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3rd Quarter Apartment REIT Review

“Grief is nature’s most powerful aphrodisiac” – Chazz Reinhold (Will Ferrell), Wedding Crashers (2005).

Back in 2005, I watched in disbelief while apartment leases were being broken left and right as residents began to purchase homes at a frenzied pace. While the economy boomed, the apartment industry suffered. Now, some have begun to whisper about the formation of a new bubble stimulated by the zero-rate environment established by the Federal Reserve to prop up an economy battered by the pandemic. In a surreal world where low wage service workers struggle to pay rent, more affluent renters have the sugar rush of cheap money to feed a new home-buying surge. Throw in a desire for more space to work from home and host dinner guests in the backyard, and buying a house… well, as Owen Wilson would say, “just, wow”.

Back in August (which was eight months ago in pandemic time), I decided to look at quarterly results from publicly traded apartment owners to gain insights into where the market was heading. Third quarter results have been posted, so I revisited three of the biggest apartment real estate investment trusts: Equity Residential (EQR), AvalonBay (AVB) and Mid-America Apartment Communities (MAA).

The stocks have continued to trade at discounts to their March peaks and their dividend yields exceed 3%. The announcement of a vaccine breakthrough earlier this week sent the stock prices higher by 10%. The recent price increases have largely erased the deep discounts to net asset values, but they remain attractive as liquid income-producing investments. Their dividends are well-funded, leverage is manageable, and it is hard to envision further downside. EQR is the riskiest of the three because of the company’s high exposure to struggling urban markets, but MAA remains the star of the group due to its focus on sunbelt cities.

The attached article contains brief comments on the quarterly results, a numerical comparison of income and asset values as well as a back-of-the-envelope “stress test” to determine the safety of the dividend payments. Finally, I offer a few observations on the Omaha market where home purchases have caused increased turnover and vacancy.

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Sunbelt Success Continues

Mid-America exhibits the divergence in the apartment industry: urban coastal cities are losing residents and many are relocating to dynamic growth centers in the south. As they had in August, executives exuded confidence in their quarterly call. Occupancy exceeded 96% and traffic was positive. Rent growth was muted due to increasing supply and competition from home purchases but remained positive. MAA is a standout performer because of its concentration in sunbelt cities throughout the southeast and Texas. The stock has nearly recovered its losses for the year.  

Suburban vs. Urban

AvalonBay and Equity Residential noted positive leasing trends during October but reported that rent declines and move-outs exceeded expectations in urban markets, particularly Manhattan, Boston, and San Francisco. Rent declines surpassed 10% in big coastal cities. Occupancy dropped below 90% in central San Francisco – a stunning figure. Meanwhile suburban properties performed well. Overall occupancy at both firms was at the 94% level. At AvalonBay, rents declined 6% for the quarter on a year-over-year basis and 2% on a sequential quarterly basis.  At EQR, rents declined 7.5% for the quarter on a year-over-year basis and 2.7% on a sequential quarterly basis. Collections remained strong – above 97%, but turnover increased. There were some glimmers of hope in the New York City core where major rent discounts and incentives have enticed bargain-hunters to seek upgrades within the market.

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Similar Trends in Omaha

In large measure, the observations made by the leading apartment executives on their earnings calls mirror our experience in Omaha. Occupancy levels which had been above 95% for the past two years have fallen dramatically over the past 90 days – approaching 93% in many areas of the city. Effective occupancy may be even lower as one month of free rent has become a common incentive.

Home Purchases Pressure the Top End

The top end of the Omaha apartment market has been hammered by an acceleration of home-buying. Low interest rates are spurring a race to purchase houses despite rising costs amid a tight inventory and expensive lumber prices. There is a 2005-feel to the environment with a high number of lease-breaks. It has not reached a mania level, but loose credit has allowed buyers to emerge who probably wouldn’t have qualified for a mortgage at the beginning of the year. In certain submarkets, added new apartment supply is also depressing the leasing environment.

More Space

All three firms have noted an increase in demand for larger apartments as working from home seems to have spurred a choice for bigger apartments. Studios are difficult to rent across the country, and Omaha is no exception. EQR reported that many of their Manhattan buildings have experienced transfers to larger units within the same property.

Students and Lower-Income Challenges

EQR and AVB reported serious challenges in their Boston and Cambridge properties due to a lack of students in the area. Omaha is no different. Although UNO has strong enrollment figures, many have opted to remain at parents’ homes. International students are a major driver of central Omaha apartment demand, and they have not returned. Rent delinquencies had vanished over the summer, but have made a growing re-appearance as stimulus payments have been exhausted. Workers in the service sector are seeking assistance once again. Delinquencies are not catastrophic – probably running 1%-2% higher – but the trend is worrying.

Stress Test

Last quarter, I used a hypothetical 5% income decline to determine whether the firms could continue to fund their distributions. I increased the pressure to 10% this time around. The dividends appear safe but would certainly come close to being curtailed in such a scenario. It should be noted that the 10% reduction of rental income was taken from an annualized rental figure that already incorporates two quarters of rental declines. The annualized figures are simply the aggregation of results through September 30, 2020 plus an assumption that 4th quarter results will match those of the 3rd quarter.

Note: This article contains the opinions and observations of the author. No investment recommendations are being provided and no representations are made to the accuracy of the content provided.

Bert Hancock

November 12, 2020

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Does Omaha need any more apartments?

A couple of years ago I published my views about the supply and demand of multifamily rental housing in the Omaha metropolitan area. My conclusion was that softness would appear by late 2017 due to an acceleration of supply. I have been pleasantly surprised by the continued strength of the market. Occupancy levels are at 95% or better in most parts of the city.

