Investment Opportunities in Apartment REITs

I have listened to the second quarter earnings conference calls for three of the largest apartment real estate investment trusts: Equity Residential Trust (EQR), AvalonBay Communities (AVB), and Mid-America Apartment Communities (MAA). Together they own over 250,000 apartments. I was struck by the generally positive tone in spite of our troubled economy. I have assembled a research report that you may find interesting.

Apartment REITs Remain Near March Lows

If you’re pressed for time, here is the HEADLINE: 
Using reasonable assumptions, apartment REITs are currently trading at discounts to the underlying value of their assets. In my estimation, at the current moment, purchasing a liquid security with low debt backed by the best multifamily properties in America yielding 4% is a better prospect than buying an apartment complex yielding 6% with 75% leverage.   

LEASING MOMENTUM, DECENT RENT COLLECTIONS, LOWER TURNOVER

All three REITs reported collections from April to June that were ahead of projections made during the crisis moments of March. All experienced a decline of about 2% on collected rents. The unemployment insurance program and $1,200 stimulus checks certainly helped. Our experience in the Omaha metro area has been similar. Collections declined by 1% during the April-June period and even lower during July in our area. Executives claimed that June and July leasing activity had returned to 2019 levels. Resident turnover was 2-3% below the same period in 2019.  

CAPITAL IS CHEAP

All companies took advantage of low interest rates. AvalonBay issued $600 million in bonds at 2.5%, Equity Residential received a $495 million secured loan at 2.6%, and Mid-America issued $450 million in senior secured notes at 1.7%. All companies have healthy cash positions and exhibit better credit ratings than during the 2008-09 recession. AvalonBay felt confident enough to authorize a $500 million stock buyback program. Low rates were not entirely a favorable factor: AvalonBay and Mid-America each noted that occupancy was hindered by home purchases driven by low interest rates. This trend has also been evident in our market.


CONSTRUCTION STARTS SUSPENDED

All three companies have cancelled new development projects with expectations of weakened rent growth and a belief that construction costs will decline as most commercial and hospitality projects are suspended indefinitely. AvalonBay had noted that construction costs in major coastal metros have declined by 5-7%.

URBAN PROBLEMS vs SUBURBAN SUCCESS

Equity Residential and AvalonBay have the majority of their portfolios located in major metropolitan areas on the coasts. The contrast in performance between urban and suburban markets was profound. AVB and EQR have 33% and 25% of their units in urban central business districts, respectively. Equity Residential and AvalonBay faced difficult headwinds in their urban properties. New leases in urban areas posted rent rates as much as 8% below earlier quarters, and renewal rents dropped by 1%. Vacancy levels approaching 9% were reported in central business districts of San Francisco, Boston and New York. The increase in work-from-anywhere employment has been compounded by a loss of foreign workers and college students in these areas. EQR noted that while 4% of revenues are attributable to commercial tenants, only 60% were paying rent – an ominous sign for central business district retail performance.

Executives at EQR and AVB were encouraged by positive summer leasing trends at their suburban communities. New lease activity was strong enough to help overall company-wide occupancy levels exceed 94%. Overall, company-wide quarterly revenues were down 2.4% at EQR and roughly flat at AVB.


SUNBELT SATISFACTION

Mid-America operates assets in the sunbelt: The Dallas metro, Atlanta, Nashville, the Carolinas, and Austin all feature prominently in their portfolio. MAA executives were ecstatic with their results. Effective rents for new leases at MAA were up 3.4% for the quarter. Occupancy exceeded 95%. Overall revenue for the quarter was up 1.4% over 2019 at MAA. Executives were confident that migration trends toward sunbelt metros would continue, and had seen evidence of acceleration.


INVESTMENT OPPORTUNITY?

All three companies are trading well below February levels. EQR trades at a 40% discount to the February high, AVB is down 34% and MAA is 20% lower. Meanwhile, EQR and AVB sport dividend yields in excess of 4% and MAA has a yield of 3.4%. In a world of zero percent Treasuries, the dividends are appealing.  


The three apartment giants appear to be trading at a discount to their net asset values.


