Across the country, the rental market is growing. Continued robust employment and strong economic fundamentals have kept property values high and delivered the highest rent growth rate since 2016.
This growth is good news for Real Estate Investment Trusts (REITs). However, with rent control policies springing up in several states, what will be the impact on the overall growth of the apartment REIT sector?
Oregon and California recently became the first states to enact statewide rent control regulations this year. Other states are either considering the idea or have begun debate within their legislatures to consider such an action. In Oregon, a new law limits rent increases to 7% plus local inflation. Lawmakers in Colorado and New York are now considering similar rent cap laws.
In California, Gov. Newsome just signed a rent control bill that gives jurisdictions the ability to limit rent increases and prohibit increases in vacant units. California lawmakers tout the new law (previously rejected by voters) as a solution to combat homelessness in the state and reduce what they consider to be overpriced rental housing.
Rent Control Impact on Apartment REITs
As occupancy rates remain at record lows and rent growth accelerates, most economists believe rent control schemes are bad news for renters. An undersupply of housing increases housing and rental costs, and over-regulation is a driving factor in the housing shortage. Although changing demographics will ultimately negatively affect apartment REITs in the future, the near-term impact of rent control will be minimal.
The twelve largest apartment REITs account for approximately $140 billion in market value and comprises over 500,000 housing units. Apartment REITs make up roughly 10-14% of the broad-based REIT ETF market. Apartment REITs also make up about 10% of the Hoya Capital Housing 100 Index, the benchmark that tracks the U.S. housing sector. Americans currently contribute about $1.3 trillion per year in direct and indirect rent, accounting for 30% of the estimated $3.5 trillion per year spent on housing, home construction, and housing-related services. According to the Bureau of Labor Statistics, Americans, on average, spend 33% of their annual income on housing.
The $5 trillion U.S. multifamily apartment market is substantial, with REITs accounting for approximately 500,000 of the estimated 25 million multifamily rental units or about 2% of the entire rental market. A primary reason REITs will feel a minimal impact from rent control policies is that most apartment REITs are skewed towards high-end apartments at the upper echelon of the rental market. This focus on higher-priced rental properties makes them less exposed to the direct effect of rent control. However, some real estate owners in certain areas are still vulnerable to hostile regulatory actions.
Bad Regulatory Control Policies have Consequences
Despite 95% of economists saying rent control laws do more harm than good for renters, politicians have decided to move forward with an ill-advised policy on the promise of “housing for all.” The consensus from economists is that over-regulation at the state and local levels has been the driving factor in the cost of housing construction, which in effect has caused a shortage of affordable housing and an increase in housing costs.
Looking at it from an economic perspective, the apartment market is as close to a perfectly competitive market as is possible, with apartment owners forced into making rent decisions based on market conditions rather than pricing whims. Rental economic fundamentals respond appropriately and as expected to shifts in supply and demand conditions, which is evidenced in the operating performance exhibited by major apartment REITs.
Markets seeing above-trend rental growth tend to experience a period of new development spurred on by the need for more additional housing. However, that market-based supply and demand model can be quickly interrupted by price-caps and rental control schemes. Over time, policies prohibiting or interfering with new housing construction – either through environmental concerns or social issues – lead to a shortage of housing and subsequent increase in housing costs.
Since most of these price controls and restrictive zoning practices often affect the lower end of the housing spectrum disproportionately, apartment REITs catering more towards luxury tenants are seeing a minimal near-term impact on their portfolios. The high-end housing market has been seeing above-average supply growth over the past decade as a result, and in turn, has experienced a lower average rental increase that is well below any proposed pricing cap.
Apartment REITs Continue to Perform
As apartment demand is driven primarily by demographics, employment growth, and wage growth, apartment REITs typically see a slightly lower dividend yield compared to other REIT sectors. However, they tend to provide more inflation protections due to the relatively short lease terms of multifamily units. Over the past ten years, apartment REITs have become more attractive as developers can create more significant shareholder value through “capital recycling” or the process of liquidating assets of lesser value to fund the development or acquisition of higher-value rental properties.
Apartment REITs are still one of the most operationally efficient real estate sectors, demanding less operating and overhead expenses while requiring less ongoing capital expenditures. Tax costs are among the most significant for apartment properties, and we expect above-inflation growth in that area. However, millennial demographics continue to drive rental unit growth. That trend is likely to continue well into the mid-2020s as long as the economy and job market remains strong.
After a mediocre couple of growth years, apartment REITs have been making a comeback for landlords since 2018. Apartment REITs have delivered tremendous performance throughout the year, as occupancies remain high and turnover falls to record lows. Rent growth acceleration has been the best since 2016, and leasing metrics are showing a 4.2% jump in 2019, a 40 basis point improvement from last year.
There is little reason to believe that these trends will not continue into 2020 and beyond, as continued income growth will help push apartment REIT yields upward and keep the momentum we have seen over the past year.
