With the rapid rise in interest rates (excluding the recent reversal), there is more interest (bad pun) in whether REITs are positioned to withstand higher short-term rates. The question is particularly important for short-term earnings growth rates (Core FFO and/or AFFO). We brought this question to the apartment REIT sector recently.
In preparation for providing updates on several apartment REITs, I wanted to compare how much of a headwind we should see in Core FFO and AFFO next year for apartment REITs.
The answer is: “probably not enough to justify preparing the model”.
Regardless, it is a sunk cost now and the model should still be useful for other types of equity REITs. It will be most relevant for those with more floating-rate debt or near-term maturities on fixed-rate debt.
We pulled all the major debt statistics on each of the big six apartment REITs:
We established the amount of fixed-rate debt maturity for each year and the total amount of floating-rate debt. Since debt exposure is not dramatically different across these 6 REITs, we used the following assumption:
Given that the 5-year Treasury is 3.985% today and these REITs can usually borrow money at a spread smaller than 1.5% over Treasury rates, most likely the actual numbers will turn out a bit better for the REITs.
To make results easier to understand, we compared the increase in projected interest expense to Core FFO per share guidance for 2022. For instance, if interest expense would increase by $.10 per share but Core FFO per share guidance was $5.00, then the headwind would be 2%. We also modeled the headwind for 2024 and 2025. If we projected 2024 interest expense would be $.05 higher than 2023 interest expense, then the headwind for 2024 is 1%.
Since rates rose dramatically in 2022 and the majority of the exposure comes from variable rate debt, the headwind is largest for 2023. However, none of the REITs were facing a headwind as large as 3%:
UDR had the greatest exposure at 2.53%.
I focused on evaluating positions as of the end of Q3 2022. If the REIT refinanced a large portion of very cheap debt into more expensive debt during the quarter, part of that impact would be missed. If the debt that was refinanced was already around 4% to 5%, then it would be a minimal headwind as the rate would barely have increased. Some REITs actually refinanced expiring fixed-rate debts into cheaper fixed-rate debts during the year.
I would expect the net impact of controlling for those factors would be pretty small, so it doesn’t rank as a high priority today.
Five things investors should know:
The impact of higher interest expense on the 6 apartment REITs we cover is minimal. The impact for 2023 is pretty small and the projected impact thereafter is even smaller.
The answer to our headline question is a resounding "Yes".
Consequently, investors shouldn’t be remotely concerned about interest rates impacting dividend coverage. The biggest risk factor here is simply the impact to the economy from higher rates and the price impact as some investors favor bonds while the yields are closer. Some investors only see the dividend yield today without seeing the growth rate. We like the long-term growth in AFFO per share (which drives dividends), so we remain very interested in building our equity REIT positions.
For instance, our shares of ESS are paying a dividend yield of about 4%. However, they’ve also grown that dividend per share for more than 25 consecutive years. That includes growing dividends during the Great Financial Crisis. At that point, dividend coverage became dramatically weaker. However, the coverage today is excellent, which should make it easy for dividends to continue growing at a respectable rate.
Outlook: We are bullish on 6 all of the apartment REITs. Exact price targets are not included in the public article, but all 6 are bullish.
Technical factors in this sector remain terrible as 5 of the 6 recorded their lowest close of the last 52 weeks on 11/09/2022. Further, growth in AFFO will be falling significantly (from absurdly high values, which we warned investors about a year ago).
However, the REITs trade at unusually low multiples of AFFO per share. Even adjusting for higher Treasury rates, we find the valuation compelling. Further, throughout the sector the price-to-consensus-NAV (net asset value) ranges from .71 to .82. I expect those NAV estimates will still be reduced slightly further, but it's rare to see discounts of this magnitude in the apartment REITs.
Investors buying into the sector should be focused on the underlying quality of the cashflows as we still expect to see some headlines about the plunging growth in rental rates. As we said a year earlier, you can't compound rental rate increases at double-digit rates. Rental growth rates were in the mid-teens. Obviously, that could not last. Now the market is in the process of overreacting to something that was painfully obvious.
Bullish ratings on AVB, EQR, CPT, ESS, MAA, UDR. We are long AVB and ESS.
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Disclosure: I/we have a beneficial long position in the shares of AVB, ESS 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.
Additional disclosure: We own several REITs that are not mentioned in this article. Per the standard policy, our disclosure does not reference REITs that are not in the article. Related to housing REITs, we also own SUI and ELS. Those are the two big manufactured housing park REITs.