Preferred Apartment Community: Safe 7% Yielder

Roberts Berzins profile picture
Roberts Berzins
1.36K Followers

Summary

  • APTS offers the highest dividend yield among its sector peers.
  • While there are some caveats that require a higher risk premium (particularly real estate loans), APTS's dividend is backed by solid fundamentals.
  • The solid underlying growth in FFOs and a conservative FFO payout render APTS a safe investment for dividend-seeking investors.

Preferred Apartment Community (NYSE:APTS) is the highest yielding apartment REIT out there. Currently, it offers ~7.3% dividend yield, whilst the average for its sector peers is 3.8%. Obviously, for a high current income-oriented investor, APTS causes a natural interest to explore the REIT further.

My thesis is based on three aspects, which bode well for the APTS's future in covering and even growing its already sky-high dividend payments.

  1. Growing FFO with acceptable level of FFO payout
  2. Flexible balance sheet despite seemingly high leverage
  3. Countercyclical assets

While there are some potential risk areas such as exposure to retail segment and issued real estate loans, the aforementioned strengths clearly outweigh the odds of experiencing a dividend cut or a permanent loss of capital.

Why APTS provides abnormally high dividend yield

In almost every situation, where a stock provides above-average yield, there are some caveats that come along. APTS is not an exception. Below, you can see the offered dividend yield for each of the publicly-traded apartment REIT as of August 31, 2019.

Source: Nareit (created by the author)

Clearly, APTS leads the list by a huge margin with its yield being ~4% above the sector average.

The main reason why the market is pricing APTS's stock in such a manner is the exposure of its asset portfolio. APTS is not a pure apartment REIT compared to most of its peers. There are 7 separate segments to which the allocation is shifted:

  1. Multifamily (37.77%)
  2. Retail (21.18%)
  3. Office (18.47%)
  4. Student housing (11.86%)
  5. Multifamily real estate loans (8.25%)
  6. Office real estate loans (1.54%)
  7. Student housing real estate loans (0.92%)

While the four largest groups comprising ~89% of the total portfolio, generally, are not perceived to be very risky, the remaining 11% should be viewed with extra caution. Loan investments require much higher premium to account for the embedded cyclicality. These investments are much more sensitive to economic downturns, and as illustrated by valuations (and ultra-high dividend) yields of mREIT vehicles, the market indeed tends to discount their future cash flows more conservatively.

Moreover, 21.18% exposure to retail segment can also be viewed negatively. Fear of e-commerce, changing customer behavior, and looming recession risks render the asset class unattractive. For instance, Simon Property Group (SPG), the largest mall REIT with ~$46 billion in market cap, has seen its share price decline by ~14% in the last 52-week period, even though the underlying fundamentals have remained strong.

Plus, it is important to add that APTS has leveraged its balance sheet more than other apartment REIT players. Its debt ratio stands at 78.6% and debt to EBITDA ratio at 9.9x, while the corresponding sector average figures are 43.3% and 8.1x, respectively. The level of APTS's indebtedness commands greater risk premium, which pushes the valuations down and lifts the dividend yield up accordingly.

So, now, when we understand why APTS is able to offer so high dividend yield, let's explore some arguments why the probability of suffering a dividend cut is low.

#1 - Growing cash flows and a healthy FFO payout

Usually, when a company pays something above 5% in dividends, the current growth and its outlook are quite minuscular. However, APTS shows the opposite.

For the quarter ended June 30, 2019, APTS rental revenue increased approximately 3.4% and the operating expenses increased 1.5%, resulting in an increase in net operating income of approximately 3.9% as compared to the quarter ended June 30, 2018. The occupancy rate experienced a small hike reaching strong 95.6%.

The development of NOI marked a 7th straight increase for the Company's rental income.

Furthermore, the mid range for APTS's underlying FFO per share growth estimates for 2019 is 5%. And according to Nareit, FFO growth is projected to advance reaching 6.3% in 2020.

So, for a current income-seeking investor, especially for this level of yield, it happens rarely that a Company is able to provide some underlying growth. Essentially, the fact that APTS keeps increasing its FFO mitigates the risk of suffering dividend cuts and, ultimately, comforts investor in receiving its quarterly cash inflows.

Last but not least, FFO payout ratio for a ~7% yielding REIT is at a very acceptable level of 73.9%. AFFO payout stands at 85.0% for the trailing twelve-month period ended June 30, 2019.

#2 - Access to capital

The debt saturation is rather high for APTS and the corresponding interest payment coverage with EBITDA lies above the sector average. However, the management has done a remarkable job in structuring the maturity schedule. As you can see in the picture below, majority of the loans fall due in 2028 and beyond. In 2019-2020, the loan amount to be refinanced is insignificant as well.

