Apartment real estate investment trusts (REITs) like industry bellwether AvalonBay Communities (AVB 1.16%) have solid businesses, since they provide the basic necessity of shelter. And yet in 2020, when the pandemic bloomed, many big apartment landlords got hammered as people moved out of big cities seeking shelter from the health scare by moving to more sparsely populated regions.
Luckily for AvalonBay, that trend didn't last very long. Here's a look at the 2021 rebound and why 2022 could be a very good year for this REIT.
The nature of things
It's important to understand the core business here, which is renting out living space. This generally involves a one- or sometimes two-year lease. Lease lengths in other property sectors tend to be much longer, with some stretching for decades. That's no small issue, given that historically, a typical economic cycle is estimated to last about seven years. Thus, a 10-year lease would allow a REIT to maintain its occupancy and rent levels through a downturn. Not so for an apartment landlord, where almost the entire portfolio will need to be released every year.
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Adding to the volatility is the way rental rates ebb and flow. Basically, an apartment that's sitting empty is a drain on an apartment REIT because it means less overall income to cover operating costs. So it makes more sense to reduce rental rates and grant concessions (like a month's free rent) than to leave a unit sitting empty until rents start to pick up again. Therefore, rents can go up and down rather quickly in the apartment sector, as can rental revenues for REITs like AvalonBay.
Put these two factors together, and you can see why 2020 was a tough year for apartment owners. AvalonBay was particularly hard hit because it has material exposure to major cities. Those are exactly the areas that people were fleeing when the pandemic hit. And given the uncertainty of the health scare, nobody was quite sure how long the pain would last.
A quick rebound
As it turned out, the answer was "not long." To put some numbers on this, same-store rents fell 3.7% in 2020 but shifted back into growth mode in 2021, rising 4.7% in the fourth quarter of the year. The results in 2020 were hit by weak rental rates, falling occupancy, uncollected rents, and concessions granted to keep apartments as full as possible. Basically, just about everything that could go wrong for AvalonBay did.
By the end of 2021, the only lingering negative was concessions. At times, concessions are needed even in good market environments to convince tenants to sign your lease over a competing location, so this isn't that big a deal and was only a 0.3 percentage point headwind. To be fair, lease rates dropped 2.2% for full-year 2021, driven by weak concessions and falling rental rates. However, the improvement by the fourth quarter showed that an important turn had taken shape.
The strength in the fourth quarter of 2021 was fairly broad-based as well, with all but one of AvalonBay's regions (Northern California) seeing same-store revenue increases. For the full year 2020, every region in which AvalonBay operated nosedived.
Core funds from operations (FFO) continued to decline in 2021. And it will probably take at least until the end of 2022 for the portfolio to fully rollover. In 2019, core FFO was $9.34 per share, dropping to $8.69 in 2020, and falling again to $8.26 in 2021.
Given the nature of the business, that's to be expected. As higher rents and occupancy trends start to flow through the financial statements, however, core FFO should move higher again -- potentially in a big way. At this point, management is calling for core FFO in 2022 to fall in a range of $9.30 to $9.80 per share. That's above pre-pandemic levels and shows just how much the apartment market has changed in two years.
A bright outlook
Assuming nothing changes, AvalonBay continues to have robust pricing power as people look to move back into the very places they fled from during the pandemic. The ability to push through sizable rent bumps, meanwhile, is buttressed by the REIT's modern and high quality portfolio, as well. Taken together, these factors suggest that 2022 will be a good year. In fact, right now, even 2023 looks very promising, since leases are rolling over and rent increases are the norm right now. Investors who own AvalonBay should be very pleased with the trends here.
