AvalonBay: A Conservative Buy (NYSE:AVB)

Introduction

Those who follow me or have read my articles probably know two things about me. One. I love collecting dividends, hence the handle. And number two I love conservative dividend stocks. That’s a major reason why I love investing in REITs. You won’t get 12%-15% return investing in these. If you want that, you should consider a tech stock or one like Starbucks (SBUX). I own a diversified mix of stocks in my portfolio, a majority of whom I consider conservative. Reason why is these stocks tend to be predictable. Predictable business models usually mean predictable cash flows. And AvalonBay Communities (NYSE:AVB) offers just that.

It’s no secret REITs have been beaten up by the rise in interest rates. But now, I believe that sentiment is starting to shift. In the last 6 months, AVB is down from near $200 a share to $170 where it is trading at the time of writing. I consider them to be one of the premier REITs in the sector and in this article, I explain why you should consider adding them to your portfolio if you’re a conservative investor like me.

Why AvalonBay?

AvalonBay is a multi-family equity REIT that owns more than 89k apartment homes in 12 states. They primarily own apartment communities in the New England, NJ/NY metro, and Mid-Atlantic regions. They also have a large focus on communities in Northern & Southern California. Additionally, they focus on the Sun Belt region, which happens to be one of the fastest-growing regions in the nation. Owning a REIT like AVB is great for a conservative investor because people will always need a place to live. Whether that be a house, apartment, RV, or even a cruise ship. Yes, I said cruise ship for two reasons.

#1. I’ve been reading recently that this has become popular since the prices of rent are so high nowadays. And reason #2. I’m really considering living on a cruise ship for a year or two as I think it would be fun. I spent 21 years and 3 months in the Navy so living on a cruise ship would be a breeze for me. I live in what is now considered the most expensive city, San Diego. So, you can see why I’m considering the move. With inflation still lingering and the cost of living so high, many people are considering alternatives just to get by.

Several people are migrating to cities in Texas and Florida because of the cheaper cost of living. Being from the South, I can tell you it’s a lot cheaper living there than on the West Coast. Of course, you don’t make as much money in those states either. But before the rise of interest rates, you could get a nice-sized home for a decent price. In San Diego, that is not possible. Even renting an apartment or a room from someone is more expensive than a mortgage payment in most Southern states.

Sun Belt Focus & Room For Growth

As you can see by the list I linked earlier, most of the fastest-growing cities are in the State of Florida. AVB currently has 3,381 homes in the state. And they are building more. In Q3, management stated they had started new developments on several properties, one in the popular city of Miami. Management also stated during the Q3 earnings call that they plan to shift 25% of the portfolio to the expansion regions and optimize their long-term growth profile.

So, considering their focus is mainly in the Southern California and NY/NJ metro areas with 18.4k & 16.6k properties respectively, AVB has a lot of room to create growth for the long term in other areas. In 2022, the cities below were the fastest-growing cities for multi-family units & single-family homes. AVB only has communities in three of these cities. Charlotte, Denver, and Dallas. So as the need for multi-family units continues to grow, I expect Avalon to expand into these cities in the foreseeable future. Although this year has shaped up to be light for apartment deliveries, in 2024 management expects apartment completions to be significantly higher. This is expected to provide incremental NOI and FFO as they reach stabilization.

Why The Price Drop?

Multi-family REITs have not had a good year. Actually, most REITs have not had a great year this year. In my article back in August I mentioned that now was a good time to buy Mid-America (MAA) and Camden Property (CPT). All three are down over the last 6 months with AVB being down the least. Both MAA & CPT are down double-digits compared to roughly 5% for the latter. One reason is rising interest rates. Another reason is the rise in apartment vacancies. As you can see it rose from 3.9% in October ’21 to 6.4% last month. AVB’s vacancy also dropped slightly during that time from 96.1% to 95.7%

Their largest peer by market cap, Equity Residential’s (EQR) vacancy rates also dropped during the same period from 96.6% to 95.9%. The recent surge in demand has caused prices to rise but I expect this to move in a positive direction as the FED continues its battle with inflation. As consumer spending comes down, I expect demand will too. When the supply outweighs the demand, I suspect vacancies will trend lower due to lower prices. Of course, there’s also a recession looming that could affect this as well.

