2023-05-11 15:47:46 ET
Summary
- AvalonBay is a residential REIT with exposure to legacy markets on both coasts.
- Strong YoY performance, but growth is expected to slow materially going forward.
- I present my HOLD thesis for his A- rated REIT.
There has been an ongoing discussion between investors for a while, about whether it’s better to invest in real estate located in legacy markets on both coasts or in the more popular and faster growing states in the South. For me, the decision comes down to demand and supply (see detailed analysis including sources in my article on BSR REIT ).
While it is true that people as well as jobs have moved to the Sunbelt during Covid, it is also true that new construction has largely moved as well. What this means for the markets is that currently legacy markets have some of the lowest levels of new construction ever, which will inevitably result into all-time low deliveries in the coming years. So, although demand is likely going to be lower because of the outflow of people and jobs, in the end, we are likely to end up with a balanced market when demand meets supply, and therefore I don’t expect a major downward pressure on rents or occupancies. With that said, it’s also very unlikely that the fast levels of growth that we’ve seen over the past year or two will continue going forward. I simply expect a balanced market growing at a more sustainable 2 to 3% rate per year. The end result is likely to be very similar in the South, though here the increased supply resulting from all-time high levels of construction are likely to be met by a higher growing demand from people moving in and new jobs being created. In the end, I think both markets are likely to end up with 2 to 3% annual growth in terms of FFO, yet in legacy markets, we’re now able to access the real estate at a significant discount. That’s why I prefer investing in legacy markets at this time.
AvalonBay Communities ( AVB ) is an apartment REIT with properties located primarily in legacy markets in the US. This makes it a great candidate for the investment strategy described above. The REIT has equal exposure on both coasts and focuses on New York, DC, Baltimore, LA, and San Francisco. In addition, management is also trying to increase their presence in what they call expansion regions (think Florida and Texas). As of the time of writing this article, their presence there was at 7% and management targets 10% by year-end. As you can probably tell, I’m not a huge fan of this decision, as it comes too late and management is essentially playing catch up with the trend, which rarely ends well. Notably, the REIT tends to focus on higher-end rental apartments with an average monthly rent of about $2,800, which makes it relatively crisis resistant as higher income individuals are more likely to be able to afford the rent even in a crisis.
Q1 earnings have been good. The company managed to grow their FFO per share from $2.24 in Q1 2022 to $2.54 in Q1 2023. That’s a 13% increase, though most of this growth was realized last year. This growth was mostly driven by strong same-store performance, as rental revenue increased by 9.5% and NOI by 10.7% YoY. For the full year, management guides towards an FFO of $10.10-10.50 per share (up 5% from $9.80 in 2022) and slightly above guidance issued in their Q4 2022 results.
In terms of their balance sheet, AvalonBay represents quality. They have an A- rated balance sheet, which is something only 6 other REITs have. I also like that 92% of debt has a fixed interest rate and the weighted average interest rate stands at 3.4% which is significantly well below the current fed funds rate.
Most recently the company has paid a $1.65 quarterly dividend which corresponds to a 68% payout ratio and a 3.66% dividend yield. Going forward, I expect the dividend to grow at a rate of 3-5%, similar to the rate of growth of their FFO.
Now turning to valuation, the REIT trades at 17x FFO, which isn’t cheap, but is below the 22x multiple which they have averaged since 2012. It’s also a touch below Equity Residential ( EQR ) which trades at 17.4x and operates a very similar residential portfolio (same markets, same quality). Their implied cap rate stands at 5.3% which implies a healthy spread over 10-year treasury yields of about 200 bps.
In terms of forecast, I don’t see significant multiple expansion until rates drop at least a little bit. With FFO expected to grow by around 5% per year and a sub-4% dividend yield, I think it’s reasonable to expect 9% total annual returns, but not significantly more. That’s basically a market return. That means no alpha, and that means a HOLD rating at this time. This is a strong, healthy company, but I think it’s worth it to wait for a price drop or look elsewhere for better (market beating) alternatives.
For further details see:
Likely No Alpha For AvalonBay Communities