AvalonBay Communities: Great Business, Horrible Price
There is very little chance that high inflation, high interest rates, inverted yield curves, student loan debt, consumer credit card debt, auto loan debt or a possible government default will leave real estate investment trusts unscathed. One of the most prominent and high priced of them all is AvalonBay Communities Inc. (NYSE:AVB).
About AvalonBay
AvalonBay Communities owns a portfolio of 276 apartment communities with nearly 90,000 units and continues to develop additional properties around the country. Collectively, these generate $2.3 billion a year in revenue, most of which is pushed to the bottom line and then as required distributed back to shareholders. Since its initial public offering, the company has produced 11.3% in annualized gains. That is close to $2,400 a month per unit, on average.
The REIT distributes the majority of its taxable income to as dividends. That is where it starts to get interesting. AvalonBay has to give back most of its income to shareholders, but that yield is only 3.7% right now. That is because it is still being propped up by the market with a total capitalization of $25 billion and an enterprise value of $33 billion.
Funds from operations is a key performance metric for REITs. It is calculated by adding depreciation and amortization back to earnings and subtracting any gains on the sale of properties. FFO provides a better picture of a REIT's operating performance than traditional earnings. AvalonBay's FFO was $1.4 billion over the last 12 months, or 18.5 times funds from operations.
Strengths
AvalonBay has a strategic focus on well-established communities, which can lead to stable rental income and tenant retention. The company boasts a robust financial position with a solid balance sheet, ensuring it can weather economic downturns and capitalize on growth opportunities. Its properties are situated in some of the most desirable markets in the U.S., attracting high-quality tenants and maintaining high occupancy rates. The company also has a seasoned management team with deep industry knowledge and is a recognized and trusted brand among tenants and investors. A big stregnth is that, over time, it has been able to raise rents at least in line with inflation.
Weaknesses
Overdependence on the United States could be an issue. While also a strength, the fact that a significant portion of its properties are located in high-cost, high-barrier-to-entry markets like California and New York could be a problem. This concentration could make it vulnerable to regional or macroeconomic shifts, or changes in regulations. The apartment rental industry is saturated with many players, from large REITs to smaller local companies, all competing for tenants and properties. Being a REIT, AvalonBay relies on debt financing, which helped out in low-rate evironments; however, rising interest rates will increase borrowing costs, which will affect profitability.
AvalonBay's growth strategy has been heavily dependent on developing new properties, which comes with risks like construction delays or demand not meeting expectations, and now increased costs. More importantly, the company might need to spend money on property maintenance and upgrades to be able to meet the demands of future tenants. These will be costly and impact financial performance.
Opportunities
A recovery or boom in the construction industry could provide new growth opportunities for AvalonBay. Even a further collapse could help the company if it could buy some properties at depressed values. Perhaps the biggest opportunity is from the rising demand for rental properties. Changing demographics and lifestyle preferences are leading to an increased demand for rental properties. Retirees that downsize might not want to lock up their money in a fixed asset. The younger generation definitely has been having a hard time with affordability. This is pushing both to rentals.
Threats
There are few threats, but they are massive. Rising costs across the board, from labor to materials to borrowing, will likely impact AvalonBay's bottom line. An economic downturn or other factors could soon lead to tenants defaulting on rent, especially if artificial intelligence does take away jobs. This may not threaten loss of tenants as much as the need to lower prices to retain and attract them.
Current investments
AvalonBay is in a solid position to expand. As of July, the company had 18 projects under construction, a commitment worth $2.4 billion over 5,760 homes, plus 56,000 square feet of commercial space. The company must see a way to generate high rents from these properties because with an average rent of just $2,400 across its portfolio, it would take nearly 30 years to recoup the capital.
Valuation
It is true AvalonBay is well positioned in attractive markets. Specifically, the company's apartment portfolio is concentrated in high barriers-to-entry locations, close to major economic centers that may be more resistent to economic volatility. Occupancy across its portfolio of properties stands at nearly 96%, and rental rates continue to be paid. AvalonBay also has a large credit facility over $2 billion to use for any new acquisitions. The company is great, but the price is where investors should hesitate.
The REIT's top line is expected to hit $2.8 billion with funds from operations of $10.40 per share. Paying around 18 times funds from operations sounds fine in good times, but does not make sense at this point. If occupancy goes down to 90% or 80%, what happens? Some may view this on a net asset value basis and think the company could sell off its assets and be worth $250 a share. That is impossible since anyone buying them would want a discount. All roads point to a lower valuation. The sector median FFO is 12. That puts AvalonBay's value in the $120 range.
This article first appeared on GuruFocus.
