Residential REITs

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Jay

Asif Suria

Apartment real estate investment trust (REIT) companies make money by renting apartments, which they own and manage. There are about 17 million apartment units in the U.S., with a median rental income per unit of approximately $650 per month.^[1] The market for multi-family housing is highly fragmented, and the top 7 publicly traded REITs account for less than 4% of the overall share.

Apartment REITs compete for tenants not only with other apartment operators, but they also compete on the relative attractiveness of owning a home versus renting an apartment. When home prices are high, renting becomes more attractive (and vice versa). Interest rates determine the attractiveness of mortgage financing, and when they are high, demand for apartment rentals increases as financing a mortgage becomes more expensive.

It is also important to note that, by law, REITs must distribute at least 90% of its cash flow to shareholders every year in the form of a dividend. When interest rates rise, so do demands for investment yields on dividends, which can depress a REIT's stock price.

Apartment REITs

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.

Operating Metrics and Market Share

• Camden Property Trust (CPT) has over 67,000 apartment units in 13 states with a focus on mid- to upper-market residential properties.^[2] Camden operates over 40% of its units in four cities—Las Vegas (11.5%), Dallas, TX (11.4%), Houston, TX (8.4%), and Tampa, FL (8.3%)—and leverages its scale in local markets to achieve high margins. The company is also moving much more heavily into the Washington, DC metro area, with thousands of apartment units in the pipeline as of the end of 2006.^[3]

• Apartment Investment and Management Company (AIV) is the largest owner and operator of multi-family apartment complexes in the U.S. with approximately 216,000 units. The company collects rent payments from tenants in 46 states and the District of Columbia.^[4] AIV's properties are more geographically diversified than several of its competitors, which helps to limit the effect of any one significant local downturn, but also makes operations more logistically challenging. With an average monthly rent of approximately $860, the company generally targets the apartment "middle market" (i.e. neither low-income nor upscale units).

• AvalonBay Communities (AVB) focuses on developing upscale housing for higher-income families in 10 states and the District of Columbia. AvalonBay owns around 43,000 units and enjoys an average rent per unit of around $1,400 per month^[5] compared to $650 on average in the U.S.^[6]

• Equity Residential (EQR) is the second largest owner and operator of multi-family, apartment complexes in the U.S. With over 165,000 units in 25 states, the company focuses on the acquisition and operation of apartments in high growth population areas.^[7] The company's average monthly rental per unit is around $1,000, placing its offerings in the mid- to upper-market range (compared to $650 on average in the U.S.^[8]). Many of the company's properties are located in California (~15%), Florida (~14%), and Texas (~10%).^[9]

• Essex Property Trust (ESS) owns and rents apartment communities in southern California, the San Francisco Bay Area, and metro areas in the Pacific Northwest. With around 27,000 apartment units across 130 properties, Essex focuses on metropolitan areas in which supply is constrained and demand is driven by strong population and employment growth. The company pursues a strategy of operating in high barrier-to-entry markets, in which obtaining proper regulatory approval and obtaining properties on favorable terms is difficult. ESS generally operates in proximity to business, transportation, employment and recreation centers in each of its markets, in order to help target employees in these areas who have a propensity to rent rather than purchase a home elsewhere.

• UDR, Inc. (UDR) operates and rents over 70,000 apartment units across nearly 250 properties. The company's properties are focused largely in California (17.5% of units), Florida (16.2%), Texas (15.9%), and North Carolina (9.3%). The company targets the middle-market of apartment lessees, with an average monthly rent payment around $820 per unit^[10] compared to a median of $650 in the U.S overall.^[11]

• BRE Properties (BRE) operates and rents apartment communities in coastal California, Phoenix, AZ, and Seattle, WA. With around 23,000 apartment units across 90 properties, the company focuses on metropolitan areas in which supply is constrained and demand is driven by strong population and employment growth. The company generally operates its properties around business, transportation, employment and recreation centers in each of its markets, in order to help target employees in these areas who have a propensity to rent rather than purchase a home elsewhere.

Trends and Drivers

• National and Local Job Market and Employment. The strength of the labor market has important implications for the company.^[12] Jobs fuel demand for all types of housing, including multi-family/apartment dwellings. Strong job growth can drive higher occupancy rates and lead to increased unit rental revenue. High unemployment and slow job growth, on the other hand, can hamper the apartment rental market and, when job growth is negative, the company can experience falling occupancy rates and lower revenue per unit, which leads to less efficient apartment buildings as the utilization of the complex falls.

• The Housing Market and New Home Construction. Factors driving the non-apartment, alternative housing market can have a substantial impact on the company. Throughout 2007, falling housing prices in the company’s key markets, coupled with decreasing new home construction and the rising cost of financing mortgages increased demand for apartments relative to houses and other living alternatives. However, if housing prices continue to fall, houses can become more attractive to purchasers, and they may substitute away from apartments and opt for single-family housing instead.

• Interest Rates. Rising interest rates have several effects on this company and other apartment REITs:^[13]

1. Other investments become more attractive, thereby hampering demand for apartment investors. This, in turn, decreases the market prices of the company’s properties.
2. Available and existing financing becomes less attractive. Getting favorable terms on any new debt to finance building purchases becomes more difficult. The company’s interest expense on its floating rate debt increases, pressuring margins and increasing financial risk.
3. The stock price can fall as investor’s demand a greater dividend yield. As a REIT, the company must, by law, distribute at least 90% of its cash flow to shareholders in the form of a regular dividend. When interest rates rise, investors demand higher dividend yields on REITs, thereby driving down their stock prices.

• Mortgage Rates. The attractiveness of mortgage financing for home purchasers has important ramifications for the apartment REITs. If mortgage rates fall and credit is plentiful, buying a home becomes more attractive than renting an apartment, thus stifling demand for the company’s rental units. On the other hand, if the availability and attractiveness of mortgages declines, as did during the fallout from the subprime lending crisis, renting an apartment becomes more appealing, so occupancy rates and rental revenue per apartment increase.

• Local population growth. The rate of population growth in the company's operating regions is another key determinant of the company's success. In towns whose populations are rapidly increasing, limited housing supply and/or the lag time in building houses leads to greater demand for the company's apartment units. The growth in local population is also closely correlated to the rate of job growth (see National and Local Job Market and Employment above).

Footnotes

1. ↑ Apartment Rental data, 2005, compiled by National Multi Housing Council
2. ↑ 2006 CPT 10-K, "Business," pg 1"
3. ↑ 2006 CPT 10-K, "Properties," pg 18"
4. ↑ AIV 2006 10-K, "Business," pg 2
5. ↑ 2006 AVB 10-K, "Business," pg 1
6. ↑ Apartment Rental data, 2005, compiled by National Multi Housing Council
7. ↑ EQR 2006 10-K, "Business," pg 4.
8. ↑ Apartment Rental data, 2005, compiled by National Multi Housing Council
9. ↑ 2006 EQR 10-K, pg 26
10. ↑ UDR 2006 10-K, "Properties," pg 18
11. ↑ Apartment Rental data, 2005, compiled by National Multi Housing Council
12. ↑ BRE 2006 10-K, "Risk Factors," pg 9.
13. ↑ AIV 2006 10-K, "Risk Factors," pg 10.