2023-11-17 17:09:55 ET
Summary
- AvalonBay Communities is a safe and reliable income stock with a 4% yield and consistent dividend growth.
- The company benefits from the trend of unaffordable housing, with the cost of buying a home far exceeding renting.
- AvalonBay has a strong financial performance, low leverage, and a well-protected dividend, making it an attractive investment for income-focused investors.
Introduction
It's time to talk about one of the safest and most reliable income stocks on the market.
4%-yielding AvalonBay Communities ( AVB ) is one of the largest residential REITs in the United States, with a portfolio covering close to 300 communities and 90 thousand apartment homes.
On top of having a juicy yield, consistent dividend growth, and a stellar balance sheet, it also benefits from one major trend: unaffordable housing.
I think we all know how expensive housing has become. Both buying and renting have become close to unaffordable for many people.
The other day, the Wall Street Journal highlighted how bad the situation for homebuyers has become.
Wall Street Journal
According to the Journal, the disparity between the cost of purchasing a home and renting one has reached its highest point since 1996.
CBRE data reveals that the average monthly new mortgage payment is now 52% higher than the average apartment rent, a situation that reminds some of the period preceding the 2008 housing crash, except this time, it's worse.
Wall Street Journal
Historically, buying and renting costs aligned more closely, but after the global financial crisis, low interest rates and abundant housing supply made it, on average, 12% cheaper to buy a home than to rent during the 2010s.
The current imbalance is attributed to surging debt costs, with 30-year mortgage rates hitting 8% earlier this year, and the increased value of domestic space following pandemic lockdowns.
In October, taking out a 30-year mortgage on a $430,000 home with a 10% down payment results in around $3,200 in monthly repayments, marking a 60% increase compared to three years ago.
In contrast, rents have risen by 22% over the same period, albeit still outpacing wider U.S. inflation.
While this is still a challenge for landlords who have too much debt, it's a favorable environment for landlords with strong balance sheets and supply in key markets.
That's where AvalonBay comes in.
What Makes AvalonBay So Special
As I already briefly mentioned, the company behind the AVB ticker owns close to 90 thousand apartments. Most of its assets are located in California and the Northeast, with a focus on expansion in the Sunbelt.
AvalonBay Communities
44% of its apartments come with a garden. Less than a fifth of its assets are high-rise assets. Close to 70% of its apartments are suburban.
AvalonBay Communities
While I completely understand that some people want to avoid markets like California (for political reasons), that market comes with a major benefit: supply shortages.
During its 3Q23 earnings call, the company mentioned that its portfolio is positioned favorably concerning rental affordability and insulation from new supply, especially in established regions.
AvalonBay Communities
Furthermore, the charts below illustrate improved rental affordability and a decline in existing home sales, supporting the attractiveness of apartment living.
AvalonBay Communities
Thanks to these strong developments and strong renters, the company is doing very well this year and poised for growth.
According to the company, it has four building blocks for growth in 2024 and beyond, including embedded growth in the rent roll, low loss-to-lease, incremental revenue from operating model initiatives, and a continued positive impact from the normalization of bad debt.
AvalonBay Communities
Unsurprisingly, in the third quarter, AvalonBay demonstrated a strong financial performance. Core Funds from Operations ("FFO") grew by an impressive 6.4%. The year-to-date growth rate is at 9.7%!
This Q3 growth number was primarily attributed to better-than-expected revenue growth, positioning the company favorably as it enters the traditional slower leasing season.
Even better, the company has raised guidance three times in 2023. The guidance for core FFO growth in 2023 is now at 8.6%, exceeding the initial expectations by 330 basis points.
AvalonBay Communities
The uplift in revenue expectations is attributed to higher-than-expected occupancy, increased rates, and improvements in bad debt and underscores AvalonBay's adaptability and resilience in navigating challenges such as higher interest rates and uncertain cap rates.
AvalonBay Communities
It also helps that the company has a stellar balance sheet.
Balance Sheet & Shareholder Distributions
The company maintains low leverage, with a net debt to EBITDA of 4.1x, falling below the target range of 5x to 6x.
Furthermore, key financial metrics such as the interest coverage ratio and unencumbered NOI percentage are near record levels, at 7.5x and 95%, respectively.
This financial strength provides stability and flexibility, allowing AvalonBay to navigate market uncertainties and invest whenever it sees opportunities.
AvalonBay Communities
While I'm not making the case for a full-blown housing crisis, I believe that the mix of elevated rates and a wave of debt maturities in 2024 and beyond could provide AVB with buying opportunities for distressed properties.
More often than not, strong players can emerge stronger from recessions. AVB is certainly a company that has this kind of potential.
Also, from a liquidity perspective, AvalonBay demonstrates a high level of excess liquidity relative to open commitments for development and structured investment products.
As of the end of the third quarter, the company enjoys $1.5 billion of excess liquidity.
AVB has an A- credit rating, one of the best ratings in the REIT space.
It also has a well-protected dividend.
AVB currently pays a $1.65 per share per quarter dividend. This translates to a yield of 3.9%.
This dividend is protected by a 62% payout ratio, and it has a five-year dividend CAGR of 2.3%. That growth rate is nothing to write home about. However, it protects investors against inflation (at least against the Fed's 2% target and everything below).
On February 8, the company hiked its dividend by 3.8%.
Valuation
I'm not the only one who likes AVB. At the end of last month, BMO Capital Markets put the stock on its list of highest-yielding S&P 500 stocks with outperformance ratings.
BMO Capital Markets - Via Seeking Alpha
I agree with BMO.
Using the (data in the) chart below:
- AVB is currently trading at 17.9x AFFO (adjusted FFO).
- Over the past twenty years, the normalized multiple was 24.0x AFFO.
- This year, AFFO is expected to rise by 7%, followed by 6% and 5% growth in 2024 and 2025, respectively.
- A return to its normalized valuation by incorporation of mid-single-digit annual AFFO growth could pave the way for over 20% annual returns.
FAST Graphs
While I cannot promise that AVB's returns will be this juicy, the company is certainly undervalued and in a good spot to generate substantial gains, even if elevated rates keep the stock from reaching 24x AFFO anytime soon.
If I were running a more conservative portfolio focused on income, I would be a buyer at current levels.
I would buy gradually and keep cash to average down in case we get a new wave of selling.
New selling pressure could be caused by prolonged sticky inflation and a Fed that prioritizes fighting inflation over financial stability.
So, please keep that in mind.
Takeaway
AvalonBay Communities stands out as a resilient income stock amidst the challenging real estate landscape.
With a 4% yield, a strategic focus on supply-constrained markets, and a diversified portfolio, AVB navigates the unaffordable housing trend successfully.
Strong Q3 financial performance, low leverage, and a stellar balance sheet position the company for growth in 2024.
A well-protected 3.9% dividend, recent hikes, and an undervalued stock price make AVB an attractive proposition for income-focused investors, offering the potential for substantial gains even in the face of elevated interest rates.
For further details see:
4%-Yielding AvalonBay Communities Is An Undervalued Income Generator