Dwelling on the Positive: Comparing Apartment REITs

Apartments remain a bright spot in an otherwise downtrodden REIT sector.
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Is anyone in the public real estate markets making money? It's true that real estate investment trusts are down this year. (The

SNL Securities Equity REIT

index, which includes dividends, is down 1.3% so far this year.) But one property sector is providing shelter from the storm, and that is apartment REITs.

The

SNL Multi-Family REIT

index has gained 9.2% since January. "It's the one sector that is kind of hanging in there," says Carl Tash of

Cliffwood Partners

, a Los Angeles-based real estate investment firm.

Fundamentals appear to be driving the surge of apartments into the sector spotlight. "Apartments remain cheap, and the stocks have very low volatility," says Marc Halle of

Alpine Management and Research

, a New York investment manager. "And, most companies have very good management teams, which mitigate most of the real estate operating risk."

In the current environment, REITs have several factors going for them -- chief among them being attractive valuation and stable earnings. "I think most of these companies continue to trade below their net asset values," says

Legg Mason

analyst Rod Petrik. "The average multiple over the past five years has been about 12 times next year's earnings, and now we are trading near 10 times."

"The reliability of apartments' earnings stream is very good," says Ritson Ferguson, president of

CRA Real Estate Securities

in Philadelphia. "Barring a deep recession, occupancy should hold and rents should ease higher. I don't see a lot going wrong."

Current economic trends provide another kind of boost. The leading reason renters leave apartments is to purchase a single-family dwelling, so the fact that an increase in rates tends to slow new home purchases is good for apartment owners. "As rates rise, apartments should be among the best performing REIT sectors," said Jim Trowbridge, a portfolio manager for

Invesco Realty Advisors

in Dallas. There are limits, of course: If the

Fed

is too successful in slowing the economy and job growth wanes, demand could slow.

Demographic trends are also favorable, as the "echo boom" fast approaches prime apartment-renting age. "The leading edge of the demo turns 19 this year and will be looking for apartments," Petrik says.

Invesco's Trowbridge suggests the other end of the age spectrum may provide new demand as well. "As the industry builds better quality apartments with single-family amenities, you are also seeing empty-nesters willing to move back into apartments." If correct, the trend should boost high-end demand over the next several years.

Not All Is Well

All the positives, of course, mean that builders have been working overtime to crank out supply. Nearly 350,000 new apartments are expected in 1999, which nearly equals estimated demand. A marked economic slowdown could bruise apartment owners, especially in the marginally overbuilt markets such as Atlanta, Dallas, Houston, Las Vegas and Phoenix.

And owners can no longer expect the kind of rent increases they've recently enjoyed. "It's unrealistic to expect rental rate increases to always be above inflation, much less twice inflation as in 1997 and '98," Petrik says. Estimates put rent growth at about 3.3% for this year and next, about a quarter-percent above inflation.

The sector could also experience cyclical pressure. "If we experience an economic decline, apartments could get hit harder," Trowbridge says. "There aren't long-term leases like the office sector. Rent growth is affected in a slowing economy." The problem would become even more pronounced in overbuilt markets.

That's why many investors stress property quality as one of the most important factors in selecting apartment REITs. While all classes of apartments perform well in a strong economy, an economic slowdown puts lower-quality operators at greater risk of tenant defaults and higher vacancies. And, lower-quality assets typically carry more debt, a greater liability in a slowdown. "The more generic apartments get hurt by higher rates to a degree because most are highly leveraged," Cliffwood's Tash says.

Those to Watch, Those to Avoid

High-quality properties in strong markets are the current favorites. One company mentioned favorably by several sources,

Charles E. Smith Residential

(SRW)

, is an upper-echelon apartment REIT with significant presence in suburban Washington, D.C. "Smith's markets are tremendous," says Petrik, who rates the shares outperform, and whose firm has provided investment banking services to Smith.

One bonus is Smith's attractiveness to potential suitors. "They have a pretty old senior management team which suggests someone might take a look," he says. "A number of REITs would drool over their portfolio." The stock currently trades at just over 10 times next year's earnings with a current yield of 6.3%.

Other multifamily REITs operating higher-end properties in strong markets, especially the Northeast and Southern California, include

Essex Property Trust

(ESS) - Get Report

,

Avalon Bay Communities

(AVB) - Get Report

, and

Grove Property Trust

(GVE)

. All are trading below 11 times next year's estimated earnings, yield north of 5.3%, with class "A" properties in strong markets.

Two other names --

Camden Property Trust

(CPT) - Get Report

and

Gables Residential Trust

(GBP)

-- represent value plays. Both have been lackluster performers, largely because of concern over exposure to overbuilt markets of the Southwest, especially Dallas, Houston and Las Vegas. "Gables is cheap and I think Camden is in the same boat," says Halle, who is long the shares. Both are trading below 9 times next year's earnings. Gables yields above 9%, and Camden about 7.5%.

Investors would do well to avoid REITs with lower-quality properties. Those names include

United Dominion Realty Trust

(UDR) - Get Report

,

Town and Country Trust

(TCT)

and

Associated Estates

(AEC)

. "United Dominion continues to go through difficulties as they try to sell weak assets," says Trowbridge, who has no position in the REIT. "Same thing with Town and Country. Associated Estates continues to miss analysts' estimates. You'd think eventually they'd get it right." The problem with repositioning weak portfolios is dilution: United Dominion has been selling properties with 10.5% yields and reinvesting in properties with 9% yields.

The message is clear: In apartments, quality counts. Those without it will disappoint and, ultimately, disappear.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback at

invest@cjnetworks.com.