Wall Street analysts lowered their ratings on shares of apartment real estate investment trusts BRE Properties Inc. and Equity Residential to sell from neutral, and cut AvalonBay Communities Inc. to neutral from buy. Although apartments have trailed the broader REIT sector so far this year, "we believe prospects for continued slowing growth and potential risk of a recession place further pressure on the multifamily sector," the analysts wrote in a report to clients. "There is also the pressure from the oversupply of homes and condos coming back on the market as rentals, which will likely increase as [adjustable-rate mortgages] reset now through 2009," they said.
The UBS analysts are also nervous that REITs have ramped up their development pipelines while multifamily permitting is declining. "With the risk of a recession, the yields on these pipelines may be lower than expected," they wrote. "We estimate yields have already come down 1% since last year." Apartment stocks were among the worst performers in REITs during the years following the 2001 recession, UBS said. For example, apartment giant Equity Residential underperformed REITs by a wide margin from 2001 to 2004, but narrowed the gap significantly in 2005, or four years after the 2001 recession. Apartments tend to outperform as the economy begins to peak, but lag behind at other times, noted UBS.
"Apartments have had the best of all worlds in this past economic recovery. Occupancies recovered to 95% from 92% as rents rose and concessions burned off," the analysts said. "Supply was muted as condo converters removed existing stocks and new multifamily was built as for-sale rather than as rental," they added. "Finally, the rapidly rising cost of home ownership finally caught up with fleeing tenants who realized that making a leap to own a home no longer made sense."
However, apartment stocks have sold off this year. Through Monday's close, shares of Equity Residential were off about 30% year to date, trailing the S&P 500 Index by 29 percentage points, according to investment researcher Morningstar Inc. "While we believe the housing fallout will be a net positive for apartments as defaulted owners become renters in the longer term ... we see the dampening effect on fundamentals in the near term as the market digests this glut of housing," UBS said.
"There is also the risk that bargain-priced homes will attract renters to once again make the leap into homeownership, especially when the mortgage market begins to normalize." Mortgages have been more difficult to obtain now that lenders have tightened standards as a result of the credit crunch. "Furthermore, fund flows continue to flow out of real estate, while the financial sector, which REITs are a part of, remains under pressure," according to UBS. "Thus, we expect REIT investors to be attracted to areas like retail and global industrial, where there is still steady growth."
Among apartment REITs, the analysts' top picks are Essex Property Trust Inc. and Home Properties Inc. both of which are rated buy. Apartment Investment and Management Co. , known as Aimco, is a buy as well. UBS also lowered its price targets on REIT stocks by an average 8% as a result of higher volatility. The price swings are being driven by ongoing concerns over REITs' access to capital given the credit turmoil, rising cap rates and slowing fundamentals, according to the investment bank, which is predicting a 40% chance of recession in 2008. The downgrade of the apartment stocks came one day after UBS analysts were out with a note saying regional-mall REITs may hold up relatively well in a consumer-led recession.
Source: MarketWatch.com