Company Reports

The REIT sector in the US offers many companies that should see relatively stable cashflow growth over the next several years. While the pandemic hurt REIT valuations in 2020, the recovery of fundamentals across most sectors combined with low interest rates led to strong total returns in 2021 and early 2022. However, despite fundamentals continuing to perform well over the past three years with many reaching historical levels of net operating income growth, the REIT sector underperformed the broader equity markets in 2023 and into the first half of 2024. We believe that is due to the sector’s negative correlation with interest rates, as income-oriented investors rotate out of the sector, higher rates lower the value REITs can create with external growth, and property valuations fall in line with higher rates. However, interest rates have fallen since the end of July, leading to a rally for the REIT sector. Still, we still view many of companies in the US REIT sector as being undervalued as the companies should continue to produce solid long-term growth.

Despite a rally over the past two months, we still view the US REIT sector as being undervalued. While the pandemic hurt REIT valuations in 2020, the recovery of fundamentals across most sectors led combined with low interest rates led to strong total returns in 2021 and early 2022. However, despite fundamentals continuing to perform well over the past three years, with many reaching historical levels of net operating income growth, the REIT sector has underperformed the broader equity markets in 2023 and into the first half of 2024. We believe that the cause has been due to the sector's negative correlation with interest rates as income-oriented investors rotate out of the sector, higher rates lower the value REITs can create with external growth, and property valuations fall in line with higher rates. However, interest rates have fallen since the end of July, leading to a rally for the REIT sector. We believe that US REITs will continue to see share price movements that are inverse of interest rate movements.

Avalonbay Communities reported second-quarter results that were relatively in line with our expectations, giving us confidence in our $221 fair value estimate for the no-moat company. Same-store occupancy improved 10 basis points sequentially to 96.0% in the second quarter. Since average rental rates were up 3.2% year over year, same-store revenue was also up 3.2%, which was relatively in line with our estimate of 2.9% growth. Same-store operating expenses were up slightly higher at 3.8% in the quarter, so same-store net operating income, or NOI, growth was 3.0%, though that was better than our estimate of 2.7% same-store NOI growth. The company reported core funds from operations, or FFO, of $2.77 per share in the second quarter, which was a penny better than our $2.76 estimate and nine cents better than the $2.68 guidance management had previously given for the second quarter.

AvalonBay Communities owns and operates high-quality multifamily buildings in urban and suburban coastal markets with demographics that allow the company to maintain high occupancies and drive strong rent growth, specifically, New England, New York/New Jersey, the mid-Atlantic, Southern California, Northern California, and Seattle. These markets exhibit traits that create strong demand for apartments like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger people. The company regularly recycles capital by selling noncore assets or exiting markets and using the proceeds for its development pipeline or acquisitions with promising growth prospects, a sound strategy that continues to produce strong returns.

The US REIT sector remains significantly undervalued, in our perspective. While the pandemic hurt REIT valuations in 2020, the recovery of fundamentals across most sectors combined with low interest rates led to strong total returns in 2021 and early 2022. However, despite fundamentals continuing to perform well over the past two years, with many REITs reaching historical levels of net operating income growth, the sector has underperformed the broader equity markets over the past two years. We believe that the cause has been the sector’s negative correlation with interest rates as income-oriented investors rotate out of the sector, higher rates lower the value REITs can create with external growth, and property valuations fall in line with higher rates. However, we don’t believe that higher rates significantly change our fair value estimates for the sector. Additionally, interest rates are down from the October 2023 highs, and REIT share prices have generally inversely followed the movements of the US 10-year Treasury.

AvalonBay Communities' first-quarter results were slightly better than anticipated, leading us to reaffirm our $213 fair value estimate for the no-moat company. Same-store occupancy improved 30 basis points sequentially to 95.9%, better than our expectations of flat growth. Average rental rates improved 4.4% year over year, slightly better than our estimate of 3.9% growth, leading to same-store revenue growth of 4.2% in the first quarter. Same-store operating expenses were up a little higher at 5.2% in the quarter, so same-store net operating income growth was 3.7%, better than our 2.3% estimate. AvalonBay reported core funds from operations of $2.70 per share in the first quarter, slightly better than our $2.68 estimate and 5.1% higher than the $2.57 figure reported in the first quarter of 2023.

