March 19, 2012 - 4:25pm EST by
2012 2013
Price: 441.55 EPS $16.70 $19.43
Shares Out. (in M): 1 P/E 26.5x 22.7x
Market Cap (in $M): 43,613 P/FCF 0.0x 0.0x
Net Debt (in $M): 17,215 EBIT 2,617 2,902
TEV ($): 61,956 TEV/EBIT 23.7x (4.2% cap) 21.4x (4.7% cap)
Borrow Cost: NA

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  • REIT
  • Industry Long


I wrote this up specifically for VIC without realizing that there is no ability to insert graphs.  Given my write up is graph intensive and that I have zero motivation to go back and put everything in tabular form, here is a link to the full report with all the pretty graphs included.


I believe asset valuations in the Multi-Family REIT space have well exceeded intrinsic value and offer a compelling risk / reward on the short side.  While I believe the entire group is mispriced, I am specifically recommending shorting the following five stocks based on size, valuation, dividend yield and NOI growth estimates.

EQR – Equity Residential

AVB – Avalon Bay

BRE – BRE Properties

PPS – Post Properties

ESS – Essex Property Trust


“…customers are actively discussing their desire to find a way to purchase and avoid the rental market and it’s re-pricing.”  

“…the notion that the cost of living expenses are going to go up and continue to go up are driving people to say, I’ve got to lock this expense down or it can run away from me, it is reducing my personal disposable income when wages are not rising and so its driving more traffic to our sales centers.”

- Stuart Miller, CEO Lennar Homes, Jan 2012


The thesis is simple; rent growth is unsustainably high and will abate sooner than the street thinks.  Once that occurs, the current astronomical valuations should compress creating significant declines in the share prices of the group.

The Variant Perception

Management teams, consultants and by default, consensus believe that rent growth in the mid single digits (implying NOI growth in the double digits) is sustainable due to “favorable supply and demand” dynamics.  I believe those dynamics are changing for three primary reasons:

1)      Rent is quickly becoming unaffordable

2)      Development pipelines are growing rapidly

3)      Homebuilders are selling more homes

Why does rent growth matter?  Because it directly correlates to share prices.  Below you can see an index (created on Bloomberg) of the five securities listed above going back to 2005.  Against the index you can see average rent growth by quarter.  Rent growth is Same Store as reported by each of the REITs in their quarterly supplemental reports.



The correlation is intuitive.  NOI margins for Multi-Family REITS run in the 60%’s, and NOI growth generally runs 2x revenue growth (combined unit and rent growth).  Additionally, and perhaps most importantly, rents for Multi-Family REITs reset every year, which stands in contrast to other REITs which tend to have longer lease lives.  The fact that changes in rent have so much leverage to the P&L and that they hit so quickly, typically means the shares are more volatile and trade based on the momentum of rent growth.


The rental market is a commodity and historically has been fairly price sensitive to changes in both demand and supply.  Going back to 2005, you can see changes in rent for the five securities mentioned above.  Note that the data I’m using for this write up come from the five companies mentioned above, however, I would note that I’ve pulled the data (manually) for seven of the 12 publicly traded REITs.  Adding in the other two doesn’t move the needle.

Figure 2: Rent Growth by Quarter, 2005 to today


Source: Company Quarterly Supplemental Reports

Rents began growing in 2005 due to two things; high rental affordability and lack of new supply.  Below you can see three graphs – the first is income growth, the second is the ratio of rent versus comparable mortgage payments and the third is new renter growth versus new supply coming online (in terms of units) as a percent of the total units in force (again for the five REITs mentioned above).  Notice that incomes were growing close to 6%, rental affordability was high (beginning in ’07) and growth in demand was exceeding supply.

Figure 3: Income Growth in the US (Bloomberg: PITLYOY Index)


Source: Bloomberg and The Bureau of Economic Analysis

Figure 4: The ratio of Rental Costs to After Tax Mortgage Payments


Source: Deutsche Bank “Rent or Buy? Buy!” by John Perry and Nishu Sood, published March 13th, 2012

Figure 5: Growth in Renter Households vs Growth in Supply of Rental Units


Source: Company Supplemental Reports for Growth in Supply, US Census for total US Households and Home ownership / Renter rates.

