Report #1 - Apartment REITs
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Apartment REITs - A Short
Estate Investment Trusts or REITs are instruments
that allow you to obtain exposure to real estate
as an asset class without directly owning a physical
structure. This is similar to using the gold ETF
to gain exposure to gold in your portfolio without
taking physical delivery of gold bullion. To avoid
corporate taxes, REITs generally tend to pay out
over 90% of their taxable earnings as dividends.
Many flavors of REITs exist including commercial
REITs, healthcare REITs, hotel REITs, apartment
In keeping with the carnage
in the real estate sector, REITs have lost over 70%
of their value over the last two years. Despite such
a precipitous drop, I still will not touch the sector
with a ten-foot pole. With occupancy rates running around
95%, apartment REITs appear to be the one bright spot
in this sector and the sharp drop in prices has left
many of them very attractively valued as discussed in
the valuation section below.
AvalonBay Communities (AVB)
With over 50,000 apartments
in 178 communities, AvalonBay is one of the largest
apartment REITs in the country and a company I have
had direct experience with as a renter. The company
generates nearly half its net operating income from
the NY/NJ metro area and New England. California represents
an additional 32% of net operating income with the rest
coming from the Pacific Northwest and the Mid-Atlantic/Midwest
regions. With a management team that is well respected
and leverage that is the lowest of any apartment REIT,
AvalonBay has traded at a premium over the last few
years and the stock was trading at nearly $150 when
I first came across the company in early 2007. Even
after declining through most of 2007, the stock was
close to $110 when I mentioned it in the blog post Quest
For A 6% Yield on 10/20/2007. At those lofty
levels AvalonBay was offering a cash dividend yield
of just 3% and I could not justify investing in the
company when it was possible to earn a similar or better
return from cash without any risks.
I continued watching the
company over the last two years looking for an opportunity
to start a position. With a decline of over 70% from
its 2007 high and a yield of 8.1%, this apartment REIT
is finally at a level that not only offers a fat yield
but also the potential of price appreciation. Both AvalonBay
and AIMCO are amongst a group of 13 REITs that are included
in the S&P 500 index. I guess at any other time, this
inclusion would have reflected upon the quality of these
companies but with financials representing nearly 10%
of the S&P 500 index and other index constituents floundering
(E*Trade and Sprint come to mind), it is hard to make
that case for quality anymore.
There are some very valid
concerns about investing in REITs at this time that
are related to occupancy rates, the safety of the dividend
and debt that is coming due this year. Let me try to
address these risk factors below.
As of the end of December
2008, the occupancy rate at AvalonBay was 95.5% and
is expected to be around 94.5% in 2009 after having
started the year with an occupancy rate of 95.3% in
January. AvalonBay benefited early in this real estate
correction as the number of renters increased because
housing became unaffordable, loan requirements tightened
up and a wave of foreclosures hit the country. However
apartment REITs are now feeling the impact of the economic
meltdown because of job losses and are likely to face
a tough operating environment in 2009 and potentially
into 2010. Beyond the softness experienced in the fourth
quarter of 2008, Avalon expects revenue to decline between
1.5% to 3.5% and net operating income to decline between
4.25% to 6.25% for 2009. However the company is not
clamping down on growth and expects to complete 8 out
of the 14 communities it currently has under development
in 2009. Current low interest rates have been favorable
for AvalonBay as the company partially used new debt
to retire higher interest debt and reduced the interest
rate of its portfolio from 6.5% at the end of 2007 to
6% at the end of 2008. Avalon expects further interest
rate related gains in 2009 by repurchasing 7.5% medium
term notes due December 2010.
The important criteria
here is determining if the current dividends and yields
are sustainable in a challenging rental environment.
AvalonBay expects to retain $75 million in free cash
in 2009 on net operating income of $550 million. Even
if their net income declines an additional 10% beyond
the 4.25% to 6.25% decline they have already modeled
into their 2009 estimates, they would still have enough
cash flow to pay the dividend on the common stock and
I believe the dividend appears to be safe for 2009.
I can certainly make peace with a 8.1% yield from a
high quality company while waiting for the eventual
recovery to occur.
Avalon raised $1.9 billion
in capital in 2008 including $1.2 billion in new debt.
Yet their leverage at 44% remains modest by industry
standards. The company plans to raise an additional
$750 million in debt in 2009 and has liquidity arranged
or identified to meet all capital needs through 2010.
The company ended 2008 with $259.3 million in unrestricted
cash and cash in escrow. It also has the ability to
tap into a further $124 million of a $1 billion unsecured
credit line. Total debt that matures in 2009 is $267
Another apartment REIT
worthy of consideration that appears to be given up
for dead by most investors is Apartment Investment Company
or AIMCO (AIV).
Depending on which financial website you use, you might
see the yield ranging from as high as 109.2% (MarketWatch)
to 40.9% (Yahoo Finance). The
actual cash yield of AIMCO is 17.92% based on management's
decision to drop the dividend payout to $1 from $2.40/share.
The number reported by Marketwatch.com is probably higher
because AIV also declared a stock dividend due to profits
generated from asset sales. The REIT has dropped a precipitous
91.33% from its February 2007 peak of $64.35 due to
concerns about the highly leveraged nature of the company
and recent changes in management leading to the resignation
of its CFO. Trading below book value and at a discount
to its peers AvalonBay, Equity Residential (EQR)
and Essex Property Trust (ESS),
the risk/reward trade off looks appealing for AIMCO.