We believe that there are several attractive opportunities across the US REIT sector for investors to consider. Following the recovery of many REIT sector fundamentals from the pandemic by mid-2021, we viewed the REIT sector as fairly valued through early 2022. However, the past two years have seen the rapid rise in interest rates and a slowing economy, which has led to major valuation declines across the sector. Our analysis of the REIT sector over the past 25 years suggests that the relative stock performance of REITs is negatively correlated with interest rate movements. The second and third quarters of 2023 saw large interest rate increases with the 10-year Treasury approaching 5%, which led to the sector underperforming. This occurred even as many REITs reported same-store net operating income, or NOI, growth at historical highs in 2022 due to high inflation. Higher interest rates, lower liquidity, tighter capital market conditions, and decelerating same-store NOI growth all led to a significant correction in the stock price for many REITs.

New single-family home sales increased 4% in 2023 to 666,000 units, as homebuilders capitalized on a dearth of existing for-sale inventory while also offering more sales incentives, cutting base home prices, and building smaller homes to improve affordability. By the fourth quarter of 2023, homebuilders began to pull back on sales incentives as the average 30-year fixed mortgage rate retreated from 7.62% in October 2023 to 6.64% in January 2024. However, mortgage rates have trended higher recently, and we now forecast the average 30-year fixed rate will be 6.50% in 2024, up from our previous forecast of 6.10%. Even so, that’s lower than the 2023 average of 6.81%, and we think homebuilders won’t hesitate to increase sales incentives if needed; they still enjoyed above-average gross profit margins last year with elevated incentives. As such, in 2024, we think new-home sales will increase 9% to 730,000 units and single-family housing starts will increase 4% to 985,000 units. However, we expect total housing starts will decline roughly 5% to 1,345,000 units due to a 23% decline in multifamily starts to 360,000 units, as there’s currently approximately 1,000,000 multifamily units under construction—the largest backlog in at least 50 years.

AvalonBay Communities owns and operates high-quality multifamily buildings in urban and suburban coastal markets with demographics that allow the company to maintain high occupancies and drive strong rent growth, specifically, New England, New York/New Jersey, the mid-Atlantic, Southern California, Northern California, and Seattle. These markets exhibit traits that create strong demand for apartments like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger people. The company regularly recycles capital by selling noncore assets or exiting markets and using the proceeds for its development pipeline or acquisitions with promising growth prospects, a sound strategy that continues to produce strong returns.

AvalonBay Communities reported fourth-quarter results that were in line with our estimates, leading us to reaffirm our $233 fair value estimate for the no-moat company. Same-store occupancy sequentially fell 10 basis points to 95.6% in the fourth quarter. Meanwhile, average rental rates were up 4.7% year over year, which drove the company's same-store revenue growth of 4.5% that was slightly below our estimate of 5.6% growth for the quarter. Same-store operating expense growth matched our 6.2% estimate, so the company reported same-store net operating income, or NOI, growth of 3.8% for the fourth quarter. AvalonBay reported core funds from operations, or FFO, of $2.74 per share, which matched our estimate for the quarter and was 5.8% higher than the $2.59 the company reported in the fourth quarter of 2022.

New-home sales have rebounded since the spring of this year as sales incentives and price reductions have attracted buyers who have fewer options in the supply-constrained existing-home market. That said, homebuilder sentiment data tells us that smaller builders remain cautious. Even so, we forecast single-family starts to increase by 3% in 2024, to 0.92 million units. However, we project this increase in single-family starts will be more than offset by a 24% decline in multifamily starts, to 0.36 million units. Multifamily construction has been robust for the past three years, but a record construction backlog and higher construction and financing costs have tamed developers' appetite for new multifamily projects.

Third-quarter results for AvalonBay Communities were relatively in line with our expectations, leading us to reaffirm our $233 fair value estimate for the no-moat company. Same-store occupancy fell 20 basis points sequentially to 95.7% in the third quarter, slightly worse than our estimate of 95.9%. However, rental rates for the same-store portfolio were up 5.4% year over year, slightly better than our estimate of 5.1% growth, and same-store revenue increased 5.2% year over year, slightly better than our 5.1% estimate. Same-store operating expenses were up a similar 5.0%, leading to same-store net operating income growth of 5.3% that was slightly better than our estimate of 4.8% growth. AvalonBay reported normalized funds from operations of $2.66 per share in the third quarter, $0.04 better than our $2.62 estimate for the quarter.

AvalonBay Communities owns and operates high-quality multifamily buildings in urban and suburban coastal markets with demographics that allow the company to maintain high occupancies and drive strong rent growth, specifically, New England, New York/New Jersey, the mid-Atlantic, Southern California, Northern California, and Seattle. These markets exhibit traits that create strong demand for apartments like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger people. The company regularly recycles capital by selling noncore assets or exiting markets and using the proceeds for its development pipeline or acquisitions with promising growth prospects, a sound strategy that continues to produce strong returns.

