Like its counterparts in the other property sectors, multifamily REITs saw pricing rise a bit due to the narrowing of credit spreads, positive economic indicators and a pickup in new issue activity. Yet the boost apartment stocks experienced recently wasn't warranted, say the researchers, who expect prices to erode even more over the balance of the year.

As it becomes evident that the market's recovery is going to be more protracted than originally thought and this blip in investor appetite subsides, investors will probably bring their attention back to fundamentals. When this happens, say BofA-ML analysts, apartment REITs will become less attractive thanks to declining fundamentals through 2010. This, they add, "is much more of an immediate impact than what other REIT sectors will experience."

On top of that, the sector is challenged by a number of factors. For one, investors are not certain about the extent GSEs will continue to provide financing to apartment properties. Fundamentals in the sector are also weakening at a faster pace than many on Wall Street anticipated, and are surpassing their suggested guidance. And, down the road, homeownership will once again become attractive, especially as prices are reduced.

As fundamentals deteriorate through the year, stock prices will probably spiral down along with them and same-store rental revenues could fall by the mid- to high-single digits. Expenses are slated to increase by 200 to 400 basis points and net operating income to fall by the high single digits to low double-digit decline.

That's contrary to many REITs' average 2009 forecasts that same-store revenues will be down just 2%, NOI to fall by 4.5% and same-store expenses to rise by 3%. Given these factors, the researchers give an underweight rating to the sector in 2009 and brought its 2010 FFO estimate to 5% lower than consensus.

If one were to buy a share in an apartment company, the firm suggests banking on Home Properties, thanks to its defensive characteristics, exposure to outperforming markets in 2009 and "compelling valuation. While no apartment REIT is immune to a downturn, HME's slow and steady FFO growth underperforms during economic booms and outperforms during recessionary periods."

Further, the REIT's tenant base is usually older and more blue collar, which means they are more likely to remain in their rental apartments. Historically, Home Properties' turnover is 40% to 50%, significantly lower than other multifamily REITs' average of 60% to 70%.

And while HME recently saw its valuation drop, BofA-Merrill Lynch contends that it just means it's better poised to recover, which means that investors who get in now could reap benefits down the line.

Instant Insights /

Waning Fundamentals Prompt Underweight Rating on REITs

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