Focus on the period from 2004 through 2007 – there is a perfect storm of high income growth, relatively affordable rents, high demand growth and tight supply.  That combination pushed rents up strongly in 2006 as you can see from the first graph.  What it also did was cause a building boom.  Below you see the development pipelines in terms of units under construction as a percent of existing units going back to 2005.  Importantly, these development pipelines are units currently in construction, not simply land held for potential future development.

Figure 6: Development Pipelines (under construction) as a Percent of Existing Units


Source: Company Quarterly Supplemental Reports

It’s intuitive but worth showing - development pipelines rise and fall as a function of rent growth.  Below you can see the two graphed against each other.  There is a lag on building by about a year historically, and there is lag on construction starts and when the units become available to rent (about 18 to 24 months according to management teams).

Figure 7: Development Pipeline growth against Rent Growth


 Source: Company Quarterly Supplemental Reports

All else being equal, the supply growth coming online in 2008 and 2009 should have crushed the market.  The market was crushed, but it wasn’t lack of demand, it was due to entirely to declines in income.  Interestingly, occupancy has stayed consistently high, as noted below:

Figure 8: Occupancy averages for the five securities


Source: Company Quarterly Supplemental Reports

The tailwind behind the rental market has been the decline in home ownership.  From 2005 to 2010, roughly 5.5 million new households formed in the US according to the Census.  Assuming 1% growth in 2011, the total formations from 2005 through the end of last year was closer to 7 million.  Over that time, the homeownership rate declined from 69% in 2005 to 66% in 2011 (again, according to the Census).  Combined, that created demand for over 5.5 million new rental units in the US - more than enough to soak up the supply created by the building the boom of 2007 and 2008.

Things today, however, are changing.  The environment is different than it was in the mid 2000s.  While it appears that the home ownership ratio is still declining, I believe the pace is slowing.  That, when combined with the declining affordability and new supply should lead to declines in rent growth.

The Thesis in Detail

The first leg of the stool – rent growth is sensitive to rental affordability.  Below, you can see a graph of rent growth versus income growth in the US.  It’s simply a combination of two of the graphs posted above.  I put them together because the correlation is visibly strong.

Figure 9: Personal Income Growth versus Average Rent Growth, 2005 to Present


Source: Company Quarterly Supplemental Reports, Bloomberg and The Bureau of Economic Analysis

Rent growth is currently exceeding income growth, which supports the thesis that renting is becoming less affordable. 

In a March 13th research note by John Perry and Nishu Sood at Deutsche Bank, the concept of rental affordability vis-à-vis homeownership was quantified and tracked back to 2007.  The findings, as you can see in Figure 4 above, suggest that the cost to rent today is roughly 114% of the comparable cost to own.  In fact, assuming ~5% rent growth broadly in the US and no rebound in housing prices, the ratio should reach 1.2x (or 120%) by the end of 2012 according to the analysts.

To further bolster the point that rent affordability matters, I would point to a February study by the Center for Housing Policy (  The study suggests that working renters are faring poorly in terms of cost of living affordability due to the combined pressures of lower household incomes and higher average rents.  According to the study, 25.6% of working renting households (estimated at 22.5 million) had a “severe housing cost burden” in 2010.  Rents increased ~4% on average last year according to public multi-family REITs, which only exacerbates the problem.

Additionally, roughly 4.9 million renting households paid over half their income in rent expense during 2010.  HUD recommends no more than 30% of income and recommends no more than 33% (  According the Census there were 38 million renting households in 2010.  Growing Households by 1% in 2011 and applying the current home ownership ratio, I estimate there are closer to 39 million renting households today.  Not to say that rents can’t grow forever, but if 13% of your customers are already struggling to make their payments and there is an alternative that is significantly cheaper, it would stand to reason that you don’t have a significant amount of pricing power.

I appreciate the fact that the five listed shorts do not cater to low end working families.  However, I would argue that they will not be immune because of the demographic they cater to.  Looking at rent growth for each of the publicly traded Multi-Family REITs it becomes obvious that they are highly correlated – when one lowers rent they all lower rents – graph below.

Figure 10: Same Store Rent Growth by Quarter, 2005 to Present


Source: Company Quarterly Supplemental Reports

Importantly, as noted in the Deutsche Bank study, there are alternatives to renting.  Rent affordability is low today, and assuming that rents continue to grow will be less affordable tomorrow.

The second leg of the stool – supply is coming online.  As noted in Figure 5 above, actual units under construction today are roughly 5% of the current existing units according to company supplemental reports.  Based on the historical relationship between units under construction and new units entering the market, this suggests that new unit growth should pick up from 1.1% in 2012 to 2.5% by 2014.

