After Q4 and full year 2018 results came in, my investment thesis for Apartment Investment and Management (AIV) remains unchanged. Narrowing margins due to compressing cap rates, rising interest rates, and increasing costs undermine growth efforts, forcing the company to engage in capital allocation arbitrage (selling properties in order to buy back shares). This, in turn, has not only complicated their commitment to deleveraging but has also actually (temporarily) increased their leverage ratio, putting additional pressure on their BBB- (barely investment grade) credit rating. Now, in 2019, growth is expected to stall to a near standstill. Meanwhile, shares are not cheap, and risks remain. As a result, AIV remains on the watch list.
One of the drivers of AIV's growth over the years has been management's disciplined execution of its pair-trade policy, whereby it sells up to 10% of its portfolio (from older, lower-growth properties) and reinvests in properties with higher rental and free cash flow growth prospects. This constant "cleansing" of the portfolio helps keep maintenance costs down and also keeps the company constantly growing at a healthy clip by arbitraging between its various property markets, while simultaneously avoiding the significant cash flow disruptions that could come from too much property turnover. However, due to the lack of attractive acquisition opportunities in its markets due to compressing margins, AIV instead turned to substantial share repurchases (6% of outstanding shares). This contributed to them increasing estimated Net Asset Value per share by about 6% during 2018.
In addition to the repurchases, AIV also continued its record of operational excellence. In the Same Store portfolio, the company set internal records for occupancy and NOI margins, with average revenue per apartment home up a robust 4%. In Redevelopment, they completed two major projects at 9% and 14% projected free cash flow IRRs and continued further investment.
AIV also made some improvements to its balance sheet, refinancing $867 million of their property loans maturing in the next three years during Q4, reducing annual interest expense by $13 million and increasing the size of the unencumbered asset pool to $2.7 billion (nearly 40% of current market cap). Additionally, the weighted average maturity of its long-term non-recourse property debt (91% of total debt) stands at a very conservative 8 years, and the interest expense is covered easily at 3.8x. With over $700 million of liquidity at year end, AIV is well positioned to cover its obligations while also continuing to opportunistically deploy capital.
Guidance for 2019 anticipates continued solid organic growth performance, with same-store NOI expected to grow by 3.6% at the midpoint of guidance and 98% of AFFO to be derived from Real Estate Operations, signaling continued improvement in quality of earnings. Another positive is that same-store revenues are expected to outgrow same-store expenses, showing that the company's properties have true pricing power that is outstripping inflation.
There weren't many negatives from AIV's solid 2018. However, the main one remains the lack of attractive acquisition targets due to compressing cap rates. As a result, while management's share buybacks were accretive to NAV per share, they interfered with management plans to deleverage by year-end. In fact, leverage actually increased as management borrowed additional funds under its credit facility in order to escalate the buybacks. This then forces management to sell additional properties this year to pay down the debt and get the leverage ratio back below 7x. As a result of the additional sales, AFFO per share will only grow by 0.01 (i.e., less than 0.5% growth) at the mid-range of guidance (leaving the possibility of a decline very real).
The valuation is the other downside to shares. While management claims that shares remain below NAV and appear prepared to continue repurchasing them in an attempt to unlock value for shareholders, I believe their assessment is more telling of the overvalued state of their portfolio. Shares continue to hover near decade highs, and the dividend stands at a mere 3.17%.
With AFFO/share growth expected to be flattish this year, it does not bode well for total returns at these prices. With leverage elevated but liquidity strong, AIV is in little danger of losing its investment grade credit rating, but needs to act conservatively until its leverage ratio is brought back into its normal range. As a result, investors shouldn't expect much more than low-to-mid single-digit total returns over the next several years.
AIV is certainly worth putting on a watch list due to its strong business model and outstanding record. However, I would steer clear of buying it until the yield adequately compensates investors for the risks and reduced growth prospects confronting the business. That being said, the portfolio and dividend remain on solid footing, so investors who already have large capital gains should view the stock as a hold and avoid taking on the significant tax expense that would come from selling.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.