I am probably not the only one feeling that way as a
director of the company purchased
150,000 shares for $922,550 on the open market last
week. There have also been a series of open market insider
purchases at Essex Property Trust in the last two weeks.
Based on the valuation
of AvalonBay when compared to peers as displayed in
the numbers section below, I
am going to commit roughly $5,000 of the new special
reports portfolio to AvalonBay and will also make the
purchase for my personal portfolio. As a more risky
play, I am also going to initiate a smaller position
to the tune of $2,500 in AIMCO. The actual number of
shares and dollar amounts will be based on the closing
price as of February 23, 2009.
Valuation of REITs:
A special metric called
Funds From Operations or FFO is used by REIT investors
and analysts to evaluate REITs instead of relying on
standard financial metrics like net income or EBITDA
(Earnings Before Interest, Taxes, Depreciation and Amortization).
FFO is obtained by adding back expenses like depreciation
to net income and excluding any income derived through
the one-time sale of assets.
FFO = Net income + depreciation
- gains from sale of assets.
FFO is preferred as a
valuation metric because it gives a better picture of
cash flow from operations than net income, which includes
non-cash related expenses such as depreciation and amortization.
Some analysts prefer to use another metric called Adjusted
FFO, which subtracts capital expenses that are required
to maintain the portfolio of properties and amortization
from net income to give an even better picture of true
cash flow generated from operations. Capital
expenditure or Capex is normally added to the value
of an asset on the balance sheet and then depreciated
on the income statement over the life of the asset.
Beyond FFO, the following three metrics could provide investors with some additional big picture insight,
- Historical dividend yields of REITs,
- Current dividend yield of REITs vs. 10 year U.S. Treasury note and
- Current earnings yield of REITs vs. the earnings yield of the S&P 500
Earnings yield of REITs is obtained by dividing Funds From Operations (FFO) by price. The earnings yield of the S&P 500 is defined as earnings divided
by price, essentially the inverse of the P/E ratio. I have expanded upon each of these metrics below.
Yields of REITs: With the exception of November
2008 when REIT yields jumped to 10.22%, you have to
go all the way back to January 1991 to find yields that
were greater than current levels. Interestingly that
was right in the middle of the 1990-1991 recession,
partially precipitated by the real estate led savings and loans
crisis. As you can see from the chart below, with
the exception of the high inflation period in the early
70s, REIT yields have spiked above 10% only three times
over the last 30 years.
vs. 10 Year Treasury: As of Friday, February
20, 2009, the yield of the 10 year U.S. Treasury note
was 2.78% (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml).
Using the iShares Dow Jones US Real Estate ETF (IYR)
as a proxy for REITs, the current yield of IYR is 9.88%.
The spread between the 10 year note and REIT yields
is an astounding 7.1%. Even if you use the MSCI U.S.
REIT index and the Vanguard REIT Index Fund (VGSIX),
the yield is still 9.76% and the spread 6.98%.
REIT Earnings Yield vs. S&P 500 Earnings Yield: With 93% of companies reporting fourth quarter earnings for the S&P 500,
earnings for 2008 were $26.16 (Q4 earnings are -$11.97). Instead of using reported earnings, I am going to use
operating earnings for the S&P 500 to calculate the earnings yield as it would take out of the effects of one time charges,
write offs and loan loss provisions. It would also level the playing field because we are going to use FFO for the REITs
instead of net income. Based on Friday's close of 770.05 and operating earnings of $54.60, the operating earnings yield for
the S&P 500 works out to approximately 7% (earnings yield utilizing reported earnings would have been 3%).
Since I do not have access to the FFO for all the REITs in the Dow Jones REIT index, the S&P 500 earnings yield is compared
to the earnings yields for some of the apartment REITs we are considering in the table below.
|Index or REIT
|Equity Residential (EQR)
|Essex Property (ESS)
The REITs compare favorably with the S&P 500 earnings
yield despite the use of operating earnings for the
S&P 500. One could easily make the argument that FFO
for apartment REITs are going to fall in 2009 but if
you look at the "numbers" section below, you will notice
that with the exception of Essex Property, FFO is expected
to be close to or above 2008 numbers. Having read the
recent quarterly call conference transcripts of (thank
you Seeking Alpha) these REITs, I can say that management
is well aware of current conditions when coming up with
these estimates. Taking these metrics
into consideration, REITs look very attractive at current
levels. Past performance may provide some insight
but is not indicative of future returns. Keeping the
current economic situation in mind, it would bear repeating
that I would not touch most REITs with a ten-foot pole.
However with occupancy levels around 95% as of the end
of January 2009 for many apartment REITs, this particular
sub-sector looks very appealing at current levels.
||Year End 2008
|Equity Residential (EQR)
|Essex Property (ESS)
Dividend, Yield and Debt Maturity in 2009
||2009 Debt Maturity
|Equity Residential (EQR)
|Essex Property (ESS)
FFO and Valuation (Pre-impairment and one-time charges in brackets)
||Full Year 2008
||$4.50 to $4.80
|Equity Residential (EQR)
||$2 to $2.30
|Essex Property (ESS)
||$5.50 to $5.90
||$1.65 to $1.95
* Using mid-point of the estimated 2009 FFO range
The Special Reports portfolio
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report is released to add position to the portfolio.
The portfolio will include dividends, special distributions
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Special Reports Portfolio - February 19, 2009
||Number of Shares*
I currently do not own any positions but plan to initiate
a position in AvalonBay after this special
report is published.
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