Summary
- The market is hating legacy market exposure right now, and everyone wants exposure to the Sunbelt region which has likely led to overcrowding.
- Valuations have gotten cheap to a point where we're essentially buying properties for what it would cost to build them (zero developer mark-up and zero premium).
- Residential REITs in legacy markets are better positioned than their Sunbelt peers with renting much cheaper than owning and significantly lower new supply.
- This has created a great buying opportunity. Below is my thesis for AVB in 2023.
Dear readers/followers,
Recently I've published many articles on residential REITs. This is no coincidence, I believe that this sector is very well positioned in the current macroeconomic storm and should be quite resilient in a high interest rate environment as well as a potential economic slowdown. Today I want to cover the last residential REIT on my watchlist - AvalonBay Communities ( AVB ). The company has been overly punished by the market for its legacy market exposure creating a good buying opportunity.
Overview
AvalonBay Communities owns and operates a portfolio of roughly 70,000 residential units located predominantly in legacy markets on both coasts of the US. Their communities tend to be on the higher-end of rental apartment communities with a monthly average rent of $2,774. 51% of their revenue is generated in the East Coast split between New England, NY, DC and Baltimore, another 21% is generated in Southern California and 18% comes Northern California. The remainder is scattered across the Pacific Northwest with a small exposure to Florida. Notably the company has decided to shift away from legacy markets and into regions with higher expected growth. Their 2022 activities have been consistent with their goal as they divested away from 9 communities in legacy markets and purchased 4 new ones in growing markets (see map below). This transition is likely to be slow - they expect to have about 10% of their portfolio in these more desirable markets by the end of 2023 which is still quite a long way from their 25% target. Still, I like the fact that management is going in this direction and creating a more diversified REIT, but I am also not scared of their current exposure. Their portfolio currently has a 96% occupancy ratio.
I covered the reasons why I believe that an exposure to California is not as bad as the market thinks in my latest article on Essex Property Trust (ESS). In short I believe that renting remains the best option for most people as owing in California has got 2.3x more expensive than renting. Moreover, new supply under construction in legacy markets is very low compared to the Sunbelt region where everyone wants to be these days. Based on the number of issued buildings permits, it is expected that stock in California and around NYC will grow by only 1.2-1.3% which is significantly lower than the 5-10% growth rates in the Sunbelt. With low supply, only minimal population/job growth is needed to have a balanced market and that's exactly why I believe that the legacy rental markets will do just fine and I don't expect a significant downward pressure on rents. This indicates that as investors we may want to be contrarian and invest in places that don't show up in headlines every week (at least not in the positive ones).
Financials
2022 was a good year for most residential REITs in terms of growth and AVB is no exception. Their Q4 2022 results show a 19% YoY increase in FFO to $9.67 per share. In addition to new acquisitions and finished developments, this increase was largely driven by a same store revenue growth of 10.3% YoY. Same store revenue growth was by far highest in Florida (17% YoY) but I want to point out that New England and NY also recorded very high 13% YoY growth (California stood around 7%). NOI increased by 11.3% YoY signaling that the REIT was able to keep expenses under control in 2022.
For 2023 management expects FFO per share to grow by almost 6% to $10.24. The overall increase should consist of same store NOI growth of 5%, additional NOI from acquisitions and/or new developments of $0.20 per share and a $0.10 per share increase of interest expense.
As already mentioned, in 2022 the company continued to shift away from legacy markets by selling 9 of their communities. I want to point out that the weighted average cap rate for these deals stood at just 4.0%. This confirms that there is investor demand for their properties and that properties are still selling at premiums.
In addition to 4 acquisitions closed in 2022 for a total of a total of $536 Million, the company continued to actively work on development of new properties via their in-house development division. As of today, the company has 17 projects under construction scheduled to be completed within the next three years. With an average expected monthly rent of $2,900 per unit, these properties should generate a weighted average NOI as a % of total capital cost of 5.8%. This is great because it is significantly above the cap rate of 4.0% that AVB sold some of their properties for and keep in mind that these were much older properties - held for an average of 12 years. The fact that the company is able to develop properties so cheaply allows it to gain access to quality properties at a lower than market price. This is very valuable and although a lot of REITs are doing this, the spread that AVB is able to achieve is quite extraordinary.
