There's No Place Like Home Properties

Feb.22.13 | About: Home Properties, (HME)

With the broader market feeling a bit toppy, you might be looking to take a more defensive portfolio posture. Portfolio repositioning may include a search for securities with low comparative valuation, moderate, non-volatile growth and perhaps an attractive, growing dividend payment. For investors looking for a conservative total return play, I think real estate investment trust (REIT) Home Properties (NYSE:HME) is worth considering. Though a stake in its apartment buildings probably won't send you to the penthouse, I think it is a company that can provide you with a level of comfort and confidence in the market going forward.

Breaking Ground

Home Properties is a REIT focused on ownership of apartment dwellings primarily in the Mid-Atlantic/Northeast I-95 corridor. The company's portfolio currently consists of 121 properties comprising 42,635 units. Though it focuses operations in the Baltimore/D.C. market, with over 50% of its units situated there, it maintains a smaller presence in other attractive, high barrier-to-entry East Coast locales as well.

Market Number of
Properties
Size
(units)
Portfolio percent
Washington-Arlington-Alexandria, DC-VA-MD-WV 32 13,161 30.87
Baltimore-Towson, MD 23 10,477 24.57
New York-Northern New Jersey-Long Island, NY-NJ-PA 28 7,225 16.95
Philadelphia-Camden-Wilmington, PA-NJ-DE-MD 13 4,071 9.55
Chicago-Joliet-Naperville, IL-IN-WI 7 2,566 6.02
Boston-Cambridge-Quincy, MA-NH 9 2,381 5.58
Allentown-Bethlehem-Easton, PA-NJ 4 996 2.34
Miami-Fort Lauderdale-Pompano Beach, FL 2 836 1.96
Portland-South Portland-Biddeford, ME 2 620 1.45
Worcester, MA 1 302 0.71
Totals 121 42,635 100%
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The company's business model concentrates on acquiring Class C and lower Class B apartment dwellings and upgrading them into mid- to upper-grade Class B facilities. Only about 5% of its portfolio would be classified as Class A. Below is an apartment property classification primer for those of you unfamiliar with the vernacular:

  • Class A: Upscale units typically inhabited by white-collar workers. They are typically newer, located in attractive areas, with high associated rent.
  • Class B: Older properties typically rented by white- and blue-collar middle class occupants. Buildings usually aged 10-25 years.
  • Class C: Lower rents, buildings potentially even older than Class B, with a "just starting out" or "perpetual renter" clientele.
  • Class D: Low quality residences with a lower socioeconomic base. Government subsidized housing.

Though the HME portfolio may be a bit more aged and rough around the edges than some of its peers in this space, perceived value should be more than skin deep for investors. I would argue that a variety of performance metrics prove Home Properties to be a company providing a compelling total return proposition for investors, despite a somewhat ugly duckling reputation.

Ordering An Appraisal

HME grew FFO, the closely watched gold standard for REIT performance, 16.6% in 2012, the highest level of YOY operational growth since the company's 1994 IPO. Though the company sees performance moderation in 2013, with expectations of 4-7% FFO growth, its shares currently trade at modest 15X TTM and 14X forward FFO expectations. When compared with other REIT apartment operators, HME's FFO valuation is attractive in my view.

I picked three other apartment REITs, Essex Property Trust (NYSE:ESS), which operates apartment communities on the West Coast, AvalonBay (NYSE:AVB) which operates on both coasts, and Sunbelt apartment owner Mid-American Apt. Communities (NYSE:MAA) on which to conduct a comparative valuation analysis.

Ticker '12P/reported FFO '13P/guided FFO Yield
HME 15.01 14.33 4.51
AVB 24.44 30.23 3.29
ESS 22.43 20.26 2.90
MAA 14.95 14.14 4.10
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AvalonBay and Essex with their quality asset pools and somewhat higher growth rates possess richer multiples and lower dividend yields than both Home and Mid-American. AvalonBay's 2013 FFO guidance is somewhat deceptive since it includes one-time costs associated with its recent acquisition of assets from Archstone. Still, minus that charge and an assumption of low teens growth, like Essex, AvalonBay trades at a better than 20 FFO multiple.

HME and MAA are valued similarly by the market and possess like business models, though MAA's portfolio concentration is decentralized into nearly 50 different markets, with no market making up more than 10% of total gross assets. HME betters MAA's dividend yield by roughly 10% and ESS and AVB by better than 40 percent. I personally like HME's portfolio concentration profile better than MAA's as I feel management is focused on a limited number of markets that it knows best.

It's fair to believe that Essex and AvalonBay deserve higher valuations than HME and MAA, but the discrepancy here is undeserved. All things considered, Home Properties provides a better risk-adjusted forward return proposition, as I consider ESS and AVB salty. I believe the stock could approach $70 over the next year and combined with the better than 4% yield, investors could realize mid teens total return.

Some Housekeeping

While much of the current Home Properties story is positive, the company's debt load is somewhat of a negative. With a 46% debt to total market cap, the company's leverage is much higher than the above-discussed peers:

Ticker Debt/MC
HME 46%
AVB 20%
MAA 36%
ESS 34%
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Though certainly an item to monitor going forward, the debt trends at HME have been improving. Over the past four years, its percentage of unencumbered assets has nearly doubled from 20 to 38%, and total debt to market cap has dropped 15 percent. In other words, the overall capital profile is improving. But compared to AvalonBay, the balance sheet is obviously not best of breed.

On a macro-level, the company is exposed to obvious pitfalls. It may be unable to fill its apartments or may not be able to raise rents going forward. Management may do a poor job of acquiring and/or disposing of properties at attractive pricing. A rising interest rate environment could have a material impact on the company's operating growth potential and ability to increase the dividend.

Speaking of the dividend, although HME was forced to drop its payout by about 13% during the '09 financial crisis, it has raised it by 6-7% each year since to a current annualized $2.80, or roughly 4.5 percent yield. I would expect modest mid- to upper- single digit dividend increases for the foreseeable future based on current fundamentals.

Home Properties holds its own in various other operating metrics including industry low tenant turnover (<35%), high occupancy (95%+), competitively high YOY Net Operating Income Growth (NOI) and Return on Invested Capital (ROIC). Management led by decade long CEO Ed Pettinella, seems to be steering the company in the right direction.

And while this would be purely speculative, I wouldn't rule out the possibility that the company is bought out at a premium some point in the future, given its concentration in attractive Northeast markets, manageable size, and reasonable valuation.

Mama, I'm Coming Home

Given the tremendous run we have seen from REITs over the past four years, value is getting somewhat hard to come by in the space. With its sound business model, low valuation, growing dividend, and improving leverage profile, Home Properties would seem to be a way to play defense in an uncertain market. While the forward total return potential may not be eye popping, investors looking for a conservative security that Mom would approve of should consider bringing HME home.

Disclosure: I am long HME. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.