Bad News REITs: Unsold Housing Exerts Downward Pressure on Rents

Includes: AVB, EOP, EQR
by: Vincent Fernando, CFA

Once again we further warn investors about the prospects for Apartment REITs such as Avalon Bay (NYSE:AVB) and Equity Residential (NYSE:EQR) since we are now seeing signs of unsold housing exerting downward pressure on rents. This is bad news for REIT shares whose current valuations demand strong rental price growth going forward in order to justify their historically high valuations.

REITs such as AVB and EQR are trading at historically high cash flow multiples and are paying out historically low dividends- unusually far below risk-free treasury yields even. If investors are willing to accept below-risk-free yields in a risky asset then they most surely are expecting cash flow growth. And when AVB pays only 2.3% vs. treasuries at 4.8% then we need a lot of growth in order to eventually match risk-free yields. Whereas in the past REITs have been viewed as defensive income-producing assets, they are priced far out of this now. Growth is their only justification.

Thus its disturbing to see real signs of unsold housing now beginning to pressure rental rates since unsold units are being converted into rental units since their owners face significant losses if they sell now given the fall in housing prices.

After six weeks of failing to lure more than a couple of dozen buyers, Mr. Franco and his partner, Jeff Blum, joined the builders of nearly 6,000 condominium units in the Washington metropolitan area who have decided in the last three months to recast their projects as rental apartment buildings.

Since the middle of 2006, the frenzied condominium market here and in several other big cities like Las Vegas, Miami and Boston has collapsed. Once roaring sales have slowed to a trickle, sparse inventory has mushroomed into a glut and soaring prices have flattened out and started falling.

In many cities, banks have significantly scaled back loans to condominium builders. Some have demanded that developers sell half or more of the units in a building before even beginning construction.

The latest salvage operation on the part of condo developers is far from a sure bet, however. Condominium buildings generally cost more to build and operate than those built for apartments from scratch. And while rents are high and rising in most cities, in many cases they still are not sufficient to turn a profit.

Industry analysts also point out that rents may start sagging if too many condos are converted into apartments too quickly. While rents were rising at a robust 6.1 percent annual pace in the Washington area late last year, according to the Bureau of Labor Statistics, some buildings in the suburbs have recently started promoting move-in specials and other incentives to lure renters.

Take the owner trying to sell a spacious two-bedroom condo for $879,000 in the former Columbia Hospital for Women, which closed in 2002, in the Foggy Bottom neighborhood of Washington. In 2004, the investor was so confident that he would make a handsome resale profit that he told his agent, Thomas P. Murphy, he wanted to buy five condos. Mr. Murphy said he flatly told his client he would only assist him in purchasing one unit in any one building.

He needs $890,000 to break even, but the offers are at $800,000 to $840,000, Mr. Murphy said. He does remember that I told him he was not getting five of them.

Could he rent the condo? Yes, but that option is not appealing, either. Mr. Murphy estimates that the unit could rent for $4,000 a month, far short of the $6,800 a month the condo costs in mortgage interest, maintenance fees, insurance and taxes.

They have a choice of how they want to lose it, Mr. Murphy said of investors and condo developers. Drip by drip or in one slap.

We indeed were negative on apartment REITS back in November last year, and have since seen their share prices generally rise about 10%, with management touting a strong 2007 outlook in their conference calls yet selling shares worth millions of dollars concurrently. Avalon Bay recently took this practice to a larger scale- upping its 2007 outlook on January 8th and then immediately issuing 4.6 million more shares (on top of 74 million outstanding) for sale in the market. Convenient timing.

Private equity also did its fair share in pushing up REIT shares.

REITs saw a staggering $117.18 billion in deals this year, up from about $30 billion for the previous two years combined. Meanwhile, the percentage of public-to-private deals rose to 57% of the total in 2006, from only 2% in 2004, according to the National Association of Real Estate Investment Trusts. Some of the biggest deals have involved private-equity pools. Equity Office Properties Trust equity office properties tru com in November agreed to be acquired by private-equity firm Blackstone Group in a record-breaking $36 billion deal including debt. Yet the company's founder and savvy real estate mogul Sam Zell wasn't part of the buyout group, which some see as one subtle hint of a real estate top. "Private equity is driving up REIT stock prices and taking shares out of the public market," said Michael Roberge, chief investment officer of U.S. investments at MFS Investment Management. "That money has to go back into the real estate market, which pushes prices even higher."

While the company mentioned above, Equity Office Properties (EOP) is a commercial property REIT, and we are more negative on residential REITs, as stated above money pulled out of these shares frequently needs to go back into the market for investments with a REIT mandate and thus commercial REIT M&A can cause liquidity to spill into residential REITs such as AVB and EQR.

All in all we have to ask ourselves how much farther these REITs can go in 2007 after eight consecutive years of outperforming the S&P 500. For us to be wrong, vacant unsold housing mustn't pressure rents. We just can't see how this can happen. As in the New York Times article we first linked too, property owners who face selling prices significantly below their cost will shift to renting in order to try and make their investment back. While rents have done well recently, this was due to property being for-sale, and thus off the rental market. Get ready for it all to come back, for rental rates to stagnate, and for REIT prices to fall. It could be a long way down if investors demand that REITs return to their historical norm and require them to pay out dividend yields above treasuries.