The Southern California apartment market had an impressive 2005, as rents and occupancies rose because of strong job growth and a lack of new supply. A new report suggests that this year's fundamentals will be even better, and this bodes well for BRE Properties ( BRE).

The San Francisco-based real estate investment trust generates more than a third of its rental income from apartments in Los Angeles, Orange County and the "Inland Empire" east of Los Angeles. The rest of the REIT's portfolio is centered on San Diego, San Francisco and Seattle, with lesser exposure in Sacramento, Denver and Phoenix (the company is in the process of selling off many of its properties in the latter two markets).

Currently, the Southern California apartment market (Los Angeles, Orange County and the Inland Empire) is seeing a 97% occupancy rate, and that will help push rents up another 6% to 7% in 2006, according to the USC Casden real estate forecast released Thursday by the USC Lusk Center for Real Estate.

"The recent run-up in home prices makes apartment living more desirable," says Delores Conway, director of the Casden forecast. "And the tight supply of land coupled with more condo conversions means fewer available units. That translates into higher rents and occupancy rates for the next couple of years."

However, more supply is coming. Los Angeles County currently leads the nation in multifamily development, with 10,900 new apartments under construction at the end of last year. But the area continues to exhibit strong job growth, and that means it won't be until later in 2007 that supply finally begins catching up with demand, Conway says.

A year ago, the USC Casden forecast accurately predicted that the Southern California apartment market would continue to be strong in 2005, projecting that rents would increase 3.5% to 6% for the year. BRE's results ended up being even better.

The company recently said same-store rents increased 9% in Southern California (excluding San Diego), compared with 6% growth in its other California markets and 8% growth in Seattle. Edward Lange Jr., BRE's chief financial officer, expects market rents to increase 7% to 7.5% this year in Southern California. Meanwhile, fve of the six new properties BRE is developing are located in and around Los Angeles.

All this means growth is coming. But investors may have already priced in the momentum. BRE shares are up 25% this year. On Wednesday, the stock reached a 52-week high of $56.68.

BRE recently projected that funds from operations, a common REIT performance metric, would total $2.40 to $2.52 per share in 2006, but about 30 cents of that is coming from a one-time gain from a recent litigation settlement. Analysts' mean estimate is $2.34, according to Thomson First Call. The company reported 2005 FFO per share of $2.15.

At $56.68, BRE is trading at 24.2 times consensus estimates for 2006 FFO. If you chop the roughly 30 cents that comes from the favorable litigation settlement, then the stock is at 27.8 times FFO.

In comparison, fellow apartment REIT AvalonBay ( AVB) trades at 26.6 times forward FFO. Archstone-Smith ( ASN) trades at 22.5 times estimated 2006 FFO.

Only one Wall Street analyst has a buy rating on BRE, with the majority having hold ratings. Deutsche Bank analyst Lou Taylor is the lone bull on BRE, and he raised his price target to $55 in February.

Taylor, whose firm does banking with BRE, values the company's portfolio using a 6% cap rate (initial rate of return), which he says is near where BRE's properties would sell for in the private market. He admits this might be a conservative cap rate, given that management itself uses a 5.25% cap rate to gauge what its portfolio would fetch in a sale. (The lower the cap rate, the higher the price a portfolio fetches).

But even BRE management admits it is being conservative. In its fourth-quarter supplemental report, BRE says the weighted average cap rate for its portfolio, on the basis of market-cap rates, is 4.75% to 5.25%. If the 4.75% cap rate is used, the net asset value of the company shoots up to $62.80, according to BRE's calculations. At 5.25%, BRE values its NAV at $54.23. Taylor's NAV estimate assumes a cap rate of 6%. Taylor says the discrepancy for the two figures likely has to do with his valuing the development pipeline higher than BRE does.

BRE is set to announce its first-quarter earnings in late April. As Taylor notes, the company has had trouble meeting its earnings guidance in the past. But this time around, there could be additional upside to report. In Southern California, Seattle and San Diego, rent growth is clearly accelerating. Even if Northern California lags a bit, the apartment market there will only be helped in the long run by the lack of affordability in houses for sale.