Source: PACAPTS

The current level of 78% debt ratio and above-average interest coverage ratio put a constraint on the APTS's future growth. Given the sector averages, the implied additional loan capacity is low. Hence, investors should not expect a major capital appreciation here. However, the aforementioned loan maturity schedule indicates that in case of a recession, the Company should be able to refinance its loans without doing extra share offerings or liquidating its properties at considerable discounts.

So, from the lens of a dividend investor, APTS is a safe stock despite the seemingly high indebtedness.

#3 - Countercyclical assets

Above, I have listed 7 individual asset groups to which APTS has exposed its portfolio. While there are some risky allocations such as real estate loans and retail, the substance of these assets and the broad allocation make the entire Company much safer.

When investing in REITs, you will look how diversified the Company's portfolio is usually within a single sector. However, APTS hits two rabbits with one shot. The portfolio allocation to 7 separate asset classes allows investors to suffer smaller drawdowns in case, for instance, one particular segment in the portfolio goes out of favour. And, secondly, the intra-segment allocation is very diversified as well - as illustrated in the picture below.

Source: PACAPTS

On top of the spread out investments comes asset-specific argument. Namely, the type of property and location indicates that APTS will withstand eventual crisis without eroding its underlying cash flows. Plus, APTS has a good chance to increase its rents even further.

  • APTS strategy is to invest in newly constructed assets that are located in fundamentally sound MSAs of 1 million or more people and have either irreplaceable location or a value proposition. The following metrics send a signal that APTS has a limited capital exposure and a reduced risk of being squeezed at the top end of the rental spectrum: (1) average portfolio age is 5.2 years (2) average rent is $1.3 per sq. ft.
  • Investments in Retail are fully made into grocery-anchored/necessity-based assets. Necessity-based retail is significantly less impacted by e-commerce and possesses countercyclical characteristics. 39 of 46 centers are anchored by one of these 5 grocers: Walmart (WMT), Kroger (KR), Albertsons, Ahold Delhaize (OTCQX:ADRNY), and Publix (OTC:PUSH). In the U.S., they control 40% of the $800 billion grocery market.
  • APTS operates and invests in class-A office properties in high-growth major markets, primarily across the Sunbelt. In my previous article about Cousins Properties (CUZ), which is one of the biggest class-A Sunbelt office players, I made a strong bull case. The key takeaway is that class-A offices coupled with an exposure Sunbelt are a perfect combo for benefiting from secular trends and, ultimately, achieving abnormally high long-term returns.
  • Finally, APTS's student housing strategy is to invest in purpose built off-campus assets that are located in close proximity to campus with market showing signs of noticeable housing needs with limited supply. The following asset characteristics illustrate why the Company is well-positioned to protect and even grow its ~7% dividend: (1) average age of the student portfolio is ~4 years (2) amenity packages appealing to the student residents (e.g. study labs, fitness centers) (3) modern properties in top tier universities with growing enrollment.

The bottom line

All in all, Preferred Apartment Community REIT is a very attractive investment, especially for a high income-seeking investor. The Company's current level of dividend is well covered with strong cash flows, which are projected to increase in the coming years. Again, usually for ~7% dividend stock, this is not the case. The flexible balance sheet and non-cyclical assets come in handy for protecting the Company's cash flow going forward.

By investing in APTS, one should be able to count on receiving high level of current income and experiencing even some moderate returns from capital appreciation.

This article was written by

Roberts Berzins profile picture
1.36K Followers
I have worked in the finance industry for 6 years, gaining experience particularly in financial reporting as well as in financial and credit analysis. Currently, I am responsible for risk management.My genuine interest in finance began from the opportunity of visiting the Chicago Board of Trade and talking there with a soybean trader. Our rather brief, but the enlightening conversation was an eye-opener for me. I understood that in order to perform well, I have to be constantly involved in the industry and keep myself updated of what´s happening in the economy, politics etc. This requirement of being on your toes was and still matches my personality. From that moment I have been constantly trying to shape my craft in finance by participating in CFA program (currently CFA Level II candidate), following new accounting standards and reading financial news on daily basis. My portfolio consists of stocks and cash. Cash/Stock ratio is determined based on the current market valuations and near/mid-term recession risk. Stocks that are included in the portfolio are always chosen based on their relative and historical valuation levels. Strong FCF and stable revenues coupled with a high probability of price stimulating catalyst event are mandatory characteristics for my stock selection.
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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.

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