Apartment Income REIT Now Deserves A Higher Valuation

Summary

• AIRC still trades at a lower FFO multiple than its coastal apartment REIT peer group.
• The primary reason for the discount historically has been high leverage. But after serious deleveraging efforts in 2021, AIRC now has one of the lower leverage ratios among peers.
• AIRC's strong operational platform allows for higher NOI margins.
• The REIT also offers a relatively high dividend yield of 3.3%.
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Andrey Sayfutdinov/iStock via Getty Images

Thesis: Strongly Beneficial Environment For Apartment Landlords Like AIRC

Apartment List recently reported that the national median rent increased by 17.8% from the beginning of 2021 through November. Compare that to the pre-pandemic average rent growth for the same period of 2.6%. The national median rent in November 2021 was $1,312, $117 more than where Apartment List economists predict it would have been in lieu of the pandemic.

What's more, this strength in the multifamily market appears poised to continue for many years to come. Consider that apartment rents tend to follow home prices higher. As of September, CNBC reports that the United States remains short some 5 million homes, compared to demand. And that situation does not seem likely to be resolved anytime soon.

Source: CNBC

This is a phenomenal backdrop for the continued strong operational performance of apartment real estate investment trusts like Apartment Income REIT (NYSE:AIRC), a primarily coastal multifamily REIT with a ~7% allocation to Denver.

The REIT is currently enjoying significant tailwinds from a post-pandemic return to normalcy and economic reopening in coastal regions. And yet, largely because of its spotty past, AIRC still trades at a meaningful discount to peers. Here's how AIRC's price/FFO stacks up based on early estimates of 2022 FFO per share:

• AIRC: 23x
• AvalonBay Communities (AVB): 27.2x
• Equity Residential (EQR): 27.5x
• UDR, Inc. (UDR): 26.7x
• Essex Property Trust (ESS): 25.5x

With a 3.3% dividend yield that is well-covered at a payout ratio of 82% based on 2021 FFO, Apartment Income REIT lives up to its name by being perhaps the best income play among apartment REITs right now.

For a fuller picture of AIRC, I recommend reading my first two articles on the REIT:

• Why I Exchanged Equity Residential for Apartment Income REIT
• Apartment Income REIT Has More Room To Run

But for now, let's get an early 2022 update on AIRC and the year ahead. In the process, we'll see why I believe the REIT deserves to trade at a higher valuation.

Early 2022 Update On AIRC

Since the announcement of effective vaccines in early November 2020, AIRC has outperformed all of its coastal apartment REIT peers:

Data by YCharts

However, since my last article pitching AIRC as a "buy" idea on September 8th 2021, AIRC has underperformed its peers.

Data by YCharts

In the past, underperformance against peers was warranted, because AIRC has historically carried meaningfully higher leverage than its peers.

But AIRC's debt levels are coming down. Moreover, the apartment REIT does enjoy some advantages and superiorities over its peers. For instance, consider that:

• AIRC experienced a lower same-property NOI decrease during the pandemic than its coastal apartment peers, and AIRC expects its NOI growth rate to come in 500 basis points higher than the peer average over the next five years.

Source: AIRC December 2021 NAREIT Presentation

• AIRC has a higher NOI margin than its peers, making acquisitions more accretive for AIRC than for peers (so long as AIRC continues being able to integrate new properties into its lower-cost operating platform).

Source: AIRC December 2021 NAREIT Presentation

• In the last decade, AIRC has managed to suppress controllable expense growth more than any of its peers.

Source: AIRC December 2021 NAREIT Presentation

• Total same-property expense growth has likewise been the lowest.

Source: AIRC December 2021 NAREIT Presentation

• General & administrative expenses (equivalent to the management fee) are also the lowest in its peer group.

Source: AIRC December 2021 NAREIT Presentation

Notice from the above image the startling statement that the CEO's compensation will be reduced, if necessary, in order to keep G&A expenses at or below 15 basis points of gross asset value. This strikes me as a high degree of shareholder alignment, at least as far as compensation goes. The CEO is highly motivated to keep operational expenses down so as not to see his own remuneration fall.

Moreover, AIRC has also executed substantial capital recycling over the last year, which has refreshed and increased the quality of its portfolio while decreasing regulatory risk.

In the latter half of 2021, AIRC sold about $1.7 billion of properties for an average cap rate of 4.36%, which management says is about 15% higher than the average property value before COVID. Most of these sold properties are located in California, New York City, and Washington D.C. With the proceeds, management expects to do significant deleveraging as well as make some acquisitions.

