MultiFamily Market Outlook - December 31, 1969

Multifamily Investments: A Smoother, Quieter Ride

The stock of publicly traded multifamily companies that NAHB tracks in its Multifamily Stock Index (MFSI) have performed well – incredibly well, in fact, when compared to the S&P 500. But while multifamily stocks may continue to post solid returns in the future, their long run of exceptional performance over the last half decade is unlikely to continue unchecked because underlying macroeconomic fundamentals are no longer favoring multifamily investments as heavily as they once did.

In January 2002, 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 for meaningful historical comparisons to be made, we set the starting point for tracking the performance of the 29 firms in the MFSI at December 31, 1998.    

Since that start date, the MFSI has increased by 54.8%, for a compound rate of return of better than 10% per year. During the same four-and-a-half years, the S&P 500 with dividends reinvested has declined by 21%, for a compound rate of return of negative 4.3%. In other words, over the last four-and-a-half years the MFSI has had a annual compound rate of return that is 14 percentage points better than the S&P with dividends reinvested.

Review

Over the past 12 months, both the MFSI and the S&P 500 with dividends reinvested have performed almost identically. On July 1, 2002, the MFSI stood at 1,606 – only 3.61 percent below where it stands today. Meanwhile, the S&P 500 is now less than half-a-percent shy of where it was 12 months ago. Despite the similar returns, however, the paths taken by the two indices have been quite different. 

During the past two years, the MFSI has essentially moved sideways – and the most recent 12 months were no exception. Two years ago, the MFSI stood at 1,539 – just nine points, or half of one percent, less than its current level. And one year ago the MFSI stood at 1,606 – its all time high – but just 3.6% less than now. While the index has not stood still over the past year, its movements have had no apparent trend. The index went up and down, but only once in the past 24 months has the index closed below 1,400. Coincidentally, on only one occasion has the index ever closed above 1,600.  In short, its trading range over the past 24 months has been very narrow.

By contrast, the S&P 500 has fallen steadily since August 2000 – a period of almost three years. This spring, for the first time in years, its rebound is giving investors reasons for optimism. Two years ago the S&P 500 with dividends stood at 3,709 – already well off its peak of 4,553 registered 10 months earlier – and almost 18% higher than its current level. Interestingly, 12 months ago the S&P 500 was at 3,042 – just slightly lower than where it is now.

Incredibly, however, the year-over-year results described in the previous paragraph mask much of the volatility displayed by the S&P 500 over the time period.  From June 2001 through February 2003, the S&P 500 fell almost 1,100 points, or 29.5%!  Since then the index has risen an impressive 432 points, or 14% – albeit from a base of just 2,617 – and is still 33% off its all-time high.   

The lesson to be taken from this is that over the past few years the MFSI has held on to its gains with very little volatility.  Conversely, the S&P 500 with dividends reinvested has fallen 42.5% from its peak and has, of late, rebounded quite strongly.  For investors looking for excellent returns and fewer bumps and bruises, the MFSI has been an excellent choice.

Future Returns

As mentioned earlier, the S&P 500 outperformed the MFSI for the 12 months ending June 2003. This was the first time this happened in more than four years, the previous time being April 2000. Before this month, the MFSI outperformed the S&P 500 with dividends reinvested for 50 straight 12-month rolling periods. However, that long period of MFSI outperformance masked a steady decline in the 12-month year-over-year (YOY) rate of return. In early 2001, the YOY rate of return for the MFSI peaked at more than 30%, and it has been essentially falling ever since. As a matter of fact, the YOY return for the MFSI turned negative for the first time in July 2002, and has remained negative ever since.   

By contrast, the YOY rate of return for the S&P 500 has been slowly improving.  Between December 1999, and October 2001, the YOY return of the S&P 500 steadily worsened.  From November 2001, through March, 2003, the YOY rate of return hovered consistently around negative 20 percent.  Since then, the YOY return for the S&P 500 has improved by 25 percentage points to reach a YOY rate of return of zero in the current month. This is the first time it has reached that milestone in 15 months, and it managed it then for only one month. 

