3 Ways to Play the Rental Housing Boom

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Housing stocks have always been an essential part of a well-diversified portfolio, and recent trends confirm that the rental housing market is heating up faster than single-family homes. But let’s face it: Few of us have the stomach for midnight maintenance calls and rowdy tenants, so thankfully there's another way to play this market: stocks, real estate investment trusts (REITs) and exchange traded funds (ETFs) that focus on the rental market.

The trends are compelling: Construction of rental housing showed positive growth in the first quarter of 2014, according to the National Association of Home Builders’ new Multifamily Production Index (MPI) released last week. The index increased three points to 53, which is the ninth consecutive quarter with a reading of 50 or above.

That’s in line with recent federal government data showing that multifamily rental housing starts rose a whopping 39.6% in April, while single-family housing starts inched up 0.8%. In short, while the housing market is recovering, tight credit and a volatile job market are motivating more people to rent rather than buy.

So what does that mean for investors? If you’re looking to cash in on the rental housing boom, look for housing stocks that directly benefits from the trend. Another option: real estate investment trusts (REITs), which are exempt from corporate taxes and are required to pay out 90% of their annual earnings to investors. REITs tend to have extremely attractive dividend yields — great news for income investors. The steady rent payments also tend to deliver more stable cash flows.

The easiest ways to play the market are with multifamily residential construction stocks, multifamily-focused mortgage REITs (mREITs), which invest in residential mortgages; and exchange-traded funds (ETFs) that hold shares in multiple REITs and trade over an exchange like stocks.

Here’s your best bet for each investment type:

Stock: Lennar (LEN)

Analysts are expecting strong earnings for Lennar (LEN), one of the largest homebuilders in the U.S., when it reports on June 25 — and with good reason.

A rebounding construction market drove rival Toll Brothers (TOL), which reported earnings last Wednesday, to double its quarterly profit. The same trends should positively impact LEN stock, but with a bonus: Last year, LEN revealed it was allocating $1 billion to building apartments in high-growth — and high rent — areas.  Many of the new communities offer luxury amenities such as stainless steel appliances, granite countertops and resort-style pools and fitness centers – directly catering to the new generation of renters.

LEN stock is only up about 3% in 2014, but it’s clearly a growth play. With a price-to-earnings-growth (PEG) ratio of just 0.6 and a forward P/E of a little more than 12, LEN stock looks undervalued now. LEN pays a nominal dividend with a 0.4% current yield, but the company knows its market and is positioning its new properties well, so LEN promises to be a solid buy-and-hold stock.

REIT: New York Mortgage (NYMT)

There are two basic types of REITs – those that hold real property and those that hold mortgages on property (mortgage or mREITs). Among mREITs, New York Mortgage (NYMT) is a so-called "hybrid mREIT", meaning that it holds a combination of federally guaranteed (agency) and non-agency debt, like commercial mortgage-backed securities (CMBS).

If your eyes are glazing over with that explanation here are two factors about NYMT that will lift the fog: First, a significant share of NYMT's capital is invested in multifamily housing. And secondly, NYMT has a monster current dividend yield of 13.8%. While it's common for mREITs to have higher dividends than their property-based cousins because they take advantage of interest rate spreads, NYMT's yield is eye-popping.

Riding the growth in multifamily homes, NYMT is up 13% this year. Because mREITs use leverage to invest in mortgage debt, they tend to be riskier than property-based REITs – they’re more vulnerable to interest rate fluctuations. A rising rate environment is anathema to mREITs, and NYMT is no exception … but I think the growth in the multifamily sector plus the hefty dividend will provide solid rewards for investors willing to stomach a little more risk.

REIT ETF: FTSE NAREIT Residential Index Fund (REZ)

If you're looking for exposure to the multifamily rental housing boom, but want to diversify beyond either single housing stocks or REITs, an ETF like FTSE NAREIT Residential Index Fund (REZ) might be just what you're looking for.

Like all ETFs, REZ offers the diversification of a mutual fund, with low expenses and the advantages of trading on a major exchange just like a stock. REZ's top holdings include multifamily REITs like AvalonBay (AVB), Equity Residential (EQR), Essex Property Trust (ESS) as well as Public Storage (PSA) common stock, which also benefits from the rental housing boom.

REZ has a modest 3.5% current dividend yield, but it has gained more than 18% this year. I think REZ is will continue to gain ground as the low-vacancy trends in multifamily housing spur higher rents and stronger profit margins. With those growth prospects and a decent dividend, REZ is a good ETF to buy and hold now.

As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities.