AvalonBay REIT: Getting In on the Ground Floor

ONCE THE POSTER CHILD FOR AN EXUBERANT real-estate market -- and exuberant real-estate stocks -- AvalonBay Communities has had its comeuppance. The real-estate investment trust's shares have fallen 61% in the past two-and-a-half years, as higher financing costs, lower rental income and leverage combined to devastating effect.

But there is some good news: At a recent 56, Avalon's shares (AVB) reflect these challenges, and the deeply depressed state of the apartment-rental market generally. The stock is trading near the company's asset value, which analysts estimate is between $47 and $70 a share, down from more than $120 two years ago.

What the shares don't reflect is a potential turn in the rental market, which could come sometime in 2011. REIT stocks should bottom well in advance of REIT operators' results.

"The market has already set a very low bar," for this company, says Alexander Goldfarb, a senior REIT analyst with Sandler O'Neill. He recently upgraded the stock to Buy with a 61 price target, in part because of the market's dour sentiment.

And if the recovery takes a bit longer to materialize? AvalonBay investors needn't panic: They will be compensated with a dividend of $3.57 a share, and a yield of 6.3%.

Based in Alexandria, Va., AvalonBay develops and operates apartment buildings. It also manages two investment funds that purchase existing buildings. At the end of the first quarter it owned or held an ownership interest in 173 communities with 50,291 apartments in 10 states, primarily on the East and West Coasts, and the District of Columbia. Twelve of those communities were under construction, and seven were under reconstruction.

Barron's last looked in on the company in March 2007, in a piece skeptical of the stock's then-"go-go" valuation ("Apartment-House Blues," March 5, 2007). The shares have fallen 56% since.

One factor likely to bolster AvalonBay's business is a peak in the unemployment rate -- currently 9.5%. That's more than double the December 2006 low of 4.4%, and analysts see it rising to 10% or 11%. When unemployment begins to fall and more people start earning paychecks, they can become renters, helping apartment REITs.

It is widely anticipated that management will lower its guidance for 2009 earnings this week when it reports second-quarter results, because the unemployment rate is higher than expected. The guidance it delivered in January was based on projected losses of about three million jobs, but more recent estimates put such losses at about five million.

Avalon told investors in January to expect funds from operations, or FFO, of $4.50 to $4.80 a share in 2009. The Street is looking for $4.55, up from $4.07 last year, which reflects an 80-cent fourth-quarter charge related to land impairment and the cancellation of a planned development. FFO is the REIT industry's measure of profitability; it equates roughly to net income with depreciation added back in.

Avalon could reduce guidance by as much as 6%, moving the FFO range down to $4.20 to $4.50 a share to give itself ample cushion, says Craig Leupold, president of Green Street Advisors in Newport Beach, Calif. He sees FFO of $4.51 this year, followed by $3.84 in 2010 and $3.69 in 2011. If management cuts its forecast further, the shares, which rallied sharply last week, could ease into the low $50s.

The expected declines in FFO reflect a combination of lower occupancy levels and rental rates and higher costs. At the end of the first quarter, occupancy rates were 94%, and rental rates on new leases were 10% to 12% below what the prior tenants paid. Renewal rental rates were up 2% on average.

AVALON IS EXPOSED TO SOME of the hardest-hit markets in the U.S., including New York and California. The New York City properties have experienced rental declines of 15% to 20% when tenants turn over. Roughly 60% of Avalon's leases expire in the spring and summer, so second-quarter results, and guidance, will be telling.

There is some debate about whether the company's higher-end properties will fare better or worse than those on the lower end. Naysayers say more expensive properties will have a tougher time filling up as renters go looking for bargains, but CEO Bryce Blair notes both are under pressure. Expensive properties are under "marginally" more pressure, but will outperform less-expensive apartments once the market starts to recover, he adds.

Some apartment REITs trade at lower multiples of FFO adjusted for maintenance capital expenditures than AvalonBay's 15.7. Some competitors also sport greater discounts to net asset value. But Avalon has by far the best balance sheet of the group and, unlike some competitors, doesn't need to raise new equity. The company's debt-to-assets ratio is 46%, the lowest among apartment REITs.