A Beneficiary of the Housing Bust: Apartment REITs

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With much of America's attention focused on the meltdown in the housing market, rising foreclosures and the economy's wheezy recovery, one unlikely sector has been quietly and steadily posting high returns to investors.

So far in 2010, apartment REITs, which own and develop rental apartment buildings, have delivered total returns, which include dividends, of 25.5%, far outpacing the S&P 500, the Dow Jones industrial average, Nasdaq and the Russell 2000, which are down 2.7%, 2.1%, 3.9% and 1.6%, respectively. Among industry groups, only gaming stocks have offered comparable returns.

Why apartment REITs?

Many of the issues that are decimating the housing sector are the same ones spurring activity in the rental market. Rising foreclosures, tough lending standards and uncertainty over how much further home prices could fall are all taking a toll on housing demand, with the national homeownership rate tumbling to 66.9% in the second quarter — its lowest level since the fourth quarter of 1999, according to the U.S. Census Bureau. The rate peaked at 69.2% in the fourth quarter of 2004; economists predict it could slip to 64% within the next few years.

"For every 1% decline in the homeownership rate, you get over a million potential new renters," says Richard Anderson, a managing director at BMO Capital Markets.

No matter that mortgage rates are hovering near historic lows. Today, most renters who could potentially be buyers are content to sit in their apartments until a definitive bottom in seen in housing prices. This is causing demand for rental apartments to increase. "They [apartment REITs] have shown consistent improvement quarter over quarter sequentially ... since the end of 2009," says Bob Gadsden, a portfolio manager at Alpine Realty Income & Growth Fund, which holds shares in apartment REITs.

And the rent-over-own cycle doesn't appear to be over. Sales of existing homes in July plunged 27.2% from June and 25.5% from July 2009, marking the lowest sales level since the National Association of Realtors (NAR) began tracking such data in 1999. NAR's chief economist, Lawrence Yun, is predicting this slow sales pace to likely continue through September and then improve, but many consider that to be a rosy forecast in light of the latest housing statistics. Worsening the situation, America's unemployment rate remains at a lofty 9.7%, with weekly claims for unemployment benefits ticking up in recent weeks, and the number of foreclosure filings rose an additional 3.6% from June to July.

Partly as a result of all this housing grief, apartment-REIT management teams have been raising their earnings outlooks. "This is one — if not the only — healthy sector out there that's showing some elements of pricing power," says Bill Acheson, a senior analyst at the Benchmark Company. "So far this year, we've seen increases in occupancy, and we've seen a turn in rent rates from big negative numbers to actually positive sequential numbers."

Of course, apartment REITs, like other sectors, took a beating during the recession. Most were forced to slash rents and offer perks and incentives, like free health club memberships, in order to retain tenants and attract new ones. Occupancy averaged 94.5% during the recession, notes Acheson, but rents plunged anywhere from 15% to 40% from their peak, depending on the market, says Anderson.

However, surging demand in recent months as well as the credit crunch — which limited the construction of new apartment buildings — is now allowing apartment REITs to start raising rents again. "There's no question that rents are recovering ... and the recovery is happening sooner than expected," says Anderson.

Investors began jumping into the sector in the third quarter of 2009 as apartment-REIT management teams began reporting increased demand and offering rosier-than-expected earnings outlooks. The sector rallied, posting total returns of 30.4% in 2009, reversing the –25.1% return reported in 2008. In the second quarter of 2010, the sector posted its first sequential quarter-over-quarter increase in net operating income since the fourth quarter of 2008, and industry experts expect year-over-year growth to come as early as the third quarter.

So is this the stock group to ride into the future? Most industry experts are bullish about the sector's growth through the second half of 2010 but aren't so sure about 2011. Much will depend on the extent to which job growth picks up. "There's only so much you can do without real job growth," says Acheson. "At the end of the day, that is the driver of apartment demand."

Gadsden believes the sector is now pricey, with much of the frothy outlook being baked into the current stock prices. "We're bullish on the fundamentals," he says, "but the valuations keep us from getting more heavily invested at this point."