Avalon Bay: A Look at Apartment REITs

In keeping with the carnage in the real estate sector, REITs have lost over 70% of their value over the last two years. Despite such a precipitous drop, I still will not touch the sector with a ten-foot pole. With occupancy rates running around 95%, apartment REITs appear to be the one bright spot in this sector and the sharp drop in prices has left many of them very attractively valued.

AvalonBay Communities (AVB)

With over 50,000 apartments in 178 communities, AvalonBay is one of the largest apartment REITs in the country and a company I have had direct experience with as a renter. The company generates nearly half its net operating income from the NY/NJ metro area and New England. California represents an additional 32% of net operating income with the rest coming from the Pacific Northwest and the Mid-Atlantic/Midwest regions. With a management team that is well respected and leverage that is the lowest of any apartment REIT, AvalonBay has traded at a premium over the last few years and the stock was trading at nearly $150 when I first came across the company in early 2007. Even after declining through most of 2007, the stock was close to $110 when I mentioned it in the blog post Quest For A 6% Yield on 10/20/2007. At those lofty levels AvalonBay was offering a cash dividend yield of just 3% and I could not justify investing in the company when it was possible to earn a similar or better return from cash without any risks.

I continued watching the company over the last two years looking for an opportunity to start a position. With a decline of over 70% from its 2007 high and a yield of 8.1%, this apartment REIT is finally at a level that not only offers a fat yield but also the potential of price appreciation. Both AvalonBay and AIMCO are amongst a group of 13 REITs that are included in the S&P 500 index. I guess at any other time, this inclusion would have reflected upon the quality of these companies but with financials representing nearly 10% of the S&P 500 index and other index constituents floundering (E*Trade and Sprint come to mind), it is hard to make that case for quality anymore.

There are some very valid concerns about investing in REITs at this time that are related to occupancy rates, the safety of the dividend and debt that is coming due this year. Let me try to address these risk factors below.

As of the end of December 2008, the occupancy rate at AvalonBay was 95.5% and is expected to be around 94.5% in 2009 after having started the year with an occupancy rate of 95.3% in January. AvalonBay benefited early in this real estate correction as the number of renters increased because housing became unaffordable, loan requirements tightened up and a wave of foreclosures hit the country. However apartment REITs are now feeling the impact of the economic meltdown because of job losses and are likely to face a tough operating environment in 2009 and potentially into 2010. Beyond the softness experienced in the fourth quarter of 2008, Avalon expects revenue to decline between 1.5% to 3.5% and net operating income to decline between 4.25% to 6.25% for 2009. However the company is not clamping down on growth and expects to complete 8 out of the 14 communities it currently has under development in 2009. Current low interest rates have been favorable for AvalonBay as the company partially used new debt to retire higher interest debt and reduced the interest rate of its portfolio from 6.5% at the end of 2007 to 6% at the end of 2008. Avalon expects further interest rate related gains in 2009 by repurchasing 7.5% medium term notes due December 2010.

The important criteria here is determining if the current dividends and yields are sustainable in a challenging rental environment. AvalonBay expects to retain $75 million in free cash in 2009 on net operating income of $550 million. Even if their net income declines an additional 10% beyond the 4.25% to 6.25% decline they have already modeled into their 2009 estimates, they would still have enough cash flow to pay the dividend on the common stock and I believe the dividend appears to be safe for 2009. I can certainly make peace with a 8.1% yield from a high quality company while waiting for the eventual recovery to occur.

Avalon raised $1.9 billion in capital in 2008 including $1.2 billion in new debt. Yet their leverage at 44% remains modest by industry standards. The company plans to raise an additional $750 million in debt in 2009 and has liquidity arranged or identified to meet all capital needs through 2010. The company ended 2008 with $259.3 million in unrestricted cash and cash in escrow. It also has the ability to tap into a further $124 million of a $1 billion unsecured credit line. Total debt that matures in 2009 is $267 million.

Another apartment REIT worthy of consideration that appears to be given up for dead by most investors is Apartment Investment Company or AIMCO (AIV). Depending on which financial website you use, you might see the yield ranging from as high as 109.2% (MarketWatch) to 40.9% (Yahoo Finance). The actual cash yield of AIMCO is 17.92% based on management's decision to drop the dividend payout to $1 from $2.40/share. The number reported by Marketwatch.com is probably higher because AIV also declared a stock dividend due to profits generated from asset sales. The REIT has dropped a precipitous 91.33% from its February 2007 peak of $64.35 due to concerns about the highly leveraged nature of the company and recent changes in management leading to the resignation of its CFO. Trading below book value and at a discount to its peers AvalonBay, Equity Residential (EQR) and Essex Property Trust (ESS), the risk/reward tradeoff looks appealing for AIMCO. I am probably not the only one feeling that way as a director of the company purchased 150,000 shares for $922,550 on the open market last week. There have also been a series of open market insider purchases at Essex Property Trust in the last two weeks.

