How You Can Profit From The Strong Rental Market

Source: Wikimedia Commons, Los Angeles

Apartment vacancy rates are at their lowest level in more than a decade and rent is expected to rise in the coming years. This is bad news if you're a renter, but could be excellent news if you're an investor, and you don't need to own a rental property in order to cash in. There are real estate investment trusts, or REITs, which specialize in apartment buildings, such as Equity Residential (EQR -1.62%), AvalonBay Communities (AVB -0.96%), and UDR (UDR -1.62%) allowing investors to spread their money among a basket of properties instead of just one.

Why rental housing will be a lucrative investment
The U.S. apartment vacancy rate is currently at 4.1%, which is the lowest level in over a decade.  Despite the dwindling supply of available apartments, rent has not risen too much, and the small 0.8% gain can be attributed to the job market and poor wage growth in the U.S.

However, the job market woes will not last forever. The employment situation has steadily improved since the end of the recession, and is currently at 6.7%, down from a peak of 10% in late 2009. The Federal Reserve is projecting that the unemployment rate will continue to fall, and expects just 6.3% unemployment by the end of this year.

As far as the poor wage growth issue is concerned, there is a clear trend toward higher minimum wages across the nation, and this will certainly affect apartment renters. The data suggests the majority of American voters support raising the federal minimum wage, so although the Democrats may not get the $10.10 per hour minimum they are looking for, it is likely the minimum wage (and overall income of the renting public) will rise in the near future.

The combination of the improving job market and long-overdue wage growth will result in rising rents, especially if the vacancy rate remains low. This creates an excellent opportunity to get into REITs that specialize in apartment buildings, but how should you decide which one to buy?

Which one is right for you?
One of the biggest and best REITs that invests in apartment buildings is Equity Residential(EQR -1.62%), which owns an enormous portfolio of multi-family properties. The trust owns or has interests in 390 properties with almost 110,000 total housing units. In addition, the portfolio is very geographically diverse, with a maximum of just over 15% of the properties located in any one metropolitan area.  The trust tends to focus on large cities, which are generally among the more stable markets, and the top locations of Equity's properties are Washington DC, New York, Los Angeles, and Boston.

Another of the bigger trusts is AvalonBay Communities(AVB -0.96%), which specializes in upscale apartment communities in real estate markets with high barriers to entry. AvalonBay focuses on areas where single-family housing is very expensive and where there is a low supply of new apartment homes. As a result, the trust's holdings are much more geographically concentrated than Equity, with about 55% of the total portfolio (about 80,000 units) located in San Francisco, New York City, or Washington DC.

UDR(UDR -1.62%) is several times smaller than either of the other two, but still owns about 46,000 apartment homes and pays a higher dividend than the other two (more on that in a bit). UDR specializes on middle-market apartment homes, and is perhaps the most geographically diverse of the three funds mentioned here.  The trust's strategy is to focus on demographic groups that have a large amount of renters, such as young professionals, blue-collar families, and older singles.

Growth and rising income is a recipe for success
In order to be classified as an REIT, the trust must distribute at least 90% of its taxable income to shareholders in the form of dividends. This produces annual yields that may not be what you would think of as "high-income", but the beauty of equity REITs is that rental income tends to increase over time, and in a fairly steady manner.

All three of these offer decent income, with annual yields of 3.5%, 3.61%, and 4.05% for Equity, AvalonBay, and UDR, respectively. However, why equity REITs can be such a great long-term investment is the combination of a growing income stream and the growth in the value of the underlying portfolio of properties (more equity), which is what can build real wealth over the long term.

If you buy a solid REIT that is well-run and diversified, low vacancy rates and rising rents can deliver excellent growth in your portfolio for years to come.