MultiFamily Market Outlook - December 31, 1969

Multifamily Stock Index Continues Upward Climb: New Data Finds REITS Benefit from Modernization Act

Although the S&P 500 did slightly better than NAHB’s Multifamily Stock Index (MFSI) during the first quarter of 2005, the MFSI is currently performing 130% better than the S&P 500 (with dividends reinvested). This strongly suggests that the fundamentals that propelled the MFSI — which tracks the stocks of 27 publicly traded, U.S.-headquartered firms principally involved in multifamily ownership and management — to record heights throughout 2004 remained very much in place during the first seven months of 2005.

Even while the S&P 500 was reaching levels not previously seen since January 2001, the MFSI was outpacing it. Put another way, what was good for the S&P was great for the MFSI  (see chart below).

Source: NAHB Housing Policy Economics

While predicting the future outcome of the MFSI is risky, the recent strong performance of the MFSI hints that there may be substantially more price appreciation ahead, especially if long-term interest rates remain at or near historical lows.

Macroeconomic factors have been a major reason for the success of multifamily REITs over the past decade, but there may well be another reason that REIT stocks in general have enjoyed such good health: the passage of the REIT Modernization Act (RMA) in 1999.

New data suggest that the Real Estate Investment Trust Modernization Act may be one of the unacknowledged reasons MFSI has enjoyed such a superb performance.

The RMA, which became effective Jan. 1, 2001, essentially allowed REITs, for the first time, to directly control ancillary services offered to tenants without disqualifying the REIT from favorable tax laws. That change has had a significant effect on the bottom lines of these companies.

First, Some Background

Three-and-a-half years ago, the NAHB introduced the MFSI to help the multifamily industry and investors better track the performance of public firms principally involved in multifamily ownership and management, and to allow for comparisons between the MFSI and other major stock indices. In order to make meaningful historical comparisons, NAHB set the starting point for tracking the performance of all the firms that qualified for inclusion in the MFSI at Dec. 31, 1998.

Since that time, the MFSI has increased by 168%, for a compound rate of return of almost 16.5%. During the same period, the S&P 500 with dividends reinvested increased by 11%, for a compound rate of return of just better than 1.5%. As a result of the 15 percentage point difference in the annualized rates of return, $1,000 invested in the MFSI on Dec. 31, 1998 would now be worth a staggering $2,684. It would be worth only $1,108 if invested in the S&P 500 with dividends reinvested.

Share prices of the publicly traded multifamily companies tracked by NAHB for its MFSI have performed exceptionally well over the past six-and-a-half years, declining only in 2002, and then by only 4%. In other years, returns have varied from a low of 2% to a high of 33%. By contrast, over the same time span, the S&P 500 has had a cumulative return of less than 1%. Using the S&P 500 with dividends reinvested bumps the cumulative return up to 11%.

The REIT Modernization Act Makes a Difference

There are many  factors that have boosted apartment REITs, and in turn, the MFSI,  including historically low interest rates, high capitalization rates, poor stock market returns, and rapid real estate appreciation in many parts of the nation. These factors have been extensively discussed here and elsewhere. But one factor that has not been discussed is the passage of the RMA, which new data suggests has also been a a major reason for the MFSI’s good performance.     

Most important among the changes introduced in the RMA was that it allowed REITs, for the first time, to own 100% of the stock of a taxable REIT subsidiary (or TRS) that provides any type of service to REIT tenants, including “non-customary services.”  Thus, a REIT, through its wholly-owned TRS, now can offer concierge, cable, broadband, housekeeping, daycare, bulk purchasing, laundry, dog walking, grocery shopping, and any other services to its tenants without running afoul of favorable tax laws. Prior to passage of the RMA, a REIT was required to earn at least 95% of its income from “passive” sources (including rents, capital gains, dividends and interest).    

To get around the 95% restriction, REITs historically established a third-party subsidiary to provide such services. However, as REITs were prohibited from owning more than 10% of the stock in such a subsidiary, REITs had little formal control over the third-party subsidiary’s providing services to their tenants.¹ By contrast, REIT competitors had always been able to provide these services without restrictions.

The RMA also reduced the REIT ordinary income distribution requirement from 95% to 90%, returning it to the level it had been from 1960 through 1980. While this change seems small, it also was helpful, because it allows REITs to more easily tap into retained earnings and reduce capital costs.

