Why I'm Buying More AvalonBay Communities
- AvalonBay is a premium quality REIT with a low-cost operating structure relative to peers.
- Its operating metrics continue to improve, and new development projects are a growth driver.
- I also highlight the balance sheet, dividend, and risks worth considering.
Real estate is a great vehicle for generating steady and growing cash flows and long-term wealth creation. Take one quick look at the Forbes list of 100 richest people, and you'll find a disproportionate share of individuals who reached this status through real estate.
Savvy retail investors know that the easiest and perhaps best way to invest in real estate is through ownership in REITs, and Apartment REITs remain a classic and top choice. In this article, I'm focused on the high-quality pick, AvalonBay Communities (NYSE:AVB), and show what make this REIT worth buying at present.
A Premium Apartment REIT
AvalonBay Communities is one of the largest and most well-regarded Apartment REITs. It has an ownership interest in 290 apartment communities, consisting of nearly 86K housing units. It has a presence in major metropolitan markets across 11 states and is well diversified by geography, including the Northeast, Mid-Atlantic, Southeast, Denver, Colorado, Washington, and California.
As the second largest Apartment REIT by assets, AvalonBay has economy of scale advantages over smaller REITs. That's because it's able to spread corporate overhead costs over a wider base of assets, thereby resulting in more favorable margins. The higher margins result in better cash flow conversion to the bottom line and the low-cost structure makes for better resiliency during a downturn.
As seen below, AVB has maintained steady 64% operating margins (with depreciation addback) in the years leading up to the pandemic, with 2020 operating margin landing at 62%. This compares favorably to that of the smaller REIT, Mid-America Apartment Communities (MAA), whose op margin was 57% in the 2016-2019 time frame, and was 56% in 2020.
(Created by author based on company financials)
In addition, AVB's A- credit rating from S&P makes it one just handful of REITs with an A- or better rating. This, combined with its scale advantages results in a low-cost debt that its lower-rated competitors and mom-and-pop investors simply cannot get. As seen in the 10-K filing below, AVB issued $600M of unsecured notes in May of last year at a historically low interest rate of 2.45%. A part of the proceeds was used to redeem debt at higher rates, including the latest January 2021 redemption of notes with a 5.37% interest rate.
Another plus is that AVB is able to use the other proceeds from the debt offering to generate healthy investment spreads. This includes the latest development project that was completed in Q1'21, with an initial cash yield of 5.6%. Additionally, it enables a ramp in future development, which could meaningfully contribute to FFO/share growth this year, as during the recent conference call:
"We completed almost $600 million of development in Q1 at a projected initial yield of 5.6%, well above prevailing cap rates we're seeing in the transaction markets, where cap rates are drifting down to or below 4%.
Given the improvement we've seen in fundamentals, we're ramping up the development pipeline and expect to start $650 million this quarter in Q2, with much of that to be match funded with expected dispositions of approximately $500 million in the second quarter."
Turning to the latest quarter's results, it's no secret that AvalonBay has continued to see headwinds from the pandemic, as Q1'21 FFO/share decreased 14.9% YoY to $1.94 from $2.28 in the prior year period. This was a result of a confluence of factors, including rent concessions to attract and retain tenants, increased operating expenses as a result of COVID-19, and lower rent collection.
(Source: April Investor Presentation)
While AVB may continue to see weakness into Q2, I see the current period operating results as being a trough for the company. This is considering the latest jobs report, which showed that nonfarm payrolls rose by 916,000 in the month of March, with unemployment rate falling to 6%. This bodes well for AVB as rent concessions, especially those granted last year, eventually fade away, thereby enabling it to resume normalized rental rates.
Additionally, I see encouraging signs from AVB, with occupancy now approaching 96% for the month of April, and it has improved every month since hitting a low of 93% last September. Plus, management noted that month-to-date average move-in rent is now 5% above what it experienced in January. As seen below, the change in net effective rent has improved sequentially in recent months.
(Source: April Investor Presentation)
Meanwhile, AVB maintains a strong balance sheet with a net debt to EBITDAre ratio of 5.6x, sitting below the 6.0x level that I prefer to see, and with potential for improvement as I expect net effective rents to continue to grow sequentially. Plus, 94% of AVB's NOI is unsecured by mortgages and AVB has $217M of cash on the balance sheet, thereby giving it the liquidity and flexibility to fund its development projects.
This also lends support to the 3.3% dividend yield, which has grown for 10 consecutive years, and has a 5-year CAGR of 4.5%. While the payout ratio may seem somewhat elevated at 81%, I see potential for it to decrease as operating metrics improve this year.
Risks to Consider
No investment is risk-free, and the following points are worth considering:
- While AVB is geographically diversified, its properties are mostly located in or around urban centers. These locations may see renewed pressure, should COVID cases rise.
- Unfavorable rent control regulations in communities and states may negatively impact AVB's ability to raise and collect rents.
- Higher interest rates in the future may result in higher cost of debt funding for AVB, thereby negatively impacting investment spreads.
AvalonBay Communities is a premium quality REIT with strong economy of scale and balance sheet advantages. While it's experienced headwinds in the current environment, recent trends point to brighter days ahead. Plus, the current strength in housing prices bodes well for future rental rate increases on apartment units.
AVB may seem pricey at the current price of $191.50 with a P/FFO of 24.4. However, this valuation metric should trend down as AVB's operating metrics improve. Plus, AVB is still trading well below the $228 level from pre-COVID. I find this sizeable discount from last year's price to be undeserved, considering that housing prices are now 10% above where they were prior to the pandemic. As such, I view AVB as a continued Buy for long-term wealth creation.
This article was written by
I'm a U.S. based financial writer with an MBA in Finance. I have over 14 years of investment experience, and generally focus on stocks that are more defensive in nature, with a medium to long-term horizon. My goal is to share useful and insightful knowledge and analysis with readers. Contributing author for Hoya Capital Income Builder.
Analyst’s Disclosure: I am/we are long AVB. 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.
This article is for informational purposes and does not constitute as financial advice. Readers are encouraged and expected to perform due diligence and draw their own conclusions prior to making any investment decisions.
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