Sharp mortgage rate increases have worsened housing affordability over the past year and ended a home-buying boom that relied on low interest rates. Mortgage costs have nearly doubled, forcing more consumers to rent or to continue renting for longer. S&P Global Ratings expects this trend to continue until homes become more affordable, which will support rental housing demand, even in a recession. We believe fundamentals for both rated rental housing REITs and social housing providers remain resilient as demand continues to outstrip supply in many markets.

Ownership Has Become Economically Sub-Optimal

Worsening housing affordability supports rental housing demand

Demand for single-family homes deteriorated meaningfully in 2022, following several strong years, as mortgage rates rose sharply. The 30-year mortgage rate climbed to levels not seen since 2008, reaching over 7% at the end of 2022 and we expect the rate to stay above 6% in 2023. Mortgage rates have essentially doubled since 2021, resulting in the lowest housing affordability level for a generation of Americans accustomed to mortgage rates that were about 300 basis points (bps) lower. This has particularly hurt the entry-level home for first-time buyers, delaying their home purchase decisions. We estimate U.S. homes are about 20% overvalued (see "Residential Overvaluation Relatively Steady As U.S. Housing Correction Continues," Feb. 21, 2023) and S&P Global economists believe housing affordability is the weakest it has been since 2006 (see "The American Dream May No Longer Be In Reach," July 20, 2022). In addition, we expect housing starts to decline to 1.2 million units in 2023 from 1.6 million last year and see a slow recovery given the challenging economic and financing landscapes. Fannie Mae forecasts total home sales to decline 20% in 2023 and then recover modestly in 2024 as the impact of mortgage rate hikes ease.

The housing market shifted quickly last year when the monthly cost of owning surpassed that of renting, based on our assumptions and calculations (see "2023 U.S. Residential Mortgage And Housing Outlook: Navigating A Softening Market," Jan. 20, 2023).

Chart 1

Owning was consistently economically optimal throughout the 15 years leading up to 2022. The cost gap between renting and owning was widest during the pandemic when the 30-year fixed-rate mortgage hovered just below 3%. Now that renting appears optimal from a monthly payment perspective, mortgage rates may have a greater influence on housing market dynamics than they did during previous housing cycles. Although home prices face downward pressure in 2023 while rental rates are likely to rise in the mid-single-digit percentage area, renting will likely remain more economically and psychologically appealing this year, which would support the investment property segment of the housing market.

Chart 2

Given the relative affordability of renting, we expect demand for rental housing to remain resilient, even in a recession, as renting remains more affordable than buying a home. The rate of rent-to-income ratio remains in the low- to mid-20% range for key markets for the rated real estate investment trusts (REITs), which we see as healthy. We expect demand for rental housing to remain robust over the next one to two years as rising borrowing costs, tightening lending conditions, and inflationary pressure continue to diminish the affordability of home ownership.

Rental housing REITs that own portfolios located in markets where home affordability is among the lowest in the country are well positioned to benefit from these dynamics. Rental growth should remain solid for suburban locations given the higher population and job growth, as well as the impact from remote working that has shifted residents to suburban locations in search of more space. Remote working has delayed the recovery of urban markets, with San Francisco the slowest to recover to pre-pandemic levels as the tech sector is shrinking its labor force while providing greater flexibility to workers.

Rental housing REITs have benefited from strong demand and less new supply over the past two years, bolstering operating performance with above-average rental rate growth and occupancy levels. We believe the sharp slowdown in the U.S. housing market will support demand for rental housing over the next few years. Moreover, the labor market remains resilient and overall tenant demographics, including credit scores and median household income (which improved over the past year), support rental demand and occupancy stability over the near term.

Chart 3

Chart 4

Moderating Rental Rate Growth Could Ease Inflationary Pressure In 2023

Shelter comprises a significant part of the consumer wallet and accounts for about a third of the Consumer Price Index (U.S. Bureau of Labor Statistics data, Dec. 2022). While we expect housing landlords to continue to raise rent in 2023, the level of rent increases will slow significantly compared to robust levels seen over the last 18 months. In many markets, rents grew 10%-15% while vacancy rates declined to historically low levels as demand recovered post COVID.

Despite being resilient for most of 2022, the labor market is likely to soften in 2023. Many employers have announced significant job cuts or hiring freezes in recent months amid a weakening economic outlook. A weaker job market could impact residents' credit health and their ability or willingness to pay higher rents. As a result, we expect rent growth to moderate from elevated levels and to normalize to the low- to mid-single-digit percent area (compared to double-digit rent increases), with occupancy remaining near current levels for the next one to two years. This is supported by a tenant base whose credit quality should remain relatively healthy, provided the impending recession is relatively shallow.

