2023-10-18 04:00:51 ET
Summary
- AvalonBay's reinvestment has declined, signaling that it is becoming a mature company.
- I estimate that AvalonBay is worth ~$164/share if management focuses on selling its real estate.
- AvalonBay looks to be worth <$160/share if management increases reinvestment and grows its total units.
AvalonBay ( AVB ) looks like an attractive company on the surface. Its investor relations page highlights AVB's 11.3% annualized shareholder returns since its IPO. Management talks about AVB being minimally exposed to the sunbelt region, where supply is growing rapidly. Plus, AvalonBay owns ~90,000 units of quality real estate (A to A+). Management has focused on acquiring properties in coastal areas where employment is growing in high-wage sectors, which should be a tailwind for rent growth. However, an upbeat AVB story begins to fall apart when looking more closely at the numbers.
Addressing Historical Returns
Past results are usually not indicative of future returns, yet people like to anchor their perceptions of a company on historical returns. I will address this aspect of AVB briefly.
AVB Chart
Yahoo Finance
AVB's revenue grew from ~36 million to over $1 billion from 1994 to 2013, causing AvalonBay's share price to rise ~550% from 1994 to 2013. However, AVB's stock is up ~30% since 2013, so most of AVB's 11.3% annualized returns are from previous decades. AVB's dividend yield fell from ~5% (in 1994-2004) to ~3% (2010s), supporting the idea that returns were relatively higher in previous decades.
AVB Dividend Yield
S&P Capital IQ
AVB Company Life Cycle
AVB Investor Relations
Note: I define reinvestment as (Development and redevelopment costs) + (Acquisitions of real estate) + (CapEx) + (Proceeds from the sale of real estate and condominiums) – (Gain on asset sales) + (Investments in unconsolidated entities) + (D&A)
Reinvestment is important to track because reinvestment is necessary to grow revenue and operating income. AvalonBay's reinvestment has declined meaningfully since 2016, signaling that AVB is becoming a mature company.
Given AVB's size ( 16th largest publicly traded REIT), it'll be difficult for AVB to grow at 6%+ annually because AVB will eventually run out of projects that earn more than its return on invested capital ((ROIC)). As a result, I expect AvalonBay's growth to decline to the economy's growth rate or lower over the next decade.
AVB Expected Growth
AvalonBay Investor Relations
Rent Growth
Companies discontinued their work-from-home policies in 2022, driving rent growth of >10% in CY2022. Given the lack of rent growth in 2020/2021, the spike in rent growth seems to be "catch-up" rent growth rather than an indication of higher long-term rent growth. AvalonBay grew rents by ~3% annually from 2009-2022, so I expect rents to grow 3-4% annually over the next ten years because of higher inflation. Management agreed with this number in its recent REITweek presentation (Q3/Q4 rent growth of ~3% YoY).
Bearish Case for Unit Growth
Reinvestment and completed developments have declined. ~300,000 in reinvestment (last twelve months) implies unit growth near 0%. LTM unit growth YoY is -2.05%.
Bullish Case for Unit Growth
The number of new apartments when current construction is completed has steadily risen since 2020. Additionally, cash and equivalents have been growing along with the number of apartments that AVB has a right to develop, so I expect heightened development activity over the next few years. If AVB returns to reinvesting >$1 billion per year, I expect ~2% annual unit growth (2014/2015 levels; unit growth was 38% in 2013 because of a REIT acquisition).
Overall, I find the bullish unit growth case more compelling. However, AVB appears to be more valuable if it grows less. I outline different scenarios later in this write-up.
DCF
Daniel B. Wilson
S&P Capital IQ
Revenue Growth: 6% (4% inflation, 2% unit growth) for years 1-5. I also assume that revenue growth declines to the risk-free rate (a proxy for the economy's growth rate) during years 5-10.
EBIT Margins: Street consensus EBIT margin estimates for years 1 and 2. Then, EBIT margins move linearly to 37% (pre-COVID levels), which assumes that operating expenses decline to pre-COVID levels.
Gain on Asset Sale: I expect AVB's gain on asset sales to be 12.5% of revenue while AVB is growing units at 2% (similar to 2013-2016). Then, I expect gain on asset sales to move toward 25% (of revenue) linearly over five years as growth and reinvestment slows (similar to 2021/2022).
WACC: Cost of debt of 5.97% (A rating for REITs), implied equity risk premium of 4.9% (Aswath Damodaran), bottom-up beta, market value of debt.
Market Value of Debt Inputs: ~$8.2 billion in total debt, weighted average debt maturity of 7.71 years, interest expense of $223 million, pre-tax cost of debt of 5.97%.
Sales/(Invested Capital): Historical average of 0.14. This is in line with the industry (0.15). In other words, AVB must reinvest $1 to generate 14 cents of revenue.
Reinvestment: (Increase in revenue)/(Sales/(Invested Capital)).
Terminal ROIC: I used AVB's ROIC in year 10 to keep things simple, which assumes ~0.7% excess returns.
S&P Capital IQ
Scenario Analysis
Daniel B. Wilson
Using my assumptions, AVB is more valuable when growth and reinvestment are lower. I believe that management can maximize AVB's value if they run AvalonBay like Apartment Income REIT Corp. ( AIRC ), which would entail 0 or negative reinvestment. However, this scenario looks unlikely because AVB's gain on asset sales has historically been far below AIRC (10-25%, rather than 50% of revenue), so management would have to sell significantly more real estate every year.
Q3 Earnings
Investors should look out for the following:
- Increased real estate sales and higher gains on asset sales. AVB is more valuable if disposition activity increases.
- Rising apartment deliveries. Management can sell more real estate if AVB owns more completed real estate. However, growth without elevated asset sales has the potential to destroy value.
- AVB gaining the rights to develop more units. The explanation is similar to number two because if AVB has the right to develop more units, future apartment deliveries will likely be higher.
However, I believe that Q3 earnings will be mostly noise. Investors seem distracted by temporarily elevated rent and FFO growth (from the COVID recovery). Given AVB's intrinsic value in the scenarios I laid out, I believe AVB is overvalued if AVB beats or misses analyst estimates.
Conclusion
AVB stock currently looks expensive in the scenarios I laid out. Given how competitive multifamily is, I expect excess returns to be close to 0, implying a share price of $106.55 if AvalonBay grows quickly (6% growth case) or $128.22 if AvalonBay grows at the rate of inflation.
Over long holding periods, annual returns should be near 8.3% (AvalonBay's cost of equity). However, I expect underperformance at current levels.
For further details see:
AvalonBay: No Longer A Growth Story