2023-06-23 10:48:48 ET
Summary
- AvalonBay Communities is a conservative REIT option with a focus on top-tier residential assets in prime locations, offering a decent yield and strong dividend track record.
- The company's stable performance, low volatility, and favorable risk-adjusted return make it an attractive choice for conservative investors seeking stability.
- However, its conservative nature may limit its appeal compared to higher-yield, faster-growing alternatives, and it may not be suitable for investors seeking more aggressive growth.
Introduction
Allow me to start this article the way I start a lot of real estate-focused articles: By mentioning that I'm a picky real estate investor. While I have a number of REITs on my watchlist, I only own two self-storage REITs while I am writing this.
I believe that a lot of real estate investments are a waste of money. The market has some great plays with subdued yields and high growth that generate strong total returns. The market also has some slow-growth plays with high yields and slow growth that also generate satisfying total returns. In the middle, we're dealing with REITs that have no real edge.
In general, it's fair to say that REITs need to be handled with care. Over the past ten years, the prominent real estate ETF ( VNQ ) has returned just 82%. The S&P 500 returned 230%. High-yield stocks returned 156%.
In this article, I want to present a conservative REIT play. AvalonBay Communities ( AVB ) is the nation's largest residential REIT with a portfolio of top-tier assets in great locations.
It comes with a decent yield and an A-rated balance sheet on top of a low-volatility stock price history.
However, in light of current economic (real estate) woes, I will also explain why its conservative yield could be a bit of an issue, as even faster-growing peers offer similar or higher yields due to stock price weakness.
Now, let's get to it!
What's AVB?
AvalonBay is the largest residential REIT in the United States. The company specializes in developing, acquiring, owning, and operating multifamily apartment communities.
Its strategic focus is on leading metropolitan areas characterized by strong employment growth, high cost of homeownership, and diverse quality of life.
While I'm not sure what diversity has to do with the strategy of a residential REIT, the company is right when it focuses on areas with a high cost of homeownership. After all, that's when renting becomes more attractive, especially in the current environment of mortgage rates close to 7% on top of elevated home prices.
As of January 31, 2023, AvalonBay owned or held ownership interests in 275 operating apartment communities, covering 82,411 apartment homes across 12 states and the District of Columbia.
Most of its assets are located in California and the NY/NJ metro area, which makes sense, given the company's comments on affordability. The company targets to invest roughly 75% of its money in these areas, which means this regional breakdown won't see major changes in the future.
Furthermore, 44% of its assets come with some form of a garden. 38% of its assets are mid-rise buildings. Only 18% are high-rise apartments.
I believe that's a favorable asset mix, as I'm not keen to invest in companies that mainly offer high-rise properties. I believe that the pandemic has caused a long-term shift towards other housing options.
Furthermore, the company operates four core brands, each targeting specific customer segments and submarkets.
- The Avalon brand focuses on upscale apartment living and high-end amenities.
- AVA targets high-energy, transit-served neighborhoods with smaller apartments designed for roommates and active common spaces.
- Eaves by Avalon caters to the value-conscious segment in suburban areas.
- The Kanso brand, introduced in 2020, offers a moderate price point, simplicity, and high-quality apartment homes without extensive community amenities, utilizing technology and smart access.
With that said, in its 2022 10-K , the company mentioned that it aims to deliver superior risk-adjusted returns by investing in markets with (the aforementioned) favorable characteristics.
I have to say that the company is doing exactly that.
A Favorable Risk/Adjusted Performance
Over the past ten years, AVB has returned 94%, which beats the VNQ ETF by roughly 13 points. Note that both assets almost move in lockstep. It also means that AVB has underperformed the S&P 500 by a wide margin during this time period, as VNQ failed to keep up with the market and its non-REIT high-yield peers.
While AVB's stock price isn't rapidly rising, it still has one major advantage: It has very low volatility. Looking at the chart below, we see that AVB shares are barely more volatile than the VNQ ETF. That's remarkable, as we're comparing a single stock to a basket of more than 160 stocks.
It makes sense, as AVB has a low-risk portfolio. It isn't dependent on consumer health like retail REITs, industrial demand, or other cyclical issues.
The company also comes with a decent yield and a strong dividend track record.
About Its Dividend
AvalonBay currently pays a $1.65 per share per quarter dividend. This translates to a yield of 3.6%. The VNQ ETF yields 4.3%. The median sector yield is 5.0%.
In other words, AVB has a below-average yield.
In this case, it helps that the company has a well-covered dividend with a great track record.
While the company didn't hike its dividend during the pandemic, historically it hiked its dividend on a consistent basis, even during the Great Financial Crisis, when a lot of REITs (even in housing) had to cut their payout.
- On average, over the past ten years, the dividend has been hiked by 4.9% per year.
- That number has fallen to 2.3% on a five-year basis as a result of the pandemic.
- The most recent hike was on February 8, when the company hiked by 3.8%.
- The company's adjusted funds from operations ("AFFO") payout ratio is 70%, which is below the median sector payout ratio of 75%.
The good news continues, as AVB's dividend is also backed by a healthy balance sheet and a strong financial performance despite ongoing woes in the real estate market.
Business Update & Balance Sheet
For example, in the first quarter, AVB experienced significant earnings growth, with core FFO increasing by 13.7%.
This performance was mainly driven by the roll-through of leases signed the previous year. Additionally, rents continued to grow during Q1, with a 4.1% change in like-term effective rent.