Solid Earnings

During their last earnings, AVB posted some solid results for the quarter. Q3 core FFO exceeded analysts’ estimates by $0.03 and total revenue of $697.6 million beat the $693.1 million consensus. Same-store residential net operating income also rose 5.3% year-over-year. Core FFO was also up 6.4% from $2.50 in Q3’22 to $2.66 in Q3 of this year. Management also raised guidance for the third time this year which is very impressive if you ask me. Three times in one year? During the current macro environment? That speaks volumes. Q4 FFO is now expected to be $2.69-$2.79 vs the $2.72 consensus.

Here is the full-year outlook for the rest of the year. Some solid single-digit growth. Like I previously mentioned, REITs are typically conservative offering low to mid-single-digit growth. YTD AvalonBay has delivered 9.7% core FFO growth which is solid all things considered. Furthermore, they managed to increase the dividend earlier this year by 3.8% from $1.59 to $1.65. With Q3 delivery of $2.66 and Q4 expected to come in higher now, even on the lower end at $2.69, this still gives them a very safe payout ratio of 62%. This is well below the REIT average. The more conservative a REIT’s payout ratio, the more cash it retains for future growth projects. This is something I like to see when dividend investing.

Well-Positioned Balance Sheet

Most know AvalonBay has one of the best balance sheets in the sector with an A credit rating. Additionally, they have low leverage with a Net debt to EBITDA of 4.1x, well below their targeted range of 5x-6x. And their interest coverage ratio and unencumbered NOI percentage are 7.5x and 95% respectively. They also have a weighted average debt maturity date of 7.5 years. At the end of the quarter, AVB had cash & cash equivalents of $0.51 billion and $1.57 billion total remaining liquidity. This financial flexibility will help them pursue attractive growth opportunities in 2024.

Valuation

AVB has not declined as much as its peers but they’re still trading below their forward P/AFFO 5-year average of 22x. At the current price of $170 at the time of writing, the stock does offer nearly 15% upside to its price target of $195. REITs have enjoyed some price appreciation this week, but I expect them to see some more volatility before the year ends due to tax-loss selling. But those with a long-term outlook now may be a good time to dollar-cost average into AvalonBay.

I like the stock closer to its 52-week low in the $150’s, but unless something drastic happens I don’t see the price touching that low again. With a forward P/AFFO of 17x, now may be a good time to DCA, and when rates reverse sometime in 2024, I expect the REIT to trade closer or higher than that range. Due to expected volatility in the coming months, I do see the price touching mid to high $160s, giving investors a great time to jump in.

Risk Factors

A huge risk factor for AvalonBay is if rates do indeed remain higher for longer. Most, including myself, expect rates to decline sometime next year but if they push higher, REIT prices will decline significantly. Although, ones like AVB will decline less. Another factor is a recession, which will likely cause a rise in vacancies, further contributing to the rise we’ve seen in the last few years. If so, this would definitely affect AVB as rent declines, subsequently affecting FFO.

During the GFC rental demand was held down in two ways. One by slowing down the way young adults form independent households, and two by reducing the flow of immigrants. Another recession could cause more of the same. If unemployment rises and there are no jobs, it will cause the flow of immigrants to decline. What does that have to do with anything you say? Think about it. Immigrants don’t usually buy, they rent. Throw in job losses, tighter consumer spending, surging credit card debt, and inflation, and you could get a spike in vacancies over the next several months.

Investor Takeaway

AvalonBay is a premier REIT with an A rated balance sheet and low leverage. This makes them well-prepared going into 2024 and management expects growth to pick up. With ample liquidity, they also expect to take advantage of long-term growth opportunities. Additionally, the REIT has delivered some strong earnings in 2023, raising guidance three times this year. Furthermore, AVB has a lot of room for growth, both in existing regions, and in the growing Sun Belt region. If you’re a conservative investor with a long-term outlook, now may be a good time to pick up some shares of AVB & deal with some volatility before rates are cut and REITs take off. On another note, if rates do remain higher for longer or the economy falls into a recession, I expect them to see vacancies rise which will likely slow FFO growth for the foreseeable future.