Description

Punchline:

Avalon Bay’s (AVB) high-quality multi-family portfolio is historically cheap relative to: 1) private market values, 2) other public apartment REITs, and 3) on an implied cap rate spread vs. the risk free rate.  AVB rent growth has under-paced income growth by 1300bps since COVID, a gap that may be poised to close in the face of single-family home affordability at all-time lows, a lack of existing home inventories, and a reversal of work from home/anywhere.  AVB will also benefit from limited new supply in their markets, particularly vs. the Sun Belt.

Company Description:

AVB is an apartment REIT who owns a mix of ~68% suburban and ~32% urban assets predominantly in the coastal markets of the US. Their apartment assets have quality ratings of A to A+ and are among the highest quality buildings owned by REITs.  Their markets are ~20% in each of the MSAs of NYC, Southern California, and Northern California and ~15% in Boston, Washington DC and “other”. 

Opportunity Overview:

Since the start of COVID, three years ago home prices in the US have grown 20-50% across the country with AVB’s submarkets seeing +30% in a macro environment that has inflation of >20%.  Apartment rental rates in coastal markets have not kept pace.  AVB’s in-place rents have grown +7%, or 2% per annum over the past 3 years.  The +30% home price appreciation, coupled with a +350bps increase in mortgage rates, has doubled the monthly payment for a home purchase inside AVB’s markets.

However, apartments in coastal cities (or “Gateway”) have seen rent growth severely lag both income and single-family home carrying costs, in part because of delayed reopenings of central business districts.  That began to shift a year ago.  Coastal cities have fully reopened with the exception of downtown San Francisco where quality of life concerns have impaired the city’s reopening.  While San Francisco’s future is cloudy, the broader MSA of Northern California has reopened and a majority of tech companies in Silicon Valley are implementing hybrid work policies which should pull demand for apartment renters back to the Bay Area. AVB’s exposure to downtown SF is only ~5%.  The other 95% of AVB’s properties are suited to capture demand from workers who cannot afford to buy a home but want to live in well located suburban and CBD locations.  The infill suburban skew for AVB uniquely competes with single family housing alternatives that are frankly unaffordable today. 

Another bear case against apartments is supply that is historically high. As you can see from the FRED data below the units under construction is elevated.  However, these units are predominantly in the Sun Belt region of the US.  This supply will disproportionately impact apartment REITs Camden and Mid America in 2023 and 2024. 

The supply in AVB’s markets will be muted. AVB forecasts supply growth in their markets of +1.6% in 2023 or below historical average of ~2% and well below the US and Sunbelt supply expectations of 2.7% and 3.6% growth respectively.  The latest update per a conference held by Citigroup in March of 2023, management said they anticipate supply growth decelerating in 2024.

Market Rent Growth expectations for AVB are low for 2023 at 3-4% in line with US averages.  AVB and all apartments will benefit from an elevated earn-in (i.e. built-in growth from last year’s leasing) in 2023 and guided to 4-6% Revenue growth.  Due to lapping easy 2021 comps AVB and most apartment operators will see an elevated earn-in for 2023.  The fear in the market is that market rent growth is low or impaired in 2023 and will continue to be weak in 2024 resulting in disappointing 2024 topline growth.  I think the market is being overly negative in the face of apartments main competitor, single-family homes, facing a shortage in the US alongside record unaffordability due to home price appreciation and elevated mortgage rates.  I think rent growth has asymmetric upside to what is being priced in.  This is particularly true for AVB, who owns properties in low-supply areas, and is among the cheapest large multi-family REITs.

There is a housing shortage in the US and home affordability is at the lowest point in decades. It is estimated that the US is under supplied by 3-5 million homes.  Existing homes inventory is at record lows, as people are locked into 3% mortgages and can’t afford to move.  I believe the market is underappreciating the potential for excess rent growth in markets where homes are unaffordable and there is low supply of houses and apartments.  AVB’s markets overlap with this clustering of factors.  Despite that, the market is focused on the current optics of decelerating rent growth after lapping easy COVID comps.  As a result, AVB can be bought at a historically cheap valuation.

Valuation:

AVB trades at a 6.5% Implied Cap Rate.  Per Green Street Advisors, this represents an unlevered discount of ~22% compared to the private market.  Outside of the GFC and the initial weeks of COVID this is the largest discount AVB has ever traded vs Gross Asset Value.  Note, apartment cap rates are more meaningful than in other parts of the REIT market.  Unlike many alternative real estate assets, apartments continue to trade regularly in the private market.  Private market Apartment Cap Rates have risen from 3.75-4.0% a year ago to 4.75-5.0% today. In AVB, you can own a portfolio of A apartments, in desirable/low-supply MSAs, 150+bps wide to private transaction levels.  I believe the unlevered discount to Gross Asset Value is “real”, and suggests AVB is extremely cheap.

