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GENERATION RENT The symbiosis of apartment REITs and Millennials

March 2017

AMP CAPITAL GENERATION RENT 1

Shelter: the raison d’etre of real estate Whilst the word may tend to conjure images of residential properties, it can be readily applied to all sectors within the asset class: offices as shelter for workers, malls as shelter for shoppers, and industrial warehouses as shelter for goods in transit through the economy. Simplistic though it may seem, this reversion back to the basic concept of shelter offers a reminder that real estate has vital functional value within society. From there, it becomes clear this is a function that cannot necessarily be innovated out of existence. Influential forces such as technology, urbanisation and demographics may continually shape the pattern of demand for real estate across sectors and geographies; however, ultimately the essential need for shelter remains unchanged. The ever-changing consumption pattern of real estate, juxtaposed against its status as perpetual imperative for a functioning society, presents an interesting dynamic and is precisely that which offers a wide range of opportunities for long-term investors. The rise of the Millennial generation and its implications for the residential market in the United States is a current and informative case study of this dynamic at work. A set of structural forces have combined to bestow Generation Y with the unofficial title of Generation Rent in direct reference to the high impact change being wrought upon home ownership in the United States by this demographic cohort. Most importantly, this is a trend that can be accessed by investors of all sizes.

2 AMP CAPITAL GENERATION RENT

There goes the neighbourhood There has been a fundamental shift within the residential real estate sector over the last decade; Americans have become increasingly likely to rent, rather than own, their homes. As depicted in Figure 1, the US homeownership rate has steadily declined since the global financial crisis (GFC) to a level not seen since Lyndon B. Johnson occupied the White House 50 years ago.

Figure 1: Homeownership rate in the US (1965 to 2016) 70%

68%

66%

64%

62%

60% 1965

1970

1975

1980

1985

1990

1995

2000

2005

2005

2010

2015

Source: US Census Bureau

Broadly, this change in American dwelling habits is a positive for residential landlords, which in turn is investible via the listed institutional apartment operators. US-based apartment REITs make up roughly 8 per cent of the global listed real estate benchmark, or more than US$100 billion of equity market capitalisation, the third-largest US sector behind mall and office owners. The apartment REITs are generally of high quality and have seen significant consolidation in recent times – five such REITs have been acquired or have merged during the past three years alone – leaving an investible set of large, well-capitalised companies with seasoned management teams, as shown in Figure 2.

Figure 2: Largest US apartment REITs by market capitalisation NAME

TICKER

MARKET CAPITALISATION ($US BILLION)

Equity Residential

EQR US

24

AvalonBay Communities

AVB US

24

Essex Property Trust

ESS US

15

UDR

UDR US

10

Camden Property Trust

CPT US

7

Source: Bloomberg, as at December 2016

The assets held by these listed apartment REITs are predominantly located in the urban core where renting is most common. The change towards rentership (and, thus, migration into the city) is a positive for increasingly dense and difficult-to-build-in urban property markets. Additionally, an increasing focus on public transportation links should further benefit the high-quality apartment names. So what are the forces driving this change?


After the fall The decline in the homeownership rate in the immediate aftermath of the GFC may be attributed to the prevailing financial challenges of the time. As the crisis began to unfold, defaults on home loans rose significantly. Figure 3 shows that loans in default as a percentage of those outstanding doubled in just a year, moving from roughly 2 per cent in late 2006 to 4 per cent by the end of 2007. The default rate continued its rise as the combination of falling home prices and a lack of options for refinancing drove more and more home owners into bankruptcy; the rate peaked at 11.3 per cent in early 2010.

Figure 3: Delinquency rate on single-family residential mortgages in the US (2000 to 2016)

Percentage of single-family residential mortgages

12% 10% 8% 6% 4% 2% 0% 2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Source: Board of Governors of the Federal Reserve System (US)

Throughout this period, the homeownership rate, unsurprisingly, fell. Lenders took ownership of homes in default, and previous owners became renters. Whilst this may offer some explanation as to the decline in homeownership in the years immediately following the crisis, the question remains as to why this trend has been sustained over the longer term. Indeed, there has been no improvement in the homeownership rate even as the default rate has improved dramatically, from over 10 per cent in 2012 to around 4 per cent in 2016. One argument is that homeownership remains out of reach. The Mortgage Bankers Association, the largest US real estate finance trade group, estimates that credit availability has improved by just 20 per cent since the GFC [Source: Mortgage Bankers Association, 2016].


