The price of the median single-family home in the U.S. hit an all-time high, rising to roughly $370,000 in April from just over $250,000 early in 2020. Higher home prices are not the only challenge facing the housing market – mortgage rates surpassed five percent this year, as the Fed’s interest rate hikes reverberated through debt markets. Between elevated home prices and higher rates, housing affordability hit a 15-year low in June.
This decreased affordability is likely to weaken demand and home prices, but REIT investors should keep the situation in perspective as conversely, rental property REITs may actually benefit from affordability issues as would-be owners are forced to rent.
Housing market warning signs
Housing market data showed warning signs this spring: mortgage applications and consumer confidence dropped to 20-year lows and some homebuilders began to reduce prices. Mizuho’s chief economist, Steven Ricchiuto, believes we may see four to five quarters of negative GDP growth as the Fed slows the economy to mitigate inflation. This trend could spell trouble for the housing market over the next six-12 months.
I expect housing prices to fall, but there are mitigating factors that could limit the decline, as today’s market differs from 2008 in important ways, in my view. Home builders have under-produced new housing for a decade, resulting in less supply than we saw in the last housing market downturn of 2008. While housing inventory has inched higher in recent months, today’s levels sit far below long-term averages and are less than half of what they were in 2020. There is less speculation in the market, and lenders have been more responsible. While the market is cooling, this time round, I don’t foresee the 20-40 percent price drops which were recorded in 2008-2009.
Rental market demand remains intact
Challenges for homebuyers may create tailwinds for operators of multi- and single-family rental properties. As prospective buyers delay home purchases due to rising costs or concerns about the economy, demand for rental homes should remain high. In markets like New York and San Francisco, it now costs more than twice as much to own as to rent. The difference is less dramatic in the Sun Belt, but there is still a 30 percent premium for buyers.
Housing is a core need and even in the event of a recession or continued high inflation, people need a place to live. That said, rents may soften slightly. In many markets, rents are up 30 percent since 2019, and while rising wages have helped offset higher costs, there are limits to how much home prices can go up before it impacts demand.
Finding value in the REIT market
We believe the thesis for investing in residential real estate remains intact. The real estate sector is down some 21 percent to date in 2022. Valuations were high coming into the year, and investors were also concerned about home price appreciation and litigation against some developers.
Single- and multi-family REITs have some advantages over other parts of the market as they offer built-in inflation and interest rate hedges, and is more recession-proof than most. Following the recent selloff, residential REITs seem fairly valued and in my opinion, the demand supports continued strength.
Our top pick in residential REITs is Apartment Income REIT Corp. (AIRC). The firm owns a diversified portfolio of stabilized apartment communities and offers attractive growth at a reasonable price. Thanks to increased rental demand, both pricing and occupancy trends are improving for apartment buildings.
This is also a good market for developers like Avalon Bay (AVB), in my view. Avalon develops their own rental properties and reports development value creation margins in the 40-50 percent range. In Q1, the company completed $220 million of development, and has an initial projected stabilized yield of 6.9 percent on those properties. Avalon is currently developing 18 properties and operates in coastal regions where economics favor renting. While rents may drop and building expenses could rise, the company appears to be well positioned.
The years of double-digit price home appreciation may be over for now, but the fundamentals supporting housing—and in particular, single- and multi-family rentals—remain robust.