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It looks like the axiom that says, "For every action, there's a reaction," applies to the housing market. Although new home sales appear to be falling off a cliff, the apartment-rental market is booming.
Many investors are profiting from the action via real-estate investment trusts (REITs) that specialize in that market. Is it too late to participate? Probably not. I'll show you how to pinpoint the best candidates in a minute, but first some background.
According to a recent report published by RealFacts, a research outfit that focuses on the apartment industry, occupancy rates and rents are rising all across the United State. Nationwide, rents are up 4% over the past year and occupancy levels are running at 94%. In San Jose, Calif., where the action is the hottest, apartment rents rose 9% on average.
All this is new. When the economy faltered in 2001, apartment rents dropped and continued falling until last year, when they bottomed out and began to turn around. What's behind the upsurge in apartment rentals? It's simple: In 2005, prices of single-family homes skyrocketed, dramatically shifting the rent vs. own equation.
The big question
Deutsche Bank Securities published a July 31, 2006, research report titled, "Rent or Buy?" that puts it all in perspective. The analysts at Deutsche did what most of us do when we think about making the move from renting an apartment to buying a home. They compared the cost of owning vs. renting.To do that, Deutsche devised a gauge for measuring the monthly cost of owning a home, called the ATMP, which stands for "after-tax monthly payment." The ATMP adds up adjustable-rate mortgage interest, property taxes and insurance, but deducts principal amortization and income tax savings.
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Deutsche compared average apartment rents to the monthly cost of owning a home in 47 different U.S. metropolitan areas. Deutsche expressed the results as the percentage cost of renting vs. owning. For instance, a rent/own ratio of 50% means that if it cost $1,000 per month to own a median-priced home, you could have rented an average apartment for $500/month.
Those ratios show why the rents have taken off. For example, according to Deutsche, in Los Angeles it cost $1,158/month to own a median-priced home in 1999. By comparison, it would have cost $885/month, or 76% of the monthly home ownership cost, to rent an average apartment.
Here's where it gets interesting. By the first quarter of 2006, the monthly cost to own a home in Los Angeles had jumped to $3,015, but you could have rented an average apartment for $1,215 a month, about 40% of the cost of owning.
The same story repeats, in varying degrees, around the country. For instance, in Miami in 1999, your monthly outlay would have been about the same for renting an apartment as for owning a home. But, by 2006, you could rent an apartment for less than half the cost of owning.
Obviously, something has to give. To get the rent vs. own equation back in balance, either rents must go up, or home prices must come down. According to Deutsche, if rents were to remain constant, home prices would have to drop 28% on average, and more than 40% in the hot markets. Conversely, if home prices didn't budge, apartment rents would have to rise 45% to return to the 1999 cost of renting vs. owning ratio. Most likely, of course, a little of each will happen. Rents will increase and home prices will come down some. Deutsche estimates that rents will increase 4% to 8% annually.
Apartment REITs
You don't have to buy your own apartment building to profit from the surging rental market. Instead, you can simply buy shares of REITs that specialize in renting apartments.If you're not familiar with the term, a REIT is a special type of corporation that owns real estate and isn't required to pay federal income taxes as long as its pays out at least 90% of its income to shareholders.
REITs typically specialize in a specific real estate sector, such as shopping centers or office buildings. Apartment (residential) REITs build or acquire giant complexes consisting of hundreds of apartments offering a variety of amenities such as exercise rooms, tennis courts and swimming pools.
Savvy investors have already caught on to the story. Apartment REITs have moved up around 25% so far this year. Some pundits advise that, given that advance, the train has already left the station. But not necessarily. The market pays for growth. If rents move up at the 4% to 8% clip that Deutsche expects, those increases will flow right to the bottom lines, and earnings and dividends will increase.
Finding the Right REITs
I devised a simple screen for finding worthwhile apartment REIT candidates. Here's how it works.Specify apartment REITs: MSN's Deluxe Screener is the Web screener I know of that provides a parameter for isolating apartment REITs.
Screening parameter: Industry Name = REIT – Residential
MSN listed 31 REITs in the residential REIT category.
Size matters: In the real estate business, bigger seems to be better. In my experience, larger REITs generally grow faster and suffer fewer problems than smaller outfits. Market capitalization (recent share price multiplied by the number of shares outstanding) is the standard company size gauge. I set the minimum acceptable market cap to $1 billion, which many consider the dividing line between small- and mid-cap stocks.
Screening parameter: Market Capitalization: 1,000,000,000
My minimum market-cap parameter cut the field down to nine REITs, which doesn't sound like many. Nevertheless, I don't advise cutting the capitalization minimum to increase the number of candidates.
Analysts weigh in: Despite the shenanigans that some analysts pulled off during the bubble years, I find that most REIT analysts are conscientious and worth listening to. So I rely on their advice, which is much easier than learning the ins and outs of more than 50 different housing markets.
MSN compiles analysts' buy/sell ratings into five categories: strong buy, moderate buy, hold, moderate sell and strong sell. Since analysts do spend all day long thinking about such things, I avoid stocks that they advise selling.
Screening parameter: Mean Recommendation >= Hold
This requirement precludes stocks rated moderate or strong sell.
Earnings growth: It's hard to make money on REITs, or any stocks for that matter, if their earnings don't grow during the time you hold them. In most industries, you'd like to see a stock grow earnings by at least 15% annually. But REITs don't grow that fast. For them, mid-single digit earnings growth is about par. So, I require that analysts must be forecasting at least 5% earnings growth over the next year.
Screening parameter: EPS Growth Next Year >= 5
The analysts' buy/sell rating and earnings growth requirements, together, cut my list down to seven qualifying stocks.
Avoid high debt: Because property owners of all stripes typically borrow heavily to finance their purchases, most REITs carry relatively high debt. Nevertheless, because debt-servicing costs reduce earnings, the lower the debt, the better. The debt-to-equity ratio (long-term debt divided by shareholders equity) is a widely used debt measure. In most industries, ratios above 1 signal high debt. However, ratios in the 2 to 2.5 range are common for apartment REITs. Consequently, I set my maximum allowable debt-equity ratio at 3.
Screening parameter: Debt to Equity Ratio <= 3
My screen turned up a list of six apartment REITs. Dividend yields are the expected next 12-month dividends divided by the current share price. The yields of the REITs turned up by the screen range from 2.9% to 4.8%. Typically, within an industry, the REITs with best growth prospects have the lowest dividend yields.
| Company Name | Recent price | EPS growth next year (%) | Current dividend yield (%) |
|---|---|---|---|
47.3 | 5.9 | 3.7 | |
50.32 | 8.2 | 3.4 | |
49.75 | 8.7 | 4.8 | |
73.9 | 7 | 3.6 | |
117 | 5.2 | 2.9 | |
56.27 | 5.2 | 4.5 |
The East and West coasts are typically the hottest markets for rentals as well as home sales. Most REITs own properties all across the country, but those with the heaviest concentration in the hot markets will probably enjoy the strongest rent increases. Each REIT's Web site is the best place to learn about their holdings. MSN's Company Report page usually includes a link.
Domash publishes the Winning Investing stock and mutual fund advisory newsletter and writes the online investing column for the San Francisco Chronicle. He has two investing books out, the most recent being "Fire Your Stock Analyst," published by Financial Times Prentice Hall. Domash does not own or control positions in any of the REITs mentioned in this column.
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