One of the most important things about apartment real estate investment trusts (REITs) is that they provide a basic necessity: housing. However, there are nuances to the broader apartment REIT sector that play out in interesting ways. Here's why, despite rebounding rents, investors still need to be prepared for weak financial results from some of the sector's biggest names.
The structure of the deal
Everyone needs a place to live, and apartment REITs provide that. For this reason, it's a fairly consistent property sector, even though economic cycles can have an impact on occupancy and rent levels. Perhaps obviously, robust economic growth tends to lead to higher rents and more people seeking out their own "pad." Downturns have the opposite effect.
Interestingly, however, apartment REITs are fairly quickly impacted by change. This is because the leases they sign are generally one to two years in length. Since leases are signed every month, there are always leases ending and new leases being signed. Thus, when there's a downturn, apartment landlords quickly adjust to attract new tenants and keep old ones. There are a couple of key tools in this regard, including lower rent levels and offering concessions (like free rent for a short period of time).
While improving conditions quickly allow apartment REITs to reverse concessions and increase rents again, the signed deals don't change. That means that their top and bottom lines are left with a drag that only time can heal as the old leases roll off. This is going to be an important dynamic over the next year or two for some of the industry's most prominent names.
An unusual event
The coronavirus pandemic led to a recession, which, as noted, is bad for apartment REITs. However, the health scare changed the normal dynamics of a downturn in important ways. Specifically, people moved out of cities in greater numbers than you might expect in an effort to avoid getting sick.
Major coastal cities have for a long time been among the most desirable locations for apartments because there are high barriers to entry for new apartments and, usually, there's strong demand. That demand, however, evaporated in 2020.
For example, Essex Property Trust (NYSE: ESS), which is focused on major West Coast markets, saw year-over-year revenues decline in every city in which it operates in the first quarter of 2021. San Francisco witnessed an 18% decline, with Los Angeles down 10.3%. The total portfolio saw a revenue drop of 8.1%.
Equity Residential (NYSE: EQR) has a more diversified portfolio but is still big-city focused. It was hit with year-over-year average rental rate declines in every market it served in the first quarter, for an overall decline of 9.3%. The worst performers were San Francisco (down 13.1%), New York City (down 12.2%), and Boston (down 10.3%). And that was on top of a 1.4% decline in the company's occupancy level.
AvalonBay Communities (NYSE: AVB), which is also diversified, suffered a year-over-year revenue decline of 9.1% across its portfolio in the first quarter. Only one region (Denver) was positive, with the rest of its operations all falling, including a 3.5% drop in southeast Florida. The worst-hit area was northern California, with a 15.3% revenue decline.
The thing is, these issues are going to linger, because every new lease signed at a lower level takes at least a year to roll off. Yes, things are improving. For example, Equity Residential's occupancy figures increased from 94.4% in the fourth quarter of 2020 to 95.6% in the first quarter of 2021 (and 96% in April). Notably, renewals from existing residents are also on the upswing, suggesting that people aren't moving out as readily as before. That should allow the REIT to firm up its rental rates over time.
But don't expect a quick reversal from any of these big-city REITs. AvalonBay, for example, is projecting second-quarter residential revenues could be off by as much as 6.25%. It won't be alone in reporting weak results.
The Millionacres bottom line
Investors should not run scared from apartment REITs with a focus on major coastal cities. History suggests that the biggest U.S. cities will come back in time. However, there's likely at least another year or two of weak results baked into the cake for landlords with heavy exposure to these locales.
All that means that investors need to expect less-than-exciting funds from operations (FFO) results in the quarters ahead from REITs like AvalonBay, Essex, and Equity Residential, even as more rural-focused peers are likely to be posting relatively strong numbers.