This apartment REIT is back in growth mode

Apartial real estate investment trusts (REITs) as an industry indicator AvalonBay Communities (NYSE: AVB) have strong businesses, since they provide the basic need for shelter. And yet, in 2020, when the pandemic bloomed, many large apartment owners were hammered as people left the big cities to take shelter from health scares by moving to less populated.

Luckily for AvalonBay, this trend didn’t last very long. Here’s a look at the 2021 rebound and why 2022 could be a really good year for this REIT.

The nature of things

It is important to understand the core business here, which is the rental of living space. This is usually a one or sometimes two year lease. Lease terms in other real estate sectors tend to be much longer, with some spanning decades. This is no small problem, given that historically, a typical economic cycle is estimated to last around seven years. Thus, a 10-year lease would allow a REITs to maintain its occupancy and rent levels in the event of a slowdown. This is not the case for an apartment owner, where almost the entire portfolio will have to be freed up every year.

Image source: Getty Images.

Adding to this is the volatility of rental rates. Basically, an apartment that sits empty is a loss for an apartment REIT because it means less overall revenue to cover operating costs. So it makes more sense to cut rental rates and give concessions (like a free month’s rent) than to leave a unit empty until rents start to rise again. As a result, rents can go up and down quite quickly in the apartment sector, as can rental income from REITs like AvalonBay.

Put these two factors together and you’ll see why 2020 has been a tough year for apartment owners. AvalonBay was particularly hard hit as it is heavily exposed to major cities. These are exactly the areas people were fleeing when the pandemic hit. And given the uncertainty of the health scare, no one knew exactly how long the pain would last.

A quick rebound

It turned out that the answer was “not long”. To put some numbers on this, same store rents fell 3.7% in 2020 but returned to growth mode in 2021, rising 4.7% in the fourth quarter of the year. 2020 results were impacted by low rental rates, declining occupancy, forgone rents and concessions given to keep apartments as full as possible. Basically, just about anything that could go wrong for AvalonBay did.

At the end of 2021, the only lingering negative was concessions. Sometimes concessions are needed even in good market environments to convince tenants to sign your lease on a competing location, so it’s not that bad and was just a 0.3 percentage point headwind . To be fair, rental rates fell 2.2% for the whole of 2021, due to weak dealerships and lower rental rates. However, the improvement in the fourth quarter showed that an important turning point had taken shape.

The strength in the fourth quarter of 2021 was also quite broad, with all but one AvalonBay (Northern California) region seeing an increase in same-store revenue. For the whole of 2020, every region in which AvalonBay operated plunged.

Heart operating funds (FFO) continued to decline in 2021. And it will probably take at least until the end of 2022 for the portfolio to be completely renewed. In 2019, the base FFO was $9.34 per share, dropping to $8.69 in 2020, and falling back to $8.26 in 2021.

Given the nature of the business, that was to be expected. As higher rents and occupancy trends begin to financial state, however, the base FFO is expected to rise again – potentially significantly. At this point, management expects base FFOs in 2022 to be in the range of $9.30 to $9.80 per share. This is above pre-pandemic levels and shows how much the apartment market has changed in two years.

A bright perspective

Assuming nothing changes, AvalonBay continues to have robust pricing power as people seek to return to the very places they fled during the pandemic. The ability to push through substantial rent increases, meanwhile, is also underpinned by the REIT’s modern, high-quality portfolio. Taken together, these factors suggest that 2022 will be a good year. In fact, right now, even 2023 is looking very promising, as leases renew and rent increases are the norm right now. Investors who own AvalonBay should be very pleased with the trends here.

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Reuben Gregg Brewer has no position in the stocks mentioned. The Motley Fool recommends AvalonBay Communities. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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