Figure 11: New Units entering the Market (in blue) versus Units under construction (in red)


Source: Company Quarterly Supplemental Reports

While not quite to peak, we are certainly getting close.  The projected 2.5% growth in units, if sustained, would not necessarily be a problem given the current rate of new entrants into the rental market, which also happens to be 2.5% as of the end of 2011 according to data provided by the Census.  But I believe that rate of growth will slow which brings me to the third leg of the stool – demand growth is set to abate.

The genesis of this research project was the January Lennar earnings call.  Mr. Miller anecdotally discussed the concept that people are fed up with higher rents and realize that owning can be a cost effective alternative.  On Tuesday (3/13/12) the Deutsche Bank report, “Rent or Buy? Buy!” ostensibly said the same thing – the cost to rent is going up; the cost to own is going down. 

Homebuilders are saying that traffic, orders, and backlog are all going up. 

Figure 12: Most recent quarterly announcements on Order and Backlog Growth


Order Growth

Backlog Growth

Standard Pacific (SPF)



Hovnanian (HOV)



NVR, Inc (NVR)



Lennar (LEN)



Toll Brothers (TOL)



Ryland (RYL)



DR Horton (DHI)



Pulte Group (PHM)*



Meritage Homes (MTH)



MDC Holdings (MDC)



KB Home (KBH)**






* Pulte’s community count was down 11%, artificially lowering the year over year comparison

** Results expected 3/23/12

Based on this, I’ve projected forward US Housing Starts.  The simple math is 20% growth in each of the next three years, which gets you to the following projection for housing starts.

Figure 13: US Housing Starts Estimate in 000’s


Source: Bloomberg and The National Association of Realtors (HSANNHSP Index) for 2011, the estimates are mine.

I’m not smart enough to know whether this projection will pan out, but it would seem that a 2014 / 2015 estimate of 1.0m starts is roughly in line with consensus expectations.

Assuming the following three things; that household formation maintains its long history of ~1.0% growth, existing homeowners do not decide to become renters tomorrow and the incremental housing starts forecasted above are all new homeowners (meaning these new homes were not built for spec or as second homes), the growth rate in new renters will begin to decline starting in 2013.  Below you can see the projection against the oncoming supply of new units.

Figure 14: Growth in Renting Households (blue) versus Growth in New Rental Units (red)


Source: Company Quarterly Supplemental Reports and my own estimates

What This Means for Rent Growth, Revenue Growth and NOI

Realizing this is a bit of a fool’s errand, I have taken a stab at modeling this out to show the sensitivity to changes in income and supply / demand on changes in rent.  Below you can see a table with

1)      New renter growth, which matches Figure 14

2)      New unit growth, which matches Figure 14 and assumes that roughly half of the pipeline will make it into service 24 months out (in line with historical trends)

3)      Average rent increase – simple averages of the four quarters of each of the five companies mentioned above.  Projected rent increase makes the following adjustment

  • Assumes base rent grows 100bps behind personal income growth
  • Adds the spread between demand growth and supply growth

4)      Personal income growth – assumes no change from January 2012

5)      Occupancy, which is kept flat in 2012 as it doesn’t affect rent or NOI.  For 2013, I have adjusted occupancy for the increase in supply versus the increase in demand.

Figure 15: Revenue and NOI Drivers with Projections

  2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
New Renter Growth  1.6% 1.3% 4.6% 1.9% 1.9% 3.2% 2.5% 2.6% 1.8% 1.3%
New Unit Growth
0.9% 0.7% 1.5% 2.7% 2.0% 2.2% 1.1% 1.1% 1.7% 2.5%
Average Rent Increase 3.4% 6.3% 5.2% 3.1% -3.5% -2.4% 4.3% 4.1% 2.7% 1.5%
Personal Income Growth        5.6% 7.5% 5.7% 4.6% -4.3% 3.7% 5.1% 3.6% 3.6% 3.6%
Occupancy  94.8%  95.4%  95.0%  94.9%  94.8%  95.2%  95.5%  95.5%  95.5%  94.4%

Source: Company Quarterly Supplemental Reports, the estimates are my own

Rolling this up we can come up with revenue and NOI expectations.  Below you can see total revenue growth, NOI growth, projected NOI, current and projected cap rate, and resulting equity value.

