2023-08-12 00:19:48 ET
Summary
- The REIT sector has suffered the worst performance in the stock market, with a decline of ~23% in the past year due to the sharp rise in mortgage rates.
- Multifamily REITs are performing better than office REITs due to rent growth outpacing inflation over the past decade, driven by low home affordability and family formation rates.
- Mid-America Apartment Communities is a potential discount investment opportunity, with a decline of over 30% since early 2022.
- Mid-America is likely undervalued based on immediate capitalization rates; however, it is not necessarily undervalued if capitalization rates increase.
- The REIT may rise dramatically if unit rents continue to climb as fast as they have; however, the opposite may also be true if a recession occurs.
Over the past year, the REIT sector has suffered the worst overall performance compared to other stock market sectors. Overall, the industry has declined by 23% over the past year, worse than financials and consumer discretionary, both with ~19% in losses. Over the past year, I have been vocally bearish on REITs primarily due to the valuation impact of higher interest rates and, specifically, real interest rates (or interest rates compared to inflation).
As mortgage rates rise, property investors require higher capitalization rates to earn a profit on their investments. Further, at the ultra-low sub-4 % capitalization rates from 2021, most investors would be better off purchasing bonds than properties. The exception is those properties with very high rental growth, primarily based on inflation. However, longer-term real interest rates partially account for that factor and remain near high levels and are near 2% today, over 3% higher than in 2021. Based on this, I expect the total change in capitalization rates of properties to be around 3% from the 2021 minimum levels, occurring over one to three years due to the immense lag in today's illiquid property market.
Office REITs suffer the most significant losses because their NOI outlooks fall as the fair-value capitalization rate rises. Conversely, multifamily REITs are performing much better because rent growth has outpaced inflation over several years. Due to this, it is possible that multifamily buildings, on average, see a smaller capitalization rate increase of 2% to account for abnormal expected NOI growth. Currently, average commercial property prices are down around 16% from their 2022 peak, but multifamily has remained far more robust due to high rental demand , indicating potential opportunity in that subsector.
One particularly interesting multifamily REIT is Mid-America Apartment Communities ( MAA ), an extensive residential REIT focused on apartments in the Sunbelt states. Its stock has declined by over 30% since its early 2022 peak, indicating a potential overreaction to the market sentiment change and property price declines. Of course, the resiliency of multifamily may not remain if construction and office conversion continue to rise or if home prices decline due to the lack of new buyers. While MAA may have a rebound opportunity, investors may also want to consider its notable risk factors.
Will Multifamily Retain Its Resiliency?
Rents have risen much faster than inflation over the past decade due primarily to a lack of homebuying activity amongst younger generations. However, it is not clear that rents will continue to rise compared to inflation indefinitely. Indeed, the sharp declines in savings and increases in consumer debt in recent years indicate it is likely impossible for rents to continue to rise faster than wages. The upcoming end of the student payment pause could be a bearish catalyst for multifamily landlords because loan borrowers are also more likely to be renters; however, direct consumer discretionary firms are most likely to feel immediate impacts.
Rent has risen around 50% faster than inflation over the past decade and continues to increase abnormally due to the significant unaffordability of homes. See below:
Home prices are exceptionally high today if we consider that mortgage rates are much higher. The single-family market has remained generally stable despite the massive increase in mortgage costs due to older cash buyers, with first-time buyers virtually disappearing . For now, the multifamily market is unlikely to experience significant competition with the single-family home market because most younger people are priced out of the market and have too much other debt. While homes are near a record-low affordability level, the housing market is also supported by low inventories. However, there is a significant geographical divide, with Sunbelt states seeing more stable home prices and coastal states seeing moderate home price declines. Accordingly, the rental "gap" between Sunbelt and coastal markets is closing, indicating potential migration benefits for apartments in Sunbelt states, benefiting MAA due to its Sunbelt focus.
The rental market shares many trends seen in the single-family home market. For one, high NOI growth and significant demand (as seen in vacancy rates) encourage substantial construction activity. That is implied by the sharp increase in multifamily construction contracting employees and the massive increase in the total loan amount to the multifamily property sector. See below:
Eventually, the ongoing construction boom, huge in Sunbelt states, may lead to a glut of apartment units. While the market is supported by low vacancy rates today, that is expected to change dramatically over the coming years as unit levels rise quickly. Many builders rely on continuing migration toward Sunbelt states, which is not guaranteed. That said, economic trends enormously benefit Sunbelt states as more technology and finance companies relocate. Many Sunbelt states also see significant retiree growth due to cost and tax benefits, pushing single-family home prices up and supporting rent growth in urban areas.
Overall, Mid-America Apartments benefits from generally supportive macroeconomic trends. While I do not expect rents to continue to outpace inflation in California and other high-cost areas, the closing rent gap between those areas and the Sunbelt should continue to lift Mid-America's NOI. Low home affordability and debt issues amongst younger Americans should continue to support rental market growth, particularly in higher-demand areas. Of course, high construction activity and the potential for significant conversions of office space to multifamily are major long-term threats to the market.