Given that YOY rate of return for the S&P 500 has been negative 30 out of the past 31 months, and that the rolling three-month rate of return over the same time period has been negative 21 out of the 31 months, it would not be surprising if to see improving performance from the S&P 500 – and we may see it outperform the MFSI. After all, the S&P 500 cannot remain a poor performer indefinitely. If, however, the last four-and-a-half years are a guide, we may expect to see the S&P 500 outperform the MFSI for a long period of time. Either way, the dominance of the MFSI over the S&P 500 is probably over.         

Major External Events

Events in the Real Estate Investment Trust (REIT) industry have had an effect on the S&P 500 as well as the MFSI. The most significant positive external event for REITs was the decision by Standard & Poor’s to include REITs in its various stock indices. At present there are 18 REITs in the various S&P indices, including five MFSI firms.  Equity Residential (EQR) and Apartment Investment and Management Company (AIV)  both are in the S&P 500 index; United Dominion Realty Trust (UDR) is part of the S&P 400 Mid Cap index; and Essex Property Trust, Inc.(ESS) and Gables Residential Trust (GBP) both are in the S&P 600 Small Cap index. 

It is important to note that three of the five firms listed above have been added to an S&P index just in the last six months. This clearly shows that residential REITs are being closely watched by Wall Street and now are key players. Collectively, the five residential REIT firms have a market capitalization of almost $14 billion, almost half of the market capitalization of this sector. 

In addition, based on market capitalization and trading liquidity, Archstone-Smith (ASN) is a likely candidate for future inclusion in the S&P 500 index, along with several other large non-residential REITs. Were Archstone-Smith to be added to the S&P 500, the market capitalization of the three residential REITs in that index alone would be $15 billion, making this sector very well represented in the overall index. 

Inclusion in any S&P index is positive, since it not only increases institutional investor demand for those particular issues but also lends added credibility to the sector as a whole. However, now that REITs in general – and these firms in particular – have been added by Standard & Poor’s, investors are less likely to be positively surprised by any future REIT additions. Thus the sudden and positive “surprise effect” – the rise in the price of a stock once it is announced that it will be included in an S&P index – is probably a thing of the past.

Changes in Taxation

A more recent and potentially very negative development that promised to have an impact on (residential) REITs was the proposal earlier this year by President Bush to eliminate double taxation of corporate dividends. However, as passed in its final form, the tax was reduced to a maximum of 15 percent, not eliminated, with dividends from REITs continuing to be taxed as before. (1) Also as part of the tax package, the maximum income-tax rate declined from 38.6% to 35%. 

Interestingly, some REIT dividends now will qualify for the new 15 percent rate. If the REIT is distributing dividends from a subsidiary or other corporation that pays corporate income tax, the dividends will be taxed at the lower rate. Moreover, any dividends paid out as part of a capital gains distribution now will be taxed at the new lower rate.            

Three things, taken together, have blunted much of the negative impact that this tax change could have had: the reduction in personal income tax rates, the lowering of the tax rate on corporate dividends to 15% (rather than its elimination), and the ability of some REIT income to be subject to the new, lower rate. Also, to the extent that the Bush tax package emphasizes dividends, it may have increased interest in REITs from the many investors who until recently scorned them precisely because they paid dividends, and thus could not retain earnings to finance future growth. Lastly, MFSI firms have a dividend yield of  7.27%, compared to 6.75% for the average REIT and 1.8% yield for the S&P 500.  Thus, despite very negative possible consequences, the recent tax changes appear to have had little impact on REITS for a variety of reasons.
          
Conclusion

Since December 1998, the MFSI has performed admirably in a difficult financial environment. It is up almost 55% over that time period and has a compound annual growth rate that is 14 percentage points better than the S&P with dividends reinvested.  Making this all the more impressive is that the MFSI has done this with little volatility compared to the S&P 500. 

However, the S&P 500 recently – for the first time in a long while – outperformed the MFSI. This created a never-before-seen situation in which the S&P 500 outperformed the MFSI over the past 12 months. This is a trend worth paying close attention to. If history is a guide, we can expect that once one index begins to outperform the other, it can maintain that advantage for an extended period of time.      

