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NEW YORK CITY—As the economy and stock markets continue to spiral downward, REIT stocks have followed suit, according to the third-quarter earnings reports released in recent weeks. The good news for investors in public apartment firms is that valuations for most multifamily REITs haven’t fallen as drastically as those in other segments–say, retail developer and owner General Growth Properties, or industrial powerhouse ProLogis. But if the outlook of apartment REIT management teams is any indication, the worst is yet to come for the sector.

The wayward and ever-weakening economy, the escalating crisis in the credit markets and unease on the part of average Americans over job security–and their subsequent hesitancy to make any major spending decisions–have resulted in a cloud of uncertainty for the heads of many companies, who just a few quarters ago were confident in their ability to push rents up and grow their businesses for the foreseeable future. Today, those same executives have turned their focus to the present–namely, capital preservation and unloading debt from their balance sheets.

For apartment REITs in particular, these sentiments expressed by management have put additional downward pressure on stock pricing, if the economic situation hasn’t done so already.

“Hearing it straight from the horse’s mouth appears to have caught the market a bit off guard,” says Dustin Pizzo, an analyst with Bank of America here who says stocks will likely continue to underperform.

Based on what these firms’ leadership have indicated so far, it seems that fundamentals have deteriorated faster than expected in the third quarter; renters have become more price sensitive and are increasingly looking to move into lower-priced units or shack up with a roommate; and, on the investment front, cap rates have probably declined by 50 to 10 basis points for core product.

Despite the gloomy outlook, there were some bright spots in the group. UBS recently upped Equity Residential’s rating from “neutral” to “buy,” calling the Chicago-based company the best positioned multifamily REIT. “EQR has not only been open and honest with investors in terms of their liquidity and capital needs, but we also believe management has taken the right steps to preserve capital and core earnings to prepare for a prolonged recession,” stated UBS analysts.

BofA’s views, meanwhile, are slightly more mixed. On one hand, EQR’s diverse geographic distribution, solid liquidity position and limited near-term development exposure makes it better positioned than most of its counterparts. On the other hand, deteriorating fundamentals and an anticipation of continued weakness in the fourth quarter will keep improvement just out of the firm’s reach for the near future. Management also reported that they’re seeing renters move to lower-priced units and doubling up, which further chips away at demand. Consequently, occupancies in weak markets declined further, and strong markets lost a bit of their edge.

Quarterly revenue growth was down by 100 to 150 basis points, and was actually in the red in seven markets, including Boston, Atlanta and the Inland Empire. Even once-strong markets, such as Seattle, Los Angeles and Metropolitan Washington, DC, have slackened. Given the decelerating fundamentals and rising cap rates, any upticks in share price over the next few quarters is unlikely. Its stock is trading at about an 8% discount to net asset value, versus 7% among its counterparts–and 16.1x 2009 estimated AFFO, compared to 14.4x for others–a fair price, according to BofA, which has a neutral rating on the REIT.

And FBR gave a market perform rating for EQR, noting that the company beat analysts’ expectations. Its third-quarter FFO per share of 65 cents hit the very top end of its guidance of 61 to 65 cents, thanks to higher core NOI, including the lease-up of recent development, notes FBR. The REIT’s management expects 2008 revenue and NOI growth of 3.25% and 3.75%, respectively, which is at the middle of previous guidance. Further, the expectation for FFO per share fell a few cents to $2.48 from $2.53.

EQR is also in a strong financial position, in terms of dealing with its loan maturities this year, according to FBR analysts. The firm recently closed a $550-million Fannie Mae secured loan through Wells Fargo, which boosts the $1.3 billion available on its unsecured revolving credit facility and about $660 million in cash and cash equivalents.

For Alexandria, VA-based AvalonBay Communities, FBR has an outperform rating. Its FFO per share of $1.28 was two cents higher than the Wall Street consensus, although it was between AVB management’s guidance of $1.26 to $1.30. Like most REITs, weakness in its core markets like Los Angeles caused same-store revenue growth to slip one percentage point to 2.7%. Consequently, the firm’s management reduced its full-year 2008 guidance.

BofA analysts have a similar view. The company’s main markets have weakened, according to analysts, and conditions should continue to deteriorate this year. The good news for investors is that AVB might need to pay a $1.75 to $1.85-per-share special dividend before September 2009, thanks to $300 million of asset sales in the third quarter at an average cap rate of 5.2%.

UDR Inc.’s Q3-per-share FFO of 36 cents fell one penny shy of FBR’s estimate, and the Denver-based company lowered its full-year guidance to $1.45 to $1.47, which is pretty much on par with analysts’ estimates. Revenue growth fell to 3.4%, down 1% from the second quarter and 60 basis points from the low point of management’s prior guidance. Combined with higher insurance and operating costs, this led to a slight decline in NOI.Meanwhile, the fundamentals in UDR’s Southern California markets deteriorated and revenue growth in the Southeast markets took a reverse turn, but the Washington, DC metro area and Northern California performed relatively well.

In light of these conditions, UDR’s leadership is looking to improve the strength of its balance sheet. To accomplish this, the firm recently completed a $194-million equity offering and a $120-million construction loan for existing developments and expanded its existing Fannie Mae credit facility this month from $139 million to $300 million at a blended interest rate of 4.8%, and extended its maturity from 2010 to 2018. The company also took the proceeds it received from a March portfolio sale and reinvested them in a recent $286-million, five-property portfolio through a 1031 exchange.

Despite these efforts, BofA has a cautious view of UDR. The firm recommends “investors continue to reduce exposure, as a faster-than-expected deceleration in fundamentals in ’09 continues to appear likely as strength in the Western region–about half the firm’s NOI–which has been offsetting weakness across the Mid-Atlantic and Sunbelt, likely moderates further,” states Pizzo.

As a result, “our primary concern remains unchanged that a reduction in core growth could be met with further multiple contraction and rising cap rates as investors demand a higher going-in yield on their investment,” says Pizzo. Consequently, BofA does not believe the current valuation for UDR is sustainable, especially with its shares trading at a 6.5% implied cap rate versus 7.1% for its peers and 7.8% for REITs overall.

Downside risks also have BofA analysts unconvinced for Post Properties. With its shares trading at a 23% premium to its peers, Pizzo relates that PPS’ current valuation is not sustainable, especially given the risks to 2009 estimates.

“We see no reason to buy the stock near term,” he says, noting that the Atlanta-based firm is in the middle of executing its turnaround plan. “We believe the shares will gradually drift toward our $16 target as visibility on 2009 earnings improves.”

Despite a negative 5% to negative 7% total return, he relates, it’s not enough to warrant a sell rating for PPS. Key catalysts for that move, he adds, include estimate reductions and risk of a dividend cut in early 2009.

BofA expects PPS to post negative NOI growth of 20% to 40%. Though the firm’s rents are significantly higher than the average for the category, its residents are becoming increasingly affected by the economy. The spread between renting and homeownership in PPS’ main markets will further reduce pricing power, and may even bring occupancy down as tenants opt to buy a home instead, Pizzo points out.

Another multifamily REIT, Aimco, is growing enough to justify its risk profile, especially given the expected 400 to 600-basis point reduction in FFO per share through 2010. “As such, we are hard-pressed to change our neutral rating, even after the 63% slide in the stock in October,” says Pizzo. BofA maintains its 2009 FFO per-share estimate of $2.92 for the Denver-based firm, below the consensus of $3.15.

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