Despite Slowing Revenue Growth in 2024, Long-Term Apartment Demand Should Support Avalonbay's Growth

Senior Equity Analyst

Kevin Brown

AvalonBay Communities owns and operates high-quality multifamily buildings in urban and suburban coastal markets with demographics that allow the company to maintain high occupancies and drive strong rent growth, specifically, New England, New York/New Jersey, the mid-Atlantic, Southern California, Northern California, and Seattle. These markets exhibit traits that create strong demand for apartments like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger people. The company regularly recycles capital by selling noncore assets or exiting markets and using the proceeds for its development pipeline or acquisitions with promising growth prospects, a sound strategy that continues to produce strong returns.

We are cautious about AvalonBay's growth prospects, given that new supply has been high in many of its markets. The majority of new supply has been in the urban, luxury end of the apartment market, where AvalonBay traditionally operates. Additionally, the pandemic has caused many millennials to consider moves to the suburbs, either into suburban apartments or their own single-family homes, though demand for new urban apartments has remained relatively resilient. Avalonbay has historically created significant shareholder value through development, though rising interest rates have cut into the expected return on new projects.

High inflation has driven revenue significantly higher as apartment leases are generally only a year long, allowing AvalonBay to push rate growth that has matched inflation. However, revenue growth decelerated in 2023 as inflation growth has come down from the 2022 highs and growth will likely be even lower in 2024. Meanwhile, many expense items are still seeing elevated growth, so same-store net operating income growth will likely be flat in 2024. Still, the company's funds from operations per share are already above prepandemic levels, and over the long term we expect demand for the company's portfolio to drive same-store NOI growth and FFO growth above inflationary levels.

Business Strategy & Outlook

We assign a no-moat rating to AvalonBay Communities. Though AvalonBay has high-quality assets, the initial rents and rent increases the company achieves on its properties compared with the initial capital investment produce returns that are below its weighted average cost of capital.

High rents are generated in major metropolitan areas with the demographics to support them. Income growth in a metropolitan area leads to rent growth, as tenants can afford higher housing costs as their incomes increase. Dense populations with a propensity to rent support high occupancies in large apartment buildings. Job growth in a metropolitan area attracts more people and leads to occupancy growth. Once an apartment building reaches a fully stabilized occupancy level, the apartment manager can increase rent on existing tenants, knowing that the marginal tenant who would move out because of higher rent can be replaced by the excess demand for the units. Properties that distinguish themselves by offering better amenities, better services, higher-quality finishes, larger floorplans, and other desirable features generate additional demand in any market and further support higher rents and larger occupancy/rent increases. Additionally, properties in desirable submarkets with easy access to transportation, are near business districts, provide food and entertainment options, and have low crime see higher demand that can translate to higher rents and higher growth. However, there are few barriers to entry to the residential market, and much of the demand in AvalonBay's markets is absorbed by supply growth of multifamily properties. Additionally, AvalonBay's portfolio of apartment communities faces competition from other options, such as single-family homeownership, single-family rental homes, condominium ownership, and other housing. The relative affordability of these other housing types keeps AvalonBay’s ability to set high initial rents and pass along rent increases in check.

AvalonBay concentrates on owning assets in metropolitan markets that have high incomes, dense populations, and positive job and income growth. The company's West Coast properties in particular are in markets that should see several years of job and income growth above the national average, which should lead to higher rent growth. On average, the company owns “A-“ quality assets, which supports higher rents for the apartment units. The company also regularly makes capital improvements and redevelops its portfolio to maintain its quality and keep it competitive in the market. Despite the positive demand drivers in AvalonBay's markets and assets, intense competition for high-quality assets in strong markets drove up the initial capital investment on the company's portfolio. Additionally, the high supply growth in many of the company's markets and the ever-present competition from alternative housing options keeps rent growth in the low to midsingle digits. As a result, the company acquired its portfolio at low initial cap rates, and the realized internal growth rate isn't high enough to exceed the company's WACC.

We use an adjusted ROIC calculation to determine if a company historically has shown or is forecast to have the characteristics of an economic moat. After adjusting the ROIC calculation to use maintenance capital expenditures instead of accounting depreciation, we calculate that over the past few years, AvalonBay has averaged an adjusted ROIC approximately 190 basis points below our 7.2% WACC. While the adjusted ROIC rises over our forecast horizon as the assets stabilize from recent transactions and developments, it does not exceed our WACC estimate, affirming our view that AvalonBay's portfolio should be assigned a no-moat rating.

None

Economic Moat

AvalonBay Communities

Archstone was a real estate investment trust that invested in apartments. In 2007, the company was acquired by Tishman Speyer and Lehman Brothers and, in 2013, the company's assets were acquired by Equity Residential and AvalonBay Communities. At the time of the liquidation of the company in 2013, it owned over 40,000 apartment units.

Archstone

AvalonBay Communities, Inc. is a real estate investment trust, which engages in the development, acquisition, ownership, and operation of multifamily communities. It operates through the following segments: Same Store, Other Stabilized, and Development or Redevelopment. The Same Store segment refers to the operating communities that were owned and had stabilized occupancy. The Other Stabilized segment includes all other complete communities that have stabilized occupancy. The Development or Redevelopment segment consists of communities that are under construction. The company was founded by Gilbert M. Meyer in 1978 and is headquartered in Arlington, VA.

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