I have listened to the second quarter earnings conference calls for three of the largest apartment real estate investment trusts: Equity Residential Trust (EQR), AvalonBay Communities (AVB), and Mid-America Apartment Communities (MAA). Together they own over 250,000 apartments. I was struck by the generally positive tone in spite of our troubled economy. I have assembled a research report that you may find interesting.
If you’re pressed for time, here is the HEADLINE:
Using reasonable assumptions, apartment REITs are currently trading at discounts to the underlying value of their assets. In my estimation, at the current moment, purchasing a liquid security with low debt backed by the best multifamily properties in America yielding 4% is a better prospect than buying an apartment complex yielding 6% with 75% leverage.
LEASING MOMENTUM, DECENT RENT COLLECTIONS, LOWER TURNOVER
All three REITs reported collections from April to June that were ahead of projections made during the crisis moments of March. All experienced a decline of about 2% on collected rents. The unemployment insurance program and $1,200 stimulus checks certainly helped. Our experience in the Omaha metro area has been similar. Collections declined by 1% during the April-June period and even lower during July in our area. Executives claimed that June and July leasing activity had returned to 2019 levels. Resident turnover was 2-3% below the same period in 2019.
CAPITAL IS CHEAP
All companies took advantage of low interest rates. AvalonBay issued $600 million in bonds at 2.5%, Equity Residential received a $495 million secured loan at 2.6%, and Mid-America issued $450 million in senior secured notes at 1.7%. All companies have healthy cash positions and exhibit better credit ratings than during the 2008-09 recession. AvalonBay felt confident enough to authorize a $500 million stock buyback program. Low rates were not entirely a favorable factor: AvalonBay and Mid-America each noted that occupancy was hindered by home purchases driven by low interest rates. This trend has also been evident in our market.
CONSTRUCTION STARTS SUSPENDED
All three companies have cancelled new development projects with expectations of weakened rent growth and a belief that construction costs will decline as most commercial and hospitality projects are suspended indefinitely. AvalonBay had noted that construction costs in major coastal metros have declined by 5-7%.
URBAN PROBLEMS vs SUBURBAN SUCCESS
Equity Residential and AvalonBay have the majority of their portfolios located in major metropolitan areas on the coasts. The contrast in performance between urban and suburban markets was profound. AVB and EQR have 33% and 25% of their units in urban central business districts, respectively. Equity Residential and AvalonBay faced difficult headwinds in their urban properties. New leases in urban areas posted rent rates as much as 8% below earlier quarters, and renewal rents dropped by 1%. Vacancy levels approaching 9% were reported in central business districts of San Francisco, Boston and New York. The increase in work-from-anywhere employment has been compounded by a loss of foreign workers and college students in these areas. EQR noted that while 4% of revenues are attributable to commercial tenants, only 60% were paying rent – an ominous sign for central business district retail performance.
Executives at EQR and AVB were encouraged by positive summer leasing trends at their suburban communities. New lease activity was strong enough to help overall company-wide occupancy levels exceed 94%. Overall, company-wide quarterly revenues were down 2.4% at EQR and roughly flat at AVB.
SUNBELT SATISFACTION
Mid-America operates assets in the sunbelt: The Dallas metro, Atlanta, Nashville, the Carolinas, and Austin all feature prominently in their portfolio. MAA executives were ecstatic with their results. Effective rents for new leases at MAA were up 3.4% for the quarter. Occupancy exceeded 95%. Overall revenue for the quarter was up 1.4% over 2019 at MAA. Executives were confident that migration trends toward sunbelt metros would continue, and had seen evidence of acceleration.
INVESTMENT OPPORTUNITY?
All three companies are trading well below February levels. EQR trades at a 40% discount to the February high, AVB is down 34% and MAA is 20% lower. Meanwhile, EQR and AVB sport dividend yields in excess of 4% and MAA has a yield of 3.4%. In a world of zero percent Treasuries, the dividends are appealing.
The three apartment giants appear to be trading at a discount to their net asset values.
I present a table on the attached pdf comparing the three companies. Some of you may take issue with my simple methodology, but I think the calculations fairly portray a set of businesses that may be undervalued. For annualized revenues, I doubled the first half of 2020. Executives generally opined that markets had stabilized, so I am taking their remarks at face value. I included a $50 per unit capital reserve in my estimates to arrive at a pro forma net operating income level. The results show that all three companies have adequate dividend coverage between 1.38x for EQR to 1.78x for MAA.
I employed a 5% capitalization rate to arrive at a value. Some could argue that this is a low number on a risk-adjusted basis, but as the cost of funds drifts below 3% the cap rate seems reasonable. Cap rates in space-constrained urban markets were well below 5% heading into March. The results indicate that public market discounts to net asset values range from 6% for AvalonBay to 20% for Equity Residential.