I present a table on the attached pdf comparing the three companies. Some of you may take issue with my simple methodology, but I think the calculations fairly portray a set of businesses that may be undervalued. For annualized revenues, I doubled the first half of 2020. Executives generally opined that markets had stabilized, so I am taking their remarks at face value. I included a $50 per unit capital reserve in my estimates to arrive at a pro forma net operating income level. The results show that all three companies have adequate dividend coverage between 1.38x for EQR to 1.78x for MAA.


I employed a 5% capitalization rate to arrive at a value. Some could argue that this is a low number on a risk-adjusted basis, but as the cost of funds drifts below 3% the cap rate seems reasonable. Cap rates in space-constrained urban markets were well below 5% heading into March. The results indicate that public market discounts to net asset values range from 6% for AvalonBay to 20% for Equity Residential. 


Finally, I reduced my revenue assumption by 5% to determine the impact on values and dividend coverage. In this exercise, all three were comfortably able to maintain their shareholder distributions. Current share prices were roughly in line with net asset values in this example.


There is no question that the pandemic will continue to negatively impact the economy. Indeed, it will be interesting to see if MAA bosses are less optimistic on the next call as Covid cases sweep across the south. I do believe there will eventually be meaningful negative impacts on white collar employment that has thus far been spared the brunt of the layoff pain. Could revenues decline by 10%? It is very possible. I do not subscribe to the conventional wisdom that “everybody needs a place to live, so apartments will be just fine”. Young professionals under the age of 30 can find their parents’ homes just as welcoming as they did during the 2008-2012 period. However, I do believe much of the downside risks have been reflected in the current share prices. These three companies boast some of the finest apartment assets in North America. Their balance sheets are strong and the dividends are well-covered. 


Please let me know if you have any comments or criticisms. I am interested in all perspectives. A disclaimer: These numbers represent my opinions and should not form the basis of any investment decisions.


Let’s hope for a vaccine. Take care.

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Aksarben Village, 15 years in the making, is nearing the finish line

March 3, 2019: By Cindy Gonzalez / World-Herald staff writer

Noddle Cos. estimates that private investment within Aksarben Village has topped $630 million. Those involved since the onset say the project, boosted by tens of millions of public dollars, has exceeded expectations. Office and research space has doubled the amount projected to be built; the number of hotel rooms and residences also have surpassed early predictions.

HISTORY:

To better understand the land evolution near 67th and Center Streets, one can step back 25 years to when elite horse racing died at the longtime entertainment venue. Controversy soon erupted as diverging interests vied for control of Ak-Sar-Ben land then publicly owned by Douglas County.

One group wanted to restart racing in an effort that some suspected would lead to casino gambling. Business leaders resisted, instead supporting a sale to First Data Resources, which was looking for space to grow.

First Data bought the northern 140 acres of the Ak-Sar-Ben grounds in 1996 and subsequently donated a large chunk to the University of Nebraska for a high-tech learning campus featuring the Peter Kiewit and Scott Technology educational institutes and student dorms.

As community leaders in the mid-2000s pondered what to do with remaining land to the south, HDR’s Doug Bisson stepped up to say Omaha had the chance to be at the forefront of an emerging “new urbanism” trend of creating walkable neighborhoods inside cities.

At the time, he was a neighborhood representative on the board of the Ak-Sar-Ben Future Trust, a nonprofit that by then had acquired the former horse track and coliseum.

That idea of resurrecting the familiar grounds with a mix of residences, retailers, offices and entertainment resonated with community officials including Ken Stinson, chairman of the future trust. Said Stinson back then: “We were trying to do things that we couldn’t find in a cookbook.”

A handful of developers, with Noddle Cos. as lead, accepted the challenge to transform the 70 acres into a kind of pedestrian-friendly, mixed-use hub that was becoming the rage in urban parts elsewhere across the country, Bisson said.

Noddle recalls drawing up, in 2005, the first site proposal for what would become Aksarben Village. Actual construction launched in 2007 with the thought that it could take about 12 years to fill out between Center Street on the south, the University of Nebraska at Omaha’s south campus on the north, and from 63rd Street west to the Keystone Trail.