Source: Green Street Advisors

On AFFO, AVB trades at a 5% discount to a broad index of REITs.  Historically, AVB’s assets have garnered a ~20% premium to other REITs.  [Note, this analysis removes office and malls which are disrupted asset classes and trade on the degree of disruption.]

Source: Factset

AVB’s cheapness is also evident outside of REITs.  AVB’s AFFO multiple is approaching 20 year lows relative to the S&P 500.   We have seen this low in 2003, the GFC and COVID.  [The calculation for this chart is the relative AFFO Multiple for AVB vs the EPS multiple of S&P 500.]

Source: Factset

REITs trade like a hybrid of an equity and a debt instrument.  AVB remains cheap, even adjusting for higher interest rates.  At a 6.5% Implied Cap Rate, AVB is trading 300bps wide to US 10 yr Treasury Bonds.   For context, spreads in excess of 300bps to the 10 year have only occurred four times over the past 20 years - during 2020 (Covid), 2016 (Brexit/Oil), 2012 (European debt crisis) and 2008/2009 (Global Financial Crisis).  A reminder that coming into the GFC, REITs were over-levered, including AVB at ~8x EBITDA.  The viability of AVB and other REITs was called into question due to balance sheet refinancing risk.  Today, AVB’s balance sheet is much improved at ~4x, with a weighted average maturity of > 7 years.  Absent the GFC and Covid, AVB rarely trades above a 300bps spread to the 10 Year.

Source: Factest

Views on Regional Banking Exposure:

The emerging banking crisis at regional banks suggest there are concerns for commercial real estate assets.  The bear case is real estate prices will be impaired because regional banks will not be able to lend as loosely as they’ve done in recent years.   I agree there may be areas of real estate, such as office assets, that could impact regional bank balance sheets and broadly valuations.  I believe apartments may benefit from regional banking tightening credit.  Existing apartments may see a setup that mutes supply to historically low levels.  Existing apartments that are >85% occupied can access FHA debt.  REITs can access debt via the bond market.  Apartment loans at regional banks as a result are mostly (re)development loans.  Development lending at regional banks is likely to be tightened as regulators impose stricter lending standards. That benefit will flow to the existing owners of apartments by muting competitive supply.

Summary:

AVB is extremely cheap, for a portfolio of quality real estate with a long history of trading at a premium to REITs and the broader market.  The market soured on apartments after lapping difficult comps in the 4th quarter of 2022 that showed rent growth decelerating.  I think the market oversold AVB and is not putting any value on four potential tailwinds that are supportive of rent growth:

1. Unlike peers in the Sunbelt, AVB’s markets will see muted apartment supply in 2023 that will further decelerate in 2024.  Longer-term, regional banks are likely to tighten development lending further muting supply. 

2. The inventory of existing single family homes is at record lows.  Home owners with 3% mortgages locked cannot afford to move.  New households will be forced to move into apartments in lieu of buying a home.

3. AVB’s submarkets did not experience excessive rent growth as rents have only grown at a 2% CAGR since COVID making their apartments more affordable in an environment that has seen ~20% cumulative wage inflation over the past 3 years.  Conversely, the monthly payment to buy a home has doubled in the past 3 years in their submarkets. 

4. The reversal of work from home/work from anywhere policies will provide a tailwind for AVB particularly, given their infill suburban skew where tenants are more likely to be accepting of longer commute times because they are only in the office 2-3 days per week.

Disclaimer:

This presentation is intended for informational purposes only and you, the reader, should not make any financial, investment, or trading decisions based upon the author's commentary. Although the information set forth above has been obtained or derived from sources believed to be reliable, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the above information serve as the basis of any investment decision. Before investing in a security, readers should carefully consider their financial positions and risk tolerances to determine if such a stock selection is appropriate. At any time, the author of this report may trade in or out of any securities that are mentioned in the report as long or short positions in his own personal portfolio or in client portfolios that he manages without disclosing this information.

This report’s estimated fundamental value only represents a best efforts estimate of the potential fundamental valuation of a specific security, and is not expressed as, or implied as, assessments of the quality of a security, a summary of past performance, or an actionable investment strategy for an investor. This is not an offer to sell or a solicitation of an offer to buy any security.

Catalyst

Better than expected 2023 and/or 2024 rent growth.

Return to historical premium valuation vs REITs, SPX.