Taken to the Woodshed
Board: Real Estate Investment Trusts
Nobody likes to be taken to the woodshed for a whuppin’. It is painful, and embarrassing. But what if one is innocent of the alleged transgression, yet gets badly whipped anyway? Well, that’s cruel and unusual punishment. It would be like giving a 2-hour time-out to Riley (my 12-year old Golden Retriever) for eating a cupcake that he never ate.
What brought this thought to mind was watching – in tortured silence – the stock of AvalonBay Communities (AVB), my favorite apartment REIT, get shot down to a 52-week low last week. It was the only REIT common stock to occupy the equity world’s cellar, while 54 NYSE-listed REITs hit 52-week highs. That, truly, is adding insult to injury.
As this sorry event occurred in the immediate aftermath of AVB’s Q4 earnings release (the stock tumbled 7% in the two trading days following the press release), one would logically conclude that AVB’s Q4 operating results and guidance for 2013 were horribly disappointing. In an investment era where “investors” have time horizons no longer than a quarter or two, any company that even mildly disappoints is likely to be taken quickly to that woodshed for some ol’-fashioned justice.
So what sins did AVB commit? Operating results for Q4 showed that FFO rose only 6.7% – which is certainly disappointing vs. expectations. But there’s a lot a lot of noise in these earnings, particularly with respect to AVB’s agreement (with Equity Residential (EQR)) to buy Archstone’s apartment assets. Archstone-related costs caused a $.16 reduction in Q4’s FFO; without these non-recurring expenses, FFO would have been $1.43, representing an increase of 15.9% (and in line with prior guidance). Also in Q4, same-community NOI growth clocked in at 5.9%, and grew 7.6% for the year – both in line with expectations.
But what about 2013? Surely AVB’s guidance must have been disappointing to warrant its stock’s trashing.
Here, too, we must dive below the surface. The REIT issued ’13 FFO guidance of $4.11 to 4.47, which is horrible at first blush (at the mid-point, down 19.4% from the prior year). However, there is even more noise here than at trackside at the Indy 500. AVB’s FFO guidance of $4.29 (at the mid-point) is after acquisition and other non-routine costs involving Archstone of $.99 per share and debt prepayment penalties and a hedge unwind of $.87 per share. Adding these to $4.29, to bring us a more realistic picture of recurring FFO, gets us to $6.15 for this year. This is virtually on target with SNL’s 2013 consensus FFO estimate of $6.17. Where’s the crime?
Ah, but perhaps AVB’s guidance disappointed with respect to 2013 NOI projections? No. Green Street Advisors’ recent January report on the apartment sector suggested that AVB would deliver same-store revenue and same-store NOI growth of 4.3% and 4.6%, respectively. AVB’s guidance is 3.5% to 5.0% for revenues and 4.0% to 5.5% for income, respectively. These guidance figures are right in line. AVB also boosted its dividend by 10.3%, in line with managements’ expectations for 2013 growth in free cash flow or about 10%.
So the Q4 results, and guidance for ‘13, were not at all surprising if we look at the underlying and recurring realities. But let’s now look at the larger picture to try to understand AVB’s fall from grace. It’s no secret that apartment REITs are in investors’ doghouse these days. According to SNL data, as of last Friday, equity REITs – measured by the SNL US REIT Equity index – delivered a 12.71% return over the past one year, but its US REIT Multifamily index was NEGATIVE during that period – by 3.58%. That’s an underperformance of 16.29%! (Over the past three years, however, apartment REITs’ performance of 66.62% was ahead of the entire REIT equity index at SNL, which rose 62.64%). Thus AVB hasn’t been plucked from among its peers for punishment (except for that embarrassing 52-week low). All apartment REITs have been dissed.
The task now for REIT investors is to determine whether the apartment REITs’ thrashing has been fairly inflicted – and where the stocks go from here. My view is that the underperformance has been greatly overdone. It is certainly true that the outsized growth in apartment REITs’ same-store NOI and FFOs we’ve enjoyed over the past few years is, and will be, abating. New supply is entering many markets (running a race with job growth), housing affordability has improved significantly with the decline in single-family home prices (home carrying costs are much more competitive with apartment rents), and housing is in a recovery phase – and will capture a higher percentage of new household formations. The days of high single-digit rent increases are over for this cycle.
That said, the for-rent apartment markets are still healthy, and apartment owners will still deliver very respectable same-store NOI and FFO growth over the next few years. Move-outs to home purchases have not spiked, eligibility for single-family home financing remains difficult, job growth is looking a little better (as are household formations), and banks are still cautious when lending to merchant developers. Construction costs for new apartment communities are, according to Camden Properties (CPT) President, Keith Odin, beginning to rise significantly. Furthermore, during most periods throughout history, home owners and apartment owners have been able to co-exist in relative prosperity. Apartment owners will capture their fair share of new household formations, and eventually rates on new home mortgages will rise when Chairman Ben decides to print less money.
Longer-term, apartment owners have the wind at their back. According to Samuel Rines, Chilton Capital Management analyst and economist, “almost 21 million people between the ages of 18 and 30 are living at home” with parents. These youngsters have a high proclivity to rent as they become independent, and apartment owners will capitalize on this trend. Longer-term demographics for apartment owners are also favorable; the propensity to rent among young adults of age 35 and younger has traditionally been around the 60% mark, but this percentage has been increasing significantly since 2005. I am guessing that young adults will increasingly want to have maximum job-changing flexibility, and will thus consign home ownership to a low priority. Oh, but I forgot: These issues are irrelevant to those who invest for the next quarter.
Finally, let’s look quickly at current share valuations. The average implied cap rate for apartment REIT stocks (according to estimates of Green Street Advisors for the apartment REITs in its universe) was 5.4% at the beginning of this year (and is no doubt a bit higher today). This compares with 5.6% (market-cap weighted) for the typical Green Street universe REIT stock. And yet apartment properties generally trade for significantly lower cap rates than in other sectors, due to GSE-available financing, relatively low cap ex requirements and, perhaps, better property market liquidity. As a result, the typical apartment REIT stock trades at an NAV discount today, while REIT stocks in other sectors are trading at NAV premiums. Furthermore, the two-year FFO/AFFO growth profiles of apartment REITs are, on average, significantly better than in other sectors. And, unlike the case in other sectors, new developments can add value.
Investors tend to treat shares poorly when earnings growth slows, even from unsustainably high levels. But value ultimately wins when time periods lengthen, and I strongly suspect that, by year’s end, apartment REIT stocks will have a performance record for 2013 that won’t require their executives to wear bags over their heads. I believe it’s a great time for contrarian investors to look for good apartment REITs with sound balance sheets (for example, AVB), bring them out of the woodshed, sooth their pain, and send them out into the world with a few kind words of encouragement.