2023-04-28 12:19:27 ET
Summary
- Names in the multi-family residential space are down considerably and represent a potential buy opportunity here for investors willing to look past economic cycle problems.
- I explain why I consider Mid-America Apartment Communities my top pick.
- Reasonable dividend yield, good growth prospects, decent base valuation. All the ingredients to produce long-term double-digit returns are there.
- Trading around $150, I rate shares a buy with 12.5%- 15% total return potential.
Apartment REITs prices have fallen sharply in recent months, with investors spooked by the fears of a recession. While not particularly cheap, relative valuations in the space seem reasonable, and I find several names buyable here. These include dividend aristocrat Essex Property Trust ( ESS ), S&P A-rated Equity Residential ( EQR ), Camden Property Trust ( CPT ), and AvalonBay Communities ( AVB ). Shares trade closely to pandemic lows and have underperformed the broader market. While I think these names will fare well going forward, I have chosen to invest in the only apartment REIT still outperforming the S&P500 index over the last five years: Mid-America Apartment Communities ( MAA ).
Choosing MAA over peers
Past performance is not indicative of future returns, but it seems this REIT has proven investors to have an edge over its peers. According to management, the critical element to MAA's success is its unique sunbelt and Texas focus. The primary markets in which MAA operates have shown lower construction activity, higher population, and job growth over the past few years. Even if several of MAA's markets should see higher home deliveries over the next few quarters, management expects absorption to remain positive.
MAA presentation, March 2023
I do not expect MAA's advantages to reverse over the next few quarters, also because I like that the REIT's rent prices are still comparatively more affordable than peers. Last month, MAA reported a rent/income ratio in its key markets at 22.5% on an average rent of $1,940. Meanwhile, ESS had a 23.2% ratio based on an average rent figure of $2,567. While I could not find a percentage for Avalon Bay, their reported average rent was $3,440.
MAA recently reported impressive Q1 2023 results, beating estimates on both revenue and FFO. In the call , management once again stressed affordability as a differentiator and specifically answered an analyst's question related to this point.
Q: Eric and Tim both mentioned in your prepared remarks that the more affordable price point is one of the reasons why you have such strong demand. And I'm wondering if there's any notable difference between your A and B product as far as demand or performance?
A: Yeah, John, this is Tim. I mean we are seeing a little bit of a diversion not significant I would say in Q1, or what you might call our more B assets were about 70 basis points or so higher on blended pricing versus the more A and some things -- part of it is some of the price point. And certainly to the extent we've seen some supply pressure more of it is coming in typically in the more urban or A style types of assets.
Regardless of the price point, the multi-family residential space seems likely to continue a secular growth trend enjoyable by all players. With young professionals preferring urban solutions compared to costly single-family, suburban properties, apartments should continue to see high demand for the foreseeable future.
Q1 2023 update
MAA reported a solid start to the year, with Core FFO and Core AFFO increasing almost 16% from $1.97 to $2.28 and from $1.95 to $2.14, respectively. As a result, MAA increased its FY23 outlook, revising its guidance's low-end. The additional $0.03 increased the midpoint forward FFO from $9.08 to $9.11 and forward AFFO from $8.16 to $8.19. Daily occupancy for the company portfolio remained steady at 95.5% with no collection issues.
To fully understand the strength of these numbers, however, I'd highlight that MAA Same-store revenues increased 11.0% year-on-year. This increase is a better result than the +9.2% reported by EQR and +9.4% by AVB. The revenue increase also translated into higher same-store NOI growth of +12.5%, again better than the +10.2% reported by Equity Residential and +10.7% by AvalonBay.
The dividend
The dividend is a decisive piece of decision-making when investing in a REIT. Mid-America Apartment Communities has a strong track record. Since going public in 1994, the company has never suspended or reduced its payments, breezing through the Dot-Com burst and, more importantly, the Great Recession.
Since 2011, the company has steadily increased payments, and the 3-year and 5-year dividend CAGR stands at 10.58% and 8.13%, respectively. The results are impressive and, on average, double those of peers. Even more importantly, together with CPT, it is the only company in the peer group showing an acceleration (3Y CAGR > 5Y CAGR). The values should be enticing to prospective DGI investors.
Is MAA paying out too much? Not at all. MAA payout ratio based on FWD FFO is approximately 61% (61.2% vs. the consensus estimate of $9.15 and 61.5% vs. management midpoint guidance of $9.11). The difference between the two is minimal, so I used consensus estimates for consistency when checking against the peer group. MAA payout was slightly below the average of 63.7%.
