Stock Values Rise as Deal Costs Go Up

BofA notes property-level conditions have moderated, as expected, but are nevertheless doing well. Year-over-year same store revenue growth fell a quarter percent to 4.2% from 2007's final quarter and the first three months of this year. Although less than the peak of 6.5% at midyear 2006, it's still healthy given the number of weak markets in the country.

BofA is advising investors to look at supply-constrained coastal markets, particularly the West, since fundamentals among markets are expected to diverge further. West Coast markets should see same-store revenues grow 150 to 400 basis points more than many Sunbelt locations this year, the firm's team says. Although employment is strong in the Sunbelt, condominium reversions and lower single-family home prices continue to pose a threat to apartments throughout the region.

The firm is forecasting decelerating, but healthy same-store NOI growth of 3.4% to 3.8% for apartment REITs in 2008 versus last year's 5.5% to 6.5%. Public firms with holdings in coastal markets should see same-store NOI growth of 3.75% to 4.5% while those in the Sunbelt should have same-store NOI go up 2% to 4%.

In transaction activity for the first two months of the year, volume fell 38% from the same period last year to $4 billion per month. Yet deals made on the coasts are achieving cap rates of 4.5% to 5.25% and even the Sunbelt markets are seeing caps ranging from 6.5% to 8%. "It's hard to make the argument that the stocks look inexpensive given limited visibility on fundamentals and the cost of financing," the BofA analysts conclude. "Rather, pricing appears fair with the group trading at a 6.2% implied cap rate."

In New York City, apartment companies have an advantage because fundamentals are better than in most other product segments. Also, Fannie Mae and Freddie Mac are more than willing to provide financing at attractive rates despite the tighter credit conditions. As a result, volume should hold up well compared to other sectors, with BofA reporting more than $7.5 billion in product was put on the block in January, a 117% increase since December 2007.

Because continued negative sentiment could put additional pressure on the sector, BofA has a Market weight rating for the REITs may see more headwinds than upside catalysts as well as moderate expected economic growth and limited visibility on the future of property-level growth and cap rates. Given all of that, the firm says "we feel it is still too early for investors to rotate into the group."

For those that are active in the segment, BofA says Essex Property Trust, which has the only "buy" rating of all the public companies the firm tracks, is the top pick due to its lower-priced West Coast portfolio of older, quality properties. BofA believes Essex is better protected from a continued deterioration in the single-family housing sector due to its class B assets in class A locations.

NAREIT also reported favorable results for apartment REITs. For all sectors, the FTSE NAREIT all-REIT Index outperformed the broader market in the first quarter, following three quarters where it trailed the broader market. Residential REITs, which include both public apartment companies and manufactured homes, was the second-best performer among all trusts--the sector was one of the hardest hit last year, says NAREIT, and trailed the overall REIT market's performance for much of last year. Residential REITs posted an overall total return of 11.2% on the first three months of this year. For apartment trusts specifically, the total return this quarter was 11.5%.