High home prices in hot markets like Southern California and Washington, D.C., are destroying the dreams of many wannabe homebuyers. But some apartment owners are reveling in these sky-high price tags, which help fuel business for the rental market.

These market dynamics prompted Merrill Lynch to release a new quarterly index, which ranks apartment REITs based on their exposure to markets where homes are most expensive. The reasoning behind the index, called Apartment REIT Housing Affordability Rankings, is simple: It's best to own apartments where single-family housing is the most expensive, says William Acheson, vice president and senior analyst at Merrill Lynch.

SOUTHERN CHARM: UDRT's Southern California holdings include Villa Venetia, a 468-unit property.
SOUTHERN CHARM: UDRT's Southern California holdings include Villa Venetia, a 468-unit property.

"One of the strongest drivers of the market over the last couple of years as we've seen it has been a combination of owning properties in supply-constrained markets and housing affordability in those markets," says Acheson. Plus, as mortgage rates rise, more wealthy households will be forced to look at the rental market.

The REITs that offer the heaviest exposure to expensive markets include Essex Property and BRE Properties with heavy weightings in California, and AvalonBay Communities with weightings in California and the New York area. Equity Residential also topped the list with an 88 housing affordability ranking, which surprised the index's creators. Equity has long been viewed as the national proxy for the apartment market, but the study shows that it might be time to alter this status quo-thinking, Acheson says.

Over the past four years, Equity has focused on repositioning its portfolio by exiting secondary markets like Kentucky and Alabama and shifting its dollars to high-barrier markets, mainly in California, Florida, and New England. "The analyst community has begun to understand what our strategy has been over the last few years, and we are pleased to see they recognize what we've been doing," says Alan George, chief investment officer at Equity Residential.

NUMBERS GAME: Merrill Lynch's index ranks REITs in terms of relative concentration in the least affordable single-family home markets. A ranking below 100 shows heavy exposure to expensive markets.
NUMBERS GAME: Merrill Lynch's index ranks REITs in terms of relative concentration in the least affordable single-family home markets. A ranking below 100 shows heavy exposure to expensive markets.

The Apartment REIT rankings are based on Merrill Lynch's Housing Affordability Indices for 54 metropolitan statistical areas. This figure is calculated by taking the median household income for each market, dividing it by the estimated minimum qualifying household income for a 30-year mortgage on the median priced, in-market home, and multiplying the result by 100. To get a REIT's affordability ranking, a market's housing affordability index is multiplied by the company's percentage of total NOI/revenue derived from the relevant market.

While the index is receiving good reviews from both REITs and analysts, it does have its limitations. Some question the study's sole focus on the single-family market, especially given the much-discussed potential for housing prices to fall in these hot markets.

"I thought it was a very good study, but the real question I have is will it be a predictor of the future?" says Tom Toomey, president and CEO of United Dominion Realty Trust, which received an affordability ranking of 109. "Jobs are going to influence operating results more than taking a look at affordability." He also pointed out that the study would be more effective if it included condominiums in addition to single-family homes.

John Kriz, managing director, real estate, of Moody's Investors Services in New York agrees that other factors need to be considered to identify geographic markets with strong long-term appeal for apartment investment. "You also have to look at relative household income, and you have to look at relative ease in building new housing product," he says.

But Acheson contends that the study's metric is a strong one. "Of course if you can find a market that has good population growth, has good job growth, and is supply-constrained—well, you just hit the bull's eye."

—Rachel Z. Azoff