Rental REITs seen as undervalued

As stocks rally on hopes that cooling inflation will mean a smaller rate hike next month, analysts are pointing investors toward a potentially undervalued slice of the market: real estate investment trusts specializing in rentals.

Firms in the sector, touting the lasting strength of the multifamily sector, have bumped up profit projections, which could buoy shares and would result in bigger dividends.

There’s no denying that apartment REITs have had a rough 2022. The macroeconomic fears that sent the S&P 500 tumbling 20 percent through the first six months knocked 23 percent off the value of the iShares Residential and Multisector Real Estate ETF.

But a market rebound last month has sparked hope that indices could exit bear territory in the rest of the year. That rising tide could lift apartment REITs.

People have jobs, therefore they can pay the rent.
Al Otero, Armada ETF Advisors

In July, second-quarter earnings that trumped expectations fueled the S&P’s best month since Covid vaccines were deemed effective. The index has recouped more than half of its year-to-date losses since mid-June, and apartment REITs have recovered even more. REZ is slightly outperforming the S&P this year.

In a note last month, Morningstar analyst Kevin Brown estimated that real estate shares were trading at a 27 percent discount. REITs have risen about 8.4 percent since.

And second-quarter earnings for the sector’s standout firms revealed both strong fundamentals and an optimistic outlook.

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AvalonBay Communities, Equity Residential, Mid-America Apartment Communities and Essex Property Trust, each topped consensus estimates for funds from operations, a measure of profitability, in the period.

And all four firms, which collectively own multifamily assets on both coasts and throughout the Sun Belt, bumped up guidance for the rest of 2022.

Al Otero, portfolio manager, Armada ETF Advisors (Armada)

Al Otero, a portfolio manager at Armada ETF Advisors, said those upward revisions at this point in the year are a testament to the firms’ confidence that revenue will rise further, even though rental REITs historically have seen less leasing activity in fall and winter.

In an earnings call last month, CEO of AvalonBay Communities Benjamin Schall called the company’s second-quarter beat “atypical, particularly since we increased Q2 guidance at the end of April.”

But even given trickier comparisons to the latter half of 2022 — rents had already begun spiking last summer — firms expect asking rents will keep rising amid low availability.

COO Sean Breslin predicted that annualized rent growth, which may have peaked this week, would decline by just 1.5 percent on average this year.

Given that the average gain for new leases and renewals clocked in at 14 percent nationally last month, according to rental analytics firm RealPage, the anticipated dip still offers ample repricing power.

Essex Property Trust, banking on that same upside, hiked its earnings expectations in July for the third time. The firm credited fewer delinquencies in the quarter, a trend it saw continuing, as the reason.

As a whole, Otero said, rental REITs seem unconcerned that a recession or inflation could affect rent collections.

“If we are in a recession or if we are entering a recession, it doesn’t appear to be a jobs-based recession,” the portfolio manager said. Last week’s jobs report showed unemployment had fallen to a 50-year-low.

“People have jobs, therefore they can pay the rent,” Otero added.

REITs such as AvalonBay have said some tenants have seen wages rise, and that its affluent renter base is in good shape to withstand the increasing cost of living.

For investors, that overperformance and rosy outlook promises to pay dividends, literally.

REIT dividends have historically stood 1.5 percentage points above the rate for the 10-Year Treasury note, according to Morningstar. Projections of rising profits should boost those payouts.

“One thing we do know is that REITs hold value,” Otero said. “They are dividend payers, and the dividends are growing.”