The Pandemic Has Modestly Affected Residential REITs

While the coronavirus pandemic has had a significant financial effect on certain property types (such as retail, hotels and seniors housing), the impact on residential rental properties has been more muted. The U.S. experienced a historic level of job losses totaling 22 million at the depth of this recession, and less than half of those jobs were recovered through August. Thus far, this recession has predominantly affected lower-income workers, including those in the retail, restaurant, and hospitality industries (renters of class C or D [government-subsidized housing] quality apartments). As a result, our rated multifamily REITs (which offer almost exclusively class A or B quality product) haven't been nearly as affected, as the vast majority of their tenants have been relatively unaffected by the recession.

In the second quarter, rated multifamily REITs reported better results than we had projected, with average rent collections of 97.2%, occupancy at 95.3% (down 120 basis points [bps] from year-ago levels) and same-property net operating income (NOI) down just 2.4%. There are some inconsistencies among the peer group in their reporting of same-property NOI (some chose to include straight-line rent, while others reported strictly on a cash basis), but we don't think this impact is significant for the group as a whole. Moreover, it will normalize over the next couple of quarters as rent is either collected or written off.

In early September, President Trump announced an executive order to extend eviction moratoriums through year end. Under the moratorium, the Centers for Disease Control and Prevention and the Department of Health and Human Services will use their authority to protect renters from being evicted, provided renters can prove they have suffered from the pandemic and meet additional qualifications. Many local governments also still have moratoriums on renter evictions, and local laws aren't superseded by the federal order. While the extended moratorium adds some uncertainty to future rent collections, we think the vast majority of tenants will continue to pay their landlords rent.

Moreover, while rent controls remain a relevant topic, we see the increased rent controls in certain cities and states as having a negligible impact on residential REITs' financial performance over the near term.

We now expect operating performance for multifamily REITs to decline similarly to previous recessions, with same-property NOI falling in the low- to mid-single-digit percent area in 2020 (with modest sequential deterioration over each of the next two quarters), followed by slightly negative to flat results in 2021 (with a weak first half followed by a stronger second half). However, despite our expectation that this recovery path will follow a similar trajectory as prior recessions, there are many factors that we think will likely make this recovery unique, potentially affecting residential REITs' operating performance over the medium to longer term.

Remote Working Will Continue Driving Demand For More Space

Greater adoption of remote working across most corporations, along with increased job mobility, has allowed employees to seek alternative living arrangements. The desire for more space, as renters spend more time at home, has been a major factor in pushing renters from smaller, costly urban apartments to larger suburban dwellings. We think this, along with record-low interest rates, drove a surge of home purchases in the second quarter, pushing the national homeownership rate up to 67.9% (up from 65.3% in the first quarter and 64.1% in second-quarter 2019). Homeownership is back to where it was before the Great Recession, and near the all-time high of 69.2% set in 2004.

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Despite the economic pressure facing many households, we don't expect homeownership levels to fall too far from the high-60% area. That said, the national rate is also unlikely to push through 70% anytime soon either, as the lack of affordable housing in many states, coupled with the financial hardships caused by this recession, restrain many renters from buying. As a result, we expect this yearning for larger spaces will also likely continue to prop up demand for larger rental apartments (two to three bedrooms) and single-family home rentals in suburban markets.

We think remote working is here to stay, with many corporations likely to grant employees more flexibility to work from home post-pandemic. Given this view, we do think the need for increased space will be critical for many renters and could drive a permanent shift in demand that benefits larger, suburban dwellings.

As State And Local Government Face Massive Budget Deficits, Higher Taxes Could Spur Migration

The coronavirus pandemic and resulting recession has wreaked havoc on state and local budgets, with the 50 states projecting that tax revenues will decline approximately $180 billion in 2020 and 2021 (relative to 2019 levels). California, New York, Texas, New Jersey, Massachusetts, and Illinois face the largest projected fiscal deficits. New York City Mayor Bill De Blasio announced that the city is likely facing a $9 billion loss in tax revenues for this fiscal year and New York State's budget division projected in September that receipts would be $14.5 billion less than it had projected in February. Barring a bailout from the federal government, many states may be forced to raise taxes significantly, drastically cut services, and/or reallocate funds to balance budgets.

In September, New Jersey passed a plan that will increase the tax rate on gross income between $1 million and $5 million to 10.75% from 8.97%. In California, two bills were introduced in August to tax the wealthy. The first would retroactively (from Jan. 1, 2020) raise the state's top income tax bracket to 16.8% from the current rate of 13.3% (already the nation's highest state income tax). The second proposed bill would impose a 0.4% tax on wealth exceeding $30 million. In Illinois, a series of higher tax rates has been proposed for those making over $250,000 annually, with rates rising to 7.99% (from 4.95%) for joint filers making over $1 million. While New York State has thus far resisted the idea of taxing the wealthy, it may have few other options without material aid from the federal government. Significant pension reform is highly controversial and unlikely to be widespread, in our view.

