Coastal Apartments 2Q22: Strong Operating Metrics Persist, Fortifying Outlook for Future Periods

Skyline of St. Petersburg, Florida

 

Growth In Large-Cap Coastal Apartment REITs

 

While there was a considerable amount of handwringing going into 2Q earnings season for the coastal apartment REITs due to worsening concerns regarding the US economy, the results are in and the group achieved a surprisingly good outcome with earnings beats for the quarter and further increases to full year 2022 guidance. To demonstrate the breadth and consistency of the environment, we note that all four of the large-cap coastal apartment companies raised the full year 2022 funds from operations (FFO) guidance with their second quarter earnings reports, and in some cases, marking the second or third earnings raise since the start of the year.[1] The big winner for the 2Q reporting season was AvalonBay Communities (AVB) with a 3.2% increase to guidance at the midpoint of their revised range. AVB’s more optimistic outlook is partially driven by an upward revision to operating result expectations. They increased their same property net operating income (NOI) growth forecast by +325bps to a range of 13.5% to 15.0%. This increase in operating expectations was also industry leading.[2]

 

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AvalonBay Continues To Pursue New Developments

AVB is also unique in that they are the most development oriented of the coastal companies and this matters greatly in the current environment because the other primary lever for external growth, acquisitions, remains spotty due to the precipitous rise in interest rates which we have seen since the start of the year and has caused a “pause” in transaction activity. AvalonBay completed two development projects in the second quarter at a total cost of $380 million and currently has 16 communities under various stages of development at a total cost of $2.1 billion. The company sees a great deal of value-creation from this pipeline of projects given the upward movement in rents in their markets and the ability to fund the projects with existing sources of capital. AVB also has a great deal of flexibility in terms of moving forward with some projects while holding off on others if they don’t believe their return hurdles can be met in a timely fashion.[3]

 

Key Revenue Drivers

 

Looking at the key revenue drivers for the coastal apartment companies, the key themes from earlier in the year remain intact. With the seasonally strong part of the leasing calendar winding down (usually peaks in August) we are impressed that occupancy levels have largely remained above 96% even though rental rates on new and renewal leases are being maintained in a range of 15-17%, historically high levels for the industry.[4] Digging deeper into this strength, we would note that demand for coastal apartments remains very strong and the core demographic for REIT landlords, highly educated (bachelor degree or higher) singles and couples in the 25–35-year-old age cohort have high paying jobs in growth industries. Equity Residential (EQR) pointed out on their 2Q earnings conference call that the rent-to-income ratio (a measure of a resident’s ability to pay rent) for incoming residents was 18-22% during 2Q, a ratio deemed to be representative of a healthy resident. EQR and their peers also highlight continued low “resident turnover” levels in their portfolios.[5] In the second quarter, there was also a notable reduction in residents moving out to buy homes. This phenomenon is highly correlated to rising mortgage rates and home prices appreciation which has moderated but continues to move higher in many markets. The management team at UDR Inc. (UDR) commented on their earnings call that multi-family rentals in their markets are currently 50% less expensive than homeownership. This compares to rentals being 35% less expensive than homeownership prior to the pandemic.[6] This statistic goes a long way towards explaining why demand for renting is strong and move-outs to buy homes are at a low level.  

 

Inflation Ushers In New Set Of Challenges

 

No discussion of residential REIT fundamentals is complete without touching on operating expenses. The group has been doing an admirable job of managing this line item since the start of the pandemic, but with inflation now running at 9% per annum, operators have a new set of challenges to contend with. In prior posts we have highlighted the tremendous cost advantages that come with the size and scale of the publicly traded landlords. Second quarter operating expenses were hit hardest by utility costs, repairs and maintenance expenses (including labor) and to a lesser extent, real estate taxes. This said, management teams have continued to use innovation and technology to streamline processes and keep operating expense growth at manageable levels. No company in our investible universe has done a better job at this than Equity Residential (EQR), which is guiding to industry leading(ie. lowest) same property operating expense growth of only 3.0% (at the mid-point of 2022 guidance).[7] 

 

Rising Rates Subside The Acquisition Environment

 

The final discussion topic to cover relating to the coastal apartment reporting season concerns the acquisition environment. Companies across the spectrum continue to describe the environment as having been in a “pause” mode or period of “price discovery” since the start of the year. There is a wider than usual “spread” in markets today for core and value-add properties, especially in larger, “institutional” markets such as major coastal metropolitan areas. Rising interest rates coupled with the potential for fundamentals to moderate from current levels has added to the discrepancy in pricing between buyers and sellers.  

 

A Bright Outlook For The Remainder Of 2022

 

In the aggregate, the above expectation earnings reports achieved for second quarter along with visibility into the second half of the year gives us confidence that full year 2022 remains on track to be one of the strongest in history for the apartment sector. With market rental rates moving higher and homeownership becoming less affordable, the outlook for the balance of the year remains bright.  

 

Footnotes:

 

[1] Equity Residential, AvalonBay Communities, Essex Property Trust, UDR, Inc.: Second Quarter 2022 Operating Results

 

[2] AvalonBay Communities: Second Quarter 2022 Operating Results

[3] AvalonBay Communities: Second Quarter 2022 Operating Results

 

[4] Equity Residential, AvalonBay Communities, Essex Proprty Trust, UDR, Inc.: Second Quarter 2022 Operating Results

 

[5] Equity Residential, AvalonBay Communities, Essex Property Trust, UDR, Inc.: Second Quarter 2022 Operating Results

 

[6] UDR, Inc.: Second Quarter 2022 Earnings Conference Call

 

[7] Equity Residential: Second Quarter 2022 Operating Results

 

Definitions:

Basis Point: The conventional measure for interest rates and other percentages in finance. One basis point equals 1/100th of 1%, (0.01%).

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Glossary Terms

Basis Point (BPS): A basis point is a common unit of measure for interest rates and other percentages in finance. Basis points are typically expressed with the abbreviations bp, bps, or bips. One basis point is equal to 1/100th of 1%, or 0.01%.

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Book Value: Book value is equal to the cost of carrying an asset on a company’s balance sheet, and firms calculate it netting the asset against its accumulated depreciation.

Cap Rates: The capitalization rate (also known as cap rate) is used in commercial real estate to indicate the expected rate of return on an investment property.

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Funds From Operation (FFO): The most commonly accepted and reported measure of REIT operating performance. Equal to a REIT’s net income, excluding gains or losses from sales of property and adding back real estate depreciation.

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