Finally, I reduced my revenue assumption by 5% to determine the impact on values and dividend coverage. In this exercise, all three were comfortably able to maintain their shareholder distributions. Current share prices were roughly in line with net asset values in this example.
There is no question that the pandemic will continue to negatively impact the economy. Indeed, it will be interesting to see if MAA bosses are less optimistic on the next call as Covid cases sweep across the south. I do believe there will eventually be meaningful negative impacts on white collar employment that has thus far been spared the brunt of the layoff pain. Could revenues decline by 10%? It is very possible. I do not subscribe to the conventional wisdom that “everybody needs a place to live, so apartments will be just fine”. Young professionals under the age of 30 can find their parents’ homes just as welcoming as they did during the 2008-2012 period. However, I do believe much of the downside risks have been reflected in the current share prices. These three companies boast some of the finest apartment assets in North America. Their balance sheets are strong and the dividends are well-covered.
Please let me know if you have any comments or criticisms. I am interested in all perspectives. A disclaimer: These numbers represent my opinions and should not form the basis of any investment decisions.
Let’s hope for a vaccine. Take care.
Rural Nebraskans suffered from heavy flooding this past March, so the IRS allowed residents of many counties to extend their filing deadline to July 31st. As we wind down this uniquely painful tax season, it’s time to reflect on what has been a most unpleasant set of surprises unleashed upon many real estate investors by the The Tax Cuts and Jobs Act of 2017.
The tax reform law was a boon for corporations. It reduced the average tax rate from 29% to 21%. Pass-through entities such as limited liability companies (LLCs) and S-Corporations also stood to benefit from certain deductions, the most common of which included a 20% deduction on net income. Although the law had been passed in 2017, much of the guidance was written throughout 2018 and even into early January of 2019.
When the dust settled earlier this year, it became apparent that the new law contained limitations on deductions that sent accountants and property investors scrambling for cover.
Real estate owners have been able to use depreciation charges to shelter taxable income. Depreciation is the non-cash expense that owners are allowed to deduct from operating income which represents the deterioration of a physical asset as it ages. In the case of apartments, the standard method is to divide the asset cost (excluding land), by 27.5 years and deduct that amount from reported net income on an annual basis. On a $1,000,000 building, the annual deduction is around $36,400 per year.
Real estate owners are also allowed to deduct mortgage interest from net income (principal can not be deducted). Therefore, many real estate partnerships, especially in the early years of operation, reported negative earnings to the IRS once depreciation and interest were subtracted from operating income. Individual investors with passive income from other investments were able to shelter this income with losses from real estate.
The 2017 law essentially invalidated the ability to report a net loss to the IRS for most real estate partnerships.
As of tax year 2018, if an apartment building runs a net loss after depreciation charges and interest deductions, it is thus deemed to be a “tax shelter”. Consider the words tax shelter to be the accountant’s equivalent of a football referee seeing a questionable call on the field and requesting a video replay review. Once the net loss was evident under prior accounting principles, accountants presented their clients with one of two choices: Either switch to an alternative depreciation schedule (ADS) of 40 years instead of 27.5 years, or limit interest deductions to 30% of net operating income. The new rules mean that ability to generate a reported loss to the IRS has all but vanished. Sheltering passive income with passive losses from real estate is now virtually impossible.
In fairness to Congress, their intention was good: reduce the desire for investors to maximize leverage in order to maximize the deductibility of interest. By reducing the tax benefits of heavy borrowing, you reduce risk in the system.
Here’s rough sketch of what taxable income looked like before and after the tax reform law:
Under the old law, a taxpayer actually reported a loss to the government. Today, the investor makes a choice. In Option 1 where the depreciation charge is reduced under a 40 year schedule, the tax would be about $2,000. In the second case where interest expenses in excess of 30% of net income are added back, the tax is around $3,500. The Tax Cuts and Jobs Act of 2017 is actually a tax increase for many leveraged partnerships.
Which option would you choose? The longer depreciation term looks more appealing, however there are two caveats: Once you elect to take the ADS, you can never go back. Second, the interest deductibility limitation is painful in the short run, but those unused interest deductions are carried forward and can offset future income. So, an investor with a longer perspective may opt for the interest limitation. A last note of caution: the interest deductibility limitation gets even more strict in 2021. During that tax year the deduction is limited to 30% of net income AFTER depreciation.
There are several very important loopholes in this law. The most egregious example is that a pass-through partnership with limited partners that do not exceed a 35% ownership threshold are exempt from the deductibility limitations. This clause unfairly penalizes pass-through companies with a high number of partners.
Now, before we conclude, I have to provide you with this disclaimer: I am not a tax expert. My examples are very generic and are purely for illustrative purposes. You absolutely should not rely on this information and you must consult with a tax professional for guidance.