Based on the valuation of AvalonBay when compared to peers as displayed in the numbers section of my longer report, I am going to commit roughly $5,000 of the new special reports portfolio to AvalonBay and will also make the purchase for my personal portfolio. As a more risky play, I am also going to initiate a smaller position to the tune of $2,500 in AIMCO.

Disclosure: I currently do not own any positions but plan to initiate a position in AvalonBay after this special report is published.

Comments

[Thomas J. G...:]

Some people (Denninger) say the whole reit sector isn't going to be able to refinance long term debt when they need to. I don't know where avb is with having to refinance it's debt. Latest Forbes shows avb only 38% debt to equity. Apartments otherwise seem like a good investment in bad times. I sold avb at over 100 and it's the only reit I'm long on now. I hope you're right about being able to sustain the dividend.

Mar 03 05:22 PM

[Chris B:]

I have one problem with REITs at this point:

New investors are purchasing foreclosure properties all around these apartment complexes (and maybe purchasing entire competing apartment complexes too!) for 30-40% less than what the REIT paid a couple years ago. That means their payments will be lower, which allows them to undercut the local REIT on rents. Wouldn't purchasing an REIT at this point be the equivalent of assuming the mortgage for an underwater landlord?

Mar 03 05:45 PM

[Asif Suria:]

@Thomas, I think what some of those people are not factoring in is the amount of debt these REITs have been able to raise at low rates from GSEs like Fannie Mae. Equity Residential borrowed nearly $1 billion in late 2008, most likely to retire the higher interest $863 million debt that is maturing in 2009. Check out the valuation and numbers section of my report for additional information,

www.sinletter.com/spec...

@Chris B. That is a good point and there is little doubt that the assets on the balance sheets of most REITs have fallen in value. However I believe that the 70 to 90% decline in apartment REIT prices already reflects this reality. Moreover consider the fact that many properties in the portfolios of these REITs have existed for a decade or two and hence I am more worried about the effect on occupancy from unemployment than from new investors coming in as competitors. AvalonBay has been active in both disposing existing properties and building new ones, with 8 new communities slated to come online in 2009.

@ED. Thank you.

Mar 03 06:45 PM

[Emerald:]

Most apartment REIT's are so heavily discounted that they are trading as if their rents have been slashed already. Your analogy is sound, but only at higher REIT prices. REIT's may suffer some declining cashflow to met the market, but they are good buys at this level.


On Mar 03 05:45 PM Chris B wrote:

> I have one problem with REITs at this point:
>
> New investors are purchasing foreclosure properties all around these
> apartment complexes (and maybe purchasing entire competing apartment
> complexes too!) for 30-40% less than what the REIT paid a couple
> years ago. That means their payments will be lower, which allows
> them to undercut the local REIT on rents. Wouldn't purchasing an
> REIT at this point be the equivalent of assuming the mortgage for
> an underwater landlord?

Mar 03 07:09 PM

[Urbane Gori...:]

The issue with debt faced by REITs is similar to most businesses today. It isn't really the debt if the cashflow is in place, and the property can carry the debt, and they have a **loan term that will outlast our recession. ** And that's the problem. Most commercial properties have underlying loans that are amortized 30 years, but due in 5 or 6. A few years back, I was looking at buying a 20 unit multiple. I could get a 30 due in 5 for about 5%. Pretty good. Those loans are no longer available, and if you can get one, lots of luck getting it for a rate like that. That means costs increase for the REIT. Couple that with dropping rents, and you begin to have cashflow problems, even if you can get the loan. (Look at GGP.) Once you have cashlow problems, you cut the dividend or pay in stocks, which dilutes the investor equity. When you cut the dividend or dilute the pool, the stock price drops. Ugly.

Mar 03 08:53 PM

[Asif Suria:]

Urbane, before I dug deeper into the apartment REITs I held the same opinion as you did that getting capital at reasonable rates is going to be very difficult for the REITs. Interestingly REITs like AvalonBay and Equity Residential have been able to raise capital at reasonable rates from Government Sponsored Enterprises (GSEs) like Fannie Mae and Avalon actually lowered the interest it owed on its portfolio from 6.5% in 2007 to 6% by the end of 2008 by retiring higher interest debt.