Rental housing REITs' credit metrics can withstand expected pressure from a looming recession and higher interest rates.

Inflationary pressure is burdening operating expenses, which we expect will rise approximately 4%-6% over the next two years. In particular, real estate property taxes (the largest expense line item for residential REITs) are likely to accelerate in 2023 given upwardly valued asset prices, rising 5%-8% on average. We expect properties in the Sun Belt to be hit hardest, while California assets benefit from some Prop 13 tax protections. Insurance, payroll, utilities, and maintenance costs are likely to rise 3%-5% in aggregate.

From a ratings perspective, we believe an impending recession will not materially weaken the credit quality of the residential REITs, and each of our rated REITs currently has a stable outlook. Favorable drivers include solid loss-to-lease rates in the mid- to high-single-digit percentage range, the growing unaffordability of single-family homes, higher than average retention rates, and relatively affordable rent-to-income ratios. As a result, we think landlords should be able to push rental rates in the mid-single-digit percentage area in 2023, barring a more severe recession. As a result of this growth, partially offset by mid-single-digit same-property operating expenses, we forecast same-property net operating income (NOI) growth of 5%-6%. In 2024 we expect same-property NOI growth to moderate to the 2%-3% range.

We have seen a number of positive rating actions in the rental housing sector given solid performance and lower debt leverage. We upgraded American Homes 4 Rent (AMH) to 'BBB' from 'BBB-' in June 2022, and recently raised the ratings on Invitation Homes Inc. (INVH) to 'BBB' from 'BBB-' due to improvement in the capital structure. We raised the rating on Mid-America Apartment Communities Inc. to 'A-' from 'BBB+' in August 2022, as the company demonstrated strong operating performance with less volatility than peers over the past several years, while maintaining conservative financial policies. Both single-family REITs have benefited from favorable single-family rental tailwinds that we expect to persist over the next several years.

Table 1

As with other REIT subindustries, capital markets activity has been slow for residential REITs as modest near-term refinancing needs and well-laddered maturity schedules have limited activity. However, we do think the markets are accessible for residential REITs and investor demand for upcoming paper will remain relatively robust. In late November, AvalonBay Communities Inc. issued $350 million of 5.00% unsecured notes due Feb. 2033 at a 135 basis point spread to the benchmark 10-year Treasury. This compares favorably to other recent REIT issuances.

Social housing providers remain resilient

We expect social housing providers (SHPs) to remain resilient through the expected shallow recession, continued inflation, and affordability pressures of 2023, supported by their regulatory framework, cash flow stability, strong demand, and access to government resources. While would-be homeowners remaining in the rental market support rising rents as discussed above, it also adds pressure to those households seeking affordable rental opportunities, keeping vacancies low at most properties. However, for affordable properties that typically operate within the confines of a regulatory agreement or with the purpose of keeping rents affordable, it does not always translate into rental or EBITDA growth as it does for REITs.

SHPs are similar to residential REITS as their business is also to own, acquire, build, and operate rental housing with footprints that range from regional to national in scope. SHPs, however, are organized as 501(c)(3) nonprofit entities with a focus on providing affordable housing. The criteria we apply to evaluate REITs and SHPs differ significantly and reflect the mission-driven nature of SHPs. SHPs are significantly smaller than REITs, with portfolios ranging from roughly 7,000 to 23,722 units and an average size of 14,359 units. In comparison, the average portfolio size of REITS is over 50,000 units. Recently we have seen a notable increase in the number of SHPs seeking ratings and subsequently entering the capital markets. This is somewhat reminiscent of the 1990s when rental development companies went public as REITs, with the benefit of moving from property-by-property transaction debt financing to a more holistic and corporate approach to their balance sheet and financing needs.

Affordable rental housing supply remains a challenge.

The worsening housing affordability situation further compounds the pressures on low- and moderate-income households facing inflationary pressure. A household is defined as cost-burdened if it is spending more than 30% of its income on housing costs, according to the Department of Housing and Urban Development (HUD). The U.S. Census bureau estimates over 40% (19 million) of renter households were cost-burdened during the 2017-2021 period, and we assume that percentage is even higher today.