So, does real estate still offer tax benefits?
Yes. The ability to deduct depreciation and interest may not be as generous as in years past, but they are still deductible. Depreciation is particularly beneficial because it is a non-cash charge. Tax advantages remain, but the noose has been tightened.
March 3, 2019: By Cindy Gonzalez / World-Herald staff writer
Noddle Cos. estimates that private investment within Aksarben Village has topped $630 million. Those involved since the onset say the project, boosted by tens of millions of public dollars, has exceeded expectations. Office and research space has doubled the amount projected to be built; the number of hotel rooms and residences also have surpassed early predictions.
HISTORY:
To better understand the land evolution near 67th and Center Streets, one can step back 25 years to when elite horse racing died at the longtime entertainment venue. Controversy soon erupted as diverging interests vied for control of Ak-Sar-Ben land then publicly owned by Douglas County.
One group wanted to restart racing in an effort that some suspected would lead to casino gambling. Business leaders resisted, instead supporting a sale to First Data Resources, which was looking for space to grow.
First Data bought the northern 140 acres of the Ak-Sar-Ben grounds in 1996 and subsequently donated a large chunk to the University of Nebraska for a high-tech learning campus featuring the Peter Kiewit and Scott Technology educational institutes and student dorms.
As community leaders in the mid-2000s pondered what to do with remaining land to the south, HDR’s Doug Bisson stepped up to say Omaha had the chance to be at the forefront of an emerging “new urbanism” trend of creating walkable neighborhoods inside cities.
At the time, he was a neighborhood representative on the board of the Ak-Sar-Ben Future Trust, a nonprofit that by then had acquired the former horse track and coliseum.
That idea of resurrecting the familiar grounds with a mix of residences, retailers, offices and entertainment resonated with community officials including Ken Stinson, chairman of the future trust. Said Stinson back then: “We were trying to do things that we couldn’t find in a cookbook.”
A handful of developers, with Noddle Cos. as lead, accepted the challenge to transform the 70 acres into a kind of pedestrian-friendly, mixed-use hub that was becoming the rage in urban parts elsewhere across the country, Bisson said.
Noddle recalls drawing up, in 2005, the first site proposal for what would become Aksarben Village. Actual construction launched in 2007 with the thought that it could take about 12 years to fill out between Center Street on the south, the University of Nebraska at Omaha’s south campus on the north, and from 63rd Street west to the Keystone Trail.
Looking back, Bert Hancock of Alchemy Development, who was among those original developers, said one of the most stunning results is the village’s allure as a home for corporate bases. “While I think everyone envisioned a strong employment base, the headquarters of HDR, Green Plains, Blue Cross, Right at Home, etc., have elevated Aksarben Village’s status as a major corporate center,” he said.
HDR’s near ten story headquarters located in Aksarben Village accompanied by a neighboring building with restaurants, businesses and offices near Mercy Road and south 67th Street in February.
NEW DEVELOPMENTS:
Earlier this year, engineering and architectural firm HDR held the grand opening of its 10-story global headquarters leased from the Noddle-Bradford partnership. Across the street, a five-story office building is rising and in January will be corporate headquarters for Right at Home.
That 100,000-square-foot building, a project of Magnum Development and McNeil Co., will have room for other tenants and retailers on the ground floor. It joins a city block within the village that also features a 10-screen movie theater, restaurants, bars and Pacific Life offices.
Other newbies headed to Aksarben Village:
A 110,000-square-foot, multitenant office building is to rise behind the new HDR headquarters, facing Frances Street, probably later this year, Noddle said. “We own the land, there is demand,” he said, though adding that construction won’t start before he secures an anchor tenant. The HDR parking garage will be enlarged to accommodate additional vehicles.
Noddle Cos. this year also plans to start building the village’s first for-sale homes. Called 64 Ave, the seven town houses along 64th Avenue north of Center will be about 1,600 square feet apiece, rise three floors and have two-car garages. This would be Noddle Cos.’ debut in the residential construction market.
Set to open this summer is the food, retail and entertainment alleyway between the HDR headquarters and its parking structure. The plaza will be called the Inner Rail, a nod to the area’s history as a racetrack. It’s gotten city approval to be an “entertainment district,” which will allow alcoholic drinks in the plaza.
Alchemy Development is to build two more housing projects, bringing on 124 units and $18 million in investment, to the southeast and northeast corners of the HDR headquarters block. One is to start this year, Hancock said. Alchemy already has 227 apartments at the village in Pinhook Flats and the Cue. (Broadmoor Development also has built hundreds of apartments at the village.)
Yet to be developed, Noddle said, is about seven acres next to HDR that’s reserved for its possible expansion, and a few other scattered pieces.