The Outlook for House Prices and REITs

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So we've been undersupplying for 10 years, and then you get to this COVID-induced pinch where people aren't moving, no, nor is anyone listing their homes in a market that was already supply constraint, and it just kind of created the perfect storm from our vantage point.

Welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard is Dallas Tanner. He's the CEO of Invitation Homes. That's the largest US owner of single-family rental houses. You've probably heard that house prices have soared over the past year. So have prices for REITs, or real estate investment trusts, which collect rents and pass them on to shareholders as dividends. In a moment, we'll hear from both Dallas and a top REIT analyst about what home buyers, home sellers, and income investors should make of the property market in the year ahead. Listening in is our audio producer Jackson. Hi, Jackson.

Hi, Jack.

I know you're not a New Yorker, but if I mentioned an unorthodox New York politician named Jimmy McMillan, does that ring any bells?

Not, not yet.

How about the phrase, the rent is too damn high? I'm sorry, I should have warned you about the profanity. Does that ring any bells?

Yeah, it's ringing some bells.

What are you picturing?

A debate stage, a guy well-dressed, maybe big beard, kind of looks like a kind of, you know, early 1800s president.

I think you've nailed it. Like many people, I first learned about Jimmy McMillan in mid-October 2010, watching a televised debate in the race for New York governor. There were 7 candidates. Andrew Cuomo, the Democrat and ultimate winner, was the heavy favorite at the time, followed by Republican Carl Palladino. One candidate, Kristin Davis, was formerly known as the Manhattan Madam because she'd run a high-end escort service. You'd think she would have made the most memorable impression that night as a political outsider, but Across the stage sat a man with karate sneakers, and as Jackson said, an elaborately sculpted beard, and a suit that he says he bought for $99, and a tie he made himself, and a Bounty paper towel for a pocket square, and most important of all, a catchphrase for the ages.

People working 8 hours a day and 40 hours a week to some third job. Once again, why? You said it, the rent is too damn high.

Jimmy McMillan was what you call a single-issue candidate, and he had founded a political party named for that issue called the Rent Is Too Damn High Party. Those words resonated with voters.

Listen, someone's child's stomach just growled. Did you hear it?

Mr. McMillan, 30 seconds for you, sir.

In the end, Jimmy got less than 1% of the vote. Some of his proposals, like nationalizing banks and cutting top banker salaries to $45,000 a year, might have scared off economic traditionalists. There was also some confusion about just how high Jimmy's own rent was. He told the New York Times at one point that he'd been living rent-free in Brooklyn in exchange for performing maintenance work. Years later, the New York Post published photos of a handsome one-bedroom apartment in Manhattan that Jimmy had been renting for $872 a month, a small fraction of market rents at the time, because the apartment was rent controlled. I mentioned Jimmy because rents nationwide are up 42% since that 2010 debate, but single-family house prices are up more than twice as much, 89%. And the gains have been accelerating. The latest reading on the Case-Shiller Index of house prices nationwide was reported in November, and it reflects pricing during the month of September. It showed an increase of nearly 20% from a year earlier. 20%. That compares with an overall U.S. inflation rate that recently hit 6.8%, the highest number in decades. After that number came out, the Federal Reserve adjusted its course saying it would be quicker to wind down bond purchases than previously planned and more open to hiking interest rates in the years ahead. One thing that's noteworthy about that is that the inflation rate reflects the cost of ordinary goods and services, and one of those goods is housing. In fact, housing gets the highest weighting in the Consumer Price Index, 22%. Only it's not called housing, it's called Owner's Equivalent Rent of Primary Residence, and it's calculated in part by asking homeowners, if you were to rent out your house today, how much do you think it would rent for? And the latest increase for Owner's Equivalent Rent of Primary Residence is just 3.5%. To paraphrase Jimmy McMillan, house prices look too darn high, and the rent growth assumption baked into CPI it looks too darn low. We've all heard stories about first-time homebuyers shopping in vain and finding nothing in their price range, being outbid by all-cash buyers paying well over asking prices. The disconnect between house price growth and rent growth raises the question of whether more families looking for single-family houses will decide to rent them for a while. I recently had a chance to speak with a man in charge of America's largest portfolio of single-family houses for rent. Hi, Dallas, is that you? It's Jack Howe from Barron's. Are you in Dallas?

Dallas, living in Dallas.

That's right.