All apartment REITs analyzed had a payout ratio in the 57%-65% zone. However, MAA's dividend yield is below the average as UDR, EQR, and ESS yield more than 4%. I argue that investors should not look at the present return in a vacuum and be fooled by only choosing based on the highest current dividend but weighing it against its growth prospects. MAA's total return potential from here could be easily in the 11.8% - 14.3% range when factoring yield + the dividend CAGR rates discussed. Using the same methodology, results for MAA are far ahead of the peer group.
Even if the current yield is below peers, the number favorably compares to MAA's 4-year average of 2.8%, indicating a potential undervaluation of almost 25%.
Valuation
MAA's valuation currently stands at approximately 18x EV/EBITDA. While the value is well-aligned with peers and does not appear stretched, it does not seem that investors are catching a particular bargain either:
Main Street analysts covering the stock have a consensus estimate for MAA at $176, implying a moderate 16% 12-month upside . At the same time, they see a 16% upside to $246 for ESS and a 10% upside for EQR. The presented upside seems compatible with the above data. It is, hence, challenging to understand why an investor service such as Morningstar currently views multiple apartment REITs as "five-star" opportunities and assigns lofty price targets. However, Morningstar's targets are underpinned by NAV valuations using cap rates in the 4.5% - 5.0% range. Even if these cap rates could be optimistic under present market conditions, the assumption does not seem unrealistic either. The following excerpts are from the Q1 Q&A session of MAA earnings (sentences have been rearranged by the author for clarity but not edited in their content):
Q: You guys talked about in your prepared remarks that cap rates are still going strong for good quality product. Could you remind us where they are tracking at the moment?
A: We continue to see cap rates call it in the 4.7, 4.75 range for assets that fit that description well located strong markets.
Q: Where would cap rates need to be for you to be comfortable buying and getting in the market?
A: I would say for us cap rates definitely need to be over 5, 5.25, 5.5 something in that range.
So, during the call, MAA management confirmed that the rates used by the Morningstar analyst are historically a bit on the rich side but in-line with the current market conditions.
For FY23, MAA expects NOI growth of 6.3% (midpoint). For 2022, total NOI amounted to $1.3 billion, so management expects forward NOI in the ballpark of $1,38 billion. My conservative assumption for an intrinsic value estimate used a 5.25% cap rate. After adjusting for new developments and cash, I derived GAV at $26.8 billion. After subtracting debt, I estimate MAA's NAV as follows.
Bear Case (control) | Base Case (author) | Bull case (Morningstar) |
$127 (16% downside) | $184 (22% upside) | $210 (40% upside) |
Implied cap rate: 7.00% | Implied cap rate: 5.25% | Implied cap rate: 4.75% |
Risks
The multi-family real estate market has benefited during the past decades from trends like falling homeownership rates and rising costs for single-family housing. I also previously mentioned young professionals' taste preference for urban, gentrified centers. While this secular trend has acted as a powerful tailwind, there is no way to be sure it will continue forever. Even worse, any reversal could impact apartment REITs quickly since leases are relatively short-term in nature (12 months).
Demand for housing in any US market is sensitive to the local economy's health. For example, if the O&G industry experiences a significant downturn, the Texas markets in which MAA operates (Dallas, Austin, Houston) would likely suffer a disproportionate slump compared to, West-Coast-focused Essex Property Trust. While I am not implying this is about to happen, it is still an important consideration to keep in mind when choosing to invest in MAA over ESS.
More generally, during an economic downturn, job growth halts, and layoffs happen, negatively affecting demand for apartments. Because of the uncertainty ahead, I believe an investment in MAA at this time should be viewed as a buy & hold commitment based on the company's long-term attractive double-digit total return potential.
Investors' takeaway
Despite impressive year-on-year results aided by the high inflation rate, multi-family residential REITs valuations have decreased considerably in recent months on recession fears. While MAA's rent-to-income ratio remains OK at approximately 22%, Mr. Market seems concerned that a sluggish labor market could throw the supply-demand relationship out of balance and whack the REIT's FFO and growth. The concerns seem warranted to some extent but are transient in nature, and secular trends remain favorable to the apartment REIT business model.
I believe initiating a buy & hold position in MAA today has the potential to earn investors a more than satisfying annualized return of close to 15%. The 3.7% yield coupled with 9.0% growth (+ ~2.0% upside to fair value – as per base case shown – over a ten years holding period) produces a total return in-line, ex-capital gain to the 10 and 15 years historical return by MAA. In my review, I did not find a believable rationale to expect that the company will not be able to replicate the same results over the next decade.
For further details see:
Mid-America Apartment Communities: A Fresh Look After Q1 Results