Quoting Avalon's CFO Tom Sargeant from the fourth quarter conference call,

"We're anxious to return to the unsecured market and I think that you'd have to have the spread differential somewhere within 100 basis points before we'd take a serious look at it. I mean, with the GSE debt and this 10-year debt in the 6.25% range compared to an unsecured offering that could be done maybe around 9% today, we're still a pretty fair piece away from where it would need to align for us to do unsecured debt."

Mar 03 11:19 PM

[reluctantQuant:]

Logic is good, but timing is dubious.

While AVB may be a "better choice" amongst its peers, take a step back and question this thesis: "employment is falling like a stone, this company operates in the "least affordable" spaces, it has very high development committments, but, HEY - they can access capital from the GSE's, which just recently got nationalized because they run THEIR business so well."

Hope that one works out for you, but I think this trade is premature.
--rq

Mar 04 08:34 AM

[Chris B:]

"However I believe that the 70 to 90% decline in apartment REIT prices already reflects this reality. Moreover consider the fact that many properties in the portfolios of these REITs have existed for a decade or two and hence I am more worried about the effect on occupancy from unemployment than from new investors coming in as competitors."
----------------------...
Even if the value of the equity portion of these properties has dropped 70-90%, the value of the debt underlying them has not. If an apartment complex could be sold on the market today for $1M, and has a $1.2M mortgage on it, owner's equity is less than zero, not 10-20% of what it used to be. Note that declines in market prices for real estate are not reflected in book value, only historical cost and perhaps wear and tear.

How long the physical buildings have existed is irrelevant. What's relevant is when they were last mortgaged and for how much. Just a couple years ago, holding equity in your buildings was considered wasteful, and many REIT managers bought into this thinking, taking out more loans on paid-for buildings to parlay into other properties. That's how you end up underwater on 30 year old apartments.

Likewise, competitors enter the market not by building new apartments, but by purchasing bankrupt operations on the cheap. From the perspective of your REIT, the competing property is still there, as always, but now they have lower costs and rents. This process is also occurring for previously owner-occupied housing, increasing the supply of rentals, especially at the high end of the market where most REITs operate. Rents are going down. Check the government stats of you don't believe it.

It is this deflation of rental rates that is problematic, because the mortgage payments on these properties will never decline. Per Yahoo, AVB's 4Q2008 ROE is under 4% reflecting a 19% decline in revenue and a 98% decline in earnings. How much room have they left themselves for declines in rents or increasing vacancies if they don't reduce rents? Obviously, just a couple of years ago, an environment where rents ever went down was unthinkable for management.

They'll eventually survive by issuing more stock or reducing that dividend to reflect reduced earnings, if earnings can even remain positive. There are no other options. That said, a dividend reduction is the cheapest financing any company can get, so it's the right thing to do here.

I'm actually considering financially strong REITs in the self-storage area such as EXR and PSA and the healthcare/senior care sector such as HCP, HCN, HR, and VTR.

The rationale for self-storage is that demand will be sustained by churn and foreclosures in the real estate market and the trend towards formerly independent households consolidating with roommates. The rationale for the healthcare / senior care REITs is demographic inevitability.

Overall this is an excellent discussion, and I thank all participants.

Mar 04 10:19 AM

[Alok Swain:]

A few points:

a) From what I have been reading from the quarterly discussion of the earning statements, the companies are not having problem refinancing. They are getting Fannie Mae loans are what are reasonable and attractive rates around 6-6.5% or so.

b) Another advantage that I see in apartment reits is the ability of these companies to raise rents when inflation makes a comeback because of the money printing going on. I am of the opinion that Real-Estate might ba a better place than Precious Metals to sheild oneself from that.

c) Plus after a long long time have the REITs shown an yield thats attractive, paying considerable longer than say 10 year or 30 year US treasuries for instace.

d) The REITs are also bying back some of their preferred shares are fairly attractive discounts, and replacing that with lower cost Fannie Mae debt or accessing the Line of Credit. Its kind of bond arbitrage actually. Its smart strategy.

e) My only near term fear is dividend cuts and replacement with PIK dividends. Its good for making the company survive the uncertain economic enviroment but kinds betrays the purpose of investors who look for dividends from tax favoured investments for clock work like quaterly dividends. But still its better to have a dividend cut and make sure the company survive than get the dividend and let the company die.

Thanks

Alok

Disclosure : Long AIV

Mar 05 12:13 PM

[ak2:]

Chris B - nice comments but be careful of storage. They are experiencing diminished demand too and there was a big spurt of supply the last few years.

Mar 17 12:40 AM

[ak2:]

Chris B - careful with storage, they are having problems too.

Mar 17 12:41 AM

[ak2:]

they need to allow you to delete comments...

Mar 17 12:44 AM