Did you grow up in Dallas?

No, my parents weren't that smug.

That's Dallas Tanner, originally from Phoenix. He had a business there around a decade ago buying distressed houses in the wake of the big housing crash. To expand, he needed a partner with deep pockets, and he found one with practically limitless access to capital, one that sounded at the time like an odd fit for fixer-upper houses. It was Blackstone, the alternative investments giant. Blackstone amassed a large portfolio of houses, put them under professional management, and structured the business as a real estate investment trust. REITs can avoid paying taxes at the corporate level provided they pass the bulk of their income on to shareholders as dividends. Blackstone took its single-family house business public as Invitation Homes in 2017. Later that year, Invitation merged with another big player in single-family houses called Starwood Waypoint Homes. It kept the name Invitation and kept its headquarters in Dallas and in 2019 made its chief investment officer, Dallas Tanner, its new CEO. Today, Invitation owns more than 80,000 houses and has a stock market value of $25 billion. Investors typically buy REITs for income. Invitation's dividend yield is a relatively modest 1.6%, but so far this year, the share price has gained more than 40%. I asked Dallas to describe his typical tenant.

Today, the customer is about 38, 39 years old, has a combined household income of around $130,000. And so that customer is staying with— between 3 and 4 years. They're looking for consistency and duration. And so they want services. They want things besides just the rent. They want smart technologies in the home. They want pest control services. They want filter services. So Those are things that we've continued to kind of fine-tune in terms of the approach.

Dallas says most houses Invitation has added under his watch have been bought one by one. He says the company has scattered sites in different locations rather than clusters of units in neat rows. And that raises the question of what made this business possible. Before the housing bust, there were real estate companies that focused on apartment buildings, but not so much single-family houses. I always assumed that was because apartment buildings are designed to maximize rental income and detached houses generally aren't. So while mom-and-pop investors will buy a rental house or two, professional investment managers generally aren't interested. Dallas says two things changed to make the business attractive. One was a 60% to 70% plunge in prices in some areas during the housing crash. Another was the rise of new software for doing things like managing rental properties and optimizing the routes driven by vendors of supplies. That raised a different question. If a plunge in house prices helped give birth to the industry, now that prices are riding high again, does the business become more difficult? Here's Dallas.

So today there's probably about 18 million people that rent a single-family home. And there's probably only 300,000, 350,000 properties that of those 18 million that are professionally managed, like what we would consider professional management. But I think you're going to see the industry actually scale up. I would believe that in the next decade, that number of 300,000, 350,000 units, it should be 1 million units out of 20 million units. It should be 5% of the industry is professionally managed. And so you're right, the easy low-hanging fruit, if you're just playing a home price appreciation game, probably isn't the same as it was back in 2010 or '11. But the services, the business model, the consistency of the customer— customer stays with you twice as long as it does multifamily. It's pretty compelling value proposition for investors.

I asked Dallas what he can tell me about inflation. He says he saw consistent home price appreciation of 5% to 8% a year until last year when it hit a high teens rate. Pushing 20%. One reason, he says, is that builders who took a bath during the housing crash have been cautious about scaling up construction. Another is that when COVID hit, homeowners stayed put, which reduced listings. A third reason is that builders have been struggling with getting some supplies. I know I ordered some new doors earlier this year. It took months for them to arrive. Dallas calls all of this a perfect storm, and he thinks it'll clear soon.

Now, I wouldn't expect it to grow to the sky. We're actually thinking it'll moderate back to kind of those more normal levels where you have a really healthy housing market and, you know, home prices are appreciating between, you know, 5% and 7%. But maybe that takes 3 to 6 more months of some of this inordinate, you know, pressure that's felt. But we're starting to see— we're expecting people to start moving around a little bit more.

I asked Dallas, how do you decide how much to raise rents?

We take a lot of market data. We don't set rate to be totally clear. We ask for what we think the market's bearing on a property with our new leases. So if somebody, you know, leaves a property, they move out, they go buy a home, whatever their circumstances, that home that's vacant, we're going to try to set to market rate. Our new lease rate growth through the first 3 quarters of this year has been, you know, almost kind of in the mid-teens at times. In our renewals where we're just renewing people year over year has been kind of more in the high single digits on average. And that's because you want to show loyalty to your customer base and you start to weigh out the cost of turnover and everything else.

