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A Yield Investment for Falling Rates

Millennials are renting far longer … how this is creating an investment opportunity with big yields

$8,000.

That’s the net worth of the average millennial. Unfortunately, this generation is doing worse financially than earlier generations.

Why?

Well, if we go by the numbers, education expenses have climbed 65% in the past ten years, and many millennials are saddled with student debt. Food costs have risen 26%, health care has climbed 21%, transportation is up 11%, and housing has tacked on 16%. On this last note, millennials buying a first home today will pay 39% more than buyers nearly 40 years ago.

Put it all together, and the net worth of Americans aged 18 to 35 has dropped 34% since 1996.

One of the effects of this financial struggle is that a great many millennials are passing through life’s traditional milestones at a slower rate than prior generations. For instance, they’re living at home with parents longer, putting off marriage until later, and delaying buying homes.

Let’s dig into this last factoid, because there’s an investing implication here …

Millennials are delaying buying homes.

Now, as to “why?” we could point toward higher underwriting standards instituted after 2008, a shortage of affordable starter homes, stagnant wages, and the simple reality that $8,000 isn’t going to go very far on a down-payment. (I live in Venice, California, where the average starter home is roughly $1.3 million … though I’m not a millennial, I rent.)

So, if millennials are waiting to buy homes, where are they living?

The answer points us toward an interesting investment opportunity today.

***Millennials are driving demand in the apartment rental markets, which is great for certain REITs

Apartment demand in the second quarter of 2019 spiked 11% from just a year ago. Of the reasons why, one of the biggest is because housing is simply too expensive for most millennials.

The CEO of Buzzuto, one of the largest residential, Class A apartment developers in the nation, said:

I think millennials ultimately aspire to have homes. I think it’s still the American dream, but I call it the dream deferred and it’s deferred because of student loans, the lack of having a large amount of equity, and they also enjoy flexibility versus fixity.

A record 82% of renters say renting is more affordable than owning. That comes from a new survey from Freddie Mac. For context, what was last year’s number? Just 67%.

A report by SmartAsset found that in some cities, the median home outweighed the median income by such a wide margin that it could take almost a decade to save for a 20% down payment.

So, higher home costs and stagnant wages are driving demand for apartments … that demand is pushing rents higher (nationally, they’re up 3% to an average of $1,390 per month, though much higher in select popular cities) … which is padding the bottom line of certain well-run REITs.

Now, let’s do a quick pivot and make sure we’re all on the same page when it comes to REITs.

***The basics of REITs

REITs (real estate investment trusts) are businesses that own income-producing real estate in all sorts of real estate sectors — think single family homes … offices … apartments …

Most REITs own dozens of properties in different geographical areas. For example, the big shopping mall REIT Simon Property Group owns hundreds of malls across America. The big office REIT Boston Properties owns over 150 office buildings across America. The big apartment REIT Equity Residential owns over 70,000 apartment units across the country.

You know how ETFs allow investors to own big groups of stocks with just one click in a brokerage account? You can think of REITs like ETFs for properties.

To be considered a REIT by the government, a company must pay out at least 90% of its taxable income to its shareholders. This means that REITs can be a great source of cash-flow for investors like you and me — and that’s no small thing considering how just this morning, Fed Chair Powell’s prepared remarks to the House Financial Services Committee all but guaranteed a July rate cut, which will put downward pressure on income investments.

***REITs offer investors lots of benefits that don’t come when owning a single stock

For example, there’s greater diversification (since you’re investing in many properties all at once) … more price stability (you rarely see huge price swings in quality REITs because real estate isn’t a volatile investment like a high-flying tech stock) … and of course, the greater yields — which is what’s driving the wealth creation in this case.

As mentioned a moment ago, to qualify as a REIT, these businesses must pay out at least 90% of taxable income to shareholders. This usually means fat dividend checks.

For example, according to Nareit (National Association of Real Estate Investment Trusts), the average REIT dividend yield for the most recent calculated period is 4.16%. Compare that to the average dividend of the S&P 500 — currently 1.91%.

Of course, many apartment and residential REITs offer greater yields.

A quick scan of apartment and residential REITs on Dividend.com reveals a 6.98% yield from Preferred Apartment Communities, 8.21% from Armour Residential, and 10.33% from Ellington Residential Mortgage, even 12.99% from New Residential Investment Corp (please note, I’m not recommending these REITs, just illustrating the elevated yields. Always buy a REIT for its underlying quality, not a lofty yield).

***Apartment demand doesn’t look to be slowing

This past spring, demand for rental apartments reached a five-year high. It has bumped the national occupancy rate to 95.8%, compared with 95.4% at the end of the second quarter of 2018.

But even though apartment construction is near 30-year highs, much of that new supply is targeting only higher-income earners. The broader rental market is tighter — so demand is still high.

On top of that, if the Fed is going to lower rates, it’s going to mean lower mortgage rates. Now, while that might appear to be helpful for millennial home buyers, there’s actually a different dynamic happening.

Starter homes represent about 21% of the available housing inventory in the U.S. But that doesn’t mean all these homes are being purchased by young families, or in this case, millennials. In fact, last year deep-pocketed investors bought roughly 20% of U.S. starter homes — that’s double the amount from 20 years ago. And in the most popular markets, they bought almost 50% of the most affordable homes and 25% of all single-family homes.

Now, here’s the thing — they’re outbidding millennials by paying in cash. Some are buying houses before they’ve even been put out on the market. So, even if mortgage rates drop, millennial buyers are still facing a major headwind here in purchasing a starter home. But that headwind is the exact tailwind that’s driving profitable apartment REIT investing.

If you’re interested in learning more, consider an apartment REIT like UDR. It owns or has shared-ownership stakes in 49,795 apartments, primarily in “high barrier-to-entry” neighborhoods in California and the Boston-New York region.

UDR’s funds from operations (a key metric of REIT profitability) has grown 6.6% annually between 2013 through 2019 estimates, versus a median of 5.3% for its peers. And without excessive debt, it’s paid out dividends for 186 straight quarters. Its dividend yield is about 3% as I write.

Of course, its total return is far higher. As you can see below, over the last 12 months, UDR is up nearly 30% compared to the S&P’s 6.9% gain.

 

Bottom line — millennials are experiencing life in a different way than prior generations. And this difference is fueling demand for apartments nationwide that’s supportive of longer-term investment gains — even better, if the Fed does lower rates, then quality apartment REITs could help bolster your portfolio’s cash flow in a low-yield environment.

By the way, the power of REITs for compounding wealth isn’t limited to apartment REITs. Our resident master income investor, Neil George, holds several REITs from various sectors in his portfolios.

One of them is a diversified corporate properties REIT, offering a 4.80% yield. The other is a medical properties REIT yielding 5.43%. Neil is bullish on both investments. To learn more about them, as well as Neil’s other income investments, .

We’ll continue to keep you up to speed here in the Digest.

Have a good evening,

Jeff Remsburg

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.