2023-11-05 07:00:00 ET
Summary
- Inflation, economic growth, and elevated rates are challenging the current economic environment.
- Morgan Stanley and Goldman Sachs predict volatile trading and recommend dividends as a potential area of investment.
- Mid-America Apartment Communities is highlighted as a strong REIT option with a track record of returns, a well-diversified portfolio, and a healthy balance sheet.
This article was coproduced with Leo Nelissen.
I’m starting this article the same way I start many others.
We truly live in challenging times.
Inflation is sticky, economic growth is weakening, and instead of helping to support economic growth, the Fed is forced to maintain elevated rates to fight inflation.
Even though the Fed may be done hiking rates (which is what I believe), we’re unlikely to return to a low-rate environment anytime soon – unless the Fed is forced to cut rapidly, which isn’t bullish.
“Both Fed Chair Jerome Powell and the FOMC policy statement sounded dovish overall, in our view. Considering the hawkish ways officials could have interpreted the positive economic surprises since the September meeting, this all suggests the FOMC is inclined to go on an extended rate pause.” – Bloomberg .
In a scenario where inflation is likely to remain elevated on a prolonged basis, we need good stocks that come with both income and safety.
As reported by Seeking Alpha, Morgan Stanley predicts that Wall Street will see volatile trading over the next six months and highlighted dividends as a potential area of investment during such unsettled times.
"The bottom line is that the more investors realize that rates might stay higher for longer, the tougher it becomes to sustain lofty multiples for equities," Morgan Stanley stated. "We expect markets to remain volatile and range-bound as earnings and valuations battle for dominance over the next six months." – Via Seeking Alpha.
Goldman Sachs seems to agree, as it projects that we’re in the slowdown stage of the economic cycle.
At this stage of the cycle, the bank wants investors to own companies with healthy balance sheets and the ability/commitment to return cash to shareholders. They prefer this over companies that invest in growth. After all, it believes that the returns on growth investments may be lower than usual in the next few quarters.
Well, that brings us to REITs!
However, we need to be careful with REITs. After all, elevated rates could erode the pricing power of some players and hurt the financial health of companies with poor balance sheets.
Also, in general, the “average” REIT doesn’t have a great risk/reward, which is why we are about finding the best of the best.
Looking at the chat below, we see that since 2004, the FTSE Nareit All Equity REIT index has returned roughly 10% per year, which is a great result! However, the S&P 500 has returned a bit more with significantly less volatility!
As most readers may know, when it comes to long-term investing, I prefer a profile of outperforming returns with subdued volatility.
The good news is that we don’t have to leave the REIT space to find stocks with a good risk/reward.
Mid-America Apartment Communities ( MAA ) is one of these stocks. It’s not just a good REIT.
No, I believe that MAA is one of the best REITs money can buy.
- Since 2005, MAA has returned 10.2% per year. This includes the Great Financial Crisis.
- The Vanguard Real Estate ETF ( VNQ ) has returned 5.8% per year during this period.
- The S&P 500 has returned 8.8% since 2005.
- Even better, MAA has done it with a standard deviation of 22.8%. That’s roughly in line with the VNQ standard deviation.
In other words, MAA has the same standard deviation as the well-diversified VNQ ETF – and a better total return!
Even better, MAA has consistently outperformed VNQ. As we can see below, MAA has returned 9.7%, 7.2%, and 3.5% on a 10-year, 5-year, and 3-year CAGR basis, respectively.
Although MAA has failed to outperform the S&P 500 over the past five years, I expect that to change in the future. I will elaborate on that in the valuation part of this article.
Having said that, the company’s favorable total return picture didn’t just happen by accident. It’s the result of decades of prudent management, resulting in a corporation that owns some of the best residential real estate in America, allowing investors to benefit from potential capital gains and steadily rising income without the risks of a risky balance sheet.
Resilience In Tough Times
The toxic mix of elevated rates, sticky inflation, and high property prices is doing a number on deals. Commercial real estate investment volume this year is at levels not seen since the Great Financial Crisis years, excluding the pandemic.
One of the hardest-hit sectors is multifamily real estate, which accounts for 35% of the market.
This segment saw 62% lower investment volumes to $29 billion.
While we’re far from a Great Financial Crisis-like situation, turmoil is spreading to some of the stronger sectors. For example, the funding gap has spread to multifamily real estate.
CBRE's analysis, conducted in June of this year, centered on loans originating from 2018 to 2020, exposing a funding gap of $72.7 billion in the office sector for loans maturing through 2025. In just four months, by October, this gap soared to $82.9 billion.
What's even more concerning is that CBRE has now identified a funding gap in the multifamily sector, totaling $21.7 billion.
When loans issued in 2021, a significant year for multifamily debt issuance, are factored in, the funding gap more than doubles to $44.54 billion for multifamily loans maturing in 2026.
The office sector's funding gap balloons to $112.8 billion.
CBRE's prediction is clear: the volume of maturing loans, combined with rising cap rates, indicates distress looming for both office and multifamily properties.
While this is obviously bad news, it comes with opportunities.
- Strong players with healthy balance sheets can buy cheaper real estate down the road.
- The market has priced in a LOT of weakness. MAA shares are roughly down 50% from the 2021 highs.
With that in mind, let’s take a closer look at MAA.
Mid-America Apartments is an S&P 500 member. The company has built a portfolio of more than 100 thousand apartments in its 29 years as a public company.