Specifically, at the end of the third quarter, management estimated that deleveraging efforts would result in a year-end 2021 leverage ratio of 5.3x (net debt to EBITDA). This would put AIRC toward the lower end of its peer leverage range, especially among coastal apartment REITs.

Source: AIRC December 2021 NAREIT Presentation

On the subject of AIRC's debt, it's interesting to note that the REIT's net cost of debt is the lowest in its peer group.

Source: AIRC December 2021 NAREIT Presentation

The 1.7% seen above includes a very low interest rate note receivable from Aimco, the developer sister company to AIRC. Even adjusting for the repayment of this note, however, AIRC's cost of debt should settle at ~2.5% with a weighted average maturity of 7.6 years.

What's more, AIRC is also using some of the proceeds of the aforementioned dispositions to fund a $510 acquisition of a four-property portfolio in the Washington D.C. area. Management expects to generate a "somewhat higher" return in 2022 from this acquisition, but in the long term, once capital improvements are executed and AIRC's unique operational platform is fully integrated, they expect this acquisition to generate ~50% higher returns.

In other words, the portfolio shakeup in 2021 is expected to be mildly accretive to FFO in 2022 but increasingly accretive into future years.

In the third quarter, AIRC began to see some of the benefits of this portfolio recycling, as well as the post-pandemic return to normalcy more generally. For instance, in Q3 AIRC collected 98.6% of all billed rent, with the remaining 1.4% treated as bad debt. This is virtually identical to pre-pandemic rent collection levels.

About three quarters of all uncollected rent during the pandemic was due from California residents. This strongly tenant-friendly state has made it easier for tenants not to pay rent without being evicted, but it has also instituted a rent relief program to make landlords whole on owed rent. AIRC hopes to collect most of the as-yet unpaid pandemic-era rent from California residents.

Same-property revenue rose 6.0% YoY and 5.4% QoQ in Q3, while same-property NOI jumped 8.6% YoY and 7.9% QoQ. Rent rates for signed new leases soared 20.6% YoY, while renewal rents rose 7.0%, and weighted average rent rates increased 15.8%.

Meanwhile, average daily occupancy rose 3.3 points YoY to an impressive 96.6% in Q3. In October, occupancy ticked up further to 97.8%. This rising occupancy rate signifies heavy demand for AIRC's apartments, which in turn indicates further rent growth ahead.

Outlook For 2022

With the heavy capital recycling year of 2021 now out of the way, AIRC will engage in a more normal level of capital recycling going forward - selling appreciated properties with little upside remaining while buying higher yielding but still stabilized properties with plausible upside.

In 2022, management foresees $0.10 per share of contribution from acquisitions plus another $0.31 from lower interest expense (largely as a result of debt paydown). This comes on top of expected NOI growth of 12%. These factors offset dilution from dispositions enough to generate an expected ~10% FFO/share growth, or 12% upon closing of planned acquisitions.

Source: AIRC December 2021 NAREIT Presentation

Let's zoom in on net operating income, which management expects to see impressive double-digit growth. The 12% figure represents the midpoint of a guidance range of 9.5% to 14.5%.

Source: AIRC December 2021 NAREIT Presentation

The number hit will depend a lot on leasing activity as well as operational expense growth. Historically, management has been successful at tamping down on rising operational costs, but the ubiquitous inflation of late could come even for AIRC.

Bottom Line

Having rapidly deleveraged to the point of boasting one of the lowest (if not the lowest) net debt to EBITDA ratio in its peer group of coastal apartment REITs, I believe the primary reason for AIRC to trade at a lower valuation than its peers is now gone. Plus, some credit must be given for AIRC's enviably low-cost operating platform that allows for peer-leading NOI margins.

With these points in mind, and considering the strong macro tailwinds of an expensive housing market pricing many renters out of homeownership, I believe AIRC deserves to trade more in line with its coastal apartment REIT peers.

If AIRC were to trade at a 26x FFO multiple, the price would need to rise over 15% from the current ~$54 to about $62.50 per share.

Such an FFO multiple would imply that AIRC will continue to enjoy at least low double-digit FFO growth for multiple years, followed thereafter by multiple years of high single-digit FFO growth. I believe this is not only plausible but probable.

Add to this AIRC's high (for the multifamily space) dividend yield of 3.3% and you've got an attractive investment opportunity.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of AIRC, AVB, ESS, UDR either through stock ownership, options, or other derivatives. 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.