Looking back, Bert Hancock of Alchemy Development, who was among those original developers, said one of the most stunning results is the village’s allure as a home for corporate bases. “While I think everyone envisioned a strong employment base, the headquarters of HDR, Green Plains, Blue Cross, Right at Home, etc., have elevated Aksarben Village’s status as a major corporate center,” he said.

HDR’s near ten story headquarters located in Aksarben Village accompanied by a neighboring building with restaurants, businesses and offices near Mercy Road and south 67th Street in February.

NEW DEVELOPMENTS:

Earlier this year, engineering and architectural firm HDR held the grand opening of its 10-story global headquarters leased from the Noddle-Bradford partnership. Across the street, a five-story office building is rising and in January will be corporate headquarters for Right at Home.

That 100,000-square-foot building, a project of Magnum Development and McNeil Co., will have room for other tenants and retailers on the ground floor. It joins a city block within the village that also features a 10-screen movie theater, restaurants, bars and Pacific Life offices.

Other newbies headed to Aksarben Village:

A 110,000-square-foot, multitenant office building is to rise behind the new HDR headquarters, facing Frances Street, probably later this year, Noddle said. “We own the land, there is demand,” he said, though adding that construction won’t start before he secures an anchor tenant. The HDR parking garage will be enlarged to accommodate additional vehicles.

Noddle Cos. this year also plans to start building the village’s first for-sale homes. Called 64 Ave, the seven town houses along 64th Avenue north of Center will be about 1,600 square feet apiece, rise three floors and have two-car garages. This would be Noddle Cos.’ debut in the residential construction market.

Set to open this summer is the food, retail and entertainment alleyway between the HDR headquarters and its parking structure. The plaza will be called the Inner Rail, a nod to the area’s history as a racetrack. It’s gotten city approval to be an “entertainment district,” which will allow alcoholic drinks in the plaza.

Alchemy Development is to build two more housing projects, bringing on 124 units and $18 million in investment, to the southeast and northeast corners of the HDR headquarters block. One is to start this year, Hancock said. Alchemy already has 227 apartments at the village in Pinhook Flats and the Cue. (Broadmoor Development also has built hundreds of apartments at the village.)

Yet to be developed, Noddle said, is about seven acres next to HDR that’s reserved for its possible expansion, and a few other scattered pieces.

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An aerial view of our new project in Aksarben Village

Photo credit: Brad Williams

ZONE 6 APARTMENTS, AKSARBEN VILLAGE
64TH AVENUE AND FRANCES STREET OMAHA NE

HDR Tower, Aksarben Village

We are excited to announce our newest apartment project in Aksarben Village. The building will feature 62 studio, one and two-bedroom units. We expect completion in early 2021. This building will be adjacent to to our other projects Pinhook Flats and CUE Apartments.

We welcome our newest neighbors: 950 HDR employees now working at the the new eleven-story HDR Headquarters.

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Apartment Development has a Big Lebowski Moment

By now, just about everyone knows the boiling frog metaphor. The business parable now sits among the regal pantheon of Vince Lombardi quotes, TedTalks about body postures, and the mystical epiphanies which occur when you gaze deeply in your Steve Jobs mirror. So let’s take the boiling frog story and give it a new level of sophistication. We’ll call it the Big Lebowski moment. This moment occurs when you are chilling out in your bathtub, just like The Dude. Your candles softly glow, the water is nice and warm, and you probably just had some help to induce your tranquil state.

The Dude Abides

For real estate developers, this can be like the construction phase of the project. You’ve done the heavy lifting of designing the building and gaining approvals from the city. You’ve negotiated the contracts and obtained your financing. You sit back a little and marvel as your dream leaps off the paper (or digital file) and becomes reality. This building is really happening. Sure, you will worry about the rogue subcontractor, the deadlines that may ebb and flow, and the weather, but if you’ve set yourself up with a well-planned project you will enjoy the next 18 months.

