The American Dream – we’ve talked about it here before. America is the land of opportunity, with incredible freedom to hustle, learn, interact, and define yourself however you choose. The two car garage and half acre yard are just the start. The American Dream is about resilience and perseverance, opportunity and not entitlement. It’s about being a good citizen and helping a neighbor in need. It is, in essence, an incredible balance of individual incentive and community encouragement.
But there is a single image that nearly uniformly represents the American Dream, owning your own home. It’s an obtainable investment for most of the middle class, and a great way to steadily build wealth over a working class career. But that image has been damaged in the past five years. Rampant foreclosures and underwater mortgages have changed perceptions and behaviors. Potential homebuyers flocked into apartments, fearing that their savings would be lost if used as a down payment on a home. Existing home buyers were underwater or worse.
But the resilience and perseverance of the American Dream did not die. Homeownership remains a cornerstone of family life, lasting neighborhoods, and communities. And as the home market returns to its long term trend, we see apartments, the beneficiary of homeownerships stumble, beginning to recede to the mean as well. –The Flaneur
Buy Low, Sell High – Now is the time to Sell the Apartment Sector
Apartments and apartment focused REITs have exploded since the housing market crash. However, the growth in apartment rents and improvements in vacancies and values has been driven by the limping housing market combined with an outflow of capital from other real estate sectors (retail, office, warehouse/industrial, etc). The housing market is regaining its footing, other real estate sectors are slowly recovering, and as such, the apartment market will return to its longer term levels of vacancy, net operating income, and cap rates. Buy low, sell high. Now is the time to sell high.
This thesis is predicated on two concepts. First, that the apartment market is overbought, and second, that the other real estate sectors are beginning to recover and draw investor dollars away from apartments.
The Apartment Hot Streak is Cooling Off
First, recent economic data shows a clear trend in the apartment market—the explosive growth is slowing down, and the market is returning to the longer term trend. Immediately following the financial crisis and housing market crash, the demand for apartments skyrocketed. Families and individuals were losing their homes to foreclosure, others had equity whipped out entirely or nearly so. The American Dream of home ownership was under attack by very real and very powerful economic forces. As a result, families, individuals, and investors left the housing market for apartments.
Demand for apartments spiked incredibly in 2010, with subsequent years seeing sustained demand at historically high levels. Simultaneously new supply was slow to come to market due to banks’ unwillingness to lend for new construction. However, as this chart clearly shows, the imbalance between supply and demand is returning to a more stable level. Demand is returning to historical norms just as supply is beginning to rise. The apartment euphoria of 2009-2012 is showing signs of a return to normalcy.
As the supply and demand dynamics return to stability, other key measures are also reversing trend. With demand waning and supply catching up, a very clear reversal in effective rent growth has emerged in the last quarter.
Further, capitalization rates (cap rates), defined as the ratio of a property’s profit producing ability compared to its market value (rents subtract expenses to operate the property, all divided by the buildings market value), have in recent history held above 6%. A lower cap rate indicates that investors are willing to pay a higher premium to purchase the property. At the height of the housing crisis, cap rates rose to ~7%, but have since returned to near 6% levels. We believe 6% represents the lowest the apartment cap rates will go, and therefore, apartment values are not likely to rise in value with an increase in rents received. Rents received are driven by effective rent growth, which we’ve already demonstrated is beginning to reverse trend.
Apartment vacancies are, at present, exceptionally low, driven primarily by the supply and demand dynamic previously described. At large scale, such as the multi-trillion dollar size of the US real estate market, the economic impacts of these macro metrics are felt over quarters and years, not days or weeks. However, reviewing the trend in vacancy levels relative to the long term trends shows that the market is due for a correction.
Other Real Estate Sectors are Recovering and Competing for Capital
Simultaneous to the apartment market cooling off, other real estate sectors are showing signs of recovery. As these sectors recover, they will compete for the capital currently invested in apartments, and in the case of single family homebuilding, they will also compete for tenants. An increase in competition will result in a decline in the value of apartment sector investments.
Financing conditions are improving for builders of both residential homes and other commercial real estate. Commercial and multifamily mortgages outstanding increased 0.3% in the 3rd quarter of 2012, compared to decreases of over 4% in some quarters in 2009-2011. Delinquency rates on loans for commercial real estate (including non-income producing land development loans) have decreased to 4.6% in Q3 2012 from highs of over 8% in 2010. 44% of banks today are reporting stronger demand for loans to finance commercial real estate. All of these metrics point to capital becoming increasingly available to fuel recovery in all sectors of commercial real estate.
Homebuilders have performed quite well in the markets over the last 12 months, a result of increased health in the financial system, returning demand for single family homes as prices have stabilized in the existing home market, and with mortgage rates at unprecedented low levels. Further, new home inventories are at 50 year lows which balance the supply and demand equation perfectly in favor of new home builders. New single family home starts are forecast to rise 27% in 2013 and another 22% in 2014. This growth will require new capital, capital that in the past 1-3 years would have been invested in alternative sectors, such as apartments.
In the office, retail, and industrial sectors, modest improvement can be seen in all significant metrics. Cap rates, which are at present 1.5-3% higher than apartment averages (meaning investors are currently placing a high premium on apartments relative to alternative real estate), are beginning to trend downward. This demonstrates an opportunity to buy high quality office, retail, and industrial investments at a relative discount. In all three sectors, effective rent growth is either stable or improving, vacancies are slowly improving, and supply and demand have balanced to support moderate growth.
The resultant picture is an apartment market in overdrive with signs of a return to the long term mean. Alternative real estate investments are showing improvements and are priced at bargain basement prices. The housing crisis is slowly and steadily subsiding, which in turn are converting current apartment dwellers back into homeowners. Now is the time to sell apartments and buy other commercial real estate sectors.
- REM – iShares FTSE NAREIT Mortgage Plus Capped Index Fund – This fund provides low cost exposures to the commercial mortgages underlying the real estate properties.
- RTL – iShares FTSE NAREIT Retail Capped Index Fund – This fund provides low cost exposure to the retail real estate sector (shopping centers and/or retail outlets for example, both existing and new construction).
- REZ – iShares FTSE NAREIT Residential Plus Capped Index Fund – This fund provides low cost exposure to the residential, healthcare, and self-storage real estate sectors in the US.
- KBWY – PowerShares KBW Premium Yield Equity REIT – Exposure to a diversity of real estate sectors. This fund is a play on the broad real estate market, with exposure to a variety of sectors including some apartment exposure. We are, in general, long real estate, which makes this fund a nice sector hedge to the less diversified funds above.
In conclusion, it is important to note that this analysis is in the context of the next 1-4 years. The apartment market is still performing well as of this writing, but it is showing clear signs of a reversal to long term means. The strategy here anticipates that reversion to the mean and builds a foundation of investments that will position a portfolio for that change while simultaneously creating dividend income.
Disclosure: As of the time of publishing, the author holds no positions in the stocks mentioned herein and does not intend to hold any position in the next 72 hours.