Furthermore, AvalonBay exceeded its core FFO guidance by $0.05 per share, primarily due to better-than-expected collection rates from residents, lower operating expenses, interest income, and other items.
The company drew down the proceeds of its equity forward, resulting in additional capital to fund development projects. The cash from the drawdown was invested at 5% interest rates, leading to incremental income and an increase in the 2023 core FFO guidance by $0.10 per share at the midpoint.
Adding to that, there are a number of tailwinds that benefit the company.
- AvalonBay's established regions experienced less volatility in occupancy and rent trends compared to the Sunbelt regions. According to the company, this stability can be attributed to rent-to-income ratios being in line with traditional levels and limited single-family home inventory on top of higher interest costs, making renting more economically favorable in its markets. The company had a 96% occupancy rate at the end of May.
- The supply picture in AvalonBay's suburban coastal portfolio is positive, with fewer new supply additions expected in the established regions (1.6% of existing stock/inventory) compared to Sunbelt markets (3.6%). When considering supply directly competing with AvalonBay's portfolio, the levels are even lower, at 1.4% of stock overall and 1.2% in suburban markets, which comprise a significant portion of the company's portfolio. These numbers are backed by comments from other companies that noted regulatory and cost headwinds to build new homes/buildings in states like California.
During its 1Q23 earnings call , the company noted shifts in the development market due to the Federal Reserve's tightening actions in recent quarters. Competitors are postponing or abandoning planned projects due to scarce third-party financing.
Hence, effective rents on the East and West coasts have increased by 10% from pre-COVID levels. Despite these rate hikes, the company noted that bad debt (uncollected rents) declined to 2% in May, which is a new low.
Speaking of the Fed and the tremendous pressure it puts on companies with weak balance sheets, I'm glad that AVB is in a much better spot.
AvalonBay enjoys low leverage with a net debt-to-EBITDA ratio of 4.6x, below the target range of 5x to 6x. The interest coverage ratio and unencumbered NOI percentage are at near-record levels of 6.9x and 95%, respectively.
Moreover, the company's debt maturities are well distributed, with weighted average years to maturity of about eight years, which buys a lot of time in the current high-rate environment.
But wait, there's more.
The company has significant available liquidity, which secures future investment opportunities.
In addition, as disclosed in our release, we also enjoyed tremendous liquidity of about $2.8 billion today, with no borrowings under our $2.25 billion unsecured credit facility and an additional $0.5 billion from just having settled our equity forward that we originated a year ago. As a result, we don't need to tap the capital markets for an extended time, and we are well positioned to lean into our balance sheets to take advantage of future investment opportunities that may emerge in our markets over time.
Thanks to its stable business and healthy balance sheet, the company enjoys an A3/A- credit rating.
Valuation & One Issue
Thanks to favorable developments in its markets - despite macroeconomic headwinds - AVB increased its full-year core FFO guidance to $10.41 per share at the midpoint, an increase of $0.10 per share.
The guidance adjustment includes additional revenue from Q1 and Q2, improved operating expenses for the full year, and additional core FFO from interest income on the equity forward proceeds, cash management, and updated transaction timing assumptions. Same-store guidance ranges were unchanged.
Based on these numbers, AVB is trading at 17.8x 2023E core FFO. The median sector valuation is 12.4x FFO.
Given the company's historical valuation range, it's a fair value, yet nothing to write home about, as investors have essentially incorporated the company's resilience in the current stock price.
The current consensus price target is $195, which is 5.4% above the current price. I agree with that.
With that said, as much as I love the company's stability and consistency, we're now in a market where a lot of stocks have sold off, offering higher yields than AVB. While most of these investments come with higher risks, they also come with a higher yield and sometimes higher long-term growth expectations.
Although AVB shares are trading 28% below their all-time high, I would prefer to buy companies with higher risks (and higher potential rewards) at these levels. This includes self-storage and faster-growing residential REITs like Mid-America Apartment Communities ( MAA ), which I discussed in this article .
While I will give AVB a buy rating, it's not a high-conviction pick, as I believe that AVB is mainly for conservative investors who like to avoid ETFs.
Needless to say, I stick to every bullish thing I've said in this article. I'm mainly avoiding AVB because I'm looking for a different risk/reward and more aggressive growth.
Pros & Cons
Pros:
- Stable and consistent performance.
- Low volatility.
- Strong dividend track record.
- Diversified real estate portfolio.
- Healthy balance sheet.
Cons:
- Below-average yield.
- Moderate growth potential.
- Higher valuation compared to the sector.
- Competition from higher-yielding stocks.
Takeaway
AvalonBay Communities stands out as a conservative REIT option with its focus on top-tier residential assets in prime locations. While AVB offers a decent yield and boasts a strong dividend track record, its conservative nature may limit its appeal compared to higher-yielding, faster-growing alternatives.
AVB's stable performance and low volatility, along with a favorable risk-adjusted return over the past decade, make it an attractive choice for conservative investors seeking stability.
With its well-covered dividend, healthy balance sheet, and resilient business model, AVB offers a reliable option in the residential REIT space.
Nonetheless, for investors seeking higher yields and more aggressive growth, exploring other options might be the way to go.
As much as I like AVB, it ultimately depends on individual risk preferences and growth expectations.
For further details see:
AvalonBay Communities: A Stable Dividend Option In Real Estate