This article is a story of how research with an open mind sometimes leads you to conclusions you do not expect.
First, let me tell you how this particular research path started. As I’ve explained on my article “Rising Rents: A Trend That Might Hit Core CPI” the market for renting apartments is presently incredibly tight. Indeed, it’s the tightest it has been since 2001. And as with any market with tight supply, rents (prices) have started trending up.
Now, residential REITs had been severely punished during the real estate implosion, both because of lower values for the assets they held and the difficulty in rolling over their credit, together with a higher risk assessment of this credit. REITs are usually highly leveraged entities, given that they have to finance expensive assets while only renting them out over a long time.
This leverage, however, will work in these REITs' favor once they have the chance to raise their rents, after all, the debt will still be the same and will have about the same cost, whereas revenues will expand, making for much higher margins.
Given this favorable background for apartment REITs, I decided to look for opportunities in the sector. Broadly speaking, most apartment REITs should benefit from this trend, even those that now look a bit more expensive.
In trying to find attractive residential REITs, I naturally drifted towards screening for them using some value criteria (in this case, a low price/book) while limiting the search to the financial sector and the residential REIT industry. And soon enough, I had a large list of REITs to choose from and do some qualitative research on.
That, however, brought the first surprise. The REIT concept was designed so that companies could go around leveraging themselves and using that leverage to buy and manage physical properties. However, almost every single one of the REITs I was looking at was not doing that. They were simply leveraging themselves to buy agency RMBS, and sometimes also non-agency. These were obviously not good fits for my investment thesis, so I started ignoring them and going one by one through their 10-Qs to find those that really were investing in physical properties.
After the work described before, I finally got myself a collection of candidates. These could be divided in two groups.
Not really apartment REITs
These were sometimes renting apartments, yes, but were doing so for very specific markets, like student apartments - Campus Crest Communities (NYSE:CCG), Education Realty Trust (NYSE:EDR) or senior housing - Senior Housing Properties Trust (NYSE:SNH).
Finally, I also found perfect fits for the original thesis: Avalonbay Communities (NYSE:AVB), Equity Residential (NYSE:EQR) and UDR (NYSE:UDR). These were without any doubt buying, building and managing apartments that would surely benefit from the rising trend in rents.
Thing is …
When I decided to delve a bit deeper into the fundamentals of the stocks that fit the thesis, this is what I found:
Avalonbay Communities (AVB)
Avalonbay Communities has a market capitalization of $12.2 billion, and is trading at a TTM P/E of 79.63 with expected earnings growth of 40.00% taking it to a forward P/E of 48.20 next year. The TTM P/E means AVB trades at a premium to the S&P500 TTM P/E of 13.0. The PEG (Price/Earnings Growth) stands at 5.78, this could suggest some overvaluation. The Price/Book is 2.94. AVB trades at an EV/EBITDA of 27.2 times.
AVB's dividend yield is 2.78%, this equates to a dividend payout of 226.16%. The dividend exceeds the S&P500 dividend yield, presently at 2.1%. The dividend is higher than the yield on the 10 year bond, presently at 1.96%.
The ROE is 3.78%.
The stock is down by -1.84% year-to-date.
Equity Residential (EQR)
Equity Residential has a market capitalization of $16.9 billion, and is trading at a forward P/E of 55.69. The Price/Book is 2.88. EQR trades at an EV/EBITDA of 20 times.
EQR's attractive dividend yield stands at 4.08%. Bear in mind that earnings are expected to fall. The dividend also exceeds the S&P500 dividend yield and beats the yield on the 10 year bond.
The stock is down by -2.35% year-to-date.
UDR has a market capitalization of $5.4 billion. The Price/Book is 2.33. UDR trades at an EV/EBITDA of 23.5 times.
UDR's generous dividend yield is 3.49%. The dividend also exceeds the S&P500 dividend yield and also beats the yield on the 10 year bond.
The stock is down by -1.71% year-to-date.
So broadly speaking, these stocks are not trading at cheap valuations, or even regular valuations, for that matter. They are expensive, mostly because they went up hundreds of percentage points since they bottomed in 2009, discounting this emerging trend in rents.
What does this mean?
What this exercise means, is that in spite of having found a possible catalyst for an upward move in a given group of stocks (apartment REITs), the insight was far from unknown. Looking at the valuation multiples on the stocks we found, it’s highly possible that the benefit we expect from the catalyst is already reflected in the share prices of the stocks.
This sometimes happens when stories are too well-known, and increases the risk of investing in these equities substantially, in a manner similar to what happens with cyclical stocks.
So at this point, while it is very likely that these companies will enjoy increased rents and earnings, it’s not a given that their share prices will benefit from this predictable event, and as such there's no obvious opportunity in these stocks.