Lastly, it seems that the MFSI firms have weathered corporate dividend tax rate reduction well. Why? Perhaps because the tax was reduced and not eliminated, or because individual tax rates were simultaneously reduced, or because residential REITs offer very high dividends, or because there has been renewed interest in dividend-paying stocks. Or all of the above.  

 (1) This is because REITs do not pay corporate income tax, and are instead required to pay out at least 90 percent of their taxable income in the form of dividends.  Thus, they were not subject to the double taxation that was at the heart of the tax reform proposal.

Starts Swing Back Up in May from April Low

For the month of May, the (seasonally adjusted annual) starts rate for buildings with five or more apartments came in at 328,000--up 35% from April's depressed number. As  noted in last month's Outlook, large month-to-month fluctuations are common in the multifamily starts series, and very often a low number one month is followed by a high one the next, as we've just seen in April and May.  Nevertheless, at 328,000 starts, the rate is the highest it's been since August of last year. Over the long run, that rate probably is too high to be sustained, just as April's (slightly revised) rate of 243,000 proved to be too low to be sustained. Looking ahead, there continues to be some reason for pessimism, as three-month absorption rates for newly completed apartments remain extremely low.  However, permit data suggest that, at least over the next couple of months, multifamily production could be fairly strong. The  rate at which new five-plus permits were issued rose 18% between April and May, while the number of permits unused at the end of the month increased by 5%.

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

Forecast: A Better Second Half-Year in 2003

On June 26, the Commerce Department revised its estimate of first-quarter growth in real GDP from 1.9% to 1.4%  (annual rate). This meager growth was supported primarily by consumer spending and housing, while spending by the nonresidential business sector weakened badly. Lingering geopolitical uncertainties and reluctance of corporate America to crank up spending and hiring continue to weigh on the economy. Thus, the hoped-for postwar “pop” in economic activity has not materialized, and the second quarter now shapes up as another episode of slow growth (we’re estimating 1.5%). Nevertheless, NAHB continues to believe that the encouraging set of pre-conditions, especially the double-fisted monetary-fiscal policy punch, will lead to much better economic performance in the second half of this year and in 2004.

On the monetary policy front, the Federal Reserve cut its federal funds rate target by another 25 basis points on June 25, to a 45-year low of one percent, and the Fed left the door ajar to more monetary stimulus down the line. On the fiscal front, the administration's Tax Relief act, signed into law by President Bush in May, really is a big deal for the economy in the second half of this year, because most provisions are heavily front-loaded. Analysis of the impacts is devilishly difficult, since the effects will depend on whether or not the tax changes are considered permanent.  Macroeconomic Advisors, LLC (MA) recently made an attempt to simulate the economic impacts of that tax relief legislation.  MA assumed that the cuts to personal tax rates, the special reduced rates for dividends and capital gains, the expansion of the child tax credit, and the relief from the marriage penalty eventually would be made permanent; that enhanced depreciation/expensing provisions for businesses would be allowed to expire as scheduled; and that taxpayers would behave accordingly. MA’s simulation showed that JGTRRA will boost GDP growth by about 1.2% in the second half of 2003 and 0.7% over the course of 2004. These numbers are broadly consistent with the assumptions of built into NAHB’s forecasts and are essential to achieving the 3.75% GDP growth we're projecting for the second half of 2003, and the 3.70% for 2004.

Real Rents Remain Ahead of Inflation

In May, rents outpaced inflation for the second month in a row. While the overall Consumer Price Index (CPI) remained unchanged at 183.3, the residential rent CPI subindex grew at a (seasonally adjusted annual) rate of 3.6%.  That was only half as dramatic as the scenario in April, when rents also increased by 3.6% while the overall CPI  declined substantially. Neverthless, the real rent index (residential rent adjusted for inflation) now stands at 107.9--the highest it's ever been.

Given persistent high vacancy rates, some may wonder why rents haven't shown more signs of weakness. One factor to keep in mind is that, because owner-occupied and rental housing are substitutes, there is an economic balance between house prices and rents, and house prices have continued to appreciate (at an average annual rate of 6.5%, according to the OFHEO House Price Index for the first quarter of 2003).