Near-Term Outlook for Residential REIT Stocks Looks Upbeat

Residential real estate investment trusts (REITs) are engaged in owning, developing and managing a variety of residences. These include apartment buildings, student housing, manufactured homes and single-family homes. Residential REITs rent space in these properties to tenants and earn a rental income in return.

The latest figures from real estate technology and analytics firm RealPage, Inc. (RP) suggest that during the current year’s prime leasing period, the U.S. apartment rental market was able to capitalize on stellar demand for rental units. Leasing activity accelerated as demand was strong during the second quarter and per the RealPage report, from April through June, net move-ins aggregated 155,515 units, which came in 11% higher than the second-quarter 2018 product absorption, as well as touched a five-year high.

With an impressive leasing activity, occupancy reached 95.8% during the June-end quarter, up from the prior-year quarter’s 95.4%. This upswing in occupancy level amid steady delivery of new units looks encouraging. With occupancy pushing up, rent growth also seems to be steady. In fact, the market achieved a 3% increase in rents from the prior-year level, attaining an average of $1,390 per month.

Here are the three major themes in the industry:

Stable Economy and Capital Availability: The strength of the economy as well as job-market health play key roles in determining residential REITs’ performance. Both these factors determine the capacity of rent that renters can shell out. Though economic growth is likely to be less robust this year, the level will remain stable, supporting the industry. And with a healthy job market, household formation and high home-ownership costs in several markets hindering transition from renter to homeowner, demand for rental housing units is likely to be decent. Moreover, easy availability of capital and comparatively lower levels of interest rates keep the momentum upbeat. In fact, with REITs relying substantially on debt for business, as well as being considered as a bond substitute for their high dividend-paying nature, the central bank’s latest move to cut rate gives a reason to rejoice.

Favorable Demographic Growth: Demographic growth continues to be strong in the young-adult age cohort, which has a higher propensity to rent. In fact, a significant change in lifestyle has taken place and life-cycle events are getting delayed. This, again, is leading to an extension of the average age of first-time homeownership. This age cohort has also witnessed considerable part of net job growth which is helping spur primary renter demand. Additionally, the cohort of ageing millennials is growing at a rapid pace and because of lifestyle choices, this age group currently has lower homeownership rates than the prior generations. Also, there are many in this age group who cannot afford homeownership. As such, demand for rented apartments might remain elevated in the near term. These apart, the student housing sector, which is part of the residential REIT industry, has been witnessing decent demand and pre-leasing velocity despite more new student beds.

Elevated Deliveries of New Units: The struggle to lure renters is feared to continue into the near term as supply volumes might remain aggressive. Currently, construction in the U.S. apartment sector remains high and per a report from RealPage, across the U.S. more than 526,000 units are under construction and more than 359,000 of those units will be delivered within the next 12 months. Although rental-housing demand has been robust in recent times, this high supply volume is a concern because it generally curbs residential landlords' ability to command more rents, and affect occupancy and concession levels. This becomes all the more challenging when demand weakens amid slowdown in economic growth.

Zacks Industry Rank Indicates Better Prospects

The Zacks REIT And Equity Trust - Residential industry is housed within the broader Zacks Finance sector. It carries a Zacks Industry Rank #74, which places it at the top 29% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates bright near-term prospects. 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.

The industry’s positioning in the top 50% of the Zacks-ranked industries is a result of positive funds from operations (FFO) per share outlook for the constituent companies in aggregate. Looking at the aggregate FFO per share estimate revisions, it appears that analysts are gaining confidence in this group’s growth potential. Over the past six months, the industry’s FFO per share estimate for the current year moved 0.6% north.

Before we present a few stocks that you may want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Industry Leads on Stock Market Performance

The REIT And Equity Trust - Residential Industry has outperformed the broader Zacks Finance sector, as well as the Zacks S&P 500 composite in a year’s time.

The industry has rallied 16.7% during this period compared with the S&P 500’s rise of 1.2%. During the same time frame, the broader Finance sector has declined 2.8%.

One Year Price Performance

Industry’s Current Valuation

On the basis of forward 12-month price-to-FFO (funds from operations) ratio, which is a commonly used multiple for valuing Residential REITs, we see that the industry is currently trading at 20.01X compared to the S&P 500’s forward 12-month price-to-earnings (P/E) of 16.39X. The industry is trading above the Finance sector’s forward 12-month P/E of 13.18X. This is shown in the chart below.

Forward 12 Month Price-to-FFO (P/FFO) Ratio

Over the last five years, the industry has traded as high as 20.11X, as low as 16.14X, with a median of 18.19X.

Bottom Line

In a nutshell, despite elevated supply in a number of markets, the apartment rental market’s fundamentals are likely to remain buoyed by a stable economy, a healthy job market with low unemployment level, job gains and wage increases, household formation and high home-ownership costs in several markets hindering transition from renter to homeowner.

Currently, there is no stock in the industry sporting a Zacks Rank #1 (Strong Buy). However, there are a number of stocks with a Zacks Rank of 2 (Buy) which investors may consider adding to their portfolios. We have handpicked three of these.

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

AvalonBay Communities, Inc. (AVB): This residential REIT is based in Arlington, VA, and is engaged in developing, redeveloping, acquiring and managing apartment communities in top metropolitan areas of the United States. The stock’s Zacks Consensus Estimate for 2019 FFO per share has been marginally revised upward in two months’ time to $9.34. It also indicates a projected year-over-year increase of 3.78%.

Essex Property Trust, Inc. (ESS): The San Mateo, CA-based residential REIT is focused on acquisition, developing, redeveloping, and managing multi-family residential properties in select West Coast markets. The company’s consensus estimate for the ongoing year’s FFO per share moved 0.9% north to $13.25, in the past 30 days. The figure denotes an estimated rise of 5.4% from the prior-year period.

Equity Lifestyle Properties, Inc. (ELS): This Chicago, IL-based REIT is engaged in the ownership and operation of manufactured home communities, RV resorts and campgrounds in North America, offering housing options as well as vacation opportunities. The company’s Zacks Consensus Estimate for the current-year FFO per share moved up marginally to $4.20, over the last 30 days. Also, it indicates expected year-on-year growth of 8.5%.

Note: Funds from operations (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.

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