Zillow reported that American homes lost about $1.4 trillion in value in the fourth quarter of 2008 alone. This value vacuum is directly connected to the dismal earnings now being reported by Apartment REITs.

But first, one amazing factoid: this one quarter decline is more than all of 2007’s losses combined. This was also the eighth consecutive quarter of declining home values, and obviously the worst quarter since the crisis began. The data is based on the company’s median home-value estimates, or “Zestimates”, for homes in 161 metro areas.

According to Zillow’s estimates, U.S. homeowners lost a cumulative $3.3 trillion in home values during 2008. Since the housing market’s peak in 2006, more than $6.1 trillion in “value” has evaporated.

Having just returned from Sacramento/Stockton to look at defaulted condominium projects, I can tell you it’s a solid mess out there. Investors from all over the Bay Area, and indeed the entire country, are making the same drive across Interstate 80 and descending on more or less the same spots. Unfortunately, the smartest investors will tell you they have no idea when it will end or what their exit strategy is, so not much is getting done on any scale.

The unemployment rate in Sacramento/Stockton is now in double digits (and climbing), and most people will have no choice but to relocate in order to find work. Consequently, there are some projects that will simply need to be bulldozed and plowed under. Talk about adaptive re-use.

At one point late last year, Fannie Mae was foreclosing on 66,000 houses a day nationwide. Undoubtedly, that number has climbed even higher. Nationwide, foreclosures made up almost 20% of all home sales in 2008. In Merced, Stockton and Madera California, more than half of all sales were foreclosures. To be clear about that figure, this indicates that more than half of the homes sold in the Merced, Stockton and Madera areas were purchased by banks. They still must be sold on or rented to an actual end-user with a job.

What it Means For Apartment REITs

This latter issue is a big, big problem for many Apartment REITs. These foreclosures not only create additional supply of “shadow” rentals, but home prices in these hard hit areas will eventually drop (if they haven’t already) to levels where it will be much cheaper to buy than to rent. The federal subsidies and tax credits about to be doled out will tip the balance even further in favor of owning.

Don’t get me wrong, I love apartments more than anything right now. Very favorable long-term demand trends remain more or less intact, but bread and butter, low-leveraged housing is where the action is.

Unfortunately, In 2007 two Apartment REITs in particular, AIMCO (AIV) and Associated Estates (AEC) were busy dumping their bread and butter, vanilla assets in places like Ohio and Indiana so they could get in on all the fun being had along the coasts and in the sunbelt states. In the process, they sold solid assets in decent markets in favor of newer, more expensive assets in the red hot “growth” markets. They also paid 2006-2007 prices using 80 percent leverage. These days, high leverage is no bueno.

AIV and AEC (among others), are now working to reduce leverage, but that primarily means selling over-bought assets into weak markets, and/or extending available lines of credit and cutting dividends (or even worse paying REIT dividends in stock). By the way, cap rates are definitely going up, so you can ignore the middle two columns:

Thankfully, there is a floor for apartments as people without jobs typically don’t buy homes, no matter how low prices might be.

Despite the bad news across much of the country, Zillow says 21 out of 161 markets are actually not so bad. In these areas, problems with the “shadow” rental market are also not nearly so bad. Home values in Pittsburgh, for example, were flat in 2008. In the Fayetteville, N.C. area, home values increased 6.9 percent in 2008.

For REITs, Boring is Best

Other areas experiencing steady or increasing home values include New York State (supported by upstate values in Utica/Rome, where there is a large air base, i.e. “gubmint” money), the Midwest and certain areas in the South. These more stable markets are not likely to experience the market contortions resulting from increasing supply and decreasing demand (both rapid), and the effect that will have on apartment rents and occupancies in places like Sacramento, Phoenix and Tampa.

So what does this mean? Definitely look for Apartment REITs to outperform other REIT investments in 2009, for whatever that’s worth. But it gets better: analysts see Apartment REITs posting the strongest effective rent gains in history in 2011. If you’re looking for the best performing Apartment REIT for 2009 however, look no further than Mid America Apartment Communities (MAA). MAA’s markets and assets are unexciting, just like the Company’s low levels of debt. In this market, boring is definitely the new black.

[Update: on April 20th, MAA announced, with some caution, that first quarter FFO will exceed prior guidance.]

Disclosures: None at the time of publication
apartment reits, reit, reits

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

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.

Disclosures: None at the time of this writing.

apartment reits, reit
Avalon Bay, Essex Properties Trust