Thus far, I’ve focused on coastal apartment REITs. My preference for these REITs has been based on:

  1. Limited supply, particularly in LA/SF and Boston which have very strict zoning making it almost impossible for meaningful amounts of new supply to come into the market.
  2. Desirable places to live in terms of high paying jobs, culture (megacities have a lot to offer during normal times), weather (CA). High per capita income growth.
  3. Tremendous tech & entertainment tailwinds in metro SF/LA – there is an ecosystem here which I believe will lead to continued outsized growth in the metro SF/LA economies over the medium term.
  4. Favorable & stable property tax regime in CA (Prop 13 caps property tax hikes at just 2% per year) and Massachusetts (Prop 2 1/2).
  5. The high cost of home ownership in NY, Boston, SF, LA, Seattle means there will always be large cohort of renters by necessity – home ownership costs are prohibitive.
  6. These shares were priced at a greater discount to my estimated NAV as fears of all things California and urban lead to indiscriminate headline driven selling. In late October, costal REITs like ESS and EQR were selling at 40-45% discounts to NAV. However, this has begun to reverse as shares of coastal gateway apartment REITs soared in anticipation of a vaccine.

Having covered the CA/urban heavy REITs in-depth, today I will give an overview of the sunbelt and take a look at the valuation of two sunbelt apartment REITs, Mid-America (MAA) and Camden (CPT). The main draw to the sunbelt as most people know is the long-term demand story – decades of strong population growth driven by a lower cost of living, warm weather and a business friendly environment (sometimes zero state income tax). Below is a snapshot of population #s over the past 50 years in a selection of Sunbelt cities. The numbers are simply staggering:

Metro Area

1970

1980

1990

2000

2010

2019

Atlanta

1,182,000

1,625,000

2,184,000

3,522,000

4,544,000

5,689,000

Austin

267,000

383,000

569,000

911,000

1,377,000

1,985,000

Charlotte

281,000

353,000

461,000

768,000

1,265,000

1,971,000

Dallas/ Ft Worth

2,025,000

2,468,000

3,219,000

4,168,000

5,149,000

6,201,000

Houston

1,693,000

2,424,000

2,922,000

3,847,000

4,976,000

6,245,000

Miami

2,141,000

3,122,000

3,969,000

4,933,000

5,518,000

6,079,000

Orlando

310,000

583,000

893,000

1,165,000

1,521,000

1,923,000

Phoenix

874,000

1,422,000

2,025,000

2,923,000

3,649,000

4,436,000

Raleigh

153,000

209,000

310,000

548,000

896,000

1,386,000

Wash DC

2,488,000

2,777,000

3,376,000

3,949,000

4,604,000

5,264,000

Source: Macrotrends

While all US equity indices are up strongly YTD, shares of MAA and CPT are in the red despite:

  1. showing more resilient NOI than coastal apartment REITs. 2020 same property NOI for CPT was down -1.3% in 3Q but will likely be flat to up in 2020/2021. Same property NOI for MAA was up 1.1% in 3Q and will be up slightly in 2020 (and likely again in 2021).
  2. The value of the apartment assets held by these REITs has increased. Sunbelt cap rates have followed interest rates down in the private market. Institutional quality Sunbelt assets are trading at all time highs – with cap rates in the high 3s/low 4s.

I believe that the disconnect between the fundamentals/private market values is largely driven by fund flows out of publicly traded real estate vehicles (ETFs ownership is ~30% for most US REITs). Apartment assets have been lumped in with troubled sectors like hotels, malls, and office. This had led many ‘investors’ to shoot first and ask questions later.

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At Friday’s (11/27) quote, I estimate that Camden trades just north of a 5.2% implied cap rate. MAA also trades 5.2% implied cap rate. There is a notable disconnect between where the sunbelt apartment REITs are trading and the private market value of their assets. Assuming a cap rate of 4.25% (a bit more conservative than recent private market transactions -see more below), CPT and MAA each look to have 25-30% upside.

