2023-10-14 07:03:56 ET
Summary
- AvalonBay's stock performance has been flat due to concerns about the rental market and interest rates.
- The company is gradually increasing its exposure to higher growth markets in the Sun Belt region, and legacy markets are performing well.
- AvalonBay's financial results have been strong, with low-to-mid-single-digit rent increases and strong lease take-up of new properties.
Shares of AvalonBay(AVB) are essentially flat over the past year as a dividend hike has been offset by fears over the rental market and interest rates. Since I wrote about the stock last October , shares have fallen about 5%, as rising interest rates have hit dividend-oriented and real estate stocks. Admittedly, rates have gone higher than I (and most) expected in the Fed’s fight to snuff out excess inflation. Over the past year, real estate as a sector ( VNQ ) has fallen about 1%, so AVB’s performance has been similar to its industry. With most of the interest rate headwind likely behind us, I do continue to view AVB as a buy for dividend-oriented investors.
AvalonBay operates high-end apartments primarily in legacy markets, like New York and California. These markets have seen negative migratory trends as residents move to the Sun Belt. Avalon is gradually trying to increase exposure into these higher growth markets with an aim to generate 25% of its business there, but for now, it remains less than 10% of the company.
The Sun Belt region saw tremendous rent growth starting early in the pandemic, while cities like New York, Chicago, and San Francisco suffered as people moved. Over the medium-term, I believe that Sun Belt real estate and rent rates are likely to outperform, but the death of legacy cities may be overstated—and vary significantly by city. Importantly, because of pessimism around their future, supply has been much lower in the markets AVB primarily operates in than the Sun Belt.
As you can see below, nationwide apartment supply has surged to record levels as higher rental rates encouraged construction. With this new supply hitting the market, we have seen national rent growth slow meaningfully and actually tip negative, according to ApartmentList . Because of its geographic focus, AVB has been better insulated from this headwind. It is also important to note we are likely nearing the worst of this supply challenge, as permits for apartment complexes have fallen by about 30% from their peak.
That favorable mix is apparent in AvalonBay’s financial results. In the company’s second quarter , AvalonBay generated $2.66 in core funds from operations (FFO), which was up 9.5% from last year. Rental revenue rose 6.3% from last year and 2% sequentially. This was primarily driven by same store lease rates rising 6.4%. On a like term basis, effective rents rose 4.8%, and while they slowed in July, remain solidly positive. Rather than seeing negative rent growth, AVB is generating low-to-mid-single digit rent increases.
One apparent blemish to the quarter was that occupancy fell 2.4%. However, states like California have long eviction processes, and so only now is AVB fully clearing out its units of non-rent paying residents from the pandemic. These units can now be rented out to paying residents, providing some tailwind to results. Indeed, AvalonBay reported a 0.7% improvement in bad debt expense due to this improvement in its eviction backlog.
Given these strong results, AVB management raised its full year guidance for FFO growth to 7.9% from 5.3% as rental revenue growth will rise 6% from 5% previously. This translates to about $10.56 in FFO/share. Metro NY rental growth is set to run about 7% and California about 5% over the full year, both at the high end of prior expectations. Some of this is due to catch-up as well as the impact of localized supply hitting the market.
Below, you can see the fastest and slowest rental inflation markets, both this past year and over the past three years.
There are several important things to note. Some of the lowest inflation cities over the past year, like Miami and Orlando, are the fastest over the past three years, speaking to the supply & timing impacts. In particular for AVB, I would note that NY is actually among the fastest rent inflation cities over the past 6 months, 1 year, and 3 years. It is no longer a “COVID laggard.” The demise of New York narrative may be quite overstated.
On the other hand, San Francisco is among the worst cities over the past year and three years. It is a laggard that continues to face structural problems given migratory flows and quality of life concerns. Importantly just 4.3% of units are actually in San Francisco, most of AVB’s footprint is in the suburbs, which may actually be seeing flow from former San Francisco residents. AVB’s geographic footprint is actually performing fairly well, which is borne out in its higher guidance.
Additionally, as noted above, AVB is trying to grow and diversify its holdings. This effort, while progressing slowly, given management’s conservative bias to avoid excessive debt financing, appears well received. In its five communities with a total cost of $490m million activity leasing, it is thus far getting $3,365 in rent, $520 above projections. This will help to generate a much better than expected return on its capital investment than planned. As these leased deliveries begin to ramp up next year, it should provide a further tailwind to NOI growth.
More fundamentally, I also urge investors to remember the big picture in the face of near-term localized supply challenges. Because of how little construction occurred after the great recession, America has built 4 million fewer homes than households since 2003. This lack of housing is why shelter inflation has run higher. With permit activity now slowing again, this gap will sustain for some time. Too little housing means, in my view, over time shelter inflation will rise faster than overall inflation, a benefit to landlords like AVB.
AvalonBay is a high-quality operator generating above-average rent increases, diversifying and growing in a measured but well-received fashion. With 3-5% rent growth and 3-5% apartment unit growth, AVB should be able to generate high single-digit FFO or $11.25-$11.50 next year. That provides 1.7x coverage of its dividend, providing plenty of capacity for another mid-single digit increase next year. Shares offer a 6.25% forward FFO yield, which when combined with mid-single digit growth, creates the potential for ~10% long-term returns.
I view the biggest risk to the investment case being another large in rates, which reduces the attractiveness of dividend stocks and leads to higher discount rates, which weighs particularly hard on the real estate sector. That said, with rates already having risen so much, that risk feels largely priced in. Additionally, if we were to see CA suburbs or the NY metro area lose rental momentum, that will be a headwind, but so far, that risk is not surfacing.
AVB may not be a company that can grow the top-line 10+%, given its industry and geographic focus, but with a favorable supply dynamic, moderate growth, and solid pricing power, it has the capacity to steadily grow and provide value for shareholders. In the mid-$170s, I see the potential for ~10% long-term total returns, making it attractive at these levels for dividend oriented investors.
For further details see:
AvalonBay: Steady Growth Potential At A Reasonable Valuation