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 million.
AVB specializes in high end apartments with rents over double the national average. With 96% occupancy rates it is obvious the company is putting its properties in the right areas. With the highest operating margin and revenue per unit, AVB is the class of the apartment REITs.