Apt. REITs susceptible to downturn, analysts say

“Apartment fundamentals will weaken materially in coming quarters,” Andrew McCulloch, an analyst with Green Street Advisors Inc. of Newport Beach, Calif., said in a research note.

“Job growth is the most important driver for apartment demand,” he wrote.

“With cumulative job losses for the current economic downturn on pace to be the worst in a half century, the apartment sector is expected to enter a period of materially weaker demand and reduced pricing power.”

At the same time, property values are falling.

“When pricing transparency returns to the market, apartment assets will be worth much less than they were in recent years,” Mr. McCulloch said.

“The only question marks lie in the magnitude of these declines and how long it will take for the U.S. economy and the capital markets to right themselves.”

Tony Paolone, an analyst with JPMorgan Chase & Co. in New York, slashed his funds from operations estimates for apartment REITs by 9% in 2009 (funds from operations are a common metric used to measure real estate performance).

His revision is based on the belief that apartment REITs’ operating income will tumble 2.4% on average next year.

“The rapid decline in U.S. payrolls suggests that landlords in virtually every market are likely to lose pricing power over tenants,” Mr. Paolone wrote in a note.

Michael Bilerman, analyst at Citigroup Global Markets Inc. in New York, downgraded two apartment REITs — Equity Residential of Chicago and UDR Inc. of Highlands Ranch, Colo. — to “sell,” from “hold.”

However, he upgraded Camden Property Trust of Houston to “hold,” from “sell.” “Deteriorating apartment fundamentals — long hidden in the coattails of the credit crisis — could emerge as the dominant negative catalyst for the group,” Mr. Bilerman wrote in a note.

However, the group does have one advantage: It still has access to debt capital through Fannie Mae of Washington and Freddie Mac of McLean, Va. — a perk that its peers don’t have in the frozen credit markets.

This advantage “materially reduces the probability of severe financial distress for the apartment sector,” Mr. McCulloch wrote.

“The upshot for apartment REITs — and it’s a big one — is that liquidity risk is tiny because of the availability of Fannie/Freddie money,” Mr. Paolone said. “Opportunity would be at the unsecured-debt level where yields are in the double digits and could be refinanced far lower by the agencies.”

Apartment REITs have been on a tear for much of 2008, with positive total returns of 17.4% at the end of September, according to the National Association of Real Estate Investment Trusts in Washington.

As of the close of business Dec. 19, the sector was off 24.3%, which still outperformed its equity REIT peers, which were down 39% on average.

However, the gloomy outlook doesn't bode well for 2009.

“We find it hard to get excited about these stocks given the valuation premiums, underwater development pipelines and core growth that pencils to be among the weakest in the REIT space,” Mr. Paolone said.