2023-09-25 17:48:02 ET
Summary
- Mid-America Apartment shares have underperformed due to concerns about rental inflation and rising interest rates.
- Their strong occupancy levels and ability to support dividend growth make it attractive for income-oriented investors.
- The company is well-positioned to manage through the supply wave in the apartment rental segment and generate better-than-average rent performance.
Shares of Mid-America Apartment ( MAA ) have been a poor performer over the past year, alongside many interest-rate sensitive stocks. Since recommending shares last October due to its potential for long-term dividend growth, Mid-America has fallen by about 14%. In fact, the company did raise its dividend by 12% to $1.40 this year but concerns about rental inflation and interest rates (which have risen more than I expected) have overwhelmed the dividend growth. While the apartment rental segment faces near-term headwinds, MAA is well positioned for them. With the ability to support ~10% dividend growth on top of its 4% yield, I still see shares as attractive for income-oriented investors.
In the company’s second quarter , Mid-America earned $2.28 in adjusted funds from operations (FFO), up 13% from last year thanks to ongoing rent growth and solid occupancy. Fortunately, in the company’s September update , trends continue to be strong. Occupancy is at 95.7% in August. While new units are leasing with about a 1.5% pricing concession, renewal activity is solid. During market booms, renewal increases tend to lag rates for new tenants as landlords want to maintain occupancy, rather than face the cost of finding a new tenant. This lag can create buffers whereby renewal rates continue to rise in a slowing market, and indeed renewal price increases are still a fairly robust 6.6%.
Due to this, management expects 6.25% revenue growth this year and 6.05% expense increases. Thanks to faster top-line growth, there will be a strong 6.35% increase in net operating income. This should translate to about $9.15 FFO, up 7.25% from last year. Notably, this provides 163% coverage of its dividend, providing ample coverage. This is consistent with the conservative approach management takes to the business, which is especially helpful to riding out downturns resiliently.
While there are concerns of overbuilding, which I will address below, MAA is not really contributing to this. It is planning to do just $100 million in net acquisitions and $250 million in development spending. While it has $3.3 billion in projects it is targeting, it is executing on this judiciously. Critically, projects in development are expected to have a 7.2% yield based on leasing activity thus far. MAA also maintains a strong balance with debt to total assets of 27.5%. Consider when you buy a property as an individual, you typically borrow 80% of the property value (putting “20% down”). MAA does nearly the opposite, using equity to fund 73% of its assets. Indeed, its excess FFO coverage of its dividend provides retained cash with which to develop properties rather than borrow.
MAA also borrows prudently to minimize exposure to interest rates. 100% of its debt is fixed rate, and it has an average maturity of 7.5 years. While it will be rolling over some debt over the next year at higher rates, no year until 2027 represents more than 10% of its debt outstanding. This reduces its direct financial exposure to higher rates.
Fundamentally, I love the fact that Mid-America has positioned its over 100,00 units largely in fast-growth Southern markets. Its markets are seeing 3x faster population growth thanks to strong internal migration (i.e. from New York to Florida). No market makes up more than 13% of its operating income, providing it diversification from market-specific risks, like over-supply or a localized economic downturn. Over the long-term, faster population growth creates more demand for housing and should be supportive of faster than national rent growth.
Indeed, we are seeing this. According to ApartmentList, rents have now turned negative on a year-over-year basis. Still, year to date, rents are up 2.5%--Mid-America is outperforming this by 70bp at 3.2%. As noted above, MAA is benefitting from maintaining strong occupancy levels where it can push on some further rent increases. Now to be clear, we are not likely to see a return to 2021-2022 rent growth in the double-digits, but MAA is positioned to generate better-than-average rent performance.
A major reason we are seeing rents slowdown is the significant new supply hitting the market, which has likely caused some gluts and weighed on rents. As rents kept rising, developers sought to capitalize on this trend by building more apartment units. As you can see below, we have a record number of multifamily units (which are primarily rented out, rather than sold) under construction. As they get completed and rented out, it makes sense that they would cause some disinflation. This is the nature of supply & demand.