Demand for affordable rental housing continues to outstrip supply. Much of what has been built over the last decade has been market rate luxury apartments. According to the Joint Center for Housing Studies, the $1,740 typical asking monthly rent for new multifamily units is well above the $1,080 that the median renter could afford. The National Low Income Housing Coalition estimates the U.S. shortage of affordable rental units for extremely low-income renters at 7 million. The shortage varies by region but exists in every state and metropolitan area. This means that there are only 37 affordable rental homes for every 100 low-income renter households.

Income/expense trends for affordable housing

With a backdrop of strong demand and constrained supply, rents will generally escalate but revenues for affordable rental housing are often limited by regulatory agreements that tie rental increases to increases in area median income levels. Owners may also choose to limit rental increases to align with their mission. Given that limitation on gross revenues, trends in expenses can have an outsized impact on performance.

Reported data for many affordable housing properties lags by at least a year, with audits typically released 6-9 months after the end of the fiscal year. Our most recent audited data is for the fiscal year 2021. From 2019 to 2021, Section 8 properties' average per-unit expenses increased to $7,072 from $5,923--a 19.4% increase. Typically, affordable rental properties do not pay property taxes in their communities; expense increases have been driven by sharp increases in insurance premiums, which rose by 67% over the last two years and a stunning 145% over the last four years for those Section 8 properties we rate. For Section 8 properties, average per-unit revenues increased 10.2% to $11,104 from $10,076 in 2019.

Expenses for social housing providers increased more modestly, rising to $10,694 average per unit in 2021 from $9,987 in 2019, a 7% increase. Year to date, 2022 expenses increased to $11,053 average per unit. Social housing providers' average per-unit revenues increased 9% to $15,521 in 2021 from $14,166 in 2019 and average EBITDA per unit increased by 15.5%.

Chart 5

Recent Rating Activity

Three SHPs requested ratings in 2022: Preservation of Affordable Housing (POAH), Mid-Peninsula Housing Coalitions (Midpen), and Mercy Housing. With these new entrants, ratings are evenly split between 'A+' and 'AA-'; all ratings carry a stable outlook. Meanwhile, National Community Renaissance of California (NCRC) issued $100 million in bonds in January 2022 to replace existing debt, finance a portion of its development pipeline, and finance future purchases, among other uses.

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Regulatory Risks And Opportunities

Several states and municipalities have taken steps--either through zoning, tax incentives, or funding programs--to stimulate the development of new affordable housing and/or to maintain their existing affordable housing stock. This has most notably been the case on the West Coast, where both California and Oregon have implemented zoning changes. Moreover, Oregon implemented the first-of-its-kind statewide rent control regulatory framework. Both states now allow the construction of small multifamily buildings, accessory dwelling units (ADUs), and other types of housing in areas previously zoned for single-family homes. Massachusetts, which for decades has operated its so-called 40B program (allowing for a more flexible approval process for developments if at least 20%-25% of the units have long-term affordability restrictions), recently enacted legislation requiring cities and towns outside of Boston served by the Massachusetts Bay Transportation Authority (MBTA) transit system to create multifamily zoning districts near MBTA stations, where practical. The governor of New York's proposed budget contained several provisions, in addition to considerable capital commitments to encourage the development of more housing, including prioritizing an increased supply of housing near transit, though at this writing its fate remains uncertain.

The White House released its Blueprint for a Renters Bill of Rights in January 2023, a framework of principles to address the broader housing crisis. While much of the blueprint is aspirational it includes provisions to provide more lead time on evictions, more transparent and fair leases, and other rights and protections for tenants. At the same time, the Biden administration announced several concrete steps already implemented by federal agencies and others. The Federal Housing Finance Agency (FHFA) will expand its classification of mission-driven multifamily loans to include those that restrict rents at levels affordable to households with incomes between 80 and 120% of area median income. Additionally, the housing finance agencies of both Wisconsin and Pennsylvania committed to restricting rental increases to 5% annually in their financed portfolios.

Housing Unaffordability And Macroeconomic Tumult Support Credit Quality For Rental Landlords

As the housing market adjusts to much higher mortgage rates, many consumers will likely rent for longer. The worsening affordability of housing will remain a tailwind for rental housing issuers until overvaluation of home prices eases more meaningfully. This should support the credit quality of rental housing landlords over the next two years. Renting also provides more flexibility in the current uncertain economic environment as consumers are facing tightening lending standards and market volatility. With the potential for a recession in 2023, the downturn in the housing market could be prolonged.