No Immediate Respite for Residential REITs From High Supply

Real estate investment trusts (REITs) invest in all types of properties — from offices to malls to hospitals and hotels. The Residential REIT category is the one which is engaged in owning, developing and managing a variety of residences. The types of residences include apartment buildings, student housing, manufactured homes and single-family homes. Residential REITs rent space in these properties to tenants and earn a rental income in return.

According to a recent study by the real estate technology and analytics firm — RealPage, Inc. — although new supply volumes remained elevated in the Jan-Mar quarter, the U.S. apartment market managed to continue the rent momentum which was achieved in the later part of 2018. Apartment rents were up 3.2% on an annual basis as of the first quarter of 2019. In fact, for six straight months, annual rent growth exceeded the 3% mark. In addition, occupancy came in at 95.2% in the recently-concluded quarter, expanding 10 basis points from the year-ago period.

Here are the three major themes in the industry:

Favorable Demographic Growth: Demographic growth continues to be strong in the young-adult age cohort, which has a higher propensity to rent. In fact, a significant change in lifestyle has taken place and life-cycle events are getting delayed. This, again, is leading to an extension of the average age of first-time homeownership. This age cohort has also witnessed considerable part of net job growth which is helping spur primary renter demand. Moreover, the cohort of ageing millennials is growing at a rapid pace and because of lifestyle choices, this age group currently has lower homeownership rates than prior generations. Also, there are many in this age group who cannot afford homeownership. As such, demand for rented apartments might remain elevated in the near term.

U.S. Economy Losing Steam: The strength of the economy as well as the health of the job market plays key roles in determining the performance of residential REITs. Both these factors determine the capacity of rent that renters can shell out. However, of late, the economy is losing steam and concerns are brewing up regarding the fate of the U.S. economy amid prevalent trade-war tensions, the economic slowdown in Europe and China, as well as the declining stimulus from the lower tax rates. However, the same situation has led to a dovish stance by the Fed, which hinted at no rate hike at all this year in the latest FOMC meeting. And with REITs relying substantially on debt for business, as well as being considered as a bond substitute for their high dividend-paying nature, the central bank’s refrainment from raising rates gives a reason to rejoice. Particularly, the rate environment is likely to fuel the number of acquisitions in this industry.

Elevated Deliveries of New Units: The struggle to lure renters is feared to continue into the near term as supply volumes are likely to remain aggressive. In fact, per the above-mentioned study by RealPage, in the past six months, demand could not keep up with new product deliveries that aggregated 127,121 market-rate units in fourth-quarter 2018 and first-quarter 2019. Also, the study pointed out that market-rate apartment properties which are under construction have more than 403,000 units which will be completed over the next 18 months. Specifically, supply of luxury/high-end properties is anticipated to be high in some markets during the prime leasing period, propelling competition in turn. Elevated supply volumes generally curb residential landlords' ability to command more rents, and affect occupancy and concession levels. These apart, the student housing sector, which is part of the residential REIT industry, has been witnessing a slowdown in leasing velocity and compression in rent growth, amid demand-supply imbalances and intensifying competition. Specifically, properties away from campus are feeling the brunt. Amid these, student REITs are compelled to improve operational efficiencies and refine strategies to gain competitive edge.s

Zacks Industry Rank Indicates Bleak Prospects

The Zacks REIT And Equity Trust - Residential industry is housed within the broader Zacks Finance sector. It carries a Zacks Industry Rank #215, which places it at the bottom 16% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates bleak near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of negative funds from operations (FFO) per share outlook for the constituent companies in aggregate. Looking at the aggregate FFO per share estimate revisions, it appears that analysts are losing confidence in this group’s growth potential. Over the past year, the industry’s FFO per share estimate for 2019 and 2020 moved down by 3.0% and 17.3%, respectively.

Before we present a few stocks that you may want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Industry Leads on Stock Market Performance

The REIT And Equity Trust - Residential Industry has outperformed the broader Zacks Finance sector, as well as the Zacks S&P 500 composite in a year’s time.

The industry has rallied 19.2% during this period compared to the S&P 500’s rise of 7.8%. During the same time frame, the broader Finance sector has declined 3.2%.

One Year Price Performance

Industry’s Current Valuation

On the basis of forward 12-month price-to-FFO (funds from operations) ratio, which is a commonly used multiple for valuing Residential REITs, we see that the industry is currently trading at 20.10X compared to the S&P 500’s forward 12-month price-to-earnings (P/E) of 16.96X. The industry is trading above the Finance sector’s forward 12-month P/E of 13.68X. This is shown in the chart below.

Forward 12 Month Price-to-FFO (P/FFO) Ratio

Over the last five years, the industry has traded as high as 20.10X, as low as 16.14X, with a median of 18.01X.

Bottom Line

In a nutshell, although the residential REIT industry is poised to benefit from favorable demographics, lifestyle transformation, and creation of households, elevated supply in a number of markets in the near- to mid-term might hinder growth tempo, straining rental rates, and resulting in high concessions.

Currently, there is no stock in the industry sporting a Zacks Rank # 1 (Strong Buy). However, there is one stock with a Zacks Rank of 2 (Buy) which investors may consider adding to their portfolios. Also, investors can keep some stocks carrying a Zacks Rank of 3 (Hold) on their watch list. You can see the complete list of today’s Zacks #1 Rank stocks here.

Equity Lifestyle Properties, Inc. (ELS): This Chicago, IL-based REIT is engaged in the ownership and operation of manufactured home communities, RV resorts and campgrounds in North America, offering housing options as well as vacation opportunities. Currently, Equity Lifestyle Properties carries a Zacks Rank # 2. The company’s Zacks Consensus Estimate for the current-year funds from operations (FFO) per share remained unchanged at $4.18, over the last 30 days. However, it indicates expected growth of 8.01% year over year.

AvalonBay Communities, Inc. (AVB): This residential REIT is based in Arlington, VA, and is engaged in developing, redeveloping, acquiring and managing apartment communities in top metropolitan areas of the United States. The stock’s Zacks Consensus Estimate for 2019 FFO per share remained unrevised at $9.32, in 30 days’ time. However, it indicates a projected year-over-year increase of 3.56%. AvalonBay currently has a Zacks Rank of 3.

Essex Property Trust, Inc. (ESS): The San Mateo, CA-based residential REIT is focused on acquisition, developing, redeveloping, and managing multifamily residential properties in select West Coast markets. Essex Property currently has a Zacks Rank of 3.The company’s consensus estimate for the ongoing year’s FFO per share remained stable at $13.07, in the past 30 days. The figure denotes an estimated rise of 3.98% from the prior-year period.

Note: Funds from operations (FFO) is a widely used metric to gauge the performance of REITs rather than net income as it indicates cash flow from their operations. FFO is obtained after adding depreciation and amortization to earnings and subtracting the gains on sales.

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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.

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