With the anticipation of further economic weakness, Pizzo says the overall picture could get worse before it gets better. He expects property-level growth to remain healthy at between 2.75% and 3.25%. However, he recommends that "investors take profits in the group, particularly into any additional near-term positive momentum created by further covering by short sellers, as we believe a further slowdown will materialize in the second half of 2008 and first half of 2009."
As the second quarter results came in, relates Pizzo, it became clear that landlords are focusing on building and maintaining occupancy to prepare themselves for a potential further downturn. Despite the declining homeownership rate--most recently at 67.8%-- slow traffic, rising concessions and the continuing economic slowdown is putting extra pressure on landlords, who are increasingly finding it difficult to increase rents. In fact, in its July survey of multifamily REIT property managers--which polled 2,500 managers in the top 15 apartment markets in the country--BofA found that rent and occupancy levels remained relatively flat.
Meanwhile, the gap between renting and owning, at 1.28x, sits below the 10-year average of 1.32x. And since jobs are closely correlated to same-store net operating income, don't expect those figures to go up soon, either.
By market, Texas saw a bit of a boost, with Houston and Dallas performing quite well, while Metro Washington, DC was weak in terms of traffic, rent growth and additional concessions. In fact, concessions seemed to increase in prevalence across most markets, notably the Sunbelt. Apartments in Los Angeles, Las Vegas and Phoenix found themselves competing with the sagging single-family and shadow inventory. Meanwhile, the Bay Area of Seattle and San Francisco saw a bit of improvement, with decent traffic, rising occupancy and rents and fewer concessions.
On the investment front, deals could continue to lag as sales volume declines and financing becomes less available and buyers opt to utilize debt assumptions and seller financing. "Over the next 12 months we believe asking prices will increasingly begin to reflect the new capitalization structure, increasing financing costs and pricing," says Pizzo. And with stock cap rates on the rise, any operating weakness or deterioration in financing will have a negative impact.
BofA downgraded three REITs, AvalonBay Communities, UDR Inc. and Essex Property Trust. AvalonBay saw its rating drop from "neutral" to "sell." Investors should sell their stock in the company since its risk profile is rising and internal growth potential is declining. It caters to the higher-end, but even that segment of the market will be affected as the economic slowdown drags on. This, along with a likely slowdown in new construction, will put pressure on rent growth. AvalonBay is currently trading at a 7% premium to its counterparts on adjusted funds from operations, a 6% premium to forward net asset value, and a 5.1% implied cap rate. These valuations, maintains Pizzo, are not sustainable.
Also dropping from "neutral" to "sell" is UDR. "We do not believe the current valuation adequately reflects the potential for a faster-than-expected deceleration in core fundamentals," says Pizzo. Even though it's reworked its portfolio, the firm still has considerable exposure to the mid-Atlantic and Southern markets. Further, UDR could see pressure on development yields and cap rates as well.
Meanwhile, Essex saw its rating go from "buy" to "neutral." Though it remains Pizzo's top pick in the apartment sector for the long term, the REIT's upside potential is limited in the next six to 12 months due to overall economic conditions.
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