The impact of the global pandemic has been felt throughout the real estate investment trust (REIT) space. Some areas have benefited, such as industrial and warehouse assets, while others have seen performance fall off a cliff, such as hotels. Somewhere in between those extremes is the apartment sector, which is seeing an outflow of residents from city regions to rural areas right now. AvalonBay Communities (NYSE:AVB) is on the wrong side of that trend, but that could be a long-term opportunity.
You've gotta have a home
One of the things that has long underpinned apartment landlords like AvalonBay is the simple fact that people need to live somewhere. So owning well-run and well-located properties is generally a fairly consistent business over time. Recessions can lead to occupancy declines and difficulty collecting some rent, but the variability over the longer term tends to be much less material than in other sectors in the real estate investment trust space.
AvalonBay also has a long history of making sure the apartments it owns are desirable. That includes actively selling assets that are getting older, buying newer properties, and building from the ground up. The goal is to ensure it has a young portfolio filled with in-demand features. Moreover, it also tries to make sure it owns properties in good locations, with a focus on high-barrier-to-entry markets with wealthy populations and decent job prospects. Effectively, that means it owns assets in and around large cities (more on this below).
So far, the REIT has done a stellar job and has rewarded investors well along the way. Although it doesn't increase its dividend every year, AvalonBay's payout has trended generally higher for decades. The dividend has grown at a compound annual rate of roughly 5% since its IPO, comfortably above the 3%-or-so historical growth rate of inflation (meaning that the buying power of the dividend has increased over time). For an investment vehicle that's specifically designed to pass cash on to investors, that's a clear testament to the company's success.
The COVID-19 headwind
Basically, AvalonBay is a very well-run apartment REIT. But its approach is out of step right now because of the global pandemic. People fearful of catching COVID-19 are moving out of the large population centers in which this REIT tends to own buildings, and shifting to more rural areas. The impact is showing up in the company's results. For example, its urban-focused portfolio has seen rental revenue decline in recent quarters as residents move out, and rent concessions are needed to lure new tenants.
The problem is that the declines AvalonBay is facing picked up between the second and third quarters. To put a number on that, rental revenue dropped 2.9% year-over-year in the second quarter, and 6.1% in the third. Making matters worse, costs increased 3.5% in the third quarter, likely due mostly to COVID-19-related operating expenses. So AvalonBay is seeing increased costs at the same time that revenue is declining. It shouldn't be a shock to learn that core funds from operations (FFO) fell nearly 10% in the third quarter. That's not a good number for a REIT, and investors have reacted accordingly, with the shares off by 33% from their early-year peak.
That said, the company's FFO payout ratio was still solid at around 78% in the third quarter. That's tighter than it was but still provides some leeway for adversity. And the investment-grade-rated REIT should still have ample access to the capital markets if it needs to raise cash. So it is going through a tough period -- but not one that's likely to completely derail the REIT. And that's the opportunity: AvalonBay's dividend yield, at 4.2%, is near its highest level since the 2008-09 Great Recession.
The key is that you need to believe that people will, as they have many times in the past, start moving back into the big cities that are the foundation of AvalonBay's portfolio. If you think there's a permanent switch to rural living underway, then you should focus on REITs that own rural apartments, like Mid-America Apartments (NYSE:MAA) (core FFO was flat year-over-year at Mid-American in the third quarter).
The long play
By investing in AvalonBay you are backing a company with a long history of success behind it that is currently out of step with migration trends. But the root cause of this is COVID-19, which is likely to be a temporary factor as the world begins to figure out how to live with the illness. Indeed, cities have always been a draw, and -- based on human history -- are likely to remain so.
With investors downbeat on AvalonBay because of its city focus, today could be a good time for dividend investors to pick up shares. Just go in knowing that this is a bit of a contrarian investment that may take some time to play out in your favor.