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3rd Quarter Apartment REIT Review

“Grief is nature’s most powerful aphrodisiac” – Chazz Reinhold (Will Ferrell), Wedding Crashers (2005).

Back in 2005, I watched in disbelief while apartment leases were being broken left and right as residents began to purchase homes at a frenzied pace. While the economy boomed, the apartment industry suffered. Now, some have begun to whisper about the formation of a new bubble stimulated by the zero-rate environment established by the Federal Reserve to prop up an economy battered by the pandemic. In a surreal world where low wage service workers struggle to pay rent, more affluent renters have the sugar rush of cheap money to feed a new home-buying surge. Throw in a desire for more space to work from home and host dinner guests in the backyard, and buying a house… well, as Owen Wilson would say, “just, wow”.

Back in August (which was eight months ago in pandemic time), I decided to look at quarterly results from publicly traded apartment owners to gain insights into where the market was heading. Third quarter results have been posted, so I revisited three of the biggest apartment real estate investment trusts: Equity Residential (EQR), AvalonBay (AVB) and Mid-America Apartment Communities (MAA).

The stocks have continued to trade at discounts to their March peaks and their dividend yields exceed 3%. The announcement of a vaccine breakthrough earlier this week sent the stock prices higher by 10%. The recent price increases have largely erased the deep discounts to net asset values, but they remain attractive as liquid income-producing investments. Their dividends are well-funded, leverage is manageable, and it is hard to envision further downside. EQR is the riskiest of the three because of the company’s high exposure to struggling urban markets, but MAA remains the star of the group due to its focus on sunbelt cities.

The attached article contains brief comments on the quarterly results, a numerical comparison of income and asset values as well as a back-of-the-envelope “stress test” to determine the safety of the dividend payments. Finally, I offer a few observations on the Omaha market where home purchases have caused increased turnover and vacancy.

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Sunbelt Success Continues

Mid-America exhibits the divergence in the apartment industry: urban coastal cities are losing residents and many are relocating to dynamic growth centers in the south. As they had in August, executives exuded confidence in their quarterly call. Occupancy exceeded 96% and traffic was positive. Rent growth was muted due to increasing supply and competition from home purchases but remained positive. MAA is a standout performer because of its concentration in sunbelt cities throughout the southeast and Texas. The stock has nearly recovered its losses for the year.  

Suburban vs. Urban

AvalonBay and Equity Residential noted positive leasing trends during October but reported that rent declines and move-outs exceeded expectations in urban markets, particularly Manhattan, Boston, and San Francisco. Rent declines surpassed 10% in big coastal cities. Occupancy dropped below 90% in central San Francisco – a stunning figure. Meanwhile suburban properties performed well. Overall occupancy at both firms was at the 94% level. At AvalonBay, rents declined 6% for the quarter on a year-over-year basis and 2% on a sequential quarterly basis.  At EQR, rents declined 7.5% for the quarter on a year-over-year basis and 2.7% on a sequential quarterly basis. Collections remained strong – above 97%, but turnover increased. There were some glimmers of hope in the New York City core where major rent discounts and incentives have enticed bargain-hunters to seek upgrades within the market.

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Similar Trends in Omaha

In large measure, the observations made by the leading apartment executives on their earnings calls mirror our experience in Omaha. Occupancy levels which had been above 95% for the past two years have fallen dramatically over the past 90 days – approaching 93% in many areas of the city. Effective occupancy may be even lower as one month of free rent has become a common incentive.

Home Purchases Pressure the Top End

The top end of the Omaha apartment market has been hammered by an acceleration of home-buying. Low interest rates are spurring a race to purchase houses despite rising costs amid a tight inventory and expensive lumber prices. There is a 2005-feel to the environment with a high number of lease-breaks. It has not reached a mania level, but loose credit has allowed buyers to emerge who probably wouldn’t have qualified for a mortgage at the beginning of the year. In certain submarkets, added new apartment supply is also depressing the leasing environment.

More Space

All three firms have noted an increase in demand for larger apartments as working from home seems to have spurred a choice for bigger apartments. Studios are difficult to rent across the country, and Omaha is no exception. EQR reported that many of their Manhattan buildings have experienced transfers to larger units within the same property.

Students and Lower-Income Challenges

EQR and AVB reported serious challenges in their Boston and Cambridge properties due to a lack of students in the area. Omaha is no different. Although UNO has strong enrollment figures, many have opted to remain at parents’ homes. International students are a major driver of central Omaha apartment demand, and they have not returned. Rent delinquencies had vanished over the summer, but have made a growing re-appearance as stimulus payments have been exhausted. Workers in the service sector are seeking assistance once again. Delinquencies are not catastrophic – probably running 1%-2% higher – but the trend is worrying.

Stress Test

Last quarter, I used a hypothetical 5% income decline to determine whether the firms could continue to fund their distributions. I increased the pressure to 10% this time around. The dividends appear safe but would certainly come close to being curtailed in such a scenario. It should be noted that the 10% reduction of rental income was taken from an annualized rental figure that already incorporates two quarters of rental declines. The annualized figures are simply the aggregation of results through September 30, 2020 plus an assumption that 4th quarter results will match those of the 3rd quarter.

Note: This article contains the opinions and observations of the author. No investment recommendations are being provided and no representations are made to the accuracy of the content provided.

Bert Hancock

November 12, 2020

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.