Two weeks ago, I wrote that a very good buyside analyst I know was selectively buying all the Apartment REITs he could get his hands on. He told me this after closing out his iStar short, which he took from $20 to $8, so I was pretty interested in what he had to say. In essence, he said that Apartment REIT fundamentals have definitely weakened, but the market is discounting them too much, and in the longer term (2-3 years), there will be no better place to be. Here’s why, along with two of my friend’s top picks, and some helpful data from Green Street Advisors to assist you in your research.
First, the bad news. Vacancy rates are climbing in many markets and rent growth has slowed as the economy weakens. Job growth drives apartment demand, and we all know what’s happened to job growth. Fewer jobs causes renters to double up with roommates, or move in with parents, friends or relatives, and that puts pressure on occupancies. In addition, the “shadow” rental market is increasing as foreclosed homes and failed condominium conversion projects are being added back into rental housing stock. This latter problem of failed condo projects is particularly acute in Florida. Reasonable people can dispute the true effect of the so-called “shadow” market on apartments, but it’s true that the combination of increased supply and slower demand will reduce prices (rents).
This is all occurring against the backdrop of increasing capitalization rates, which is a yield/valuation metric in commercial real estate. “Cap” rates are just like bond yields, as they move up, par value goes down. Consequently, as investors demand higher cap rates in many markets, asset values are declining. Many Apartment REITs have relatively low levels of debt, but for those operators with higher leverage, declining asset values is not good and no different than any other high leverage scenario – everything must to go right for that strategy to be rewarding. If things don’t go right, more highly levered players could be forced to sell assets in order to reduce leverage.
In terms of good news however, most apartment owners are not nearly as highly levered as operators in other REIT sectors, so they are not suffering from the same high profile debt issues in the retail, industrial and hotel businesses.
In addition, apartment assets continue to perform very well relative to other commercial real estate, and low multifamily loan delinquencies reflect that. Underscoring this thesis was a report out from the Mortgage Bankers Association this week showing that the 30-plus-day delinquency delinquency rate for multifamily assets held in commercial mortgage-backed securities (CMBS) was still below 1%. Delinquencies did tick up, although only slightly (by 0.10 percentage points to 0.63 percent).
The 60-plus-day delinquency rate on multifamily loans held or insured by Fannie Mae rose 0.05 percentage points to 0.16 percent. The 60-plus-day delinquency rate on multifamily loans held or insured by Freddie Mac fell 0.02 percentage points to 0.01 percent.
Multifamily loans held by insurance companies were performing even better. Of the 35,135 commercial/multifamily loans in life company portfolios, only 36 loans were 60plus days delinquent at the end of the quarter. These loans represented an aggregate unpaid principal balance of less than $144 million.
“Commercial/multifamily mortgages have not seen the same kind of deterioration in performance witnessed among other real estate loans, and at the end of the third quarter, delinquency rates for every investor group remained at the lower end of their historical ranges,” said Jamie Woodwell, MBA’s vice president of commercial real estate research.
Fortunately, despite the meltdown in the capital markets and the takeover by the federal government (and perhaps even because of it), Fannie Mae and Freddie Mac are still providing plentiful debt financing for the apartment industry, and they are doing it in such a way as to move final maturities out into years where there will be less pressure from other CRE maturities/refinancings. If you can show (prove) 1.25x debt coverage at no more than 80% loan to value, Fannie Mae will happily write you a loan. Many large portfolio acquisitions are being financed by Fannie Mae as well, including the nearly $1 billion UDR, Inc (UDR) portfolio sale to DRA Advisors.
The case for multifamily is simple. For many years in the earlier part of this decade, the easy credit environment increased the homeownership rate at the expense of rental housing. Now the easy credit years are over, and those folks who could once qualify for a single family mortgage simply by having a pulse will no longer be able to do so. Moreover, the economy will not be in the tank forever, and job growth will eventually return. These dynamics are causing some industry observers, including the National Multi Housing Council, to go so far as to predict a shortage of rental housing as early as 2011.
I wrote about those dynamics extensively in this article on Apartment REITs. That article includes historical graphs of homeownership rates and vacancy rates, and recommends two Apartment REITs: Avalon Bay (AVB) and Essex Property Trust (ESS). That’s convenient, because those are the very two REITs that my buyside friend is loading up on, and he’s doing it with real money.
Avalon Bay Communities is a real estate investment trust which primarily focuses on developing high-quality, multi-family apartment communities for higher-income clients in high barrier-to-entry regions of the U.S. As of September 30, 2008, the company owned or held ownership interests in 177 apartment communities, with 50,034 apartment homes in 10 states. They have a great development pipeline in several strong markets and will be well-positioned for the eventual rebound.
Essex Property Trust is a fully integrated real estate investment trust that acquires, develops, redevelops, and manages multifamily apartment communities located in supply-constrained markets, primarily in strong markets along the West Coast. Today, Essex’s portfolio has grown to 133 apartment communities, comprised of 26,790 units, with 1,658 units in active development. The portfolio is currently concentrated in Southern California, the San Francisco Bay Area and the Seattle metropolitan area.
These two also happen to be carrying low levels of debt, so they are relatively safe from the turmoil in the capital markets. The three apartment REITs with the most leverage on their books are Denver-based AIMCO (AIV), Birmingham, Ala.-based Colonial Property Trust (CLP) and Richmond Heights, Ohio-based Associated Estates Realty Corp. (AEC). These would be best to avoid for the time being.
Green Street Advisors, a Newport Bach, Calif.-based consulting and research firm, produced some terrific data which illustrate the effect of a hypothetical 150 basis point increase in cap rates on the leverage ratios of several Apartment REITs. Nobody knows how high cap rates will rise, so 150 basis points may or may not be the right number, but it does help indentify those higher-risk Apartment REITs, particularly in this environment of toxic near-term debt maturities.
Under this 150 bp scenario, AIMCO’s liquidity leverage pushed up to 76 percent; its solvency leverage moved to 81 percent. For Colonial, the numbers would edge up to 78 percent and 82 percent, respectively; for Associated, they rise to 77 percent and 83 percent, respectively. “That gets dangerous because you can’t lever properties at about 70 percent to 80 percent,” said Andrew J. McCulloch, an analyst at Green Street.
These three REITs (among others), are all working to reduce leverage, but that primarily means selling assets into weak markets, and/or extending available lines of credit, cutting dividends, moving maturities back, and, if stock prices rebound, possibly secondary stock offerings (which are obviously dilutive). The full article can be found on Multifamily Executive Online
|Leverage ratios (Now)
|Leverage ratios if cap rates rise by 150 basis points|
|Company||Liquidity Leverage*||Solvency Leverage**||Liquidity Leverage*||Solvency Leverage*|
|American Campus Communities||56%||56%||68%||68%|
|Camden Property Trust||55%||55%||67%||67%|
|Colonial Properties Trust||66%||69%||78%||82%|
|Education Realty Trust||59%||60%||71%||72%|
|Essex Property Trust||47%||51%||38%||42%|
|Mid America Apartment Communities||53%||58%||63%||68%|
|Source: Green Street Advisors|
|* Liquidity Leverage ratio = book value of debt divided by estimated asset value|
|** Solvency Leverage ratio = marked-to-market value of liabilities plus preferreds divided by asset value|
Unless Fannie Mae and Freddie Mac stop lending on apartments, which is unlikely, Apartment REITs should be able to avoid any real trouble with high leverage. But for the time being, it’s probably wise to pursue a policy of absence of doubt, even with apartments.
Click here for a full Apartment REIT list, including current dividend yields.