Summary
- AvalonBay had strong growth in revenue and earnings in recent quarters, continuing a steep growth trend started in 2012.
- The company has healthy growth statistics and expects almost 20% growth in net operating income in a few years.
- Its weakness ahead lies in its economic outlook and its impact on the labor market in the cities.
Investment Thesis
AvalonBay (AVB) has had a strong performance in recent years, with recovery underway from the dip during the pandemic. However, we see the path to sustain its current growth trajectory to be difficult and perhaps unlikely. And the recent jump in the price has placed it at the top end of our valuation range.
Company Overview
AvalonBay Communities, Inc., as described in its 10-k , "is a Maryland corporation that has elected to be treated as a real estate investment trust (“REIT”) for federal income tax purposes. The company develops, redevelops, acquires, owns, and operates multifamily apartment communities in New England, the New York/New Jersey metro area, the Mid-Atlantic, the PacificNorthwest, Northern, and Southern California, as well as in expansion markets of Raleigh-Durham and Charlotte, North Carolina, Southeast Florida, Dallas, and Austin, Texas, and Denver, Colorado." As of January 31, 2022, the company owned or held a direct or indirect ownership interest in 97,321 apartments, including operating apartments, wholly-owned apartments, and for-sale residential condominiums across 12 states plus the District of Columbia.
Strength
Location is the key for AvalonBay. The company focuses on leading metropolitan areas that have historically been characterized by growing employment in high-wage sectors of the economy, higher cost of home ownership, and a diverse and vibrant quality of life. From what it describes, most of the areas it builds the communities in are close to transportation, recreation centers, entertainment, shopping, and dining.
AvalonBay Number of Same Store Apts by Location (Calculated and Charted by Waterside Insight with data from the company)
The location brings growth to the company. By being associated with the higher-wage, higher-growth area, it directly benefited from years of the economic boom in the metropolitan areas and also has a certain cushion going into an economic downturn as the labor demand continues to be strong in these areas, and unemployment rates are still low.
There has been substantial revenue growth since 2012 for AvalonBay and a strong recovery since the dip in the pandemic.
Its AFFO has been stable and continued growing on a TTM basis in the most recent quarter.
AvalonBay Revenue vs AFFO (Calculated and Charted by Waterside Insight with data from the company)
The company's latest rental revenue growth reported in Q3 last year was 11% YoY, and the net operating income growth reached 13.4%. Most of its stats point to healthy growth, especially with "bad debt" and "rent relief" trending significantly lower compared to a year ago in its revenue.
AvalonBay Overall Growth Stats (Company Q3 Presentation)
Look ahead; the company's funding needs for development underway are mostly matched. It has a $1.75 billion revolving variable rate unsecured credit facility that it can borrow under.
AvalonBay Funding Needs (Company Q3 Presentation)
According to the company's own internal projection, these future developments could deliver over $130 million of net operating income additionally in the next few years. Based on its annual operating income of $626 million in 2021, that is about a 20% increase in total.
AvalonBay Future NOI (Company Q3 Presentation)
Taking a look at AvalonBay's dividend payment history shows that it has almost continuously raised dividend payments in the past ten years, although the growth ratio has slowed down due to the base effect. Last year, it paused the dividend growth. Its current dividend yield is at 3.5%.
AvalonBay Dividend Growth (Calculated and Charted by Waterside Insight with data from the company)
Overall, the company is in a healthy financial condition and in a growth trajectory.
Weakness/Risks
AvalonBay currently has one of its highest levels of total liabilities at $8.08 billion as of Q3 of 2022. Almost 87.9% of the total debt is in fixed rates, and the rest is in variable rates. The majority of it comes from unsecured notes, while the rest is from term loans, mortgage notes payable, lease liabilities, etc.
AvalonBay Total Liabilities Breakdown (Calculated and Charted by Waterside Insight with data from the company)
The company's history suggests that it is manageable for Avalon to make decent earnings still with this level of debt exposure, although perhaps there will be a dialing-back from the current level by about 10% in its earnings.
AvalonBay Debt vs EBITDA (Calculated and Charted by Waterside Insight with data from the company)
Looking at its consolidated debt maturities, the company's balance outstanding in Q3 2022 was lower by 1.5% YoY, but was at a similar level to that seen in 2017.
AvalonBay Debt Payment Schedule (AVB 2022 10K)
However, comparing its debt payment schedule from the past five years with the next five years, it obviously has a higher burden ahead. This year will be at a similar level to the past three years, and 2024's payment will likely be halved, but the years after will see a steep jump.
AvalonBay Past 5 vs Next 5 years Debt Payment Schedule (Charted by Waterside Insight with data from the company)
And if we look at the macro picture, historically, the owner's equivalent rent cannot stay at this elevated level given where the Fed Funds Rates are. If the rent levels regress back to their logarithmic trendline when the Fed reaches its terminal rate, assuming 5%, it would be about 30% less than its level currently. Or it falls back to lower rent and a low Fed Funds rate to be back to the trendline, which is still about a 10% decline. But that scenario will require the Fed to quickly call it quits and cut rates in a large fashion. We don't think that is likely to happen in a short period of time. Granted, it is hard to foresee rent would decline that much in major metropolitan areas, as the price stickiness in rent is very high. During its almost 40 years of history, the owner's equivalent rent rarely had any large-scale decrease. But a pause or even mild decline is likely, given the restrictive monetary policy that is aiming at creating demand destruction in the labor market in order to lower the inflation rates. That will undoubtedly be a negative impact on AvalonBay's revenue and income.
US City Rent vs Fed Funds Rate (Calculated and Charted by Waterside Insight with data from FRED)
Financial Overview
AvalonBay Financial Overview (Calculated and Charted by Waterside Insight with data from the company)
Valuation
We take into account all the analysis above and use our proprietary models to assess AvalonBay's fair valuation with a ten-year projection forward. In our bullish case, AvalonBay doesn't have any negative earnings growth or cash flow growth in the next ten years, which gives it a $159.85 valuation. In our bearish case, the company sees a negative cash flow growth in 2023 and 2024, but recovers well with some double-digit growth that leads it to almost double its cash flow in ten years' time; it is valued at $113.05. After all, it had almost four years of negative cash flow after the 2008 recession. In our base case, the company also has negative cash flow growth in '23 and '24 but bounces back strongly afterward; it is valued at $132.08. The current market price, especially after the latest jump, is higher than our base case but lower than the bullish case.
AvalonBay Fair Valuation (Calculated and Charted by Waterside Insight with data from the company)
Conclusion
AvalonBay has prime locations, a strong balance sheet, and sufficient funding on its side going into a possible economic recession. It appears investors are right to be optimistic, given its past performance. However, to sustain its current trajectory of growth will mean a pivot from the Fed or a quick and large retreat of inflation rates; neither is highly probable. We caution the current price could be approaching the top end of the valuation with a weak macro backdrop ahead, and recommend a hold at this level.
For further details see:
AvalonBay: When Strong Balance Sheets Collide With Weak Macro