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A Subprime Sucker Punch

Shares in multifamily real estate investment trusts (REITs) have taken a beating of late. Through Oct. 23, apartment REIT shares plunged by 11.9% due in large part to the subprime lending meltdown in the residential sector that scared many investors away from any housing-related stocks. By comparison, the FTSE NAREIT Equity REIT Index covering all the major property sectors posted a 4.40% decline during the same period.

That's bad news, to be sure, but many analysts are confident that apartment REITs will outperform the broader market in 2008.

“Anything that has a residential flavor to it seems to be getting dragged down by all of the bad news,” says Keven Lindemann, director of real estate at SNL Financial, a financial research firm based in Charlottesville, Va. “But if you read what the analysts are writing, they are projecting that these apartment companies will do just fine next year.”

Poised to rebound

Apartment fundamentals remain healthy despite the dip in total returns. The national vacancy rate declined by 20 basis points to 5.6% in the third quarter, reports Manhattan-based real estate research firm Reis Inc. New supply has also been handily absorbed.

While 24,000 new units were completed during the third quarter, net absorption of roughly 43,000 units easily outpaced completions. Reis also reports that landlords boosted effective rents by 1.4% to $964 per unit during the third quarter.

According to Lindemann, analysts project growth in median funds from operations (FFO) among apartment REITs to grow 5.7% in 2008 vs. 4.7% for all REITs. In addition, Lindemann also expects apartment REITs to benefit from strong fundamentals in the year ahead.

Historically, Lindemann says, any bearish outlook of the apartment market stems from deteriorating fundamentals. “But that's not what we're seeing in the market,” he says. Issues such as new supply and the increasing number of condominium reversions are “marginal problems.”

Condo reversion factor

According to Real Capital Analytics, some 8,124 condo units were converted to rental units during the first nine months of 2007, up from just 3,380 units during the same period last year. Real Capital Analytics tracks commercial real estate property sales $2.5 million and higher.

This so-called “shadow market” can be a headache for apartment REITs because the additional units compete for the same tenants. According to Lindemann, waves of condo reversion activity won't hurt every apartment REIT.

But reversions could still be a headache for some large apartment owners. One such company is Denver-based United Dominion Realty Trust (NYSE: UDR). With roughly 70,129 mostly Class-B apartment units scattered across the nation, United Dominion has a major stake in both the California and Florida apartment markets.

Roughly 47% of the REIT's net operating income was derived from these two markets during the first half of 2007. What's more, data from Real Capital Analytics shows that 69% of all condo reversions during that period occurred in the formerly hot California and Florida markets.

Another potential threat could come from strapped homeowners looking for rental income. Goldman Sachs REIT analyst Jonathan Habermann wrote in a late September research note that increased condo reversions could measurably affect United Dominion.

“Our concerns of a growing shadow market of homes competing with rentals in the company's low-barrier markets could result in slower earnings growth,” noted Habermann, who held a neutral opinion on the REIT as of mid-October. A spokesman for United Dominion declined to comment for this article.

Citigroup REIT analyst Jonathan Litt expects that the weak condominium market will continue to be a thorn in the side of many apartment REITs over the next few quarters.

“Headwinds should continue to weigh on the [apartment REITs], driven by economic uncertainty and an increase in supply from vacant single-family homes and condos being rented out,” wrote Litt in his Oct. 3 research note.

Decisions made by the Federal Reserve also will play a key role in how the apartment market performs in 2008. Lindemann of SNL notes that the apartment sector is “extremely” sensitive to interest rates because lower borrowing costs fuel home sales. “If interest rates continue to get cut, then plenty of apartment market watchers will view that as a bearish signal,” Lindemann says, “because that could ultimately hurt demand for apartment units.”
— Parke M. Chapman

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