While local governments have the option to declare bankruptcy, we think a large portion of them will instead raise property taxes to narrow their deficits. While this could make the decision to own a home less attractive, further decreasing the affordability of homes in certain states (which could benefit multifamily REITs by creating a greater pool of prospective renters), higher property taxes could be a disincentive for people choosing to live in one of the more affected cities/states. The challenge here is that taxpayers are more mobile than ever before, and higher tax burdens will likely accelerate outmigration from the affected states (creating a vicious cycle that would necessitate increasingly progressive tax hikes to close budget deficits).

For residential REITs, while the lack of affordable housing in many of the most affected states makes it difficult for renters to transition to homeowners, we think significant tax hikes would accelerate outmigration trends. As a result, local businesses and economies would suffer, ultimately lowering demand for rental units as well.

Increased Crime In Major Metropolitan Markets Could Impair Filling Vacancies

Violent crime is on the rise in many major cities. According to The Wall Street Journal, homicides were up 24% year over year through July in the top 50 cities in the U.S., with double-digit increases in 36 of them. In New York City, the violence has been even more pronounced, as New York City recorded 791 shootings from May to the end of August (up 140% from the same period in 2019) and 180 murders over that same time frame (up 51%).

Several large cities, including New York City, Washington D.C., Los Angeles, and San Francisco, have recently voted to cut police budgets, which could heighten criminal activity. On its own, we don't think increased crime has necessarily been a significant factor for people leaving major metropolitan markets this year. However, a prolonged resurgence in crime could lead to additional people leaving cities or deter those thinking of moving back.

Suburban Markets Are Poised To Outperform Urban Markets In 2020 And 2021

In second-quarter 2020, there was an exodus of residents from densely populated urban markets, most notably New York, San Francisco, and Boston. Within our rated REITs, occupancy in suburban markets was averaging 300-400 bps better than in urban ones at second quarter end. For instance, at Equity Residential, the largest multifamily REIT by total market capitalization, occupancy was 96.6% for its suburban properties as of June 30, 2020, compared to 93.3% for its urban assets. Rent concessions have increased in the major urban markets (now commonly four to six weeks of free rent per year) to attract new tenants and retain existing ones.

Over the longer term, we would anticipate that this gap in occupancy will narrow. After all, cities are vibrant and dynamic, with culture, amenities and energy that can't be replicated in suburban settings. Moreover, new supply will likely be built in suburban locations to meet the heightened near-term demand. That said, given the many factors that are at play, such as remote working, we do expect suburban markets to remain in favor over the near to medium term.

Supply Pressure Should Ease Somewhat In 2022

While the pace of development has continued for projects under construction, new development starts slowed greatly during the first couple of months of the pandemic. While construction has since resumed at a solid pace, we nevertheless expect supply pressure to ease somewhat in 2022, following relatively high levels of new construction delivered in both 2020 and 2021.

Unlike many other property types, we don't think barriers to entry are significant in housing. While land is a restriction in urban, coastal markets, development of high-rise apartment buildings can minimize that factor. Moreover, given the lack of housing that exists in many markets, developers don't face the same extensive permitting and zoning hurdles that many other property types have. That said, we expect most new supply to come from markets in the Sun Belt region, given the outsized job growth and population migration expected over the next several years (relative to other regions).

The Critical Age Cohort For Renters Will Peak In 2024

While we don't see this is a significant risk factor for multifamily REITs, the prime renter cohort (those aged 25-34) is expected to peak in 2024.

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While this may affect demand slightly, the population for this cohort is expected to plateau rather than fall significantly. Moreover, people are continuing to form households later in life (delaying marriages and having kids), which has extended the renters' cohort beyond the traditional 25-34 years (with many renters now in the 35-44 age cohort).

Credit Implications For Rated REITs

The rated residential REITs, by and large, entered this recession with strong balance sheets and sufficient liquidity to manage through challenging times. In fact, debt to EBITDA for residential REITs at the end of 2019 was nearly three turns lower than it was at year-end 2007, highlighting the conscious decision management teams made to reduce leverage during the late stages of this most recent economic recovery.

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We think Sun Belt-focused REITs American Homes 4 Rent, Camden Property Trust and Mid-America Apartment Communities, Inc. are probably the best positioned over the near term to reap the benefits from increased workforce mobility and continued population migration to southern states. While new supply will eventually be built to meet this likely surge in demand, we expect operating performance at these REITs to exceed residential REIT peers over the next two years.

While some REITs have relatively large development pipelines that may require larger concessions to lease up, we think the relatively strong rent collections and occupancy levels portend relatively stable cash flow generation over the next two years. As a result, we don't anticipate many rating changes, and we have a stable outlook on seven of our eight rated REITs.

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