Unfortunately, the day of reckoning has only been postponed, not cancelled. I believe 2018 will be the first year since 2010 that landlords will be caught short-handed. While I don’t see vacancies rising to the 10%-plus levels we experienced during the dark days of 2004-06 when just about anyone with a pulse was purchasing a house, any pullback in occupancy will feel painful simply because we haven’t been exposed to much adversity in recent years.

Omaha has become large enough now, at nearly 950,000 people, that submarkets can have widely disparate experiences. Northwest Maple Street is an entirely different beast from the Blackstone neighborhood. However, on a macro level, a decline in occupancy of 2-3% seems possible.

There are two reasons why my prediction of market softness has been delayed until 2018. Omaha has grown faster than I thought and developers have been mindful of delivering units at a slower pace.

On the supply side, it’s hard not to ignore the revival of midtown Omaha. Over 1,200 apartments are under construction or just opening south of Dodge and east of 72nd St. Prudent builders released units to the market more slowly than anticipated, however, and the real impact will be felt in 2018 and 2019 when major projects in Blackstone, Aksarben Village and other midtown neighborhoods hit the streets.

On the demand side, population and employment growth have been stronger than I thought possible. We have exceeded 1% population growth for the past few years with a high degree of contributions from international and domestic migration.

My theory has been for many years now that Omaha can absorb 1,200 apartments per year without disrupting decent rent growth in line with inflation. During the recession multifamily permits dropped precipitously to just over 300 units in 2009. Pent up demand and pinched supply signaled a robust market from 2010 – 2016. Now supply is exceeding the 1,200 unit “magic number”. By 2019, Omaha could experience a glut of 2,000 apartments. In the grand scheme of all rental housing, this amounts to about a 2-3% weakening in occupancy levels. This is not disastrous when taken in the context of the metro area.

The pain will be be felt at the top end of the market. The 2,000 unit overhang will attempt to command units nearing $2 per square foot due to the massive building cost and land inflation since 2013. Geography matters. East Omaha will suffer the brunt of the weakness. Developers are correct to recognize the trend towards urban living. It’s unfortunate that they all decided to recognize the trend at the same time.

Like most booms, the story is more about cheap money than it is about demographics. There was a moment this past summer when the 10 year Treasury bond yield began to head towards 3%. Cassandras who had been warning for years that hyperinflation was lurking just around the corner and gold was a safe haven, suddenly began to sound like they were on to something. But as the summer waned, the Treasury dropped to nearly 2% again. It is only about 2.3% now. This rate reprieve has given green lights to many new projects.

Forecasting interest rates is a fool’s errand, but what can not be disputed as we enter our 10th year of extraordinary central bank intervention in the money supply, is that asset price inflation has been rampant. Stock market multiples are as high as they were during the dotcom bubble. If you call a broker looking to purchase an investment property today, you will go straight to voicemail.

The problem is not one of America’s sole making. The Federal Reserve is planning to decrease its purchases of agency bonds and Treasuries. Under normal circumstances, this would signal a dramatic rise in rates. But America does not operate in isolation. Japan, Europe and China have been increasing their supply of money at an ever faster pace. If the US Treasury rises to 2.75%, a fund manager in Zurich will surely be buying when the alternative is less than 1% domestically. The yield on American bonds can not escape the gravity of sub – 2% yields elsewhere. The international market for capital won’t let this US diver come up for air.

The truly international scope of cheap money infects housing as well as securities. Try bidding on properties in San Francisco, Sydney, Vancouver or Toronto and you’ll see what I mean. Even in Omaha, the numbers are distorted. When developers can continue to borrow money at cheap rates, the estimate of risk gets diminished.

I identify five major risks threatening the Omaha apartment business today: The first is the persistently low interest rate cycle. As mentioned above, the cheap cost of capital is giving green lights to developers who might have otherwise tapped on the breaks by now. The second is student loan debt. Young people are the lifeblood of new apartments. They are under tremendous financial pressure today due to the enormous amount of college debt that’s been incurred. While we have a robust economy with local unemplyment rates hovering near 3% today, a slowdown in the economy would stall wage growth and diminish the affordability of high rents. Student loan debt has surpassed the eye-watering level of $1.4 trillion dollars. Yes, that’s trillion with a “T”. Number three is the challenge facing university enrollment. UNO has been growing but is nowhere near it’s target of 20,000 students by 2020. Small colleges are shrinking or disappearing (Grace University is the most recent casualty). National college enrollment peaked in 2011. Fourth, the possible limitations on international workers from the current administration could dampen population growth. Omaha grew by 9,800 people in 2016 and over 1,000 represented international migration.

The fifth challenge facing apartments deserves its own paragraph. The apartment market must also compete with its big brother: the single family home market. The very slow recovery in single family home starts has worked in the apartment market’s favor. Peaking near 6,000 units during 2005, the supply of houses has only now climbed back above 3,000 on an annual basis. The lack of inexpensive new homes has prolonged the renter experience. But this trend will reverse if the economy stays strong and wages continue to grow. Single family permits are on an upward trajectory. When coupled with multifamily permits, the  entire supply of housing is exceeding levels not seen since 2008. The same low interest rates that help apartment developers are the double-edged sword that drives house affordibility.

What’s more, I do not subscribe to the belief that there has been a permanent paradigm shift away from homeownership. Young people still want to start families. When they have children, and if they have the means, they will move to Elkhorn and Sarpy County where pristine schools beckon. Homeownership will probably never return to the insanity of the mid-2000’s but the dream of owning a home did not vanish from society. Millenials may have delayed their family expansion, but the overwhelming human instincts of procreation and self preservation have not ceased. And there’s no place better than a good suburban home for this most American of pursuits.

 

 

 

 

 

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