In addition, previous foreclosures can impact a prospective homeowner’s ability to get a loan for a number of years (depending on terms), meaning that many would-be buyers may be simply unable to get a loan given the concentration of defaults during the GFC. Lastly, greater regulatory scrutiny on the largest banks, which financed the majority of mortgages leading up to the GFC, has been passed on to consumers via larger down payments, more stringent credit checks, and higher income requirements. Lack of financing availability clearly plays a role in the homeownership slump but it is not the sole catalyst nor does it explain the continued downward trajectory. A changing American workforce is likely involved as well.

Enter the Millennials A major demographic shift is underway in America. Millennials – or those born between 1980 and 2004, according to the US Census Bureau – are now the largest share of the American workforce, as depicted in Figure 4. By 2025, Millennials will represent 75 per cent of the American workforce [Source: US Bureau of Labor, 2016]. As the largest source of new demand for housing, be it home sales or rentals, this cohort wields significant influence over the residential real estate market.

Figure 4: United States population distribution by demographic (2015) 5

Homeland Generation

Millennials

Generation X

Baby Boomers

Silent Generation

Number of people (millions)

4

3

2

1

0 0

5

10

15

20

25

30

35

40

45

50

55

60

65

70

75

Age Source: US Census Bureau

Undoubtedly, the most important such preference of the Millennial demographic is a greater propensity to rent. This should come as no surprise. After all, this is the generation that pioneered and embraced the “sharing economy”, a collaborative approach to consumption that draws heavily on the notion of renting. This propensity is manifest in the increasing use of rented apartments, particularly in the urban core, at the expense of homeownership. As outlined in Figure 5, underpinning this preference is a set of sociological, lifestyle, and financial factors, which directly affect the willingness and ability of Millennials to purchase a home.

Undoubtedly, the most important such preference of the Millennial demographic is a greater propensity to rent. This should come as no surprise. After all, this is the generation that pioneered and embraced the “sharing economy”, a collaborative approach to consumption that draws heavily on the notion of renting.


Figure 5: Why Millennials rent TYPE

FACTOR

DESCRIPTION

SOCIOLOGICAL

Household formation

• Millennials are marrying later in life. The average age of first marriage in the United States is 27 for women and 29 for men, up from 23 and 26 in 1990 and 20 and 22 in 1960 [Source: University of Virginia Research, RELATE Institute, 2013]

• Since marriage is an important catalyst for household formation, the result is that Millennials are spending a larger portion of their young adulthood as renters and delaying the transition to home ownership LIFESTYLE

Community

• Millennials value proximity to culture, nightlife, restaurants, and access to the best neighbourhoods in urban centres that would otherwise be unaffordable (with the discourse of affordability less about renting versus owning, but more so about “renting here” versus “renting there”) [Source: Urban Land Institute, 2015]

• Apartment complexes may offer amenities such as a gym, pool, communal kitchen, and leisure area – all of which are social spaces – which represent perks that enhance the sense of community and may enable the renter to cut down on other bills [Source: CBRE Research, 2015] Flexibility

• Millennials change jobs more readily and regularly than prior generations [Source: How Millennials Want to Work and Live, Gallup, 2016]

• Mobility is therefore highly valued, with a strong willingness to relocate in the pursuit of career opportunities [Source: RealtyTrac survey, 2015; “Global Generations”, EY, 2015]

• Clearly, renting is more conducive to this need than owning, and institutional apartment landlords have gone further to accommodate this preference with early termination clauses in lease agreements often allowing for changes in employment FINANCIAL

Student loans

• More Millennials have a college degree than any other generation of young adults [Source: The Council of Economic Advisors, US Government, 2014]

• 60 per cent of college graduates have a student loan debt of some form [Source: US Department of Education, 2016]

• The burden of student loan overhang therefore cannot be ignored – it is the second highest form of debt in the United States at US$1.3 trillion with the average student loan debt of the Class of 2016 sitting at US$37,000 [Source: US Department of Education, 2016] Share of income

