Multi-family REIT arena looking more favorable

Real Estate Weekly, Dec 15, 1999 by Paul Puryear, Bill Crow

In our opinion, investing in the multi-family REIT arena looks more favorable today than any time during the past couple of years. Drivers to underlying fundamentals, namely supply and demand, are significantly better today than a year ago.

Specifically, while we continue to carefully monitor the construction starts and permits data and acknowledge some difficulties in some southwestern and southeastern markets, all indications are that excessive construction should not be an overwhelming problem in the upcoming 12 months.

Furthermore, the economy has continued its persistent march, leaving unemployment levels low and consumer demand for housing high. In fact, the strength of the U.S. economy and fears of inflation have resulted in higher interest rates - a plus for apartment owners as the economic decision of rent versus own shifts toward apartments.

Reflecting the solid fundamental underpinnings and financial performance that has generally met or exceeded expectations, apartment REITs have outperformed other REIT sectors year to date. Inclusive of dividends, apartment REITs have delivered an average year-to-date total return of 5.5 percent through November 18th.

Despite the fundamental outlook, multi-family REIT shares by and large remain undervalued, plagued by apparent investor apathy regarding cyclical, small cap and value stocks. While we acknowledge that the positive total returns generated by year to date make the group look a little more expensive than other sectors on a multiple basis, we continue to stress net asset value as the primary valuation gauge. We remain consistent in our long-held belief that well-managed REITs should trade at least in-line with and generally at a modest 10-15 percent premium to underlying net asset value. Currently, all six of the multi-family REITs we formally cover remain priced at meaningful discounts to NAV. We believe this valuation parameter was validated again in late September when Walden Residential announced a going-private transaction at a price nearly identical to our previously published NAV estimate for the company.

Industry Perspective - Looking Ahead

We continue to believe that over the long run, multi-family REITs can take advantage of the tremendous consolidation opportunities, margin improvement abilities via economies of scale, increased revenues from non-traditional sources, and certain demographic trends to produce attractive total annual returns for shareholders. We have historically favored middle-income apartments that we consider to be less susceptible to the negative affects from new construction, since the very nature of the economics of new construction virtually demand that it be aimed at the high-end renter. These same attributes still apply to the sector. We are also attracted to REITs that operate in economically vibrant markets where supply of new apartments is limited. Specifically, we have long favored Essex Property Trust due, in part, to its focus on supply constrained markets in the San Francisco Bay area and Southern California. We are also attracted to the investment opportunities present in Charles E. Smith Residential Realty. C harles E. Smith should realize above-average same-store NOI growth emanating from the vitality of its markets (Washington D.C., Chicago, Miami and Boston) and the higher barriers to entry existing in Smith's primary submarkets.

As long as demand meets supply, we believe the better operators should realize top-line gains in line with or slightly exceeding inflation (i.e., 3 percent rental revenue growth), while operating expenses could grow at perhaps 50-100 basis points less than the rent revenue growth rate. Adding leverage and a bit of external growth, we continue to believe over the longer-term, well-run multi-family REITs are capable of generating 6-9 percent FFO growth that, when combined with 5-8 percent dividend yields, should provide investors with attractive mid-teens total annual returns.

As we have written in past comments and reports, the combination of a robust economy featuring low unemployment, healthy job growth and relatively low interest rates enticed apartment builders to increase the pace of construction in late 1998. Furthermore, the rising cost of acquiring apartments reduced the gains from spread investing and swung the risk/reward pendulum toward development.

With multi-family starts and permits data available through October of this year, it generally appears as though developers have displayed a degree of discipline that has rarely been witnessed during an expansion phase of previous economic cycles. Although October permit data bounced off September's 28-month low point, it appears to us as though nationwide starts in 2000 should fall in the low 300,000 range.

It is evident to us that the global economic concerns of last fall, the mountains of market and sub-market specific data available to lenders, some weakness in low barriers to entry markets such as Houston, Las Vegas and Phoenix, higher interest rates, and limited access to capital on the part of REITs have combined to curtail apartment construction.