MAA - Residential REITs Are Setting Up For Huge Gains In 2024

2023-12-26 02:33:19 ET

Summary

• Home prices on aggregate have held up really well despite some analysts warning that aggressive monetary tightening by the Federal Reserve would crash home prices.
• However, residential real estate investment trusts, which essentially own and operate residential real estate, have seen valuations dive to multi-year lows.
• Not only do we expect robust rent escalation and higher home prices to support higher NAV gains for MAA and CPT, but we also see room for P/FFO multiple expansion.
• We see a P/FFO multiple of 18.0x as fair value for MAA and CPT, translating to a potential 24% gain purely from multiple expansion even in the conservative scenario that FFO growth will be flat.
• We initiate coverage of MAA and CPT with a "Strong Buy" rating.

U.S. residential real estate as an asset class has had a mixed performance over the last two years. On the one hand, home prices on aggregate have held up really well despite some analysts warning that aggressive monetary tightening by the Federal Reserve (Fed) would crash home prices.

Home price indices including the S&P/Case-Shiller U.S. National Home Price Index, the Zillow Home Value Index, and the Federal Housing Finance Agency House Price Index, all show home prices nationwide have barely fallen since the Fed hiked interest rates. Instead, home prices are still up by 3%-4% from a year ago.

On the other hand, residential real estate investment trusts (REITs), which essentially own and operate residential real estate, have seen valuations dive to multi-year lows. Below is a list of the top 10 leading residential REITs by market capitalization.

1. AvalonBay Communities, Inc. ( AVB )
2. Equity Residential ( EQR )
3. Invitation Homes, Inc. ( INVH )
4. Sun Communities, Inc. ( SUI )
5. Mid-America Apartment Communities, Inc. ( MAA )
6. Essex Property Trust, Inc. ( ESS )
7. Equity LifeStyle Properties, Inc. ( ELS )
8. American Homes 4 Rent Class A ( AMH )
9. UDR, Inc. ( UDR )
10. Camden Property Trust ( CPT )

The chart below shows how these names have performed since the COVID-19 pandemic hit the stock market in 2020. We have greyed out most of the names except for MAA and CPT, which are our favourite picks within the group. All of these residential REITs are still trading well below the 2022 peak, and some are still priced at levels near the peak of the pandemic.

Given the improving economic environment accompanied by cooling inflation, resilient corporate earnings, and a healthy labour market, it is not surprising that U.S. equity indices including the S&P 500 Index ( SPX ) and the Nasdaq 100-Index ( NDX ) are up 23.8% and 53.4% to date, respectively. With the S&P 500 less than 2% away from surpassing its all-time high of 4,818 points, is the deep discount on residential REITs justified?

Lingering Pessimism Towards Real Estate Is An Opportunity For Alpha

We are puzzled to see residential REITs being completely left behind by the equity bull market. Unlike many technology startups where cash flows tend to be unpredictable and may stretch far into the future, cashflows from residential REITs are fairly stable and predictable. Residential REITs are also unlike companies with volatile earnings that justify a higher risk premium during periods of economic uncertainty. Instead, residential REITs are well-diversified investments that enjoy steady rent escalation over time, are backed by real assets, and have an exceptional track record of delivering exceptional returns for investors over the years.

We have been struggling to understand what could justify the stark underperformance of residential REITs. Thus far, our extended conversations with economists, analysts, and investors have yielded little in deciphering the lingering pessimism. Most of the arguments against residential REITs boil down to the risk of interest rates potentially staying higher for longer, unrealistically high valuations pre-pandemic, or simply because real estate is just boring for tech investors.

The more we search for answers as to why residential REITs are undervalued, the more we are convinced that investors are underappreciating the massive potential of the asset class for the coming decade.

Healthy Demographics And Supply Shortages Can Only Mean Steady Rent Escalation And Higher Home Prices

Here at Stratos Capital Partners, we search for opportunities to generate alpha by looking for high-quality companies that are undervalued and temporarily underappreciated by investors. Typically, such opportunities become available when market sentiment is overwhelmed by fear.

Since the Fed embarked on its monetary tightening cycle in March 2022, sentiment towards real-estate assets has deteriorated into extreme pessimism. The financial media was inundated with warnings that residential real estate prices would crash due to high mortgage rates and plunging home sales. Almost every real-estate-related sector suffered sharp declines in 2022 including REITs, homebuilders, and real-estate asset managers. And when the equity market eventually rebounded in late 2022, the rally was rather uneven. Homebuilders such as D.R. Horton ( DHI ), Lennar ( LEN ), and PulteGroup ( PHM ) soared, while asset managers such as Blackstone ( BX ) also enjoyed a spectacular run. However residential REITs continued to lag far behind.

The underlying fundamentals driving residential REITs did not deteriorate like the market had expected. On the contrary, we continue to see healthy demographics and an acute shortage of housing due to more than a decade of underbuilding to continue to drive home prices and rents higher. Not only have home prices not crashed as predicted by many, but we are increasingly confident that home prices and rents will far outpace inflation in the next 2 to 3 years.

Mid-America Apartment Communities ( MAA ) And Camden Property Trust ( CPT )

Within the residential REITs space, we look specifically for names that are strategically positioned to benefit from healthy inward migration trends among the Sun Belt states. We also prefer large-cap names that benefit from economies of scale, have established a decent foothold in the Sun Belt states, and have demonstrated a track record of quality performance over the years.

Our screening conditions resulted in Mid-America Apartment Communities and Camden Property Trust being our favourite picks. Both are currently trading at an attractive Forward P/FFO multiple of around 14.5x and a Forward Dividend Yield of slightly above 4%.

As the accompanying chart shows, both MAA and CPT have also managed to deliver steady FFO growth over the years.

Not only do we expect robust rent escalation and higher residential home prices to support higher NAV gains for MAA and CPT, but we also see room for P/FFO multiple expansion to further boost share price performance in 2024. We see a P/FFO multiple of 18.0x as fair value for MAA and CPT, translating to a potential 24% gain purely from multiple expansion alone.

According to data compiled by Nareit , P/FFO multiples for U.S. equity REITs as a whole have fallen back to levels last seen in 2009.

Although the plunge in P/FFO valuations was broad-based across U.S. equity REITs, only commercial offices registered a decline in net operating income. Other segments of the market have actually witnessed a steady improvement in net operating income since the peak of the pandemic in 2020.

Similarly, occupancy rates for major categories have been on an upward trend except for commercial offices.

It appears to us that negative sentiment resulting from the deteriorating performance of commercial offices may have indiscriminately spilled over to other real-estate categories.

We view this dislocation in rising net operating income and declining valuations in residential REITs as an opportunity to take advantage of the unwarranted pessimism that is holding back high-quality REITs such as MAA and CPT.

In Conclusion

MAA and CPT are undervalued and are supported by robust fundamentals. Not only do we expect robust rent escalation and higher residential home prices to support higher NAV gains for MAA and CPT, but we also see room for P/FFO multiple expansion to further boost share price performance in 2024.

We see a P/FFO multiple of 18.0x as fair value for MAA and CPT, translating to a potential 24% gain purely from multiple expansion even in the conservative scenario that FFO growth will be flat.

We initiate coverage of MAA and CPT with a "Strong Buy" rating.

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