Its assets are located in some of the hottest markets, including Georgia, Texas, Florida, the Carolinas, and Tennessee. It has no assets in California , which is a market a lot of readers want to avoid.
It’s also one of the few companies with a credit rating in the A range. In this case, the company has an A-/A3 rating.
Not only is MAA operating in attractive markets, benefitting from net migration and economic re-shoring, but it also has financially healthy tenants.
The average rent-to-income ratio in the U.S. is roughly 30-35%. Mid-America Apartments’ tenants have a ratio of 22%, which tremendously lowers occupancy risks.
The median resident age is 45 and 80% of its residents are single, with occupations in healthcare, tech, and finance.
Having said that, the company is currently trading more than 40% below its all-time high – despite all the good news I just brought up.
This has to do with a general distrust toward REITs in the market and supply risks in multifamily housing.
During its recent 3Q23 earnings call, the company mentioned that the high volume of new supply deliveries in various markets is impacting rent growth for new residents, which is expected to continue for a few quarters.
However, there is optimism that new supply deliveries are likely to decrease significantly by late 2024 and into 2025, potentially alleviating supply pressure.
Having said that, despite supply challenges, the new properties in the company’s initial lease-up have outperformed expectations, generating higher NOIs and earnings.
These properties have achieved rents 15% above original expectations, leading to a projected average stabilized NOI yield of 6.7%.
Thanks to these developments, MAA reported same-store revenue growth in line with expectations, driven by higher occupancy.
- The average physical occupancy was 95.7%, leading to revenue growth of 4.1%.
- Various demand metrics, including job growth and migration trends, remained strong.
Moreover, resident turnover decreased by 4%, collections were strong, and the new resident rent-to-income ratio remained stable. Lead volume was consistent with pre-pandemic levels.
As a result, the company reported a core FFO (funds from operations) of $2.29 per share for the quarter, exceeding expectations.
It also maintains a stellar balance sheet, as its A-/A3 rating already may have suggested. The company has 100% fixed-rate debt, an average weighted interest rate of just 3.4%, and a well-balanced maturity schedule, as seen in the overview below.
It also has a net leverage ratio of less than 3.5x, which is well below the sector average of 4.7x.
It also has a stellar dividend history, including stable payouts during the Great Financial Crisis, allowing the company to generate the elevated total returns we discussed in the first part of this article.
The numbers in the slide below confirm this as well.
Currently, MAA yields 4.6%. The five-year dividend CAGR is 8.7%. On December 31, 2022, the company hiked by 12%.
This dividend is protected by a 68% 2023E core adjusted FFO payout ratio , which is based on the company’s guidance, which brings me to the valuation.
MAA Offers Deep Value
I started this article with some bad news.
Commercial real estate is not in a good space.
However, MAA is doing very well, which translated into strong guidance.
The core FFO projection for the full year was maintained at $9.14 per share, reflecting a 7.5% growth rate over the prior year.
This growth is based on favorable aspects related to overhead and interest costs, but it is expected to be offset by higher-than-projected same-store operating expenses for the rest of the year.
As we can see in the table above, the midpoint of the total revenue growth projection for the year remains unchanged despite the impact of pricing moderation.
This moderation is offset by an increase in projected average occupancy for the year, indicating a balanced financial outlook.
The guidance for same-store operating expense growth for the full year has been increased by 45 basis points to 6.5% at the midpoint.
This change was primarily attributed to the ongoing pressure in labor costs, partially driven by building higher occupancy.
Nonetheless, it did not impact core AFFO, which shows that MAA is protecting shareholders against inflation, at least for the time being.
With all of this in mind, let’s take a look at the chart below, which includes some terrific information we can use to establish the risk/reward – in addition to everything we have discussed so far.
- MAA is expected to completely ignore real estate woes. This year, core AFFO is expected to grow by 8% , according to analysts.
- Next year, AFFO is expected to grow by 2%, followed by 8% in 2025E. These numbers are obviously subject to many variables, but they show the company’s growth potential.
- MAA is trading at 14.8x AFFO , which is below the long-term normalized multiple of 18.6x.
- A return to that multiple with the expected AFFO growth rates paves the way for a 21% annual return through 2025. Theoretically speaking, that is.
While I cannot make the case that MAA will rally this high, I really like the risk/reward and have been buying real estate stocks at these levels.
Depending on my plans and cash flow, I may buy MAA as well.
If you’re in the market for conservative and consistent dividend growth with the opportunity to beat the market with a highly favorable volatility profile, MAA may be right for you!
Takeaway
In today's challenging economic landscape, characterized by stubborn inflation and the Fed's efforts to combat it, finding investment opportunities that offer both income and safety is crucial.
Mid-America Apartment Communities stands out as a compelling choice.
With a strong track record of returns, a well-diversified portfolio, and a healthy balance sheet, MAA offers resilience during tough times.
The company operates in promising markets, benefits from financially secure tenants, and maintains a stellar dividend history.
While commercial real estate faces headwinds, MAA's financial outlook remains positive, with projected growth and a favorable valuation. The stock is trading at an attractive multiple and has the potential for significant returns in the coming years.
I recently interviewed Mid-America's CEO, Eric Bolton, and he explained that "we've seen this movie play before...we're optimistic about the demand-side of the business...net migration is very favorable...the balance sheet is incredibly strong...and we're seeing more distressed with developers, as the environment is coming our way ."
Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
For further details see:
Mid-America Apartment Communities: A Sunbelt SWAN