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Still Cheap REITS

Roger Conrad
Roger Conrad
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Residential property REITs continue to pay big dividends and are gearing up for growth, even as other property plays languish. Here's how to profit.

As we noted in the June 22 PF, half a decade of low mortgage rates and soaring property values encouraged would-be renters to buy homes instead of rent apartments. The result: The cost of renting an apartment is relatively low compared to the cost of buying a home.

We're still early in the game. But the eight apartment real estate investment trusts (REITs) highlighted are already raising rents and reducing vacancies.

Apartment REITs' outperformance will continue until the cost of renting comes back into balance with that of buying. And given how out of balance things are now, that could be a long time.

As a result, we continue to advise a shift from commercial to residential REITs. This issue, we're adding Canadian Apartment Properties to the Income Portfolio.

Quality First

In the June issue, we profiled eight residential REITs with extraordinary potential. We've made two deletions from the list since June.

Gables Residential was taken over soon after that issue went to press. The other is BRE Properties, which we continue to advise selling.

At this point it's essential to focus on higher-quality residential REITs. Six of the nine REITs on our list this time around pull investment-grade credit ratings and a seventh—Mid-America—has the financial strength to do so.

All also have payout ratios that are well below 90 percent of funds from operations (FFO). FFO is a much better measurement of REIT profitability than earnings per share, since it takes into consideration the unique tax advantages of real estate.

On the operating level, our REITs have a very high average occupancy rate, which all of them have managed to increase during the past year. And none of these REITs were significantly impacted by the hurricanes that struck the Gulf of Mexico. In fact, Mid-America is likely to pick up business from evacuees that elect not to return to New Orleans.

Though up an average of about 100 percent during the past five years, these REITs still trade with an average yield of nearly 6 percent. Average price-to-FFO and price-to-book value are also well below that of the average stock and REIT.

Selecting The Sector

For a combination of low price and high quality, our top three picks from the apartment REIT sector are current Income Portfolio members: Mid-America, Home Properties and new addition Canadian Apartment Properties. Both of the former posted solid second quarter earnings numbers and the news should be equally good when they announce profits again in early November.

For conservative investors, the best bet is still Mid-America. The REIT has consistently improved the operation of its residential portfolio by lowering vacancy rates and raising rents, and the opportunity for expansion is immense.

Moreover, despite a 190 percent total return in the past five years, it still yields above 5 percent and sells for less than 15 times FFO. For those who have yet to get in, Mid-America is a buy up to 48.

Home Properties' occupancy rate remains down slightly year-over-year, but has improved sharply on a sequential basis (from the prior quarter). Rents are also on the rise and the REIT has successfully purchased several high quality properties as well, which should begin fueling higher FFO as well.

The shares have been weaker than Mid-America's since we added it to the Income Portfolio, but with the dividend now well covered by FFO and among the highest in the group, it's looking more like a bargain. If you haven't yet added Home Properties, it remains a buy.

Outside of those three, new additions to the list Camden Property Trust and Post Properties feature the best combination of quality and price. Camden owns 65,992 apartment units in a dozen states plus the District of Columbia. The focus is high-end, primarily gated communities and the REIT typically provides such amenities as swimming pools, spas and tennis courts.

The REIT's customers are certainly well heeled enough to pay up for such services. And it's had no problem finding renters, with occupancy above 95 percent at last count and up substantially during the past year. Rent growth has also been solid of late. The good news is both of these trends will be helped going forward, as more affluent prospective renters elect not to buy houses at today's prices. And the REIT is positioning itself to get their business with 10 apartment communities now under construction.

There's also the chance of a credit rating boost, with S&P assigning a "positive" outlook on Camden's BBB credit rating. Conservative investors can buy Camden up to 57.

Once considered the premier apartment REIT, Post Properties' shares have hit a drought in recent years, returning only 22.8 percent the last five years. That severe underperformance, however, had a lot more to do with a very high prior valuation than anything at the REIT's operations, which are steady as ever.

Second quarter 2005 FFO surged to 52 cents from 35 cents a share a year ago, as the REIT reaped the benefits from selling older assets and developing others, particularly in the condominium market. Occupancy is strong and the payout ratio low, a testament to the high quality of its nine-market, 23,533 apartment portfolio.

It's also proof of management's ability to thrive even in a tough market. One of the nice things about poor performance is that Post is no longer so pricey. At less than twice book value and a yield of nearly 5 percent, Post is a quality buy up to 38.

Watch Them

The remaining four apartment REITs on the list are holdovers from the prior list. For Equity Residential and United Dominion Realty, we still have a problem with price. Both are still well above initial buy targets of 35 and 20, respectively.

Both trusts, however, remain solid with low payout ratios, high occupancy rates and solid bond ratings. If their prices come off a bit more, both will be buys. And neither has much to worry about if the overall economy falters, given the underlying strength of their portfolios. But for now, Equity Residential and United Dominion are holds.

As we pointed out in June, AMLI Residential and Apartment Investment and Management are for speculators only. The news flow during the past four months has been mixed. AMLI's credit rating, for example, has been withdrawn while Apartment I&M reported lower vacancy rates and higher rents.

Both REITs have managed to reduce payout ratios to an acceptable level based on second quarter earnings, and odds are they'll post more improvement when third quarter results are released next month.

As a result, they're now suitable for aggressive investors--AMLI up to 33 and Apartment I&M up to 40. Conservative investors, however, should stick with the first four picks discussed in this article.

Roger Conrad will be available to take your questions until Monday, October 17. Please use the form below to submit your questions.

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