Merrill Lynch Bullish on Apartment REITs

by REIT Wrecks on March 31, 2011

“Why buy when you can rent?” This is the question being asked by Bank of America Merrill Lynch’s U.S. economics team, and in tandem with BAML’s REIT analysts, the firm published a series of research pieces on apartments and rental housing yesterday. The firm outlined a number of ways to play what it believes will be a fundamental shift toward rental housing, with the most “palpable” being apartment REITs, including Avalon Bay (AVB), Essex Properties Trust (ESS), Apartment Investment & Management (AIV) and Colonial Properties Trust (CLP). The firm outlined several risks to their thesis, but overall the reports focused on what may be a persistent, long term shift in in the nation’s housing patterns:

“There has been a significant shift from ownership to renting, and in our view, this will continue for three reasons. First, foreclosures will naturally transition many homeowners to renters. Second, young adults are not good candidates for homeownership in this market of tight lending standards and high unemployment. Third, it will be challenging for current renters to become homeowners given the drop in net worth and income.

While we expect the bulk of the shift into rentals to occur over the next three years, we look for the trend to persist as a result of policy changes that make homeownership less attractive. The latest rhetoric out of Washington hints that the mortgage market will become more restrictive and the incentives for homeownership will be reduced. We also expect additional downsizing as aging baby boomers move into apartments.

One of the most persistent questions surrounding this thesis is the so-called “shadow market” but the report suggested that “much of the oversupply from foreclosures of single-family homes will not meet the demand, either in the type of home or location.” The analysts did not go into any further detail into what I have referred to as “The Shadow Market Media Myth”, but suffice to say that the shadow market problem in 2005-2006 may have been much more nettlesome, and less well-known, than the one that exists today. Still, the risks outlined in the report included rising rates, foreclosed homes becoming more competitive as rentals and supply coming on faster than anticipated.

With respect to construction, BAML says that not only did multifamily construction not participate in the single-family construction boom, it also dropped materially during the recession. As a result, BAML says the inventory of multifamily homes is lean. The report notes that the rental vacancy rate has declined from a peak of 11.1% in 4Q09 to the lowest vacancy rate (9.4%) since 2003.

The main impetus for lower apartment vacancies is a shift in demand toward rental housing, since 65% of those who rent are renting apartments. This adjustment is already well underway; indeed the homeownership rate has fallen to 66.5% from a peak of 69.2% in 4Q04, translating to 2.8 million “lost” homeowners. The analysts say that additional demand will come not just come from a shift toward rentals, but also from downsizing among homeowners.

Merrill Lynch recommends a barbell investment approach, where upside can be captured through the high end, coastal development portfolio of AVB, which is adding new supply in low vacancy markets, and “middle market” REITs like CLP and AIV, based on their lower average rents. Merrill believes that the REITs like CLP and AIV may see an even greater increase in demand from new renters that previously owned homes as well as from current renters that choose to trade down, because their average rents are less expensive.

Perhaps the most compelling argument for the shift in demand toward rentals is the rhetoric coming out of Washington D.C., and the tone of this rhetoric has shifted from encouraging ownership for all, toward a more balanced approach toward owning and renting. Even Barney Frank, Democrat of Massachusetts, said that United States policies in recent years promoted the idea of homeownership too hard and at the expense of rental housing. ‘I wish people could own more homes,’ he said in an interview with the New York Times. ‘But I also wish I could eat and not gain weight.’

Merrill Lynch concludes that the end result will be a stricter housing finance system where credit is not as available, rates are higher and incentives for renting are greater.

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