A couple weeks ago, I published a post about Post Properties here. I have received questions about my investment thesis. I explained in the post that I believe the massive amount of student loan debt will delay Millennials purchasing homes for an extended period of time. However, the growing student loan debt is just one macro factor that is driving renter demand. In addition to the student loan debt, there are large demographic shifts happening in the U.S. I believe these shifts will continue and will persist for a very long period of time. Most of this post will cover the demographic shifts that I am seeing. The changes in demographics drew my attention towards apartment real estate investment trusts. I believe NexPoint is in the right market to capitalize on the new environment and will be a great business going forward.
NexPoint Residential Trust, Inc. is a real estate investment trust (REIT). The company is focused on multifamily investments primarily located in the Southeastern and Southwestern U.S. The company’s investment objectives are to maximize the cash flow and value of properties owned, acquire properties with cash flow growth potential, provide quarterly cash distributions and achieve long-term capital appreciation for its stockholders through targeted management and a capex value-add program. The company owns approximately 39 properties representing over 13,000 units in over eight states.
Today there are 43 million Americans living in rental housing. This is up 9 million people in the last decade. This has been the largest 10 year increase ever. 37% of American’s are now living in rental housing which is the highest proportion since 1964. Many economists have blamed the financial crisis for these statics. However, I believe demographic shifts are having a bigger impact than anyone realizes. The Millennial generation has increased the amount adults in their 20’s. This is the period in life when renting housing is most common. Not only are there a lot of 20 somethings in the U.S, but also, they are getting married and having kids much later than previous generations. Delaying these events is pushing back the point in time when they might purchase a home. The number of renters would actually be higher today if the financial crisis had not happen because it forced many renters to move into their parents/friends houses. Most of these renters are still living with parents/friends. In combination, these trends are showing up in homeownership rates.
These trends have boosted the number of renters in all age, income, and household type categories. Interestingly enough, renter demand isn’t as strong from Millennials as you might think. The largest increase over the last ten years was a 4.3 million boost coming from renters in their 50’s and 60’s. Millennials only added 1 million renters. Households 40 and older make up the majority of renters.
Demand for Mid Cost Rentals
There is a huge unmet need in rental housing. Over the last ten years, the supply of mid cost ($400-$800) rentals increased 12%. However, there was a 31% increase in rental households demanding these rentals. From 2001 to 2014, rent prices increased 7% while household incomes fell 9%. These trends have increased the number of cost-burdened (paying more than 30 of income in rent) renters to 49% of the rental population, this is a record. Today 26% of renters are severely burdened (paying more than half of their income in rent.) This is also a record. There is growing evidence that households lacking stable, decent-quality housing are more vulnerable to health problems and developmental delays among children. It is expected that demographics alone will be responsible for an additional 1.3 million renters to be cost burdened over the next decade. This indicates about 55% of rental households will be cost burdened. The unmet demand for mid cost rentals is a large problem.
As mentioned, the growth in rental households is not coming from where you might think. Millennials only added 1 million rental households. In the last decade, the number of adults aged 20-29 increased 11%. However, renter households from this age group only increased 2%. This demonstrates the phenomenon of Millennials continuing to live in their parents/friends homes.
As shown, there was massive growth in rentership from the 30-49 age range. On net, less than 2 percent of the 30-49 households made the transition from renting to owning over the decade. By comparison, more than 11 percent of baby-boomer households became homeowners when they were at a similar stage of life in 1984–1994. The largest increase in rental household came from baby boomers at 4.3 million driven by the decrease in homeownership. These large rentership rates from baby boomers are likely to persist. As people age, the probability of them making the rent-to-own transition decreases while the probability of own-to-rent increases. As more baby boomers make the own-to-rent transition, the unmet demand for rental housing could grow even further.
Forecast of Future Demand
Demand going forward is expected to be strong. Half of the Millennial generation are still in their teens and many will become renters in the next ten years. It is projected that 12 million millennials will be added to the rental population over the next ten years.
Another trend that will boost rental demand is strong immigration. Minorities are expected to account for three quarters of household growth over the next decade. There is a large gap between white and minority ownership rates. The probability of minorities renting is much higher. Therefore, strong immigration will translate into more demand for rental housing.
The other trend that we will likely see is the continuation of the own-to-rent transition from baby boomers. As many will reach 70 in the next ten years, many will transition to renting. This will accommodate their need for accessibility. I expect this transition to keep pressure on homeownership rates over the next ten years.
There is currently a large lack of supply of low and mid cost apartments. Historically, newer apartments would age and the rent would filter down to supply the low and mid cost markets. However, there has not been enough apartments filter down into these cost markets to satisfy demand.
Costs of Development
Developers face a variety of regulatory and financing obstacles that limit their ability to add significantly to the lower-mid cost stock. Local zoning regulations often restrict the area available for multifamily development, especially in suburbs, which can increase the competition for available sites and raise land costs. Many regulations and zoning reviews are resulting in per-unit construction cost increases. It has made it almost impossible to build a new multifamily apartment complex that the median renter ($875) can afford. Most developers are focused on the upper end of the market which is causing the gap between supply and demand of low-mid cost rental housing to get wider.
