Despite Another Strong Quarter, Questions Ahead for Some REITs

So far, 2015 has been a noteworthy year for the apartment REITs. Two longtime public companies, Home Properties and Associated Estates, were sold. And Equity Residential announced it was selling 23,262 apartment units to Starwood. 

With those transactions in the background, dispositions were obviously at the forefront of the recent earnings calls. But that wasn’t the only theme. Here’s a look at the main trends coming out of third-quarter earnings:

Fundamentals Stay Strong

For the apartment REIT universe as a whole, the quarter was great and continued a strong year, which saw median same-store net operating income at 5.3% and 6.1% in the first and second quarters, respectively, according to Fitch Ratings. 

“On the fundamentals side, [3Q] was a great quarter,” says Britton Costa, director of U.S. Corporates, REITs, for Fitch. “Occupancies remain high and same-store NOI growth was in that mid–single-digit level, which is still pretty high on an absolute level.”

The apartment sector outperformed the RMS REIT Index in the third quarter by 540 basis points, according to Rod Petrik, managing director at Stifel Nicolaus. Additionally, it said apartments were the second-best–performing REIT sector next to storage, with 16.1% growth.

Green Street Advisors saw the same trends. “The third quarter was maybe slightly ahead of our expectations,” says John Pawlowski, a research associate at Green Street. “And our expectations were ahead of consensus. We had a bullish view of operations for several quarters.”

Buying and Selling

The two privatizations and the EQR sale grabbed the headlines this year. And rightfully so. With the EQR portfolio sale to Starwood, Green Street says REITs as a whole have been net sellers so far in 2015. 

“Acquisition volumes have been pretty muted year to date,” Costa says. “That really is a reflection of high capital values and private markets' appetite for real estate.”

With that sale, it’s easy to understand why analysts were quizzing REIT CEOs about dispositions. “The biggest topic on all of the calls is, ‘Do you foresee an EQR-like transaction for your portfolio?’ ” Costa says.

But that doesn’t mean all REITs are sellers. Post Properties announced its re-entry into Denver with a $90 million development, while Aimco made a large purchase in San Francisco. Both moves puzzled analysts. The more common approach for apartment REITs has been to funnel disposition proceeds into development.

“Most companies believe that development makes more sense than acquisitions at this point in the cycle, as yields remain attractive,” wrote Petrik. “Most public REITs increased development in 2015 and have remained at consistent levels through 2015. However, we expect to see development starts and deliveries shrink in 2016, given higher land and construction costs. AVB has the largest absolute development pipeline, at $2.8 billion. Monogram has the largest pipeline under construction relative to its size, representing 18.1% of its enterprise value.”

Trouble Spots

Despite its optimistic view of this sector recently, Green Street pulled down its 2015 to 2017 NOI growth projection from 4.7% to 4.5%. “Construction is at its highest level since 1987,” Pawlowski says. “We brought down our rent growth outlook because of new supply and less job growth to support that new supply.”

Green Street says property taxes, which are about one-third of total taxes, could also weigh on profits.

“We’re bringing up our operating expense outlook, which is largely driven by tax commentary from REIT executives,” Pawlowski says. "For instance, UDR mentioned that the New York City tax abatement burn-off will have a big impact in 2016 and 2017.”

Supply is another often-cited concern. It’s been an issue in Washington, D.C., though that metro area is enjoying rent growth once again. Other markets, like high-growth Sun Belt metros, New York, Boston, Seattle, San Jose, and downtown Los Angeles, are seeing supply. The biggest issue, however, is Houston, which is plagued by oil woes and is welcoming new supply.

For 2016, Stifel’s Petrik expects more of the same. “We believe 2016 will look a lot like 2015,” he wrote. “We expect a slight tick-down on the revenue side and moderate increase on the expense side, resulting in slightly lower NOI. Investor fears typically surround the supply picture for 2016. We continue to believe the country is undersupplied and that national supply and demand will once again be in equilibrium in 2016.”