• The number of renters spending at least half of their income on rent reached a record high of 11 million people in 2014, with over 21 million spending over 30% or more [Source: Joint Center for Housing Studies of Harvard University, 2016]

• This suggests that saving for a down payment and making the transition to homeownership is especially challenging for a Millennial demographic at an entry level or early stage of workforce participation Source: AMP Capital


Adaptation With renting being both more accepted and more common, there are meaningful implications for real estate assets. Clearly, the movement of the prime renter demographic into the city centre will have an impact on apartment values. Cities have historically had a larger share of renters compared to suburban areas. So it is not surprising to see that the populations of US cities have become increasingly composed of renter households alongside the national increase in renters. Of the 11 largest US cities, nine had more renters than homeowners in 2014 versus just six of these same cities in 2006. The average increased by roughly 5 percentage points, and all 11 saw the number of renters increase. Even less expensive, homeowner-dominated cities like Philadelphia and Atlanta saw an increase in the number of renters versus owners.

Figure 6: Percentage of renter households in major US cities (2006 and 2014) 80% 70% 60% 50% 40% 30% 20% 10% 0% Atlanta

Boston

Chicago

Dallas

Houston

Los Angeles 2006

Miami

New York

Philadelphia

San Francisco

Washington DC

2014

Source: American Community Survey, NYU Furman Center

As a result of this migration away from the suburbs and towards the city, the apartment business has become a more attractive full-cycle investment. A bigger pool of renters means a more stable business at a given level of supply; additionally, an increasingly older tenant mix (Millennials rent later into life) should improve affordability ratios and allow for healthier rent increases. Lastly, because of land and entitlement constraints in dense, urban areas – which will become increasingly more onerous over time – high quality, core product will become scarcer as demand from renter households continues to increase, and thus, should appreciate at a faster pace. The increased number of workers living in the city, where owning a car is less necessary and relatively more unaffordable, has ensured that access to public transport has become increasingly important. This has not gone unnoticed; listed real estate management teams now cite in great detail the level of access to public transportation routes when describing new development projects. Transactions also indicate that a property’s proximity to a bus stop or train station directly impacts its valuation. The increase in pricing for higher-quality, urban, and transit-oriented property has runway to continue as Millennials become a larger proportion of the American workforce.


Don’t dream it’s over The implication appears to be that the American Dream, as it pertains to homeownership, is dead and buried. Millennials will rent forever, right? Not quite. Despite clear differences in life views and goals, Millennials do overwhelmingly aspire to homeownership – at least, eventually – in line with predecessor generations. Seventy five per cent believe that home ownership is an important long-term goal, and eight in ten already own or plan to own at some point in the future [Source: Demand Institute Housing & Community Survey, 2013]. And not only does the dream live on, but so too that utopian vision epitomised by the white picket fence. The notion of Generation Y as perennial urbanites is another portrayal that may not be entirely accurate; this demographic, upon having children, is just as inclined as past generations to head for the suburbs, as shown in Figure 7. The typical rationale applies – namely, access to better schools, more space at home, and safer neighbourhoods.

Figure 7: Millennial location preferences for their next home (2016)

14%

48% 38%

Suburban

Urban

Rural

Source: The State of the Nation’s Housing, Joint Center for Housing Studies at Harvard University, 2016


At this point, it is important to recognise that the Millennials are, of course, ageing. Household headship rates (ie. the people counted as heads of household) rise from around 25 per cent for those in their early 20s to around 50 percent for those in their 30s. As more of the cohort moves into older age brackets, Millennials are expected to form around two million new households per annum on average. As noted above, household formation and starting a family are important catalysts for the shift from renting to owning, and the shift from the urban core to suburbia. The shift of this demographic group into the 30 to 39 year old age bracket is demonstrated in Figure 8.

Figure 8: Ageing of the Millennials 4

Population Growth (millions)

3

2

1

0

-1

-2

-3 20 to 24

25 to 29

30 to 34

35 to 39

40 to 44

Age Group 2005 to 2015

2015 to 2025

Source: The State of the Nation’s Housing, Joint Center for Housing Studies at Harvard University, 2016

And yet, if it is imprudent to assume Millennials will be perpetual renters, it is equally remiss to assume that the Generation Rent phenomenon will only be a flash in the pan.