While the level of upside here is not necessarily exciting, I believe there is limited fundamental downside here given:

  1. Buying a set of assets (which are increasing in value) at a discount.
  2. Inherent stability of assets generating predictable, growing cash flow
  3. Strong balance sheets – Like the large coastal REITs CPT and MAA have conservative balance sheets with sub 30% LTVs and primarily use unsecured funding (MAA recently sold 10 year debt priced to yield 1.8%).
  4. Capable management teams – Management teams at both MAA & CPT have been good stewards of shareholder capital both in terms of operations and capital allocation. I expect this to continue.
  5. Opportunity to create value per share via capital recycling – i.e. selling assets at high 3s cap rates & redeploying into development activities at a 5.5%+ development yields.

While the sunbelt has shown strong population growth, loose zoning and ample buildable land make the supply picture far less knowable/favorable than we see in SF/LA/Boston, etc. Similarly, ample land allows for relatively inexpensive home ownership – in many cases the monthly cost of owning vs. renting is negligible (particularly with sub 3% 30y fixed mortgages). Lastly, as these metro areas evolve, they require additional investments in infrastructure (little state support given no/low state taxes) which can and does lead to higher property tax growth. Property taxes are the largest operating expense component for apartments – large property tax hikes can put a big dent in NOI. So while the population growth (demand) story shines bright, supply/competition from home ownership and higher property tax growth tempers my enthusiasm.

That said, sunbelt apartment REITs trade at notable discounts to private market values. As previously noted, private market values are of particular relevance in analyzing apartment REITs because 95% of apartments are owned privately. Quite simply, the private market is THE MARKET as far as apartment real estate goes. As we sit today, institutional grade apartment assets in the sunbelt are transacting in the private market at high 3s/low 4s cap rates. These mark all time highs for these assets. Here is a quote from Camden CEO Ric Campo:

Source: Seeking Alpha Transcript of Camden 3Q20 Conf call

While private buyers entering at a 4 cap are unlikely to generate the same type of mid teens IRRs we’ve seen in the past, with a typical syndication/private capital structure (70% debt) and given exceptionally low financing costs, here returns tend to be about 10% before fees (model shown here). Further, in general apartment lenders seem rational to me – at least considering their alternatives-i.e. a world of 0.85% yielding 10 year Treasuries. Lenders are receiving triple the interest rate (a 150-180 basis point spread).

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As such, it is conceivable that cap rates for apartment assets (coastal and sunbelt alike) could trend even lower given how pricey other asset classes have become (many equities, bonds, crypto). Apartment assets provide very durable streams of inflation protected (rents reprice annually) cash flow – equity and debt investors alike may be willing to accept even lower returns in the future. I’d certainly rather own apartments, even at a cap rate in the 3s, instead of bonds over a 10+ year horizon.

On Camden’s 3Q call, Campo went on to discuss the opportunity for ‘capital recycling’ which quite simply means that in today’s environment, Camden has the opportunity to create value for shareholders by: 1) disposing of properties at advantageous cap rates (sub 4%) and (2) redeploying that capital at much higher rates of return. Of course, the reader must be wondering: with private market pricing at all time highs, how can Camden deploy capital at high rates of return? Development. Over the past decade, CPT has sold older assets at advantageous prices and redeployed the proceeds into development projects, earning higher yields. It will likely execute a similar playbook going forward.

Source: Camden Investor Presentation

Camden and other apartment REITs have demonstrated an ability to develop assets at attractive yields (NOI of development / cost of development). Of course there are challenges/risks associated with development, mainly:

1) Construction costs

2) Availability of financing

3) Lease up risk

In today’s economic environment, all of these pose challenges- construction costs have yet to come down (and can be made worse by work rule changes due to COVID). While financing is readily available for stabilized asset (a stabilized asset is constructed and leased), financing (both debt and equity) is generally scarce for apartment development. While the overall demand has been strong historically in Camden’s markets, the present economic uncertainty poses a higher level of lease up risk. Unlike an office or retail project which typically has a meaningful component of pre-leasing (signing tenants to contractually binding leases prior to the shovel hitting the dirt), apartments are not leased until the project is complete (or very nearly complete). This creates a higher risk situation for the developer (which in turn can make lenders hesitant, particularly in a murky economic environment).