However, I see MAA as particularly well positioned to manage through this supply wave. According to management, new supply is generally asking for rents that are 21% higher than MAA’s existing rent, targeting a higher-end consumer. As such, these properties are not directly competing with MAA’s portfolio, so while there is likely some impact, it is muted. Note that Mid-America has an average rent per unit of $1,673. For perspective, the median national rent is $2,052. Of course, MAA operates in lower-priced Southern markets vs New York or San Francisco, but its customer is more “young professional” than “ultra-luxury.” As you can see below, MAA units rent for less across all of its markets vs new supply, and even in Tampa where 78% of units face exposure from supply, it is not seeing pricing trends that diverge from its total portfolio, validating the thesis they are not directly competing.
Additionally, I would note while we are seeing significant supply hitting the market as these units under construction are completed. This level of supply will not last forever. Just as surging rents incentivized development, slowing rents (combined with higher financing costs) disincentivizes new construction. Sure enough, last month new starts on multifamily properties came in 40% below their peak according to the Census Bureau . While this is a volatile series, we are likely nearing the worst of the supply pressures—that is generally a good time to be investing.
I also would recommend investors take a step back. The reason we have seen the surge in supply is because of the demand for shelter, which pushed up prices, both rent and home prices. This is because of how little construction activity there was last decade. Over the past 20 years, even with the recent jump in multifamily construction, we have created 4 million more households than housing units.
my own calculation, Census Bureau
The US housing market is structurally running at a supply deficit, which means over time that landlords have more pricing power than renters. While significant construction activity can cause downshifts in rents, this is more likely to be transitory than permanent, given the larger supply/demand balance. Combine that with MAA operating in in-demand markets, and I would expect its rent inflation to, on average, run faster than the pace of overall inflation.
Lastly, I would note that nominal per-capita disposable incomes are continuing to rise, up over 6% from last year thanks to strong employment and nominal wage growth trends. Higher incomes support higher rents, all else equal.
Of course, every investment has its risks. There are several I see. In the near term, a recession would lower income growth and likely lead to slower rent growth, though economists have been lowering their recession probabilities. I also am expecting the lower rate of new-unit construction starts to continue, which will reduce the supply headwind in coming months. If construction activity picks back up, we may see rent growth underperform my forecast. Lastly, if interest rise substantially more, the discount rate on future cash flows increases and may lead to cheaper multiples across the sector--similar to what has played out the past year. In this case, even if MAA raises its dividend and meets my forecast results, shares may not appreciate as much as I anticipate.
In the long-term, I view MAA's geographic concentration in the South as attractive given long-standing migratory trends. Should this reverse, that would be a headwind for the business. Given these patterns have been consistent and shown little evidence of reversing, I view this as a low probability.
With its geographic mix, conservative payout, and price point, MAA is positioned well for a period of pressure from higher rates and new supply. With construction already slowing, some of these pressures should actually begin to slow over the next year. I would look for MAA to generate low (2-5%) single-digit rent growth and unit growth next year, which will translate to $9.75-$10 in FFO. Shares offer a 7.5% FFO yield, which I view as attractive given my view rent growth should exceed inflation over time (i.e. 2.5%+).
MAA is trading at discount to other apartment REITs. Below you can see my expectation for MAA compared to four large apartment REITs, and the consensus FFO according to their Seeking Alpha ticker pages. MAA trades at a discount to the group. This is partly due to the fact that AvalonBay ( AVB ) and Equity Residential ( EQR ) in particular have more New York/San Francisco urban exposure, saw worse rent performance in 2020-2021, and now face less headwind from in the near-term new supply in growth markets in the South.
However, in the long term, I prefer MAA's geographic exposure--you want a real estate portfolio where people are moving to, not moving from. Additionally, as discussed, MAA's lower price point relative to supply means the impact over the next 12 months is likely to be less than feared in my view. If MAA's multiple can approach the sector median of 15x, they would be $145-150 in a year's time. I believe this is a conservative target, given its growth profile and am targeting an above-median multiple as these concerns fade.
Particularly with its 1.63x coverage ratio, we should be able to see dividend growth that matches or slightly exceeds FFO growth for the next few years, and I would look for an 8-11% dividend increase to be paid out in January. At a 4.3% yield with ~10% growth potential, I view MAA as a good choice for income growth investors. I would use this decline to buy shares. As we see supply pressures slow, I believe shares can conservatively recover back above $150-$155, or to about a 4% yield on my expected 2024 dividend, providing a ~20% total return potential.
For further details see:
Mid-America Apartment Can Withstand Rental Market Slowing