by Aaron Levitt | September 11, 2012 7:30 am
Investors in commercial real estate have certainly had a lot to smile about over the last few years. After getting hit hard by the global credit crisis and resulting recession, prices for commercial real estate have bounced back aggressively. Assets in real estate investment trusts (REITs) and real estate-focused funds have swelled as investors have sought protection in real assets and solid dividend payers.
Perhaps benefiting the most have been real estate investors in the apartment sector. As the U.S. housing crisis has thrown the market for single-family homes in a loop, the multifamily sector has seen its star shine. Since the depths of the mortgage crisis, apartment REIT shares have soared nearly 255%. The reason: The downturn forced millions of families out of single-family homes into rental units. That mass exodus has helped drive up rental rates and ultimately, the bottom lines for firms operating in the sector.
However, despite the group’s recent outperformance, some cracks are beginning to show. While multifamily REITs aren’t exactly setting themselves up for outright fall, these issues could be trouble for investors because the subsector was one of the major contributors to real estate’s recent outperformance.
So far, the apartment REIT subsector has produced a very attractive 9.59% year-to-date return as of Aug. 22. However, that’s well below the 16.57% all equity REIT average. While market fundamentals are strong, many REITs appear to be fully priced. Lowered growth prospects, along with individual industry challenges, are now finally being incorporated into REIT valuations. That could mean some continued underperformance for the multifamily players.
The heart of the problem stems from slowing growth rates in rents and occupancy rates. According to data provided by Axiometrics, which surveys 5.5 million apartments in more than 140 metropolitan areas across the country, the percentage of occupied apartments appears to be flat-lining at close to 95%. Occupancy rates for class-A and class-B properties have held at roughly 95% for the last year, while class-C properties have been slowing inching up to that mark.
This echoes similar data from real estate analytics firm Reis (NASDAQ:REIS). That firm showed the balance stabilizing between occupied and vacant apartments. The percentage of vacant apartments fell to 4.7% in the second quarter, down from 4.9% in the first. Overall, that was the smallest quarterly decline in national vacancies in two years. With limited room for increasing occupancy, recent revenue increases have been based more on rent growth than occupancy improvement. However, rents are showing signs of weakness as well.
Axiometrics recently reported the lowest year-over-year growth in rents since August 2010, dropping to just 3.73% in July. Rent growth in excess of 4% is immensely difficult to maintain year after year, especially when for-sale housing is relatively cheap. In many areas, renting is finally beginning to get more expensive than purchasing a home.
Then there’s the issue of more supply about to hit the market. As the multifamily and apartment sector has been the go-to real estate investment of the last few years, construction activity has increased. Developers will open roughly 87,000 new apartments this year, nearly two-thirds during the second half. Approximately 129,000 units will go online in 2013, and there are more than 800,000 new units currently in the planning phases.
This apartment and condominium construction has recently pushed the National Association of Home Builders index to the highest level since 2005 in August.
Exchange traded funds like the iShares FTSE NAREIT Residential Plus Index (NYSE:REZ), which focuses on the sector, as well as individual firms like AvalonBay Communities (NYSE:AVB) and UDR (NYSE:UDR) have seen their shares surge as investor interest peaked. However, given that many of the major growth factors pushing the apartment REITs forward are showing signs of stalling, investors in the subsector could be in for some muted near-term performance. While these securities should have no problem churning out those delicious dividends, the total return could less than in previous years.
That means it could be finally time to shift some real estate dollars to the other subsectors. Perhaps, the biggest bargain could be the retail REITs. Beaten down from falling consumer confidence and jobs growth, retailer sentiment is finally turning a corner. Sales have been rising, retailers are expanding and many retail REITs are finally experiencing higher rental rates as well as occupancies. Basically, the retail real estate subsector is now where many of the multifamily REITs were two years ago.
The easiest way to participate in the sector is through the iShares FTSE NAREIT Retail Capped Index Fund (NYSE:RTL). The fund holds a variety of companies across the entire retail property spectrum, including giants like Simon Property Group (NYSE:SPG) and smaller firms like CBL & Associates Properties (NYSE:CBL). The ETF has an expense ratio of 0.48% and a 12-month yield of 2.72%.
The real lesson here is that the apartment sector has been a major contributor to REIT outperformance. To keep that performance going, investors may need to do some rebalancing. The retail sector could be a good place to start.
As of this writing, Aaron Levitt didn’t own any securities mentioned here.
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