Multifamily REITs to Flourish in Major Metros: Morningstar
- May 24, 2018
The multifamily market has remained strong, with positive employment conditions and an economy that shows renting is now a more favorable option for people than homeownership. Despite this, some markets are beginning to see an excess of supply over demand, which leads to slower rent growth and the possibility of higher vacancies within the next two years. Although this may seem impactful, according to Morningstar Credit Ratings’ Big Cities Hold the Keys for Apartment Research report, this forecast will not make a large dent in a multifamily REITs ability to generate solid NOI, meet financial obligations, maintain solid balance sheets and strong management teams.
The report takes a look at how market conditions in the New York City, Boston, Los Angeles, San Francisco and Washington, D.C., metros will impact four of the largest multifamily REITs: AvalonBay Communities Inc., Equity Residential, Essex Property Trust Inc. and UDR Inc., during 2018 and 2019. These five metros contribute 90 percent or more to the NOI of AvalonBay and Equity Residential, as well as more than 65 percent for UDR. For Essex, the company’s portfolio holdings are only on the Pacific Coast, although 80 percent of its NOI is derived from the Los Angeles and San Francisco Bay areas. With this, each metro has the power to make a significant impact on the portfolio performance for each of these REITs.
“Growth in property cash flows has been gradually slowing across portfolios after a strong post-recession run,” Chris Wimmer, vice president at Morningstar Credit Ratings, told Multi-Housing News. “Elevated supply of new rental units is something we typically see at the top of the apartment cycle.”
New York City
When it comes to metro breakdowns, Equity Residential has the greatest chance of feeling an impact from market conditions changing in New York City. The firm has 17 percent of its NOI coming from the city, with the largest portion of its portfolio being in Manhattan. The company has more than 6,6000 units, averaging a rent of $3,800, which according to Morningstar, sets up the chance of a significant portion of its portfolio achieving below normal rent growth over the next two years. AvalonBay will be less affected, even though the company has a higher NOI (23 percent), due to the fact that its properties are not limited to Manhattan. The firm has less than 2,500 apartments in New York City, 2,900 in Long Island and 4,000 in New Jersey. UDR has the smallest amount of its NOI supplied from Manhattan (10 percent).
A modest rent growth of 1.8 percent is forecasted for the city from 2018 to 2019, as supply is expected to have a more significant increase than absorption rates, pushing vacancy higher to 3 percent by year-end of 2019. Employment growth is set to be close to the national average annual rate of 0.7 percent, or 1.5 percent for the two-year period.
For the Washington, D.C., metro area, AvalonBay, Equity Residential and UDR will all face weak fundamental drivers over the next two years. Each firm has a similar exposure to the area, producing a mid- to high-teens percent NOI, with majority of investment in the suburbs of Virginia. AvalonBay has more than 12,000 units in the area, 8,000 of which are in Virginia. Equity Residential has around 16,000 units, with more than half (9,000) located in Virginia. Out of UDR’s 8,575 units, 72 percent of that is also located in Virginia.
The metro is expected to see 29,000 units come online between 2018 and 2019, a increase of 6 percent. This will surely outpace absorption by 4,400 units, which will increase the vacancy rate to 7.2 percent by the end of next year. Due to this, average rents are only forecasted to increase by 3.1 percent. The largest portion of supply growth is expected to occur in the District of Columbia, which is only around one fifth of the REITs combined metro area exposure, according to the report. That being said, rent growth is forecasted to be higher in Virginia, where apartment development is lower than the district.
“Weaker market fundamentals in the New York City and Washington, D.C. metro areas will only affect revenue and profitability at the margins,” Mike Magerman, vice president at Morningstar Credit Ratings, told Multi-Housing News.
Boston shows a heavy development pipeline in the works, but is expected to provide only adequate demand and rent growth through 2019. Although there is sufficient employment growth to support the housing demand, the Boston metro struggles with having a smaller exposure than the bigger markets in this report. AvalonBay gets around 14 percent of its NOI from Boston, while Equity Residential derives 10 percent and UDR is at 6 percent.
The metro is expected to have around 15,400 units developed between 2018 and 2019, taking the top spot of the markets in the study, with a two-year inventory increase of 8 percent. Its year-end vacancy of 5.6 percent is higher than the 10-year average of 5.2 percent, but the forecast for rent growth is unsure. Boston did have the best 2017 rent growth in comparison to the three major northeast apartment markets, ranging from 2.3 to 3.9 percent, but long-term rent growth has produced an average of 1.8 percent over the last decade.
Apartment demand and above-normal rent growth is forecasted for the Los Angeles metro within the next two years, driven by the increase in employment. Essex Property Trust’s portfolio is exclusively in the Pacific Coast and is set to stand out from the others due to its concentration in an area where supply and demand are better matched. Forty-five percent of the firm’s NOI is generated in the Southern California market, which includes Los Angeles and Orange Counties, San Diego County and others nearby. Of the total units, 47 percent are located in Los Angeles, while the rest is split among other counties. Equity Residential comes in second place in terms of its Southern California NOI, with 26 percent produced from that area, followed by AvalonBay (21 percent) and UDR (19 percent).
Los Angeles county is expected to deliver 20,000 units, while Orange county will deliver 8,000. This will produce two-year increases of 2.2 percent and 3.4 percent, respectively, pushing vacancy up by 20 basis points in Los Angeles and 80 basis points in Orange County, by the end of next year.
The prices of homes in San Jose and the East Bay remain high, fueling apartment supply growth through 2019. Essex once again has the highest percent of NOI within the Northern California Market (San Francisco, San Jose and East Bay), with 37 percent. Avalon Bay and Equity Residential both follow with 20 percent. UDR rounds out the list with 13 percent NOI from that area, derived from San Francisco and San Jose only, where it has more than 2,700 units producing an average rent of $3,486 per unit per month.
The forecast for San Francisco calls for 6,000 units delivered within the next two years, leading to an inventory increase of 3.7 percent. San Jose is set to expect 7,800 units to come online, for an increase of 5.6 percent. This will lead to a two-year rent growth of 4.3 percent in San Francisco and 7.5 percent in San Jose. In 2017, rent growth was at the lowest of these five markets, with 0.8 percent growth, a large dip from the metro’s 10-year average of 2.4 percent.
According to Morningstar, although there may be some decline in activity and rent growth, it does not expect any negative impact made to these portfolios, despite dealing with possibly weaker market fundamentals. The report anticipates that each REIT will have a sufficient amount of capital throughout 2019 to manage disruptions.
“Multifamily REITs that we rate are all well-established through at least two economic cycles and are well positioned to withstand another,” added Magerman.
Data and charts courtesy of Morningstar Credit Ratings