REIT Landlords Can't Have It Both Ways

Includes: AVB, EQR
by: The Stalwart

The Stalwart submits: You can't have it both ways: either a rising housing market helps landlords or a falling market helps them. For both scenarios to be positive would make being a landlord the ultimate property business, and then none of us would be in the business of selling homes.

The latest 3Q06 results from Equity Residential (NYSE:EQR) confirm our previous post which outlined why we found it strange that the prevailing argument for residential REITS has been that a weakening residential housing market will be good for residential REITS since people will increasingly opt to rent rather than buy their residence, in turn pushing up rental prices.

Now fellow residential REIT Avalonbay (NYSE:AVB) did indeed report 7.3% higher rental rates from established properties when its 3Q06 earnings came out last week. And indeed, we have reports such as this one which tells us that apartment rents in general are "soaring". EQR's latest result show 5.9% higher same store revenue, and we're told that most of this has come from higher rental rates (rather than occupancy gains). This helped Free Funds from Operations (FFO) rise over 10% for the quarter.

They were making bumper profits selling condos. But when we then looked at the 9M FFO figures, we see that FFO is actually down YoY, even after 3Q06's increase. Even if we imagine that 3Q06 is just the beginning and there's further rental rate strength to come, the question we have is why was FFO higher back when the housing market was stronger? We thought a weak market was a boon for these guys? Shouldn't then a strong housing market be a bad thing? Well, turns out these guys were making good money selling condos (converted from rental units) when the housing market was seeing better times.

Thus even if housing weakness might be good for rents (and we don't wish to concede this point -- we don't believe it is), REITs that made money flipping condos will see this source of profits start to dry up.

We just came out of EQR's 3Q06 conference call and it looks like full-year 2006 guidance is being brought down partly due to just such a reason. The company has seen weaker than expected condo sales and thus is bringing down this business' expected profit contribution. Please check the conference call for this number since we noted it quickly, but it seems condo sales made up 8 cents of the 62 earned in FFO for 3Q06.

As the analyst from Credit Suisse said on the call, how might EQR expect to "back-fill" lost condo sales earnings given that the company gave a pretty weak feeling on 2007's sales prospects? Management answered that while they still see the condo sales business as viable in the long-term, gains (and maybe even losses?) will be lumpy. No answer was given as to how lost condo sales income would be replaced. Our point here is that we could see rental rate growth just replacing lost condo sales income.

Further signs of unsold property entering the rental market: The second key point from the call was that management talked further of rental weakness based on new condo supply coming onto the market. Properties which used to be for sale are being switched into rental units. Developers are doing this (with EQR mentioning that many of their unsold condo developments will be turned into rental units - and we note that they won't be the only ones to think of this), and also management said that they know that individual property owners are doing this as well.

In fact, management said that the internet has made it much easier for individual property owners to operate in the rental market (Craigslist comes to mind). EQR also said that much of this new supply is pricing below current rental rates in order to quickly become occupied. Renting properties is first and foremost about occupancy. Thus we can imagine that new supply comes on and is very eager to just fill the first 70% or so even at lower than normal prices. (This is frequently done not by lowering the monthly rental payment, but by giving a few months of "free" rent.)

Right now only a few areas -- the ones which have seen housing hit hard such as parts of Florida and California -- are seeing this pressure on rental pricing power, but we feel that it just goes to prove that renting property and buying property are pretty fungible goods.

As in our previous post, we don't see housing weakness as good for landlords such as EQR.

Disclosure: Author is short shares of EQR and AVB

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