Since the COVID-19 pandemic, residential real estate has been one of the best-performing asset classes. Landlords were earning rental income and seeing their assets appreciate at levels in the mid-teen percentages. In some hot markets, like Phoenix and Austin, home prices rose 50% or more.
This increase in home prices translated into rising rental rates. But now that home-price appreciation is flattening out, we're seeing decreases in rents, as well. Does this present a problem for apartment real estate investment trusts (REITs) like Equity Residential (EQR 0.42%)?
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Equity Residential focuses on young, affluent, knowledge-based workers
Equity Residential is an apartment REIT with a focus on affluent, young urban dwellers. The company focuses on metropolitan statistical areas (MSAs) with a strong labor market for knowledge workers, limited new-residential construction, and high single-family home prices.
Currently, the company's primary markets include Southern California, San Francisco, Seattle, Boston, New York, and Washington, D.C. These have always been expensive single-family residential markets.
The typical tenant is probably someone who might want to buy a starter home but is struggling with affordability. Home affordability has taken a nosedive over the past year as the Federal Reserve hikes the federal funds rate in order to combat inflationary pressures.
In addition, home prices rose dramatically since the beginning of the pandemic due to people exiting urban areas and a big increase in investor activity. During the days of the pandemic, lots of money was raised for single-family rentals in order to imitate single-family rental REITs like American Homes 4 Rent and Invitation Homes.
There's also the fact that the United States has been underbuilt since the days of the Great Recession, with some studies seeing a housing gap of anywhere between 5.5 million and 6.8 million homes. This works out to be years of housing starts at the current rate. Residential real estate is scarce in this country, and that benefits Equity Residential.
Asking rents are beginning to fall, but some are due to seasonality
According to a recent market report, median asking rents are beginning to decline. It looks like they peaked in August 2022 and are down 3.6% from the peak. They're still up 4.8% on a year-over-year basis, however.
As they say, all real estate is local, and that's especially important here. If rents are falling in, say Saint Louis, but are still rising in San Diego, then Equity Residential will have less of an issue. Another factor is seasonality. Just like house prices and listings, rents tend to sag in the winter months and pick up in the spring and summer.
While asking rents may be declining, that doesn't necessarily mean that Equity Residential will experience declining rent growth. This is because the asking is relative to what the prior tenant was paying, and rent increases are highest on a new tenant.
Renewal rates are generally smaller, but comparing the rent in December, versus August, isn't really relevant for forecasting Equity Residential's projected rent increases. That said, new-lease rent increases are moderating, falling from an 8.3% increase in September to a 5.3% increase. The company noted that tenants are becoming more price sensitive in San Francisco and Seattle, two markets that experienced significant price appreciation over the past few years.
The fundamentals remain strong for apartment REITs
Ultimately, the fundamentals remain strong for Equity Residential. The apartment vacancy rate in the United States remains near historical lows, and the company has exposure to some of the best markets. The lack of single-family homes for sale, along with falling affordability, means that many affluent renters will remain in place.
Equity Residential is guiding for 2022 funds-from-operations (FFO) per share to come in between $3.52 to $3.54. The REIT will give 2023 guidance when it announces fourth-quarter earnings and is trading at 17 times the guided 2022 FFO per share. It also has a 4.1% dividend yield. While softening in the housing market will slow rental appreciation, the company should still exhibit positive growth.
