Apartments Now

Written by Antonia S. Perdomo    Tuesday, 20 December 2011

With rents under pressure, it takes some guts to buy an apartment REIT. Pity the poor landlord. With interest rates low, middle class families are moving out of apartments and into their own homes and condos. Last year real estate investment trusts specializing in apartment buildings suffered an average 8% decrease in funds from operations, an industry statistic that measures profitability. Green Street Advisors, a Newport Beach, Calif. firm that rates REITs, expects the profitability of apartment REITs to fall another 17% in 2003. In short, the near term looks pretty dismal, and some dividends will be cut. But the long term case for apartment buildings is still intact. Eventually the unused inventory will be absorbed, and rents should keep up with inflation. REITs have gotten cheaper; the sector has seen a 7% price decline over the past 12 months. Craig Leupold, an analyst at Green Street, says that once the economy picks up and interest rates rise, demand for apartments will increase. A REIT is a flow through investment, much like a closed end fund. It owns buildings or mortgages and passes its profits through to shareholders. So long as it distributes at least 90% of taxable income to shareholders, it owes no federal income tax of its own. A typical apartment REIT offers a 7% yield. In measuring real estate profits, analysts usually ignore the bottom line (the net income reported to the Internal Revenue Service) and focus instead on funds from operations, which is defined as net income plus real estate depreciation. Green Street goes one step further, subtracting from FFO an estimate of maintenance level capital expenditures. This is no small matter, since landlords have to spend a fair amount of money replacing carpets and roofs. Someday the apartment depression will end. Green Street expects apartment REITs to show a 5% increase in adjusted funds from operations in 2004. This is the stuff from which dividends are paid. Leupold doesn't have many picks in this sector. One of the few that he's currently recommending is Avalon Bay. With 40,000 units, the REIT is heavily concentrated in California and the Northeast, where higher occupancy rates and greater demand prevail. Leupold expects Avalon's adjusted FFO to grow 1% next year and jump 6% in 2005. Given that Avalon Bay's adjusted FFO is already 1% higher than the dividend, the dividend is fairly secure. A less persuasive case can be made for Archstone Smith, whose adjusted FFO is 20% shy of its dividend. To finance its generous payout, Archstone will be selling some assets this year. That kind of liquidation can't go on forever. The apartment sector doesn't represent a screaming buy. Green Street estimates the market value of REITs and finds apartment REITs trading at only a modest 3% premium. On the other hand, a 6% or 7% dividend with at least some prospect of holding its own against the next bout of inflation is not too bad in today's market.

Last Updated ( Tuesday, 20 December 2011 )