New Data Shed Light on 2001

Recently, data covering 2001— the first year in which the RMA was effective — became available. And while the data are not broken down by REIT type (apartment, office, medical, lodging), the information provides a first glimpse into this rapidly evolving corporate form. ²

Table 1 shows the distribution of TRS ownership across parent REITs, for all 404 TRSs filing a Corporate Income Tax Form. About 85% of TRSs had only one parent, while the remaining TRSs had multiple REIT shareholders.  Table 2 shows that, of the 183 REITs with at least one TRS, about 50%, or 96 REITs, have only one TRS, while the others have more than one. At the extreme, there are 13 REITs with seven or more TRSs.

Table 3 shows the number of TRSs owned, organized by the asset size of the REIT. Not surprisingly, smaller REITs were likely to have shares in fewer TRSs than larger REITs, with the largest REITs having, on average, shares in four different TRSs. This strongly suggests that having very large TRSs may not be as advantageous as having several smaller ones. This may be due to geographical diversity, mission differentiation, differences in capital structure, or still other factors.  

Tables 4 and 5 split TRSs into two groups: those that filed tax returns prior to 2001 (as third-party subsidiaries), and those filing their first returns in 2001— thus, the new entities. This comparison not only is legitimate—the IRS permitted tax-free conversions of third-party subsidiaries into taxable REIT subsidiaries—but it’s particularly informative, because it allows us to compare new and preexisting third-party subsidiaries.

A comparison of the two tables immediately shows that the new entities were far more likely to have net income than were their older brethren. To be specific, the total net income for preexisting third-party subsidiaries was a negative $352.6 million, as compared to a positive $201.6 million in net income for newly established entities. Interestingly, except for 85 new TRSs with assets of less than $1 million, all TRSs  with assets of less than $100 million had negative net income.

Despite showing substantial negative net income, preexisting entities paid slightly more than $75 million in taxes in 2001, compared to slightly less than $10 million for new subsidiaries. Also interesting is the fact that roughly two-thirds of the total taxes paid by established entities were paid by the largest TRSs, while taxes paid by the newly formed TRSs were more evenly divided, with the TRSs with the fewest assets paying slightly over half of the total taxes.                                

By observing that the sum of Tables 4 and 5 is the entire universe of TRSs, it is worth noting that the total assets of these entities is almost $20 billion, or almost 10% of the total assets of the REITs that own these TRSs. Moreover, these entities have gross receipts of almost $10 billion, gross profits of more than $5 billon, and non-operating income of almost $3 billion.

Also worth noting is that the 154 new TRSs comprise anywhere between a third to a half of the assets, receipts, profits and non-operating income of all TRSs. The substantial amount of activity being conducted by newly minted TRSs suggests that the RMA has already substantially altered the REIT landscape. 

The large number of new TRSs may be the result of REITs fully anticipating the tax law change, and rearranging their corporate structure in light of it. If that is the case, we’ll see progressively fewer new TRSs being established in future years. By contrast, the 154 new TRSs may simply be subsidiaries of very “non-customary service” oriented REITs, and in that case will probably be followed by many more TRSs in the future as increasing numbers of REITs provide nontraditional services.

¹ In order to comply with this regulation a REIT would typically own only 10 percent of the voting shares of a TPS; however it would own close to 100 percent of the nonvoting stock, preferred stock, or debt.  And, to still better ensure that the TPS acted in the best interest of the REIT, the remaining voting shares were often held by the REIT’s managers or shareholders.  Despite this arrangement the inability of the REIT to directly own the stock meant that REIT shareholders could not be assured that the TSP would always act in their best interests. Also, some of the income earned by the TSP accrued to the voting shareholders’ benefit rather than the REIT shareholders.

² The data come from the IRS’s Statistics of Income division (SOI), from Form 1120-REIT, TRS Form 1120, U.S. Corporate Income Tax Return, and Form 8875, Taxable REIT Subsidiary Election.  The corporations analyzed are TRSs that filed Form 8875 as well as Form 1120 for tax year 2001. The data on these TRSs are from the SOI Business Master File, and represent the entire universe of TRSs that filed a tax form in 2001. There were 480 firms that filed Form 8875, Taxable REIT Subsidiary Election Form, and of those 480, 404 filed Form 1120, U.S. Corporate Income Tax Form.  

Starts: They're Up, After Going Down, After Going Up

Five-plus starts continued their monthly roller coaster ride as the second quarter of 2005 closed out. Housing starts in buildings with five or more apartments rose 16% in June to a seasonally adjusted annual rate of 302,000. This came after a slide in the rate — it  fell by 32% in March — followed by a rise — up 36% in April — and another drop of 24% in May. It's important to remember that starts are generated from a survey of about 900 of the approximately 20,000 permit-issuing places in the U.S. Sampling error, along with the inherently lumpy nature of multifamily production (all units in a large building are started at the same time), mean that no one should be too surprised by monthly fluctuations appearing at times without apparent explanation.