While this sounds risky and negative, this creates opportunity for experienced operators like Camden and Mid-America (amongst coastal operators, AVB is best known for its development prowess) to earn attractive yields on development. In many cases, yields here are 5.5+% which makes development an attractive use of capital (even relative to stock repurchases). In order to succeed, the developer/operators needs to:

1) select the right project – correctly anticipate demand (occupancy & pricing)

2) finance the project

3) manage the project successfully – complete on time & on budget

4) lease the project up – starting from 100% vacancy in a tough/potentially tough economy – this is no easy task.

Fortunately CPT/MAA have shown an ability to do this time and again. Competitive advantages include: 1) accumulated market knowledge/ construction experience which enables them to select the right locations and come reasonably close to estimated completion cost/time (2) Financing – MAA/CPT have very strong balance sheets and financing is not a hurdle (3) market knowledge coupled with leasing teams armed with industry leading software tools put CPT/MAA in position to successfully lease up their projects.

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While there are few opportunities for the REITs to buy apartment assets, there are ample opportunities to create value by selling assets at all-time high prices and earn high rates of return on the proceeds. That said, development activity is limited to 4-5% of the total portfolio (to mitigate risk) – as such, as a base case I expect capital recycling/development will accrete about 1-2% to NAV per share for CPT/ MAA over the next 2-3 years. Coupled with debt paydown (AFFO payout below 100%) and NOI growth, I expect that CPT/MAA will increase NAV 5-6% per year while paying 3%+ dividend yields.

However, to the extent that CPT/MAA become more aggressive in selling assets at sub 4% cap rates while developing assets at 5.5-6.5% cap rates, this would create additional value for shareholders.

Here is a look at the valuation of Mid-America and Camden:

CPT

MAA

NOI – 2021e $ million

656

1,000

NOI – 2023e $ million

696

1,060

Share Price (11/27/20 close)

97.6

124

Units o/s (thousand)

102,000

119,000

Market Cap $ million

9,955

14,756

Enterprise Value/Total Cap

12,576

19200

Apartment Units (thousand)

53,000

100,500

EV/ Apartment Unit

237,283

191,045

Implied Cap Rate (2021)

5.2%

5.2%

Implied Cap Rate (2023)

5.6%

5.6%

Fair Value 2021

127

162

Fair Value 2023

138

173

Cap Rate used for Fair Value

4.25%

4.25%

Upside to 2021 Fair Value

30%

31%

The above assumes that 2021 NOI is flat compared to 2019. On the one hand, population growth has generally been strong and renewal rents have been positive. On the other hand, 2021 will see some flow through impact of negative new lease rates signed in 2020 as well as higher operating expenses – mainly property taxes. As mentioned above, property tax growth is higher in sunbelt markets than in California or Massachusetts where it is capped. Looking out 2-3 years I expect NOI (akin to adjusted EBITDA) growth of 2.5-3% driven by continued high occupancy and modest rent growth (demand should be solid but we are likely to see some supply growth). This could prove slightly conservative.

I use a 4.25% cap rate in valuing the assets – this is slightly more conservative than where assets are currently trading (3.75-4.0%) and gives a bit of cushion if interest rates rise. If valued at a 4% cap rate, the 2021 fair values for CPT and MAA would be $136 and $174, respectively.

Risks

– Investors continue to shun REITs in favor of growth/tech stocks.

– Expense growth, in particular property taxes are greater than expected.

– Supply growth accelerates, depressing rent and occupancy.

Disclosure: I am/we are long MAA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long CPT, EQR, ESS, AVB



Via SeekingAlpha.com

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