When the housing stocks started tanking, another group of real estate shares took off. I’m talking about the apartment Real Estate Investment Trusts (REITs).
The PHLX Housing Sector Index (HGX) is down around 29% from its peak in July 2005. Meanwhile, Archstone-Smith Trust (ASN), the second-largest U.S. apartment company in terms of market value, is up 34%.
Another apartment REIT, AvalonBay Communities (AVB), has climbed 42%. Throw in reinvested dividends and you’re talking about a total return of nearly 46%.
Why are investors rushing into these stocks? Here’s their investment thesis: Housing is unaffordable, and both sales and prices are falling. But since Americans have to live somewhere, they’ll end up renting. That will push demand up, supply down, and rental rates through the roof.
This was all true for a while, and if you made money in these stocks … great! But now it looks like the times are changing. And that means these supposed “housing bust havens†aren’t all they’re cracked up to be …
Three Strikes Against
The Rental REITs
First, the great condo conversion is reversing directions. See, one major force that tightened the rental market was strong condo sales.
At the tail end of the boom, investors were snapping up apartment complexes all over the country, fixing them up, then trying to re-sell them as condos.
Last year, roughly 200,000 apartments were bought for conversion last year, according to the Wall Street Journal. That was more than twice the level in 2004.
Now, many of these conversions are proving disastrous. The housing slump soured investors on what were essentially glorified apartments and sales withered on the vine.
That’s left many conversion investors scrambling. They’re rapidly switching their properties back to rentals, putting supply back onto the market. It happened to a complex in my own neighborhood, and the same scene is being played out all over the country.
Here’s another thing: The bulls argue that rising construction costs have made it less economically feasible to build new rental complexes. As a result, less apartment complexes have been built.
But I’m starting to see new condo buildings advertise units as rentals or purchases. So while we may not have seen many new apartment complexes built in recent years, we have seen plenty of condo buildings get constructed. Those may convert (at least partially) to rentals. That’s yet another heap of supply to deal with.
Second, wannabe flippers are becoming reluctant landlords.
Many neophyte real estate investors poured into the market during the boom, snapping up townhouses, single-family homes, and tower condos. They expected to resell these properties for big profits.
Now, nothing’s selling. And every month, these “investors†are being forced to shell out thousands on mortgage payments, taxes, and insurance.
Rather than leave their properties vacant and unsold forever, more and more are trying to go the landlord route. You can see it every day in the newspaper — instead of saying “for sale,†a lot of ads now say “for sale or for rent,†listing a sale price and a per-month rental rate.
How much vacant property is out there waiting to be converted? The answer will shock you. About 2.5% of all of the nation’s homes were sitting vacant in the third quarter, according to the Census Bureau.
Not only is that up from 1.9% a year earlier, it’s also the highest since the Census started keeping track in 1956.
Third, even market participants are talking about a less robust market.
For example, the National Multi Housing Council (NMHC) represents apartment owners, managers, and financiers, and publishes a quarterly index of market conditions.
The NMHC’s measure of market tightness dropped sharply from 85 in July to 70 in October. That’s the lowest reading since January 2005. Moreover, the percentage of respondents saying rental market conditions are looser than three months ago shot up to 14% from just 6% in July and 2% in October of last year.
Bottom line: Apartment REITs may be reaching fresh all-time highs, but their fundamentals have been getting worse. It’s like investors are saying,
“Valuations? We Don’t Need
No Stinkin’ Valuations!â€
At their current prices, apartment REITs are looking frothy. And as they keep going up, their dividend yields are sinking toward nothingness. Archstone-Smith is a good example …
The stock currently trades at a whopping price-to-earnings ratio of 58.7. That’s more than triple the 17.6 P/E of the S&P 500!
Now you might argue that earnings aren’t the best way to value REITs because investors are more concerned with a different measure of profitability called funds from operations (FFO). Think of FFO as a measure of a company’s core earnings because it excludes potentially distorting events like the sale of a building.
Well, Archstone-Smith is trading at 24.2 times its 12-month trailing FFO. Not only is that up from 20.2 a year ago, it’s the highest I can find going back to at least 1994. And if that ratio holds for the full year, it’ll be the most expensive ASN has been since at least 1991.
Overvalued? You better believe it!
What about the stock’s dividend? After all, investors usually buy REITs because they have above-average yields.
Sorry … Archstone-Smith sports an indicated yield of — get this — 3.05%. That’s far below both short-term, risk-free rates (three-month bills recently yielded 5.08%) and longer-term Treasury yields (4.61% on 10-year notes). It’s less than half what the stock was yielding in early 2005. Heck, it’s the lowest I can find going all the way back to the mid-1980s.
So, given their deteriorating fundamentals, multi-decade-high valuations, and paltry yields, now is not the time to pile into apartment REITs. In fact, I’d be looking for the exits.
Until next time,
Mike
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