While the housing industry receives growing media attention, many are overlooking a prime opportunity in a related sector. With so much focus on home sales, it's going unnoticed.
I'm talking about apartments.
My colleague Carla Pasternak recently highlighted new investment opportunities in the apartment REIT (real estate investment trust) sector resulting from a growing imbalance between supply and demand for rental units.
She calls this growing trend "Renter Nation."
Jeffrey Friedman, CEO of apartment REIT Associated Estates Realty (Nasdaq: AEC), projects approximately 5.5 million new households will form during the next three years. Of these new households, an estimated 70% will be renters. And that's just the demand part of the equation.
The other good news is that these 3.8 million new renters will be competing for available units. The prolonged drought of new construction means there are not enough apartments, as demand will outpace supply by 2.5 million units, according to the National Association of Real Estate Investment Trusts. This is expected to reward apartment owners with higher values on their properties and rising rents.
Here are a few of my favorite lesser-known apartment REITs.
|1. Home Properties
| Home Properties (NYSE: HME) is attractive because of its East Coast real estate and exceptional track record for redeveloping apartments.
The markets where Home Properties mainly operates (Washington, D.C., Boston, Baltimore, Philadelphia and New York) are some of the best rental markets in the country, characterized by lower-than-average unemployment rates and above-average home prices, making it difficult for middle-income families to afford homes. Home prices in these markets average more than $334,000.
The company focuses on apartment properties that have at least 150 units and high barriers to entry, such as suburban locations, access to highways and excellent school districts. Only a few properties in a given market satisfy all of these criteria, creating an advantage that is difficult for competitors to replicate.
The company redevelops its properties after acquisition, then it sells them for a profit. In the past 17 years, Home Properties has acquired and repositioned 216 properties while earning at least a 10% return on these investments. The current portfolio consists of 121 communities and 42,635 units.
The success of this redevelopment strategy is apparent in the company's financial results. Funds from Operations (FFO) per share, a key REIT cash-flow metric, improved by 16% in 2012 to jump to $4.13. FFO growth is projected to be more modest at 4% to 8% in 2013 mainly because of the timing of property sales, which will occur earlier in the year than acquisitions.
Home Properties raised its dividend 6% in February to a $2.80 annualized rate yielding 4.4%. Payout based on 2013 FFO per share guidance is about 64%, which leaves plenty of cushion for more dividend growth.
|2. Associated Estates Realty
| Another small apartment REIT worth considering is Associated Estates (NYSE: AEC).
This company owns apartment communities in the Midwest, Mid-Atlantic and Southeast regions of the United States. The portfolio currently consists of 52 properties and 13,950 rental units across 10 states. Associated Estates also has three new projects and a property expansion under way that will begin adding to FFO this year.
The company owns high-end properties that have an average age of just 14 years and high quality ratings. Associated Estates has consistently produced community income growth that exceeds that of its peers. Although smaller than other REITs, the company has been expanding aggressively and adding properties.
FFO per share rose by 23% in 2012 to $1.27, and Associated Estates hiked its dividend by 6% in December 2012. At the new forward annualized dividend rate of 76 cents a share, shares yield 4.3%. FFO payout is modest at 60%. The company's expansion also has led to steady growth of 125% in the past five years.
|3. RAIT Financial Trust
| Investors who want exposure to more than one real estate sector should consider owning shares of RAIT Financial Trust (NYSE: RAS).
This REIT is not a pure play on the apartment boom, but it does own 33 apartment properties across the United States. Apartments represent $600 million of its $1 billion real estate portfolio. RAIT also owns office buildings, retail properties and undeveloped land, and it provides property management services on a fee-based basis. Its largest operation is commercial, retail and multifamily real estate lending. During 2012, RAIT funded $376 million in loans.
During the financial crisis, RAIT's real estate lending business suffered sizable losses that nearly led to the company's demise. However, the new management team has put in place a more balanced business strategy and engineered the company's turnaround. RAIT delivered 15% growth in FFO per share to $1.10 in 2012, and analysts predict 22% FFO growth this year.
Dividend growth has also been impressive. RAIT has raised its dividend five times in the past two years. In December 2012, the company raised the annual dividend to 40 cents a share. This is an 11% gain from the previous quarter and a 67% increase from the prior year. Payout is conservative at 30%. At the new higher dividend rate, RAIT shares yield a generous 5.6%.
Risks to Consider: Home Properties was forced to cut its dividend in 2010, RAIT paid no dividend at all in 2009 and 2010 and Associated Estates has raised its dividend only twice in the past six years. However, I think dividend cuts are less likely in the future because of rising FFO and more conservative payout ratios for all three REITs.
Action to Take --> My top pick overall is Home Properties. The company has carved a niche position for itself as a top renovator of high-end properties. Associated Estates is attractive for its above-average growth. RAIT is also a strong choice but a bit riskier because of its exposure to the real estate lending market.