Note the 2012 estimates for NOI and NOI growth are based on current consensus expectations for the five stocks I’m recommending shorting.  The forward estimates beyond 2012 use the Figure 15 estimates to create a revenue growth assumption, which is followed by an NOI assumption at almost 2x the rate of growth.

For valuation, the cap rate in 2012 is the current implied cap rate of the five stocks, in aggregate.  Going forward, I’m assuming fair value in the 7 cap range, which is roughly in line with where the average REIT trades today (ex apartments).

Figure 16: NOI Estimates and Valuation

  2012 2013 2014
Total Revenue Growth      5.2% 4.4% 2.8%
NOI Growth 10.7% 8.1% 5.2%
Current NOI 2,902 3,137 3,299
Current Cap Rate 4.8% 6.0% 7.0%
Current EV 60,848 52,279 47,135
Current Market Cap 43,613 35,043 29,900
Per Share   $441.55   $354.79   $302.71
Change   -20% -15%
Cummulative Change       -31%

Source: Several Analyst Reports to arrive at combined 2012 NOI consensus, the 2013 and 2014 estimates are my own

Historical and Relative Valuation Perspective

The current trailing cap rate for these five Multi-Family REITs is 4.5%, which is in line with the lowest it’s been going back to 2005.  Additionally, apartment REITs are the most expensive REIT group I could find (based on implied cap rates).

Figure 17: Historical Cap Rate for the Five Stocks Mentioned Above


Source: Bloomberg for total capitalization for each quarter, SNL for annual NOI

Figure 18: Implied Forward Cap Rates by REIT group


Source: SNL for total current capitalization, forward NOI for each company taken by the most recent sell side analyst report published. 

The average REIT is trading for a 6.7% forward cap today.  Note that the Apartment REIT only includes the 5 stocks mentioned in this report, which also happens to be five of the most expensive.  Using the entire group (there are 12) the average implied cap rate is 5.6%, still the most expensive REIT group.

How I Chose the Stocks to Short

I believe that the entire group is mispriced and thus I believe you could short any one of these stocks and likely do very well.  However, I wanted to take a basket approach to rule out geographically specific drivers that might affect the thesis (again, I would point you to the decline in same store rents – they all go together).

I started with this universe of Multi-Family REITs, courtesy of UBS.  Then sorted it based on cap rates.

Figure 19: Multi-Family REITs with current valuations


Source: UBS for the names, Bloomberg for the prices and dividends, Sell Side analysts for the ’12 NOI estimates, and Company supplemental reports for the capital structures.

Next, I organized them into four groups, Market Cap, Cap Rate, Dividend Yield, and NOI Growth Estimate.  Obviously the bigger it is, the more expensive it is, the least costly to borrow (dividend) and the lowest growth were all favorable characteristics for shorting the stock.  I assigned equal point values for rank within the four groups (1 to 12, 12 being the best short candidate), added up each score (48 being the most possible points you could get and the best short candidate) and this is what came out.


Risks to the Thesis

There are several risks to the thesis which could ultimately prove me wrong. 

1)      Personal income growth could pick up (personally, I’m hoping this happens), or alternatively, we could find out that there is no significant relationship between personal income growth and rent growth

2)      Interest rates could go lower, or the current spread between REITs and the 10 year treasury (about 200 bps by my calculation) could collapse causing multiple expansion for the group

3)      The markets where these REITs operate could prove completely resilient to US macro headwinds despite what has happened in the past

4)      Household formation growth could accelerate, which would be an economic positive but a negative to my short thesis

5)      The Homebuilder Recovery could stall leaving my ~1m starts projection by 2015 way off and keeping the supply / demand characteristics favorable for Multi-Family REITs

Any or all of these could happen.  The one thing I would say about them is with the exception of bullet 2, these risks are the current consensus for owners of Multi-Family REITs.  To pay a trailing 4.5% cap (forward 4.9 cap) you MUST assume rents are going to grow mid single digits and new units are going to be fully absorbed for at least the next 5 years for the valuation to make any sense whatsoever.  In short, if I’m wrong, then the stocks are fairly valued.



There will be several catalysts to look for with this short.

1)      Personal Income Growth is reported monthly - the ticker is PITLYOY Index.  The next report will come out on the 30th of March

2)      Housing Starts are reported monthly – the ticker is HSANNHSP Index.  The next report will come out on the 20th of March

3)      Homebuilder earnings reports – the next is KBH which reports on March 23rd

4)      Multi-Family earnings reports – they begin reporting in late April

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