The US is also on-track to face population decline over the coming decade, and many of the factors supporting the rental market extend from demand trends amongst the baby boomer generation. As the current retirement boom slows over the coming years, the single-family home should slow, potentially causing a shift back toward buying and away from renting. Thus, while Mid-America's economic outlook over the coming 1-3 years is strong, I expect its NOI could eventually slow or reverse as the boom eventually creates a glut. A severe recession would almost certainly accelerate that, as today's low savings levels amongst most Americans would rapidly cause payment issues should unemployment rise. Further, a recession could erode wealth levels supporting the cash-buying boom in single-family homes, potentially indirectly lowering rent prices.
What is Mid-America Apartments Worth?
Before the rise in interest rates, multifamily apartment capitalization rates were at record lows of around 4-5% around the US in late 2021. Mid-America apartments' properties were well within that range then, and the REIT reported capitalization rates on new buyers is only around 4.9% today, having barely budged despite the sharp property price declines seen in other markets. To a large extent, capitalization rates for multifamily buildings across the US have not risen over the past year and have fallen in some Sunbelt cities. The market remains heavily supported by strong NOI growth rates in that area, driven by economic and social factors creating excess rental demand in those states.
Property investors expect those trends to continue indefinitely. While I agree that the market is robust today, I also believe significant construction activity and unaffordability will eventually force the trend to slow. Thus, I do not expect a 3%+ capitalization rate increase (as I do for most properties), but a 1-2% rise still seems likely. Accordingly, I will value MAA based upon a 5.5% to 6.5% fair-value capitalization rate, admitting that its "fair value" capitalization rate today is likely around 5% . In a worst-case recession scenario that impairs the rental shortage trend, I expect MAA's capitalization rate would eventually rise to 7.5% and higher if unemployment causes evictions; however, while possible, there is little significant evidence for that occurring today.
Mid-America's TTM operating income is $686M, while its depreciation is $552M, giving it a ~$1.238B NOI. Last year, its operating income was $538M, while its depreciation was also $538M, giving it an NOI of ~$1.076B, a substantial 15% annual growth rate. The REIT's total shares outstanding and debt have hardly risen in recent years, so the bulk of that growth comes from "same store" activity, indicating the company is benefiting immensely from the Sunbelt rental demand shortage. At its current NOI and "current" ~5% capitalization rates, Mid-America's property portfolio is likely worth around $24.75B. The REITs total other tangible assets are around $375M, bringing its estimated asset value to ~$25.13B. The REIT also has total liabilities, minority interest, and preferred equity (based on its market value ) of ~$5.28B. Thus, the REIT's net asset value, if it were to liquidate today, would likely be around $19.9B, or ~$171 per share.
The stock is currently at $145, giving it ~18% upside potential to its estimated fair value. That said, I expect capitalization rates to rise due to the massive increase in mortgage rates eventually. At a 6% capitalization rate, MAA's estimated property portfolio value falls to $20.6B. After adding other assets and removing liabilities and equity, its standard NAV estimate drops to $15.7B. That figure equates to a share price target of $134, about 7.5% below its current price.
In a worst-case recession that impairs the rental boom in Sunbelt states, pushing capitalization rates up to 7.5%, MAA's estimated property portfolio would fall to $18.4B. After adding other assets and subtracting other stakeholders, its estimated NAV would be ~$13.5B or a share price of $116. While this scenario is possible, it appears generally unlikely, given Sunbelt states' current strength of the multifamily market.
The Bottom Line
Based on the company's market capitalization, its implied property portfolio is worth ~$22.19B. Using its TTM NOI, its implied capitalization rate is currently ~5.6%. Given the current ~5% capitalization rates for MAA's property type, the REIT is technically discounted by around 18% to its NAV. That said, given the lag between capitalization rates and mortgage rates and the significant momentum in Sunbelt multifamily properties, I expect capitalization rates in the 5.5% to 6% range to become more normal by next year. As such, I believe MAA is trading at its fair value today, which is also implied by the fact that it has held the $140-$160 price range since last year.
I have a neutral outlook on MAA today, but the stock could see significant positive or negative price action based on various developments. I believe reducing long-term mortgage rates could greatly benefit MAA, removing the potential for a rise in capitalization rates. Should the company continue to experience tremendous same-store NOI growth, it would likely be undervalued today by 20-40%. Based on this possibility, I believe MAA could have some upside in the immediate future if economic conditions remain stable.
That said, I am not particularly bullish on MAA. While there is a significant acute rent shortage in most of the Sunbelt market, construction and office conversion activity could cause that to reverse. If a glut occurs, particularly with a rise in unemployment, MAA could quickly sink well below its current value as property investors brace for a surprise reversal in NOI. That scenario seems unlikely for now, but given various volatile social and economic factors today, it is certainly not impossible.
For further details see:
Mid-America Apartment Communities: Sunbelt Multifamily Properties May Not Remain So Resilient