Despite the threat of rising interest rates, commercial real estate actually did pretty well over the course of 2015. Total returns for the FTSE/NAREIT All Equity REIT Index were 2.8%. That performance managed to beat the S&P 500, which recorded a 1.4% total return for the year.
And one of the hottest subsectors of commercial real estate was apartment REITs.
Building on successes and factors created during the great recession, the apartment REITs had a great 2015. In fact, apartment REITs and other residential commercial real estate had a total return of 17% for the entire year.
The market-beating return follows other wins in the previous few years. But the real beauty for investors is that many of the factors that helped propel the sector forward are still very much in place.
The apartment REITs should keep killing it well into the New Year.
Rising Rents and Occupancy
The success of the apartment REITs can be summed up in just two words — “housing stinks.” While the U.S. housing market has moved from its recessionary lows, it still isn’t exactly humming along. For a lot of people, getting a mortgage is still pretty hard. Stagnant wage growth has prevented many people from securing the needed 20% or so down required for many mortgages these days.
Additionally, the rise in interest rates — which should have killed REITs according to some — has made getting a mortgage that much more expensive for potential homebuyers.
Today, the homeownership rate sits at a 30-year low. This shift in home-buying and ownership continues to have a positive effect on apartments and the firms that own them.
That positive effect comes down to record-setting rent growth.
Rents across the country grew at the fastest rate since 2007 and the biggest since the recession. On average, rents jumped 4.6% last year. The 15-year average is only around 2.7%. Real estate data provider Reis (REIS) now estimates that the average U.S. apartment costs $1,180 per month to rent.
This increase in rents has flowed right back into the bottom lines of apartment REITs — and to their investors. Sector earnings and funds-from-operations (FFO) metrics have been pretty great across the board.
And while it’s reasonable to think that the apartment REITs won’t experience the same sort of huge jump in rents or 17% total return in 2016, they should continue to keep going this year.
For starters, many millennials still don’t want houses. The employment picture has gotten much better for many millennials and the chronic problem of moving home after graduation seems to be abating. That’s causing an increase in household formation. But the generation isn’t buying homes. According to the National Association of Realtors, the percentage of first-time buyers is at its lowest in decades. The generation still prefers to be close to bars, restaurants and the hustle-and-bustle of urban life.
Secondly, the continued retirement crisis still has many baby boomers looking to downsize their homes — either because they need the cash infusion to fund retirements or simply because they can’t afford to keep them. This could provide a steady stable of tenants for an entire retirement — 20 years or more.
Two Apartment REITs to Buy
Given their potential to still outperform, investors may want to consider becoming a landlord and adding a dose of apartment REITs to their portfolios.
A simple way could be to add the broad residential-focused iShares Residential Real Estate Capped ETF (REZ). However, REZ isn’t a pure play on apartments. For that we have go into single picks and luckily we two doozies in Equity Residential (EQR) and Mid-America Apartment Communities Inc (MAA).
Equity Residential was founded by real-estate mogul Sam Zell. Zell has made a name and a fortune for himself in commercial real estate over the last few decades, but the apartment REIT could be his crown jewel.
EQR has nearly 400 different residential properties under its wing, making it the largest apartment REIT in the U.S.
More importantly, those properties are located in fast- and strong-growing rent areas like Boston; New York; Washington, D.C.; and San Francisco. Apartments in these prime markets have helped EQR see positive FFO over the last few quarters. Through the end of the reported third quarter, Equity Residential managed to report a 13% jump in FFO over the same period in 2015.
That’s translated into higher dividends as well. EQR currently yields 2.8%
However, it’s not just relying on rent growth to fuel its future. The firm has begun to partner with sharing economy hotelier Airbnb Inc. That partnership could allow EQR to benefit when one of its tenants “rents” their apartments as a hotel room.
While Mid-America isn’t as big as EQR, it still packs a huge punch. The apartment REIT owns 253 communities across the Sunbelt of the United States.
This property portfolio allows MAA to benefit in two ways. First, cool, hip urban centers like Atlanta and Austin drive higher and higher rent growth. Secondly, places like Orlando feature higher foreclosure activity in the wake of the recession. That drives rental activity. The combination drives Mid-America’s bottom line and its dividend.
On the back of higher FFO growth, MAA recently announced a record increase to its quarterly payout for 2016. With many of the same trends continuing in the New Year, Mid-America should be able to raise its 3.6% payout further.
The bottom line? With rental growth, occupancies still high and the housing crisis not ending anytime soon, the apartment REITS still have it. And two of the best are EQR and MAA.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.