Comparatively Speaking, Multifamily Is Still a Good Investment

Anyone who’s watched his or her 401(k) plummet in recent months knows that the stock market has had a rough time lately. But some segments of the market have done better than others, and one of the relatively few bright spots has been multifamily.

If, four years ago, you had invested in publicly traded corporations, limited partnerships and Real Estate Investment Trusts whose primary business involves ownership, development, construction, rehabilitation and management (or both ownership and management) of multifamily communities, rather than an index fund that tracks the Standard & Poors 500, you would have made a smart choice.

How smart? Any money invested proportionally * among such stocks – there are 29 of them – on Dec. 31, 1998, would have grown 42.7% by Dec. 31, 2002. During that same time, the S&P 500 (with dividends reinvested) lost 24.5% of its value.

To more easily track the performance of these public firms involved in multifamily housing, NAHB created and introduced the Multifamily Stock Index (MFSI) last year. To allow historical comparisons to be made between the MFSI and other financial indices, the starting point for tracking performance data for these publicly traded firms was set at Dec. 31, 1998.

The Year In Review

In spite of the fact that over the longer term the MFSI has had great success, the past year has been a difficult one for virtually all segments of the stock market – and multifamily ownership and management was no exception. Table 1 makes it clear that over the past 12 months a majority of firms on the MFSI have seen their shares prices fall, many by more than 10%.

Despite these steep declines, the MFSI did not fall as sharply as the S&P 500 because of the large positive impact dividend payments have on total return.  Looking at Figure 1 (below) we see that the MFSI began the year at 1,519 and by June was at an all time high of 1,606, an increase of 5.7%. However, during the second half of the year the index gave back all the gains of the first half and more, and by the end of 2002 registered a loss of 6%.

_{Figure 1} 

By contrast, for the 12 months ending Dec. 31, 2002, the S&P 500 fell by slightly more than 22%. As a result, on a relative basis, 2002 was a good year for the MFSI – the best ever recorded. Figure 2 (below) shows that during 2002, the relative performance of the MFSI compared to the S&P 500 was outstanding, setting performance records on four separate occasions in the second half of 2002. And, with the exception of a small spike in September 2001, the relative performance of the MFSI compared to the S&P 500 was almost always higher in 2002 than at any other time.

_{Figure 2}

On Jan. 1, 2003, America First Apartment Investors converted from a Limited Partnership (LP) to a REIT. With that change, the MFSI now contains 23 REITS, 5 corporations, and one LP (New England Realty Associates), which also happens to be the smallest firm in the index. At present, the 17 largest companies in the index are REITs, and 22 of the largest 25 also are REITs. During 2002, no new companies were added to or removed from the MFSI.

Recent Ups and Downs     

From Dec. 31, 1998, through Dec. 31, 2002, the total return posted by the 29 firms in the MFSI was 42.7%. By contrast, the S&P 500 with dividends reinvested lost 24.5%. As a result, the annual compound rate of return experienced by the MFSI was 9.3%, while for the S&P 500 it was negative 5.6% – a difference of almost 15 %. Since August 2000, when the S&P 500 reached its peak of over 1,500, investors in multifamily investment and management firms have seen their portfolios increase by an additional 7.8% while the S&P 500 with dividends reinvested has fallen by a staggering 40%.
    
Looking back at Figure 1(above), it seems that the performance of the MFSI can be cut into four distinct periods.  From December 1998 through March 2000 the MFSI did well.  It began the period at 1,000 and 14 months later was at 1,110 – an increase of 11%. While that may not have seemed like much of a return compared to the returns being recorded by the NASDAQ and other indexes, it was, by historical standards, an excellent rate of return.  However, from March 2000 through August 2001, a period of only 17 months, the index rose spectacularly, climbing an amazing 44%. This achievement is all the more remarkable because during this time the S&P 500 began the long descent that, three years later, still continues.

From the end of August 2001, through June 30, 2002, the index first fell and then fully recovered. In the end it was in exactly the same place it was 10 months earlier. Since June 2002, however, the index has performed quite poorly. The MFSI began at 1,606 but quickly fell to 1,346. It then rebounded slightly, and currently stands at 1,427 – a decline of 11.4% from the all-time high of 1,606 recorded on June 30, 2002, just six months ago. 

While there are many possible reasons for the recent poor performance of the MFSI, two seem most plausible. First, with interest rates on home mortgages at historic lows, many long-time renters who never before considered buying have become first-time homeowners. As a result, the number of apartment renters has decreased and vacancy rates have risen, impacting profits. Another reason for the decline is that after falling for eight straight years, the unemployment rate is slowly rising as economic growth slowed from the levels of the late 1990s. This means fewer new households are being formed.  

