There has been, and always will be cycles in multi-family real estate. Traditionally, the cycle begins with a depression, followed by a recovery, a boom, a bubble and a bust. This five step pattern has defined the cyclical nature of commercial real estate for decades. In essence, real estate bubbles are the product of overbuilding, or supply outpacing demand. Exuberance from investors during times of relatively high returns, such as the 1980's, has historically driven over-development, and caused a market bust, resulting from an oversupply of real estate.
However, with the MSCI IShares REIT Index (RMZ^) and the Dow Jones Residential REIT Index (DJURN^) down 6.21 percent and 6.83 percent since September, it appears we have missed the overbuilding cycle altogether, and skipped right to the bust.
What Is Different in 2012?
On the surface, 2012 appears to present us with an extremely favorable environment for multi-family development. Quantitative easing has driven interest rates down to the rock bottom levels, and we have seen vacancies in multi-family rapidly decline since 2009. However, U.S. total commercial construction spending is at a current level of 45.40B, down from 47.54B in October, representing a decrease of-4.50%.
The Difference: Lenders
What is different in 2012 is the highly constricted lending environment which has disrupted the traditional regressive bubble model. While lenders are willing to originate loans to single family home owners, Institutional lenders have changed the way they do business.
NMHC's quarterly survey of CEO's and senior executives of apartment related firms nationwide, covered by NAREIT's article Multi-Family Market Fundamentals' Improvement Slows (11/2/2012) reported: "The bulk of the survey participants, 73 percent, reported that financing for new construction is only available for top-tier markets or properties."
This is in stark contrast to nearly every other economic cycle of real estate in the past, where periods of success in real estate have been followed by periods of overbuilding.
Fundamentals remain strong in the multi-family sector. Much of the growth we have seen between 2009 and 2012 has been the product of internal growth, driven by rent tenant upgrades and a horrible housing market.
While I believe fundamentals will remain strong, multi-family REITs momentum will be stunted by a lack external growth and a slower pace of internal growth through housing recovery. Driven by the fear of new housing coming online through 2013, I believe we have already seen our first round of momentum investors drop off the apple cart.
2013: High Yielding REITs and Low Interest Rates Equals
An article recently published on SA titled The Illusion of Causality Between Treasuries and REITs, by Sholam Yaffa, pointed to a lack of empirical evidence supporting a correlation coefficient between treasury yields and REITs yields. Sholam was right; however, treasury yields have never really been accepted as a divergent corollary indicator in the first place.
Interest Rate Sensitivities of REIT Returns (Webb, Myer, Ling 2003), published by the International Real Estate Review, analyzed seven different interest rate proxies for equity REITS and established that "the OLS results for the entire 27-year sample period suggest that only changes in bond yields (HIGH in particular) have a significant impact on the returns of equity REITs."
High yielding corporate bonds should be viewed as a competitor, rather than an indicator, when evaluating their effect on REITs. My prognosis for 2013 is that rates will remain low due to QE3 and dividend yields will become more attractive.
The following chart illustrates the comparison between Baa Corporate Bond Yields and NAREIT MSCI REIT Index (RMZ^).
How I am Valuing Multi-Family REITs in 2013: Modified NAV
As I have expressed, I believe that higher yielding REITs, with solid fundamentals will serve as bond proxies in 2013. If I am right, the higher yielding REITs, with strong balance sheets, and reasonable growth prospects will be the most appetizing to investors seeking yield and ROI.
My valuation strategy moving forward is a modification of NAV. My modified NAV is based on a trailing twelve month (TTM) NOI. This differs from forward looking NAV valuations that account for growth via estimates of future straight line rent increases. While I will take growth prospects into account in my decision making, I believe my modified NAV will give me a better indication of a REIT's current asset level value.
Why I am Buying United Dominion Realty (UDR) at $21.00
For my own portfolio, I am going to buy United Dominion Realty at $21.00. With a current price of 23.44, and an industry wide bearish moving average, I think we will reach this level soon. A $21.00 valuation would give United Dominion a dividend yield of 4.2%, with negative spread of 26 basis points compared to Baa corporate bonds daily return index. A $21 price target will represent a 23% discount over my NAV estimate of $27.39.
What I Like: United Dominion Realty has $82 million cash on hand, and has a history of disposing outdated properties and investing significant capital into tenant upgrades to spur internal growth. Their current strategy of divesting from markets such as Florida, Arizona and Texas, generated proceeds of over $400(M), and was a swift exit from markets vulnerable to unfavorable price to rent ratios. Currently, the company maintains a healthy diversification in fundamentally strong markets, such as California, Washington D.C., and Boston, where rent to own spreads will remain high. The average occupancy of United Dominion's portfolio is very strong at 95.6%, and same-store occupancy through 2013 should stabilize at these levels.
Risks: They have a development pipeline that could negatively impact internal growth and stabilized rent (due to decrease tenant upgrades and leasing) on same store properties should they need to divert capital. However, through equity offerings, redemption and paying down credit lines, the company has a liquidity of over 1 billion through a combination of cash and un-drawn credit facilities. This should provide ample wiggle room in terms of United Dominion's immediate capital needs for debt maturities, development and capital expenditures.
Current Share Price: $23.85
Assumed Cap Rate: .065 or 6.5%
Debt Coverage Ratio: 2.7X
FFO Multiple: 18.8X (19.6X is the industry Average)
Dividend Yield: ( 3.75%) (3.22% is the industry average as of 11/9/12)
Dividend Yield Spread to Baa Corporate Bond Yield (One Year Percentage Change)
To surmise my estimates, 2013 will lack the growth the past three years the market has afforded to multi-family REITs, however, I do not believe the selloff is a product of the traditional boom bust cycle of real estate. Fundamentals will remain strong for multi-family REITs with solid management and great locations. As bond yields plummet, multi-family REITs will attract a new kind of investor. Bond investors and dividend hunters seeking yield and balance sheet strength, should be patient, and buy at discounts to NAV in order to capitalize on moderate growth and high yield in 2013.