Cash rules everything around me Whilst age is indeed significant for household headship rates, income is even more so. Analysis conducted by the Joint Center for Housing Studies of Harvard University shows that household headship rates are highly correlated to income in the 25 to 34 year old age bracket, with rates of 40 per cent for those earning less than US$25,000, rising to 50 per cent for those earning $25,000 to $50,000, and then 58 per cent for those earning more than $50,000. The recent decline in homeownership, and its forward projection, needs to give due consideration to the role of real income levels. As the political discourse in the US has constantly reminded us in recent years, the recovery in American jobs since the end of the GFC has not necessarily been matched by a recovery in real income. According to the Hay Group, a subsidiary of global executive search

firm Korn Ferry, US salaries have fallen 3.1 per cent in real terms since the end of 2008, which is the worst among the G20 group. To see an uptick in the homeownership rate, real income growth is still needed; a household cannot necessarily age its way to housing affordability. Delving deeper, it is clear that the affordability issue can be even more challenged in the metropolitan areas that are most attractive to Millennials. Figure 9 offers a comparison between the median income and median home price in select US cities, which provides insight into some of the least affordable markets for prospective homeowners. Notably, five of these six cities also rank in the top ten as “best cities for Gen Y” based on a survey of 500,000 Millennials conducted by remuneration research firm PayScale.

Figure 9: Median income, median home price, and Gen Y city rankings for select US markets 1200

14

11.7x

12

1000

10

8.5x

8

6.9x 6.0x

600

5.6x 4.3x

400

4.2x

6

Multiple

US$ (1000s)

800

4

200

2

0

0 San Francisco

Los Angeles

Boston

New York

Seattle

Washington DC

Rank = 9

Rank = 16

Rank = 5

Rank =7

Rank = 1

Rank = 4

US Average

Best Gen Y Cities in the US - Ranking Median Income (LHS)

Median Home Price (LHS)

Multiple (RHS)

Source: Equity Residential, Moody’s Analytics, Nielsen and Company Data as of January 2016; PayScale “Gen Y On The Job”, Best Gen Y Cities, 2016

Finally, it is worthwhile to note that despite maintaining an aspiration to eventual homeownership, Millennials have come of age in an era over which the GFC cast a long shadow, and its after-effects have been painfully manifest in lower incomes and higher rents. To expect a degree of cautiousness and trepidation from this cohort as it enters prime first-time home buying years is perhaps only natural.


The bottom line The social and demographic changes impacting the residential real estate sector are ostensibly a net positive for apartment landlords. The homeownership rate has been in decline for over a decade and a lack of affordability is undoubtedly part of the problem. A more scrutinised and cautious banking system, a consumer that is still dealing with the impacts of the greatest financial crisis of our time, and more onerous underwriting standards have all made it more difficult for Americans to purchase their own homes. However, this trend is not one borne out of financing issues alone. The emergence of the Millennials as the single largest demographic in the United States, accounting for an ever growing proportion of the American workforce, has brought with it a shift in the value paradigm driving residential real estate consumption. Cyclical affordability issues and demographic change has resulted in a larger share of the population living and renting in the city centre. Over the property cycle, the US apartment REITs should therefore be in a stronger position to push rents, given the larger demand base, and quality management teams with insight into the needs of Millennials will be best placed to deliver value for investors. The challenges in adding supply to densely populated city centres will further support valuations for existing, high quality assets, whilst exposure to those submarkets with the most favourable demand dynamics will continue to represent another key differentiator. This is certainly not to say that the US apartment REITs will always outperform. Indeed, there will be times when better opportunities present themselves, particularly if investing in the listed real estate sector with a global remit. However, we believe that this subsector is a more attractive through-cycle investment because of the structural tailwinds described in this whitepaper.


CONTACT DETAILS For more information on how AMP Capital can help grow your portfolio, visit our website, www.ampcapital.com Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital. © Copyright 2017 AMP Capital Investors Limited. All rights reserved.