2023-11-08 23:08:00 ET
Summary
- REITs are under pressure due to rising interest rates. However, most economists expect the Fed to start cutting rates in 2024.
- Mid-America Apartment Communities' share price has dropped almost 50% since December 2021. However, the underlying business remains strong with dividends increasing by 40% since then.
- MAA has a sustainable business model with high-quality properties, underpinned by a strong balance sheet and ample resources for opportunistic growth.
- This is a good moment to start building a long position, by locking in an attractive dividend yield of 4.7% and enjoying a rising dividend, implying an attractive yield on cost for those with a longer-term outlook.
REITs are under pressure. Historically, REITs have performed well even with high interest rates. However, after a decade of ultra-low interest rates, market reactions to change are often initially shocking. Central banks, including the Fed, are aggressively raising interest rates to combat rising inflation, which I believe is a temporary problem. This topic merits a separate article.
Higher interest rates challenge fixed income investments, as yields on risky investments now compete with those of risk-free cash deposits, increasing the spread or risk premium. When REIT yields match cash deposit rates, it's problematic. However, there's good news: interest rates have likely peaked.
The Fed has announced maintaining the federal funds rate at 5.25% to 5.5%, unchanged since July, marking a 22-year high. I predict interest rate decreases once inflation pressure eases, as high debt costs impact sectors like mortgages. This too warrants another article. According to Bankrate's Economic Indicator poll for Q3 2023, 94% of economists expect the Fed to start cutting rates in 2024, with only 6% foreseeing cuts in 2025 or later. No experts predict rate cuts this year.
Theoretically, if REITs are down due to increased rates, they should rise when rates decrease. In turbulent times, it's crucial to stick to REITs with strong balance sheets and quality assets in highly sought locations. Refinancing at higher rates is likely, favoring stronger players. Additionally, as weaker players are forced to sell properties, often at lower prices, stronger ones can capitalize, potentially yielding higher returns for shareholders.
This theoretical framework applies well to Mid-America Apartment Communities (MAA), which I believe is a strong buy for several reasons.
Attractive Entry Point:
MAA has fallen almost 50% since its peak in December 2021 not because its cash flows have weakened, but just because the broader REIT market is down.
Based on the chart above, one might think that MAA is in severe distress. I mean, 50% drops in the share price are not usually associated with stable blue-chip companies. However, during this dark period for the share price, the dividend kept on increasing at a rapid rate! In fact, the quarterly dividend increased by 40% from $1 in Q3 2021 to $1.40 today. Usually, when the dividend is on the rise, especially this much, the share price follows. Here, we have a breakdown of this relationship.
Because of the large drop in the share price, combined with significant dividend increases, the dividend yield has increased to more than 4.5%. Securing a dividend yield in the mid-4% range, with prospects of enjoying significant increases for years to come, allows investors to lock in a very attractive yield on cost. I am confident that MAA will continue increasing its dividend in line with historic practices. In fact, MAA has never suspended reduced its dividend in its nearly 30-year history as a public company. It has an outstanding dividend history, with a solid record of growth and stability, including stable payouts during the Great Financial Crisis and the Great Recession.
Sustainable Business Model:
MAA owns modern, high-quality properties across various states, which are in high demand, such as the ones illustrated below.
Tenants are affluent individuals working in high-paying sectors such as healthcare, banking, and tech space, with an average resident income of approximately $90,000. Most importantly, rents are approximately 22% of their income which suggests that this business model is affordable.
How many times have we heard that rents in many locations such as New York are through the roof, with renters even spending more than 50% of their income on rent? This is clearly not the case for MAA, which is very positive and highlights the sustainability of the underlying business model.
At this point, one might argue that there is a construction boom in many areas that could lead to oversupply. I would like to highlight three things. First, MAA will likely take advantage of opportunistically acquiring distressed assets, typical in the boom-bust cycle for developers (see point 3 below regarding the strong balance sheet). Second, MAA has the staying power to weather the storm. Third, and importantly, MAA rents are on average approximately $350 per unit less than new supply. What I also appreciate is the prudent dividend payout ratio in the low 60% of Core FFO, which bodes well with the dividend analysis in section above and the ability of MAA to continue with its outstanding dividend track record.
Stellar Balance Sheet:
MAA maintains a rock-solid balance sheet, backed by its A-/A3 rating.
In fact, MAA is one of eight public REITs to be A- rated or above.
The company has 100% fixed-rate debt, an average weighted interest rate of just 3.4%, and a well-balanced maturity schedule, with a weighted average maturity of 7.5 years, and a net leverage ratio of less than 3.5x, well below the sector average of 4.7x.
Common equity represents approximately 65% of its total capitalization, and in more normal times, as was the case just a few months ago in June, when the share price was 25% higher, common equity represented more than 80% of its total capitalization, as illustrated below.
Such a capital structure is certainly impressive, allowing investors to sleep well at night.
Moreover, MAA has $150M cash on hand, full capacity available on its $1.25 billion revolving credit facility and $625 million commercial paper program, which provides ample firepower for increasing the development pipeline and pursuing acquisition opportunities.
In other words, MAA is extremely well positioned not only to play defense and weather the storm but also to play offense and take advantage of distressed opportunities as and when they present themselves.
Valuation:
Given the sell-off over the past couple of years, MAA is quite cheap relative to historical standards. The annual core FFO per share for FY 2023 is expected to come in at $9.14, continuing the positive streak experienced over the past few years.
Given the current share price of approximately $120, this equates to an FFO multiple of approximately 13.5x, which is quite low relative to historical MAA normalized multiples of more than 18x, and low for a high-quality, low-debt apartment REIT. Note that historically, we have seen FFO multiples hovering around 30x.
What is even more telling about the low valuation is the high dividend yield of almost 5%. This is almost 200 basis points higher than the 4-year average dividend yield for MAA of 2.92%. The chart below shows the rapid increase in the dividend yield over the past year, which has increased by a whopping 51.85%.
To be fair, most apartment REITs have shown a similar trend in dividend yields, as illustrated in the graph below. Nevertheless, MAA has among the highest yields in its peer group, despite having one of the lowest debt ratios.
Risks:
Like all investments, there are always some risks. In my view, the main risk is if interest rates remain elevated for a prolonged period of time, which means refinancing will be done at much higher interest rates, which in turn will eat away from MAA's free cash flow. Another risk is if the construction boom continues, this will likely add pressure on occupancy. In any event, MAA's industry-leading balance sheet allows it to have staying power and make sure it makes it to the other side, not only surviving but thriving. Given its high-quality assets and strong underlying business model, with a low dividend payout ratio, I see the risk of a dividend cut close to zero. The only risk is if the dividend doesn't grow as fast as one would expect. Even in this case, locking in a dividend yield of around 4.7%, even with minimal dividend growth should economic conditions deteriorate substantially, is still a good entry point.
Conclusion
In summary, MAA ticks all of my boxes in terms of asset quality, debt profile, and sustainable business model. The strong will get stronger, and my expectation is that MAA will produce a high-quality earnings stream and consistently compound Core FFO and dividend growth through market cycles, which will translate into top-tier shareholder returns within the multifamily sector, as has been the case historically. In other words, history is likely to repeat itself.
For further details see:
Mid-America Apartment Communities: Undervalued With An Attractive Yield Close To 5%