As a residential REIT, Avalon Bay has pursued the strategy of buying or building high-end apartment communities in areas with high barriers to entry. The company currently has 200 apartment communities, either up and running or in development. High barriers to entry usually entails high real estate prices, ruling out home ownership for many who can afford relatively high apartment rents. The Avalon Bay communities are primarily located in the Boston, New York City, Washington, D.C., Los Angeles, San Francisco and Seattle areas.
The current valuation for the Avalon Bay shares is to a great extent based on strong demographic and economic trends in the company's favor including:
- The growth of the target young adult and jobs for those young adults are strong in the markets targeted by Avalon Bay.
- Home ownership is declining for the target population, and that demographic may be less inclined to desire home ownership in the current housing market environment.
- A recovery in the single family housing market is not expected in the near future.
- The supply of new apartments is falling, with construction levels now 40% below the 2008 levels. Lower supply means stronger pricing power.
- Apartment rental revenue is in the fifth year of a new up cycle, following a six-year down cycle. The last up cycle lasted 18 years.
Looking at the financials, for 2011 Avalon Bay reported earnings per share of $4.87, compared to earnings of $2.10 in 2010. Funds from operations – FFO, the money which supports the dividend – was $4.57 per share, up from $4 a year earlier. Dividends paid for the year totaled $3.57 per share or 78 percent of FFO. Company guidance for 2012 is FFO of $5.25 to $5.55 per share. The midrange value represents an 18% increase over 2011. For 2012, the quarterly dividend was increased to 97 cents, up from the previous 89.25 cents. The new, $3.88 annual dividend would be a 72 percent payout ratio on the midpoint of the 2012 FFO guidance. The dividend increase was the first payout increase from Avalon Bay in over three years.
Avalon Bay is definitely a real estate company with growth prospects and a plan in place and being implemented to take realize those prospects. The main problem with Avalon Bay as an investment is that it appears the stock price has run out ahead of a fair valuation at this point in the growth cycle. The AVB share price is up 23% in the last year, while competitors such as Apartment Investment and Management Company (AIV), Essex Property Trust (ESS) and Equity Residential (EQR) have gained 0% to 14%. Although Avalon Bay may be the premium company of this sector of the REIT world, the stocks typically bunch closer together. Another troubling valuation factor is the low dividend yields for all of these residential REIT stocks. The yields range from 2.7% to 2.9%. Avalon Bay has a 2.9% yield based on the new, higher payout, the first of which has not yet been paid.
If Avalon Bay is – as hypothesized here – overvalued, investors can judge an entry point based on an expected dividend yield. Two years ago, the dividend yield on Avalon was 4.4%. Since then, the share price appreciated by 66%. Waiting for the stock to yield 3.5% would indicate a pull back to $111 from the current $132. If an investor believes the stock is a value at a 4% yield, the shares need to drop to $97. The point here is that Avalon Bay has a lot of long-term potential, but the current stock price is too rich for the current dividend yield and for probable FFO and dividend increases in the future. The big REIT money will start to look elsewhere for better yields and the share price of Avalon will come down to more attractive levels.
About the author:
I practice Judaism and my faith is very important to me. I visit family in Israel once a year, but I am educated and work in the United States where I hold an MBA and a bachelor’s in English. I am a patient man, enjoy wine but am not a connoisseur, and I listen more than I speak.