September 4, 2019

Bounteous Apartment Growth Soon Will Wilt

The millennials are big renters, but the next generation, Gen Y, won't provide as many work-force entrants. So multi-family housing investments aren’t great long-term.

Reported by Larry Light

Art by Mar Hernández

Priced out of home buying, burdened by student debt and crummy starter jobs, the millennials have created a boom in rental apartments. But just wait. When that generation rises up the income scale and buys a house, the following age cohort will be a big disappointment to landlords.

Reason: Generation Z, born 1997 and later, won’t be as numerous as the millennials (1981-96) as they move into young adulthood. While they numerically are bigger than previous generations, it will take a long while before a significant number of them leave their parents’ homes.

That won’t be welcome news to investors, particularly those who have been riding an upward trend in apartment-focused real estate investment trusts (REITs). During the economic recovery, beginning in 2009 through last year, residential REITs—mostly apartments, with less numerous single-family houses and mobile home rentals added—have dominated other sectors.

On the basis of total return, meaning price appreciation and dividends, residential REITs have scored a 16.6% annual average increase since the recession. This is the largest REIT sector by market cap. The second and third biggest, retail (malls) and health care, logged 12.5% and 11.2% respectively. Office REITs were up 10.3% and industrials (notably warehouses: think of all those Amazon fulfillment centers) grew 13.7%, statistics from NAREIT, the industry trade association indicate.

That glorious record for rental housing is endangered, however. “There’s been a demographic tailwind, and it’s on its last legs,” noted Frank Haggerty, portfolio manager at Duff & Phelps Investment Management. By 2025, he added, “It will flip the other way.”

Starting in 2020, net headcount reductions will appear in 25- to 29-year-olds, and by 2025, the declines will be evident for a wider group, the 25- to 34-year-olds, according to a study by Green Street Advisors, a real estate research organization.

Meanwhile, developers continue to build apartment buildings. New multi-family (a.k.a., apartment) units hit a record 357,000 in 2017, dipped a small amount last year, and in 2019’s first quarter outpaced comparable periods in previous years, signaling a still-robust expansion of supply.

Trouble is, through 2023, demand from new renters will slow to half of the rapid rate of the past five years, Green Street projects. In light of the demographic changes ahead, the research group warns, that “if developers don’t adjust their behavior, there will be greater supply and demand imbalances.”

Why the Rental Revolution?

Despite strong job growth, millennials as a whole have not kept pace with previous generations of young people and have been unable to purchase homes. Lower incomes and loan burdens are just part of the reason.

The home-buying affordability problem is still a vexing one, especially for young adults at the start of their earnings path, Census Bureau data shows. US home sales prices dipped during and right after the recession, but have been on a steady climb for much of this decade. Since 2012, they’ve doubled, topping an average $250,000 last year, and dipping only slightly in 2019’s second quarter to $207,700.

The result is “a notable lack of affordable, entry-level homes and that has made it a challenge for millennials to transition from renting to homeownership,” Ryan Severino, chief economist at JLL, the commercial real estate services firm, told the National Apartment Association’s publication.

While mortgage rates have gone down lately—plumbing near historic lows of 3.58% for a 30-year loan, versus a recent high of 4.94% last November, Freddie Mac reports—lenders remain much more demanding than before the housing bubble burst in 2008-09. “Mortgages are still hard to get,” said Lowell Bolken, portfolio manager for real estate securities at Securian Asset Management.

Rents have followed the same upward trajectory, although they have remained at a much more affordable level. Since the post-recession low, the average rental has climbed some 40% to $1,000 per month.

Bolken uses the illustration of a $200,000-per-year computer programmer in Seattle, who buys a $1 million home, with 20% down and ends up paying around $5,000 in monthly mortgage fees. Atop that, of course, are property taxes and other expenses.

If the programmer, who is making a decent dollar, rents an apartment, the outlay would be around half the mortgage payment, RENTCafe’s calculator indicates. Someone just out of college, with a literature degree and working as a barista, couldn’t even hope to buy a house.

Certainly, the decline in home ownership extends beyond millennials. Aside from the difficulty of getting a mortgage, said Zach Mallow, director of research at Virtus Real Estate Capital, “wages have been stagnant and fewer houses are built, so we have less supply, which makes them less affordable” as prices are bid up on them. The median household income for renters is $35,000 annually, he pointed out.

Indeed, adults over 35 now have a 58% home ownership rate, down from 69% in 2005, the Harvard Joint Center for Housing finds. A part of this is baby boomers downsizing, shifting to rental units with the kids gone from the nest. Another factor is income stagnation that affects parts of all generations. For the under-35 bunch, the level is 35%, versus 43% in 2005.

Things Look Good—For Now

From a landlord’s perspective, the near-term path ahead seems propitious. At mid-year, apartment REIT stocks were up 19%, compared to 15% for the broader S&P 500. A potential stumbling block for REIT stock performance in general has been removed by the Federal Reserve’s abandonment of plans to boost interest rates: REITs depend on borrowing.

The largest apartment REITs have been putting up handsome numbers. In price terms, AvalonBay Communities has advanced 25.8% this year through August, Equity Residential raced ahead 32.1%, and Essex Property Trust climbed a heady 35%. That’s almost double the S&P 500’s showing.

Occupancy rates for apartment trusts are high, ranging from 95% to 97%. And rent hikes top 3%, well ahead of inflation. By region, the hotter apartment markets are in the Northeast and Midwest, where demand exceeded supply in the first quarter, the Harvard housing center reports.

Supply right now matches demand in the South and the West. Within those regions are a range of conditions. Duff & Phelps’ Haggerty says New York City had an over-supply of rental inventory but that is being erased, while Washington D.C. “still has too many units.”

The REIT version of earnings, called funds from operations, or FFO, is looking especially lush lately for the apartment segment. For 2019, AvalonBay and Equity Residential are expected to generate 6% increases, with Essex Property rising 5%.

FFO is net income, with depreciation and amortization added back because properties tend to go up in value not down, like industrial machinery. The metric subtracts gains from sold assets, as they are not recurring.

Still, at some point, millennials will shuck the rental life and buy houses. “Baby boomers will move into senior care facilities or they’re just going to die,” noted JLL’s Severino. Then they’ll will their houses to their millennial kids. Or the millennials will finally pay off their burdensome student loans and move up the economic ladder, so they can at long last afford a house on their own.

And apartments have one built-in weakness as investments. Their leases usually are year to year. Other types of commercial real estate, like offices and malls, have multi-year leases, hence more stability. Upshot: When the millennials move on up from renting a living space, the impact will be relatively fast.

REITs, Unloved by the Stock Market, Suffer as Rates Rise