Once construction winds down, the stress starts kicking in. Will my glorious creature be the pony that every child wants to ride or do I have an old nag who buries its nose in clover when a rider approaches? Or, even worse, did I open one of those dodgy carnivals in a parking lot of a vacant retail strip center and my ponies just got quarantined by the Douglas County Health Department? Rents get adjusted, special lease incentives are offered, sweat beads appear on your brow and the pulse quickens. In Big Lebowski terms, The Nihilists have just arrived while you’re sitting in the tub, and they’ve started to break your stuff in the living room.

It gets worse. The Nihilists have brought a weasel with them (Hey, is that a marmot, man?). They throw the weasel in the bathtub. All hell breaks loose as the furry ferret turns into a screeching water snake keen on drawing blood from a sensitive region of the body. The tranquil tub becomes a frothing cauldron. For real estate developers, the angry weasel represents their debt. Real estate projects are highly dependent upon leverage. Most developers borrow 70% to 80% of their total project costs. Rising interest rates can threaten even the best developments.

Most construction loans have an interest-only period that terminate about 24 to 36 months after the start of construction. The end of the term is often referred to as the “conversion date”: the date at which the loan resets. On the conversion date, the interest rate adjusts to the current market level and the developer must begin paying some principal on the loan. For the past five years, rates have been in an innocuous range around 4%. Conversion dates came and went without much trepidation. Now, rates have risen dramatically. Many construction loans that were marked at LIBOR plus 3% two years ago will soon reset in a new and very weasel-ish world of 5% rates. One-year LIBOR sat at 1.73% in June of 2017, today it sits at 2.74%.

Well, that’s not so bad, you may say. After all it’s only 1% higher than it was a year ago. Yes, but the problem is exponential: your cost of money just went up by 20%. If you borrowed $10 million to build 100 apartments, you now face an additional $100,000 per year in interest expenses. On a per unit basis, that’s $83 per unit per month that you need to generate. From where I sit in Heartland, USA, $83 per month is a substantial amount of money. It’s probably a 10% increase on a one-bedroom apartment. My sister lives in San Francsco where they step over $100 dollar bills like soiled pennies, but here the number is the difference between two tanks of gas or an upper deck seat to see Kendrick Lamar. In other words, its a problem.

In a market facing over-supply, the pressure could become intense. Apartment construction has exceeded rates of household formation for the past six quarters. Higher interest rates will add to the challenges and pose a threat to developers in a way that has not been witnessed since 2007.

The interest rate environment places the Federal Reserve in a complicated position. The effective Federal Funds Rate is 1.75% and a 25 basis point increase is expected this week. Right now, markets place a probability of 41.7% on rates landing in the range of 2.25% to 2.5% by the December 2018 meeting.

Source: CME Group

There are three problems with this outlook:

  1. The 10 Year Treasury Yield stands at 2.96%. A surge in short term rates would almost certainly invert the yield curve – a signal that portends most recessions. The 5 Year Treasury is already at 2.80% which demonstrates a flattening yield curve.
  2. LIBOR rates track short term Fed Funds rates. Most short term financing is set on LIBOR plus a spread. If you extrapolate my example above regarding apartment rents to the entire economy, I do not believe that borrowers can cope with another 1% increase in the cost of short term funds.
  3. Increased rates will draw capital to the US and strengthen the US Dollar. The foreshadowing of this momentum has already set central banks into a frenzy of currency market intervention in Turkey, Brazil and Argentina. If the Mexican Peso joins the crowd, you could have a full blown currency crisis like 1994 or 1998.

 

The Mexican Peso (MXN) has fallen dramatically against the US Dollar (USD) since April. Source XE.com Currency Charts

Therefore, Jerome Powell must walk a tightrope. He must work to reduce inflation pressure and curb lending excesses, yet the risk of a recession rises with each quarter-point increase. He surely does not wish to create a lending crisis.

The intersection of interest rates, inflation and housing is even more complicated. Most measurements of the CPI show that housing costs are the major driver of inflation. I highly recommend reading the Bloomberg piece on the topic. There is some frustrating irony here: my industry, the one most susceptible to the risks of rising interest rates, is also the cause of the inflation which requires the Fed to raise rates. It’s a logical spiral that circles the drain like dirty water in a candlelit southern California bathtub.

 

 

 

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