains on their shares of MAA may choose to just hold them forever. We see them as overpriced relative to their peers following their run higher, but they are still a good REIT with very solid dividend growth prospects. Investors who want to hold them forever can just plan to keep collecting dividends and ignore price fluctuations, at least until the next buying opportunity occurs.
Key Traits for Each REIT
Each REIT is at least slightly unique. We put together brief summaries. These summaries should provide a quick overview.
AVB has excellent management with expertise in developing new properties and an impeccable balance sheet. Both AVB and EQR have high-quality portfolios focused on coastal markets with a high cost of living and a very strong correlation in returns. When the right prices are available, this is a great fit for most buy-and-hold portfolios due to the strong balance sheet, solid management, covered dividend, and regular growth.
EQR has a history of being friendly to shareholders by selling off properties and creating special dividends when the market is undervaluing shares. Because the special dividends are funded by asset sales, the regular dividend may be reduced afterward. Investors who reinvest the special dividend would’ve seen substantial growth in total payments. Both AVB and EQR have high-quality portfolios focused on coastal markets with a high cost of living and a very strong correlation in returns. When the right prices are available, this is a great fit for most buy-and-hold portfolios due to the strong balance sheet, solid management, covered dividend, and regular growth.
CPT has regularly scored well on all metrics except for usually being a little too expensive relative to peers. The portfolio contains newer buildings and focuses on the southern states. You won’t find Seattle, New York, or Boston in this portfolio, which makes them stand out. The emphasis on Texas and Florida could be particularly appealing to investors who expect more baby boomers to gravitate towards warmer low-tax states since an influx of boomers would drive up house prices. Overhead expenses are very reasonable compared to most REITs but don’t have quite the same scale as AVB, EQR, or ESS.
ESS has the vast majority of features investors want in a REIT. They have a track record of 25 consecutive years of increasing dividends per share, excellent management taking lower pay, and solid rent growth year after year. Their portfolio is exclusively on the West Coast, so investors would be wise to pair ESS with other apartment REITs for a more diversified total exposure. We expect dividend growth to continue indefinitely due to solid coverage (providing protection from recessions) and regular rent increases.
MAA often carries the highest dividend yield and the lowest FFO multiple. We don’t expect either of those factors to change as they both reflect key aspects of MAA’s portfolio. MAA targets non-gateway cities and avoids California (the opposite of ESS). Their properties usually trade at higher capitalization rates, implying more net operating income relative to the fair value of the assets. Over the long term, we expect slightly lower average rent growth, but the higher yield on the properties makes up for it. MAA is an excellent apartment REIT to include for both diversification and yield.
UDR targets slightly lower quality apartments than AVB or EQR, but still allocates heavily to several of the same markets. That can create some diversification benefits if investors expect renters to “trade down” during the next recession. However, their very strong share price performance leaves shares with lower dividend yield and less upside. UDR is a good apartment REIT, but it shouldn’t carry the same multiple as ESS.
AIV carries more risk than the rest of the “big 7” apartment REITs because their leverage is regularly higher than peers. Management has been more than competent and funded some developments through issuing operating units at NAV (net asset value), which is usually materially higher than the share price. That is an excellent technique for growth because it enables the REIT to expand while having a lower cost of capital. Their dividend is covered, as are dividends among all of the big 7 apartment REITs, but their leverage would leave them more exposed to a recession. The portfolio is concentrated in the same markets as AVB and EQR (mainly coastal), but slightly lower quality (similar to UDR).
Apartment REIT Sector – General Notes
The apartment REIT sector has a few key traits investors should know about:
- Over the long term apartment buildings and apartment REITs benefit from rising wages, which enable renters to pay higher rates.
- Outside of recessions, growth in rental rates is pretty reliable.
- Apartment REITs can enhance shareholder value by developing new properties when profit margins on new development are high.
- There are 7 big apartment REITs and a handful of small ones. The big apartment REITs have better economies of scale and generally fit very well in dividend growth portfolios. Over a 15 year period, we would expect all of the big 7 to outperform a direct investment in apartment buildings due to better overhead expense control and lower interest rates on debt.
- The big apartment REITs are a little conservative on their dividend payout ratios because it enables property development.
- A moderate amount of capitalized expenditures is required each year for major maintenance projects (roofs + parking lots).
- Growing rental rates requires keeping properties competitive. Upgrades to kitchens and bathrooms are common and will usually occur every year throughout each portfolio.
- In the short-term, higher Treasury prices (lower yields) often encourage higher prices for apartment REITs. This connection is silly since higher Treasury yields would mean higher mortgage rates. Higher mortgage rates enable apartment owners to raise rents at a faster pace.
- Apartment REIT prices fall when investors believe developers will add too many new apartments to the market. Newly built apartments offer move-in discounts that temporarily hurt occupancy rates and rental rates within close proximity.
Recent Notes on the Sector
The apartment REITs haven’t done much lately, but they roared higher for most of 2019. The most interesting development for apartment REITs is the narrative. When we were buying apartment REITs hard in early 2018, the market believed rental revenue growth would be weak because supply was expected to boom. In reality, new apartment deliveries in 2018 were slightly below 2017. Deliveries in 2019 were materially below 2018:
Source: Yardi Matrix – RENTCafe
Now investors believe rents will be booming. New deliveries sank from 331,765 to a projected 299,442. Does that justify our 42% to 61% returns on apartment REITs since early 2018? You might think rental rates must be roaring higher to create the change in price. No, that isn’t it either:
Source: Yardi Matrix – RENTCafe
To be fair, some apartment REITs are clearly beating that 2.7% figure. EQR has guidance for a 3.3% growth rate in same-property revenue. MAA is guiding for 3.25% in revenue. ESS is guiding for 3.3% in revenue and 3.7% in same-property NOI:
This is a good time to point out that apartment REITs have been gradually increasing their NOI margins as revenues grew faster than expenses. Consequently, same-property NOI has grown faster than rental rates.
However, the big chart on rental rates serves as a useful overall measure for the performance of apartment rental rates. With lower projected growth for 2019, we see many apartment REITs setting new all-time highs.
So why do investors like apartment REITs?
- They generally have solid growth in most years.
- They have economies of scale to get very attractive interest rates on debt.
- They have solid management teams. Within the big 7 apartment REITs, there isn’t a single team we consider poor. Each team continues to make solid decisions on capital allocation.
Other Notes on individual REITs
The debate on ESS vs. MAA comes down to portfolio positioning. Investors betting on MAA previously had a substantial cushion due to a large difference in multiples. Today, the difference is much smaller. Now the results should be driven more by the performance of the real estate portfolio. ESS delivers the west coast portfolio:
Meanwhile, MAA delivers the “Zero California” portfolio:
So what does ESS have going for them in California right now? Well, housing permits in California are trending lower than across the rest of the country:
You can see that throughout most of the country the annual new housing permits are equal to about 1% of existing supply. However, within the ESS portfolio, those new housing permits are only equal to about 0.8% of the existing supply. Those housing permits are used as a leading indicator of the growth in rental units. If fewer new units are constructed in California, then rental rates can increase quickly so long as wage growth keeps up.
We’ve tightened the target ranges for each apartment REIT and expect to be updating price targets more frequently. Among the apartment REITs, we find the most appealing valuation is currently coming from Essex. By comparison, MAA’s huge rally finally has shares looking a bit expensive relative to the sector.
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Disclosure: I am/we are long AIV, EQR, ESS, MAA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.