The share prices of U.S. real estate investment trusts have fallen by approximately 30% from their 2021 highs because of higher interest rates and stress in some commercial real estate sectors. We think that the correction is overdone and the current valuations offer an attractive entry point for patient investors. Our core REIT coverage is trading at a discount of approximately 25% to our fair value estimate. We estimate that the average REIT within our U.S. coverage is currently trading at a dividend yield that is 126 basis points higher than the historical average. We see marked differences in valuation across different REIT sectors in the United States. For instance, the industrial sector is fairly valued, with stock valuations already accounting for future growth, but other sectors like offices, hotels, and malls are trading at attractive discounts.

New-home sales have remained resilient despite worsening housing affordability in recent months amid rising mortgage rates, with little relief in home prices in most markets. Year-to-date new-home sales through July were about even with the year-ago period, compared with a 22% decline in existing-home sales. The key to homebuilders’ relative success this year has been their ability to improve affordability by offering sales incentives, lowering base prices, and building smaller homes. According to the National Association of Home Builders, the share of builders offering incentives was 55% in August, up from 52% in July but down from 62% last year. One fourth of homebuilders reported lowering base prices by 6% on average. Homebuilders have also boosted production of speculative homes to capitalize on the tight supply of existing for-sale homes. Spec building also helps builders better manage construction cycle times and costs.

AvalonBay Communities reported second-quarter results that were relatively in line with our expectations, leading us to reaffirm our $241 fair value estimate for the no-moat company. Same-store occupancy fell 20 basis points sequentially to 95.9%, below our estimate of 96.3% occupancy for the second quarter. However, average rental rates increased 6.7% year over year, slightly better than our estimate of 6.2% growth, leading to same-store revenue growth of 6.3% that was relatively in line with our 6.1% estimate. However, operating expense growth continues to outpace revenue growth, with same-store operating expenses up 8.2% in the quarter. The high expense growth was driven by a 30.7% growth in utility costs caused by the company ramping up bulk internet access across its portfolio, which increased revenue growth but also increased internet and electricity usage. Other expense items like repair costs, office operations, and marketing costs also saw double-digit year-over-year growth in the second quarter. As a result, same-store net operating income grew 5.4%, which matched our estimate for the second quarter. AvalonBay reported normalized funds from operations of $2.66 per share in the second quarter, a penny below our $2.67 estimate.

Through the first four months of 2023 (typically viewed as the “spring selling season” for homebuilders) new home sales significantly outperformed existing home sales. Indeed, April year-to-date new home sales declined roughly 10% year over year compared to over a 26% decline for existing home sales. New home sales improved sequentially during the first four months of the year, and April sales increased 11% year over year, albeit on an easy prior-year comparison (April 2022 new sales were down 24% year over year).

First quarter results for no-moat AvalonBay Communities were relatively in line with our expectations, leading us to reaffirm our $241 fair value estimate. Same-store occupancy improved 30 basis points sequentially to 96.1%, better than our assumption of flat occupancy growth. Average rental rates were up 9.6% year over year, in line with our estimate of 9.9% growth. As a result, same-store revenue increased 9.5% in the first quarter. However, same-store operating expenses were up 7.1%, the highest single quarter in at least 15 years, as the company saw office operation costs increase 23.3%, utility costs increase 22.9%, and insurance costs rise 11.3%. Same-store net operating income grew 10.7% in the quarter, slightly better than our estimate of 10.0% growth. Core funds from operations came in at $2.57 per share, which was 13.7% above the $2.26 figure reported in the first quarter of 2022 but 2 cents below our estimate due higher to general and administrative costs.

AvalonBay Communities owns and operates high-quality multifamily buildings in urban and suburban coastal markets with demographics that allow the company to maintain high occupancies and drive strong rent growth, specifically, New England, New York/New Jersey, the mid-Atlantic, Southern California, Northern California, and Seattle. These markets exhibit traits that create strong demand for apartments like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger people. The company regularly recycles capital by selling noncore assets or exiting markets and using the proceeds for its development pipeline or acquisitions with promising growth prospects, a sound strategy that continues to produce strong returns.

U.S. home sales slowed significantly in 2022 as rising mortgage rates and elevated home prices made homeownership less affordable for more Americans. By mid-2022, the average 30-year fixed mortgage rate had increased roughly 300 basis points year over year to over 6%. According to estimates from the National Association of Home Builders, this rate increase priced out more than 16 million households. We also think higher rates and general economic uncertainty caused some qualified prospective buyers to move to the sidelines. All told, 2022 new- and existing-home sales declined 17% and 18% year over year, respectively.