The company has recently declared a $6.60 per share dividend (+3.8% YoY). Remember that the safest dividend is the one that just got raised and an almost 4% increase is pretty solid. At the current stock price AVB yields 3.8% with a very healthy forward looking payout ratio of 64%. While I don't expect the dividend to grow by more 3-5% per year for the next few years, I think it's completely safe.
AvalonBay has an A- rated balance sheet with about $8.4 Billion of debt, 92% of which has a fixed interest rates. The company does have significant maturities of debt in 2023 and 2024 of $600 Million and $460 Million, respectively. When they refinance, the interest expense will increase somewhat, but management has already included this in their guidance as a $0.10 per share reduction in FFO. The weighted average interest rate stands at 3.4% which is significantly below the 10-yr treasury yield and fully in line with peers.
Valuation
The company currently trades at 17.4x FFO which is considerably below its long term average of 22x. That's a 26% upside when things normalize or an 8% annual return from multiple expansion.
When compared to peers in terms of P/FFO, it trades:
- at a premium compared to ESS (which I consider riskier, because it only has West Coast exposure)
- on par with CPT (which most investors would consider safer, but since I like the supply/demand dynamics of legacy markets I rate it on par)
- at a discount compared to MAA (which I consider safer because it only has exposure to the Sunbelt region excluding California)
With that said, I think AVB is fairly valued compared to peers.
REIT | P/FFO |
ESS | 15.8x |
AVB | 17.4x |
CPT | 17.5x |
MAA | 19.6x |
With a NOI of $1.76 Billion in 2022 and a 5% expected increase in 2023 (to $1.85 Billion), the company trades at an implied cap rate of 5.7%, which is fully in line with most residential REITs at the moment. Compare this to the cap rate AVB achieved on their 2022 disposals (4.0% for much older buildings) and the cap rate it achieved through their development program (5.8%). The current valuation essentially implies that we can buy AVB's properties for the price it would cost to build new ones - assuming zero developers profit and zero market mark-up. That's a great deal! In fact, compared to the realized cap rates on their disposals, we are buying the properties at a 40% discount to their fair market value.
Based on this AVB seems undervalued and I expect the stock to trade at 21-22x FFO again when things normalize and people realize that legacy markets are not going anywhere. With a 2023 FFO forecast of $10.24 and assuming 4% growth until 2025 (below management's expectation of 6%) I have a PT of $240 per share (+40% from today).
So with that said, what can we reasonably expect from AVB going forward?
- 3.8% dividend yield (growing at 4% per year)
- 4% FFO growth for the next two to three years
- 8% annual return from multiple expansion as the company returns to 19.5x FFO
- total return of 15.8% per year
Remember how I generate alpha:
- start with a thesis why a given industry/sector should outperform
- stay overweight in those sectors for as long as the thesis is valid
- look for companies with sound fundamentals that are either undervalued or fairly valued with exceptional growth prospects
- if a company becomes overvalued, trim the position and rotate into another stock/sector that is still undervalued
- if a company becomes increasingly undervalued and the thesis is still valid, add to the position
- generate alpha and repeat
My total return then comes from the dividend yield, EPS growth, and multiple expansion as the valuation normalizes over time. I always target a total return in excess of market returns (>8%) to generate alpha.
What things do I look for when selecting individual stocks to buy?
- strong and safe fundamentals
- good management teams with a track record of caring about shareholders
- healthy EPS growth
- well-covered dividend
- discount relative to peers and/or historical fair multiples
- other catalysts.
Verdict
Like most residential REITs, AvalonBay had a good year in 2022. Going forward growth is expected to slow but should still average 4-6% per year. The company's portfolio is heavily weighted in legacy markets on both coasts, but management is trying to shift away from those markets and into faster growing ones (Sunbelt, Denver, Pacific Northwest). Personally I don't mind the legacy market exposure and believe that they will do fine going forward. This is because renting remains by far the best alternative for people living there (with owning up to 2.3x times expensive) and because new supply is at very low levels compared to the Sunbelt which only requires minimal job growth to keep a balanced market.
But because the market hates California and NYC exposure right now, the stock sold off significantly creating a great entry point for investors. The stock is trading at an implied cap rate of 5.7% which is equal to the yield on cost that AVB earns on their developments. I am willing to buy properties for how much it costs to build them any day of the week and therefore rate AVB as a " BUY " here at $172 per share with a PT of $240 per share.
For further details see:
AvalonBay Communities: Strong Upside Potential Despite Legacy Market Exposure