For a couple of years following the Starwood merger, Invitation was a net seller of houses. Now it's back to being a net buyer. The company also has a supply deal with homebuilder PulteGroup to buy homes that are designed to be rentals. In September, Invitation received a request from the Federal Trade Commission for information on how it conducts business generally and how it has done so during the pandemic. The company was the subject of some negative news stories focusing, for example, on tenants who had big rent increases or received eviction notices. The stories suggested that big corporate ownership of single-family houses was creating mayhem in the market. One story in the New York Times was titled, "A $60 Billion Housing Grab by Wall Street." It said that giant companies are, quote, "squeezing renters for revenue and putting the American dream even further out of reach." Invitation has said it's a tiny player in rental houses percentage-wise, without the ability to dictate rents that the market will bear. Dallas says he thinks that some of the coverage has been unfair and politically motivated. I asked whether he's a good landlord.

We don't get it right necessarily 100% of the time. You're in the business of housing. Anyone that's been in the business of housing knows a few things. One, it's sensitive. It's important. We offer a core product that we all need. But, you know, 99.9% of the time we do a really good job. We hold ourselves accountable. We survey over 25,000 times a year with our customers going in and out of our portfolio to give us feedback. We've got an A+ rating with the Better Business Bureau, and our Google and Yelp scores are north of the 4% marker.

What about the value of renting from Invitation versus a mom-and-pop landlord? Back in my days as a renter in Queens in New York City, I had mostly terrific landlords, some of whom were older folks in two-family homes who lived on the bottom floor while renting the top floor to me. My rent inflation minimization strategy was simple: be as polite and helpful as possible. I didn't quite achieve Jimmy McMillan levels of rent containment, but I did okay. I'm not sure I would have done as well with a big company landlord, but Dallas says a big company can offer plenty of things mom-and-pops can't.

Okay, how about this for starters? You can go look at all of our homes, not have to have a real estate agent with you, and we can give you keyless entry. You can go in and out, you can check floor plans, you can walk your kids through it without the pressure of a salesperson looking over your shoulder. By the way, if your furnace goes out in Chicago or your air conditioning goes out in Phoenix in the middle of the night of the summer, I can get somebody to your house within a couple of hours because we have so many vendors on retainer. If it's me today, I'm a renter, I would much rather rent from a professional company that's got all those services and mobile apps and all those things where I can be really efficient versus maybe renting from, you know, Joe Smith, my landlord.

Jackson, you have told me that this podcast has a pretty big audience. What are the chances that there's an actual Joe Smith out there who is a landlord listening?

I'd say pretty high, maybe like 65%.

So, Joe, if you are listening, first of all, thank you for listening. And second, You know that when Dallas mentioned Joe Smith the landlord, he wasn't talking about you, right? I mean, you probably get this kind of thing all the time. I bet you're an excellent landlord. Jackson, anything you want to add for Joe?

Yeah, and just because you have a generic name doesn't mean you're a generic person.

Exactly. You could be totally unique. You probably play an instrument, and your middle name is probably Razzle Dazzle. I mean, that actually seems less likely now that I hear myself say it.

Yeah, the odds are down to 0.01%.

I wanted to learn more about whether REITs in general and Invitation Home Shares in particular are still attractive after this year's big run-up. So I spoke with a top REIT analyst, and that's next after this short break.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

Welcome back. REITs have had a heck of a year. Vanguard has an exchange-traded fund that passively holds a basket of REITs. The ticker is VNQ. This year so far, it's returned 35%, which is about 9 percentage points more than the S&P 500 index. I think it's natural to wonder, after an investment has had a year like that, is it due for a sell-off next year? Also, as I mentioned earlier, the Fed recently signaled that it has become more open to raising interest rates in the coming years. Bonds generally do poorly when interest rates rise. Does that mean REITs will struggle too? Not necessarily.

So we're calling for around 10% total returns in the year ahead.

That's Richard Hill, who's in charge of REITs coverage at Morgan Stanley. One thing that's noteworthy about his prediction is that Morgan Stanley's house view on the broad U.S. stock market is that it will end next year 5% lower than it is now. So when Richard says he expects REITs to return about 10% next year, it's quite a bullish view relative to his firm's baseline for stocks. Richard thinks returns will be driven by healthy growth in cash flows and the sector's dividend yield of close to 3%. So what kinds of REITs should investors favor? Here's Richard.

