UDR (UDR -0.16%) owns over 400 apartment buildings with more than 58,000 units, making it one of the largest apartment real estate investment trusts (REITs) in the United States. On the whole, UDR, which is geographically diversified as well, is performing well right now. But there are two worrying trends that investors need to monitor.
Operating apartment complexes involves a lot of moving parts
On some levels, owning apartment buildings is a fairly simple business to understand. You build or buy a property, then lease the units out to tenants, collecting rent each month for as long as they live there. That overlooks a lot of the little things that are important.
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For example, you have to have a system in place for reaching potential tenants. You have to have the ability to show apartments to potential tenants. Before you do that, you have to have crews come in and spruce up your vacant apartments, cleaning, doing general maintenance, and painting. Those types of tasks don't go away when a tenant moves in, though. When something breaks, you need to fix it sooner rather than later, or your tenants will be very unhappy.
UDR has been aggressive in its efforts to keep its costs low. For example, it uses digital technology wherever it can, from advertising apartments to setting up showings to reporting maintenance needs. It also tries to cluster its apartments geographically so it can share staff between assets. But the REIT can't avoid the impact of inflation.
That's one of the big issues that investors need to monitor today: UDR's cash expenses grew by 7.4% year over year in the second quarter. That in and of itself isn't a problem. The more significant issue is that cash revenue only grew by 6.9%. In other words, its costs rose faster year over year than its revenues. Costs also outpaced revenue growth sequentially. Compared to the first quarter, cash revenues were up 1.2% while cash costs increased 2.6%. Inflation is clearly having a negative impact on the company's business.
UDR is doing OK, but what happens next?
To be clear, UDR's business isn't spiraling into the toilet. That's unlikely to happen unless there's a major problem, like a second Great Recession or another pandemic. And even then, the company's track record suggests it will muddle through. At the moment, the REIT is doing reasonably well, with adjusted funds from operations (FFO) up 6% year over year in the second quarter and toward the high end of management's guidance.
Occupancy is a fairly solid 96.6%, which provides support to its adjusted FFO. But its occupancy levels fell in all but one of its geographic regions year over year in the second quarter. And in the one region where occupancy didn't decline -- the Northeast -- it was flat. Overall, it declined 0.4 percentage points year over year. Compared to the first quarter, meanwhile, occupancy was flat.
When a REIT's occupancy levels are high, it's easy to get excited by its success. But very often, the next move won't be higher, it will be lower. And that puts downward pressure on the rent roll. If UDR's occupancy trends remain negative, conditions for the REIT could become increasingly more difficult, especially if its costs keep rising.
A troubling combination
UDR is a fairly well-run apartment REIT, so long-term investors shouldn't jump ship just because of a few negative data points. But, at the same time, shareholders should keep an eye on its costs and occupancy levels. The trends are showing some weakness, and you'll want to be prepared in case there's more bad news ahead.
Basically, it might be time to steel your resolve about the company's business, noting that the shares have already pulled back by a third from their 2022 highs. Or maybe you'll want to recognize the headwinds and prepare to buy some stock anyway, given Wall Street's dour view of the company.
