What to Look for When Buying Residential Real Estate Stocks

If you want to invest in residential real estate but don't want to be someone's landlord, here's what you should know.

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There are a few different types of stocks that are tied to residential real estate.

For example, homebuilders are more successful during stronger housing markets. The same goes for real estate businesses like Zillow (NYSE: Z)(NYSE: ZG) and Redfin (NASDAQ: RDFN). Building supply stores like Home Depot (NYSE: HD) and Lowe's (NYSE: LOW) also benefit.

However, the stocks that let you directly invest in residential real estate are real estate investment trusts, or REITs. These companies own properties such as apartment buildings and single-family homes. Those properties generate rental income and other profits for investors.

What's a REIT?

A REIT is a special type of company designed to let investors put their money to work in real estate assets. There are two main categories of REITs -- equity and mortgage. Equity REITs own physical properties, while mortgage REITs invest in mortgage-backed securities and other financial assets. For the rest of this discussion, you can assume I'm referring to equity REITs.

In addition to meeting other qualifications, REITs must pay out at least 90% of their income to investors as dividends. In exchange for doing so, they're exempt from corporate taxation. This often makes REITs excellent choices for income investors and those who buy stocks through retirement accounts like IRAs.

Most REITs specialize in a certain type of property. Some REITs choose to invest in residential properties, such as apartments and single-family homes. Others focus on even more specific types of residential real estate.

What to look for when buying residential REITs

When it comes to residential REITs, there are a few things to look for.

First and foremost, you want to see consistency. Solid REITs produce consistent income and growth through a portfolio of properties whose occupancy and rental income aren't too sensitive to economic downturns. Consistent dividend growth is a nice feature as well. While past behavior isn't a guarantee of the future, it's a good idea to look for REITs with a multi-year track record of increasing their payout.

You also want to see REITs with a reasonable debt load compared to peers and a sustainable dividend. There's no set-in-stone rule about how much debt is too much, but I like to see less than half of a REIT's total capitalization in the form of debt. As for the dividend, high payout ratios are common with REITs, but I like to see no more than 90% of funds from operations (FFO).

It's also good to look for some type of competitive advantage. For example, larger REITs have efficiency advantages as well as greater financial flexibility that comes with scale.

Finally, I always look for REITs with management teams that actively create shareholder value. For example, many REITs use capital recycling as a major part of their strategy: They strategically sell properties to reinvest the proceeds in more attractive opportunities. Others create value by developing new properties from the ground up.

5 examples of great residential real estate stocks

There are dozens of residential REITs to choose from, many of which can make excellent long-term investments. Here are five of my favorites in a variety of sub-specialties, just to give you an idea of what's available.

Company (Symbol) Property Subtype(s) Market Capitalization Dividend Yield
Equity Residential (NYSE: EQR) Urban and suburban apartment buildings $30.7 billion 2.7%
AvalonBay Communities (NYSE: AVB) Urban and suburban apartment buildings $29.0 billion 3.0%
Mid-America Apartments (NYSE: MAA) Apartments in high-growth, non-urban areas $14.3 billion 3.1%
American Homes 4 Rent (NYSE: AMH) Single-family rental homes $7.6 billion 0.8%
American Campus Communities (NYSE: ACC) Student-focused apartment communities $6.4 billion 4.0%

Data source: CNBC. Market cap and dividend yield data as of 8/26/19.

The two largest residential REITs, Equity Residential and AvalonBay Communities, have quite a bit in common.

Both are similar in size and have similar investment strategies. They focus on apartment communities in coastal, high-barrier, urban and suburban markets. Examples of where these companies invest include Boston; New York; Washington, D.C.; Seattle; San Francisco; and Southern California. And both have been around for decades.

They also have excellent track records of creating value for their shareholders. For example, Equity Residential has been very active in capital recycling. They strategically sold more than $8 billion of properties from 2016–2018 and used the proceeds to reinvest as well as pay a special dividend to investors.

AvalonBay is the more active of the two when it comes to developing new properties from the ground up, which can be a great way to create value. After all, if you can build a $10 million property for $8 million, you create instant equity for investors.

The proof is in the numbers, and both companies have handily beaten the overall stock market over the past 25 years:

AVB Total Return Price Chart

AVB Total Return Price data by YCharts

Unlike Equity and AvalonBay, Mid-America Apartments concentrates its efforts on higher-growth areas of the U.S. outside of urban markets. Its apartments are, on average, significantly cheaper than those offered by Equity Residential and AvalonBay. The company takes advantage of high-growth markets while providing downside protection from recessions. Again, it's tough to argue with the numbers: Mid-America Apartments has produced a 1,670% total return over the past 20 years. That's roughly eight times the S&P 500's returns over the same period.

The vast majority of residential REITs invest in apartment communities, but some buy single-family rental properties.

American Homes 4 Rent is a large example with nearly 53,000 homes in its portfolio. The company aims to take advantage of single-family rental demand in certain markets where the cost dynamics are in favor of landlords. And while it's the youngest REIT on this list, early results have been promising. Since the 2013 IPO, American Homes 4 Rent has generated a total return of 73% for its investors.

Finally, American Campus Communities is a great example of a REIT that specializes in a narrowly focused type of residential property. Specifically, they invest in and manage apartment complexes located near or on major college campuses that are intended specifically for student housing.

The idea is simple. Dorms and other existing on-campus housing options

  • are outdated,
  • lack amenities students want,
  • often don't have modern technological infrastructure,
  • offer little privacy, and
  • are expensive compared to off-campus options.

By designing properties specifically for students, the company has a big advantage over its competition. Since pioneering the off-campus student housing industry a couple decades ago, American Campus Communities has grown a portfolio of 170 properties, so it seems like the trend is catching on.

Remember, these are long-term investments

Like most stock and real estate investments, residential REITs are best suited for long-term investors. There are too many factors that can influence the short-term prices of residential real estate stocks, even if their underlying businesses are doing just fine.

Don't put any money into a residential REIT that you'll need within the next five years. Longer timeframes are even better. Over time, residential real estate can be a great way to generate income and build wealth, and a residential REIT can let you do so without the headaches and time commitment of becoming a landlord.

Matthew Frankel, CFP owns shares of American Campus Communities. The Motley Fool owns shares of and recommends American Campus Communities, Zillow Group (A shares), and Zillow Group (C shares). The Motley Fool has the following options: short February 2020 $205 calls on Home Depot and long January 2021 $120 calls on Home Depot. The Motley Fool recommends Home Depot, Lowe's, and Redfin. The Motley Fool has a disclosure policy.
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