Tax Cut Consequences

If passed as proposed, President Bush’s economic stimulus package will depress share prices of REITs because it contains a provision eliminating taxes on corporate dividends.  Doing this will effectively result in REIT and non-REIT dividend paying firms being treated equally. Currently, REITs are exempt from corporate income taxes because they distribute at least 90 percent of their income through dividends. However, non-REIT dividends are subject to corporate income taxes. In both cases, dividends are subject to the personal income tax. If non-REIT dividends are no longer taxed at the corporate level, then REITs will lose their privileged tax status. 

If this status is lost, it is inevitable that some investors will move some of their money from REITs to other stocks that pay untaxed dividends. The more this happens, the more REIT share prices will fall. Mitigating this effect is the fact that REITs pay a much higher dividend than any other group of companies, and if one wishes to invest in residential real estate, there are few alternatives. Thus, a mass exodus from REITs is highly unlikely.

Another consequence if this proposal is passed is that some REITs may elect to shed their REIT status, pay corporate income taxes and free themselves from their dividend requirement. In this case, the number of REITs would shrink and the corporate structure of public real estate firms would change.                   

Size and Return

The MFSI is comprised of 29 companies, the largest of which is worth almost 1,000 times more than the smallest. This makes it difficult to generalize about the health of any one (smaller) company by glancing at the index. There is no reason to believe that Equity Residential, with a market capitalization of slightly less than $7 billion, is directly comparable to the nine companies in the index which have a market capitalization of less than $60 million each – a capitalization of less than 1% of the value of Equity Residential. Equity Residential is so large that its market capitalization is greater than the sum of the market values of the 22 smallest firms in the index. With such large differences in market capitalization across index firms, it is instructive to see if and how investment returns are related to market capitalization and if there are distinctly different groups of multifamily firms. 

Total Return

Figure 3 compares the total rate of return earned by the largest 13 firms in the index to the total rate of return enjoyed by the smallest 16 firms in the index. Large firms are those with a market capitalization of more than $400 million on Dec. 31, 2002. The total market capitalization of the 13 larger firms is about $26 billion, while it is slightly more than $2 billion for the 16 smaller firms.

_{Figure 3} 

Looking at Figure 3, we see clearly that over the past four years larger firms have slightly outperformed smaller ones. Between December 1998 and December 1999, both groups performed about as well. However, from December 1999 through December 2000, larger real estate entities did substantially better than their smaller counterparts. Since then, the gap between the two groups has narrowed, as smaller firms have been slightly superior performers. 

Dividends and P/E Ratios

Figure 4 shows that dividend yields for both groups of residential ownership and management firms have been steadily converging for the past four years.

_{Figure 4}

In December 1998 the dividend yield for smaller real estate firms was close to 12 percent per year, almost double the rate paid by larger firms. Since then, the dividend rate for large firms has drifted up to almost 8%, while for smaller firms the rate has declined to just above 8%. 

As was the case with dividends, P/E ratios for the larger and smaller firms also have been converging for the past four years. Figure 5 shows that four years ago the P/E ratio for larger firms was about 16, while for smaller firms it was about 12. 

_{Figure 5}

During the intervening years, the P/E ratio of larger firms has remained remarkably steady and is now exactly where it was four years ago. By contrast, the overall P/E ratio of the 16 smaller firms in the index has moved substantially. After starting at about 11.5 in December  1998, it quickly fell to a low of 7.2 in late 2000. Since then it has tripled, achieving a level higher than it had ever reached, and in September 2002, it surpassed the P/E ratio of the 13 larger firms in the MFSI. 

While this may suggest that smaller firms are more highly valued by the market than larger firms, a closer look at Table 1 suggests otherwise. What appears to be occurring is that a number of smaller firms are doing poorly and, as a result, have seen their P/E ratios rise despite declines in their share prices. In addition, several other smaller firms actually are losing money and thus have no P/E ratio at all. Collectively, this has caused the P/E ratio of the entire group to rise to an unusually high level. 

Conclusion

While the past year was hard on multifamily corporations, when we compare their performance to the market as a whole we see that the MFSI was very resilient, falling a mere 6% compared to 22% for the S&P 500 with dividends reinvested. Since December 1998, the MFSI is up 42.7% compared to a decline of 24.5% for the broad market. This market segment clearly has been a safe harbor in an otherwise stormy financial sea. 

We also see that bigger companies have performed slightly better than smaller ones over the past four years, and that dividend yields and P/E ratios for the 13 largest MFSI firms have been far more stable than for the 16 smallest firms.

^{*Weighted by market capitalization, as is the S&P 500}