Apartment REITs Pull Ahead
But Good Times May Not Last

After several years of trailing the performance of most other real-estate investment trusts, "multifamily" REITs have now pulled ahead of the pack.

But the good times could be short-lived for these investments in apartment holdings.

On the surface, all seems rosy. With fewer Americans eager to buy homes, more are renting and allowing landlords in many markets to raise rents at the fastest pace in years while cutting back on concessions. Strong job growth also has increased the demand for rentals.

Apartment REITs as a group reported the best net operating-income growth during the first quarter of 2006 -- 7.5% -- since 2000, according to Lehman Brothers, which includes 12 companies in its survey. Their stocks, which include Archstone-Smith and AvalonBay Communities Inc., are trading at 20 times their 2007 funds-from-operations per-share estimates, pricier than the 16.6 times for REITs overall. Funds from operations, or FFO, is a commonly used earnings metric for REITs that excludes gains or losses from property sales while adding back depreciation, among other adjustments.

But healthy apartment fundamentals aren't the only reason behind these rich valuations. Analysts say the stock prices also reflect an expectation that the merger-and-acquisition activity, which has recently taken place among the multifamily REITs, will continue. In the past nine months, three REITs in the sector have gone private at rich premiums relative to their stock price, says Ross Smotrich, a REIT analyst with Bear, Stearns & Co. Mr. Smotrich doesn't own any multifamily REIT stocks. Bear Stearns does have investment-banking relationships with some REITs.

"I think people are basically taking the pricing out of the prior deal and applying it to the companies that are still out there," Mr. Smotrich adds. "They don't take into account that not all companies are ready to go private."

So here is the million-dollar question: Are the multifamily REITs already priced to perfection or are they reflecting an optimism that is going to be justified? David Harris, a bearish REIT analyst at Lehman Brothers who publishes recommendations on six apartment-REIT stocks, seems to be leaning toward the former point. "Some criteria suggest investors are pricing in a more bullish scenario than may actually happen," he says. Mr. Harris doesn't own any shares of multifamily REITs, although Lehman does business with some of the companies.

By all accounts, the apartment market will continue to hum along, at least through year's end. But analysts point out several troubling factors that could eventually hurt multifamily fundamentals, issues to which some believe investors aren't giving enough credence. First, a slowing economy and lower rates of job growth could weaken the demand for apartments. In addition, a number of apartment REITs have announced plans to ramp up development, so oversupply could be a factor, too.

Another concern is the cooling condominium market. The apartment REITs have benefited hugely from the hot condo market, either through executing condo conversions or selling assets at an extremely low capitalization rate, which is the return on investment during the first year of ownership. So analysts say it is to be expected that these REITS will be affected somewhat by any reversal in the condo market.

Signs of trouble are appearing in certain markets. Apartment demand in Dallas is waning as more home builders are luring buyers through an increasing number of sales incentives. And in Tampa, Orlando and southeast Florida, a large amount of apartment supply that had been taken out of the market for condo conversion is already returning to the rental pool.

Green Street Advisors, a Newport Beach, Calif., real-estate research firm, said in a recent note to clients that the apartment REITs with the greatest exposure to Texas and Florida include Post Properties Inc. (31% of net operating income -- an important measure of a property group's profitability), Camden Property Trust (30%), Mid-America Apartment Communities Inc. (28%) and United Dominion Realty Trust Inc. (27%).

Green Street analyst Craig Leupold says these companies aren't being hurt by the trends at this point. But the abnormally high revenue-growth rates in Florida could moderate to a rate more in line with those experienced in other apartment markets, he adds. Investors there, for instance, might be disappointed to see a reduction in the rental-growth rate from the current 9% level to something closer to 5%, which is still considered strong. Green Street has a "sell" recommendation on United Dominion and "hold" ratings on Camden Property and Post. It doesn't rate Mid-America.

So in some cases, the sky-high valuations of these apartment stocks seem incongruent with their exposure to certain risks. Post Properties, for instance, trades at one of the richest multiples in the REIT group, at a 14.4% premium based on Citigroup's net-asset value estimate. Yet the Atlanta apartment company operates in low-barrier markets with signs of overbuilding, such as Texas, Florida and Atlanta. Post is also making plans to ramp up condominium development despite signs that sales are slowing in the markets in which they are developing condos. At 4 p.m. yesterday in New York Stock Exchange composite trading, Post was up $1.25, or 2.8%, to $46.65.

"We struggle to understand the business strategy and the valuation relative to the fundamentals," says Citigroup analyst Jonathan Litt, who has a "sell" rating on Post's stock. He doesn't personally own any shares of Post, although Citigroup has a relationship with the company.

Home Properties Inc. also might be benefiting from apartment-REIT exuberance. Its total return, year to date, is 37.2%. But the Rochester, N.Y., company's recent business activities -- including the announced sale of its Detroit portfolio and a shifting of utility costs from the landlord to the tenant -- "were executed later than we would have liked," says Richard Anderson, a senior REIT analyst at BMO Capital Markets, who has an "underperform," which means he believes the stock's total return will fall short of the Standard & Poor's 500-stock index's return. Its shares were up $1.01 to $54.87 yesterday on the Big Board.

Another possibly overpriced REIT? Apartment Investment & Management Co. The Denver company's total return -- the combination of stock-price appreciation and dividend yield -- this year is 26.9%. But it is also in the process of getting over a difficult past few years, which included some operational missteps and management changes. Therefore, "the stock has performed well, but that's partially a function of weak results to compare to," says Mr. Anderson, who has an "underperform" on Aimco.

In the end, even in the face of slowing job growth, for instance, multifamily valuations could very well remain elevated for an extended period, given the sea of capital being thrown at commercial real estate, concludes Ross Nussbaum, head of REIT equity research at Banc of America Securities. "However, this would only serve to make the assets and multifamily REITs look even richer, setting the stage for an ugly end to the story if or when the capital flows subside." Mr. Nussbaum doesn't personally own any multifamily REIT stocks, although Banc of America does investment-banking business with a number of them.

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