Long-Term Supply Issue
Today 80% of newly constructed rentals are multifamily apartment buildings with 50 or more units. The median cost of these apartments is $1290 which does nothing to address the problem. This means that downward filtering of higher cost rentals will have to account for the supply of mid-low cost rentals. In the last decade, downward filtering boosted supply by 11%. The only problem is, because mid-low cost units are older, all of these gains were offset by rentals that were permanently removed from the supply because they had to be demolished. Therefore, only 8% were added in the below $400 range and there was just a 12% increase to the $400-$800 range. A 12% increase does almost nothing when there is 31% increase in demand for rentals in the $400-$800 range. This problem continues to get worse.
Since 2011, rents have increased at an average pace of 2.7% a year. However, in the last 12 months they increased at a faster 3.6%. With overall inflation at just 0.4 percent, the real increase in rents in the preceding 24 months was larger than in any other two year period since 1987.
The national vacancy rate sits at 6.7% its lowest rate in 30 years.
In the last five years, there has been a 1 million unit reduction in vacancy. Over 750,000 of the million were units priced below $800. Today, vacancy rates of units priced below $800 is only 3.9%. This is the lowest it has ever been. You should expect continued pressure on rising rent and falling vacancy rates in the coming years. Much of the future growth will be from minorities and senior households who typically have lower incomes.
NexPoint owns multifamily properties in the Southeastern and Southwestern U.S. The great part is they offer Class B apartments in the $500-900 range. Right where the demand is greatest.
NXRT has shown many quarters in a row with exceptional organic growth. The growth is driven by their rehab capex spending and the strong rental market. They are on pace to have about $30 million in capex for 2016. As of Q2’16, they have about $42 million in-progress rehab projects. Over the last four quarters, NXRT has achieved 12.2% same store NOI growth. This is double its peer average at 6%. Thier occupancy rate also outperforms peers at 94.8% vs. 94% for peers.
The company has averaged a capex ROIC of 21.2%. Assuming this continues into 2017, investors can expect $5.8 million in incremental NOI. This translates into $0.28 in FFO bringing estimated FFO to $1.73 for FY’17. At $1.73, NXRT only trades at about 11x FFO. Its peers trade closer to 17x.
The management group has done very well and they have a lot of skin in the game. All of the top direct holders are in the management group. Combined they hold 4.25 million shares or 20% of the company. James Dondero is the President of NexPoint Residential. He is also Co-Founder and President of Highland Capital Management. On top of the 20% owned by management, Highland Capital owns 1.65 million shares or 8.22% of the company. All together, between management and Highland, they own 28% of NXRT and continue to buy more.
NexPoint is a very underfollowed company that trades at a very reasonable valuation. The metric worth paying attention to is Funds from Operations (FFO). This is calculated as net income available to common shareholders determined in accordance with GAAP, excluding gains (or losses) from extraordinary items and sales of depreciable property, plus depreciation of real estate assets, and after adjustment for unconsolidated partnerships and joint ventures all determined on a consistent basis in accordance with GAAP.
Returning Cash to Shareholders
NXRT has a nice 4.29% dividend yield. This is the lowest it has yielded since the stock became public so I wouldn’t be surprised if they decide to raise it in the next few quarters.
The balance sheet is quite levered. The debt/equity ratio is about 3x. However, they are becoming less levered every quarter and I don’t see any reason why this trend won’t continue with the demand I see.
This chart above shows how different NXRT’s business is from other REIT’s. They have more debt than their peers but their debt agreements are much more favorable because they are variable. With interest rates continuing to stay low, they are not having to pay much interest on their debt. Monetary policy from the Fed will have a large impact on the cash flow of the business. We know the Fed wants to raise interest rates and I believe there is a good chance they will in September if they economic data remains decent. On June 6th, NXRT entered into a credit facility of $200M with terms 1 month LIBOR + 2.2%. Today, they have $258M in variable rate debt. Even if they Fed raises rates, LIBOR will likely not be greatly affected. Bottom line is, if interest rates in the U.S rise quickly, their debt agreements could swing from being a tailwind to a headwind. I cannot predict where interest rates are going. I have no idea and I am not going to waste my time trying to guess. Therefore, I will monitor relevant interest rates but focus on their business.
I am trying to get away from doing rigid valuations. Investing is an art not a science. I just put this one together quickly. I don’t want to put much emphasis on it. It does indicate that there is value in the stock even if it grows at 3% a year. NXRT is growing at 20% so far in 2016. I believe NXRT can grow at 10% or more a year for many years considering the demand for apartments they offer.
If you look towards the bottom right you can see the est. NAV is between $19.44 and $24.78. The midpoint is $22.11 or 12.8% above current market prices. I find it hard to believe that NXRT continues to trade at a large discount to NAV. I believe this is an opportunity for investors.
NexPoint is a terrific business. Demand for their units is incredible. It could take decades before today’s Class A apartments filter down to satisfy demand. I believe we are going to continue to see NexPoint acquire properties and grow NOI. Management owns 20% of the shares giving them plenty of incentive to perform. I look forward to watching this company grow in the future.