We are recommending a barbell approach in the year ahead of what we consider to be growth and value. So let me unpack that for a second. When we think about growth, these are stocks that might screen expensive. Many REITs screen expensive because they've had a really great run, but we think they have outsized earnings catalysts. So those are stocks like AvalonBay in apartments, Invitation Homes in single-family rental, Welltower in seniors Housing. Those are 3 names at the very top of the list.

Okay, AvalonBay, that's ticker AVB, or Alpha Vicinity Burrito. I'm not very good at military call signs. Invitation Homes, that's INVH, Indigo, Nutritious, Vicinity, Hula Hoop. And Welltower, or Well. Those are the growth REITs. And what about value?

I would put retail real estate in that value bucket. We really like Simon Property Group here. We really like Kimco here, and we really like Phillips Edison here.

Got it. Simon Property is ticker SPG, that's Special Parcel Gargantuan. Kimco Realty trades under KIM, and Phillips Edison is PECO. That's pterodactyl ecclesiastes colitis ovation. Just remember that pterodactyl starts with a silent P.

Jack, that's super helpful.

I asked Richard what he likes about Invitation Homes, and he mentioned that rents on new leases are rising at mid to high teens percentages, and that growth can last for years because only around 25% of Invitation's tenants leave in a given year. He said that with demand exceeding supply, negotiating power has shifted in favor of landlords. But he also said that he doesn't think rents have gotten excessive.

Rents are still pretty affordable for single-family rentals. Rent-to-disposable income is in the low 20% range. That's pretty attractive. We don't get to start to get concerned about affordability until we get into the high 30% range.

I asked Richard the same question that I had asked Dallas. In light of some of the critical news reports, do you think Invitation is a good landlord? He does. Okay, let's look at retail. We all know of a struggling mall or two, but Richard points out that malls make up just 15% of retail real estate. He says they get a lot of media attention because everyone loves a great tragedy. Over the next 5 to 10 years, 35% of U.S. malls will need to be, as Richard says, rationalized. In other words, closed or repurposed. But there's not a lot of REIT exposure left to low-quality malls, and the much larger universe of open-air shopping centers is healthier. So Richard thinks there's plenty of room for strong players to perform well. He also points out that despite what investors sometimes say, ecommerce did not kill store-based retail.

Ecommerce was the tipping point, but what's killing retail real estate is retail real estate. Retail real estate has grown at 350% since 1970. The U.S. population has grown at 61%. We just need less of what we have right now.

Simon Property has been doing something unusual lately— buying struggling retailers. It went in on purchases of JCPenney, Forever 21, and Brooks Brothers, for example. Richard says that he estimates that Simon is worth more than its recent trading price, even excluding the value of its retailer investments. He also likes that although Simon pays a $6.60 dividend per share now, down from $8.30 before COVID that the company is producing the same free cash flow that it did in 2019. In other words, Simon can afford to work its way back to the former dividend payment, and Richard thinks it will. I asked about inflation. What does it tend to mean for REIT performance?

REITs perform the very best in a below-average and rising inflation regime. Not shockingly, that's where we were for most of 2021, and REITs have done really well. But REITs also do pretty good in an above-average and rising inflation regime, which is exactly where we're going to be in the early part of 2022, which leads us to be pretty constructive on REITs.

It gets a little more complicated than that. For example, Richard mentioned something called a bear flattener yield curve. That's basically when short-term yields rise faster than long-term ones, and it's viewed as bearish for the stock market. But Richard says it tends to be good for REITs. He describes some past cycles where inflation picked up and He zeroed in on 2005 as the best analogy for now.

Ian Formigle: '04 was an exceptionally good year for REITs, similar to 2021, and we think 2005 is going to be a good playbook for REITs in 2022. REITs ended the year in 2005 up 12%, but it was not easy getting there because they were down 10 percentage points at one point in the first half of 2005. Given stagflation fears. So I think as the market debates inflation, growth, at a time that the Fed is taking away stimulus, it could be a bumpy ride for REITs and a little bit more volatile than what we've seen in at least 12 months, but we do think it will end up being a pretty good year.

[Speaker] Thank you, Dallas and Richard and Joe Razzle Dazzle. And thank all of you for listening. Jackson Cantrell is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, please write us a review. And if you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @jackhowe. Joust, apple, cuckoo, kangaroo, howdy, outhouse, upstairs, gumball howdy. See you next week.

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