Source: U.S. Census Bureau; NAHB Economics Group

Sometimes it's possible to get a better picture of what's going on in a fluctuating series like this one by using a moving average to smooth it out. The three-month moving average for five-plus starts fell within 1,000 units of the actual starts rate in June, suggesting that June's 302,000 is a better indicator of what to expect over the next several months than the numbers reported in April or May. A number in the neighborhood of 300,000 also is where NAHB's forecast expects the five-plus starts rate to settle by the end of the year, after the inevitable month-to-month swings even out.

Real Rents Rise for Second Consecutive Month

The real rent index continued to recover in June, according to the most recent Consumer Price Index (CPI) numbers released by the Bureau of Labor Statistics. While the residential rent component of the CPI increased at a seasonally adjusted annual rate of 3.4% (well in line with its average performance over the past year), the overall CPI remained perfectly flat.

Although prices on most items crept up during the month, on a seasonally adjusted basis this was perfectly offset by energy prices, which declined for the second month in a row. As usual, the movement in energy prices was driven by a large change in prices for petroleum-based products.

The bottom line is a real rent index (which adjusts residential rents for inflation) that moved up from 107.5 to 107.8. This constitutes a substantial increase for the second consecutive month, but the index had reached 108.0 in January, and was as high as 108.3 in late 2003.

Economy Healthy — With 'Room for Growth'

Although there are some negatives for the U.S. economy, the economic recovery/expansion that's been in progress since the 2001 recession ended still looks quite healthy and there’s still plenty of room for growth. GDP growth for the first quarter of this year still stands at a highly respectable 3.8% pace, but the Commerce Department’s “advance” estimate for the second quarter shows a slowdown to 3.4%.

This estimate may very well be revised upward but, in any case, the composition of second-quarter GDP has set the stage for a solid rebound in the third quarter of the year. The labor market report for July was quite upbeat, showing strong growth of payroll employment, a pickup in the labor force participation rate and maintenance of a 5% unemployment rate. The report also showed a significant increase in average hourly earnings — good news for workers, but a factor that may feed into unit labor costs and inflation down the line.

GDP growth should settle back in the final quarter of this year. We’re currently forecasting 3.5% growth for next year, a bit above the August Blue Chip consensus but below our estimate for this year.

As expected, the Federal Reserve hiked short-term rates by another 25 basis points at the conclusion of the Aug. 9 meeting of the Federal Open Market Committee (FOMC), raising the federal funds rate target to 3.5%. The FOMC continued to describe monetary policy as “accommodative” and suggested that upward rate adjustments will continue “at a measured pace” — meaning no more than a quarter-point hike per FOMC meeting.

The FOMC's characterization of economic activity painted a picture of strengthening aggregate spending and “elevated” pressures on core inflation. We’re expecting another quarter-point hike in the Fed’s target for the federal funds rate at the Sept. 20 FOMC meeting, and we’re still projecting a funds rate of 4% by year end.

However, the Fed’s growing preoccupation with core inflation has encouraged us to add a quarter-point increase to our forecast for 2006 — taking the federal funds rate to 4.5% by the March 28 FOMC meeting. 

MFSI Hits New All-Time High

The MFSI increased by a whopping 151 points, or 6.5%, during the month of June. With this large increase, the MFSI is at its highest reading of all time, shattering the old mark of 2,392 set just five short months ago. With this recent rise, the MFSI now finds itself almost 30% higher than it was just 12 months ago. During the past month, the S&P 500 with dividends also rose, but by just slightly more than one-tenth of 1%, and is now almost 6.5% higher than it was 12 months ago.

Source: NAHB Housing Policy Economics

Because the MFSI increased by so much more than the S&P 500 with dividends during June, the performance gap — or percentage difference — between the two indexes widened dramatically from 116% in May to 130% in June, which is eight percentage points higher than the previous high-water mark of 122%, set in December 2004. Despite the very strong 46% rise in the S&P 500 since its low, set in late 2002, the MFSI has risen a staggering 72% during the same 34 months.

In addition, the MFSI continues to dramatically outperform the S&P 500 over even longer time periods including the past three, four, five and six years. Since December 1998, the MFSI has risen by 146% while the S&P 500 with dividends reinvested has gained only 6.9%. During June, the price-to-earnings ratio (P/E) of the MFSI rose slightly to 18.54, while the dividend yield (defined as the total cash dividend payments divided by the current stock price), which moves in the opposite direction, fell and now stands at 5.35%.

The MFSI is an index of 27 publicly traded US headquartered firms, including 23 REITs, principally involved in multifamily ownership and management.