Apartment REITs Are Too Pricey to Move Into

 | Jan 04, 2013 | 2:30 PM EST  | Comments
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As Chez Melvin finally begins to return to normal and the last crop of holiday guests departs today, I have had time to renew my rounds of calls and conversations with my network of traders and investors. After discussing the current round of bowl games and the upcoming NFL playoffs, one associate reminded me that I haven't really talked much about stocks and sectors to avoid in the coming year.

While I am not a short-seller, we have had some luck finding stocks that traded at high valuation and were heavily owned by institutions that were best avoided by long-term investors.

This year my top sector that investors should avoid at all costs is a familiar one. I have been somewhat bearish on apartment REITs for some time now. Apartment-related REITs have jumped the past two years as the credit crisis created enormous demand for rental housing. Astute investors who realized this and bought the shares back in 2009 when they traded below tangible book value have done extraordinarily well, as most of the apartment investments have doubled or better since then. Now, as with all things Wall Street, the shares have appreciated to the point where they are grossly overvalued. They may be popular, but they are not cheap.

Take a look at the shares of the largest apartment REIT. Equity Residential (EQR) owns about 12,000 units in 15 states and has a focus on coastal states. It is a very well-run company, and Chairman Sam Zell is one of the best real estate investors of the last half century. The company has been selling assets it considers non-core and using the proceeds to buy apartments in more favorable locations. It also constructing new complexes, and six are still being built. In November, Equity announced that it was  teaming with Avalon Bay (AVB) to purchase the apartment-related assets of Lehman Brothers. This is a very well-run company with some great assets.

However, there is too a high price for everything, and this company trades at a too-high level. The shares trade at 97x trailing earnings and 37x the always highly accurate analyst estimates for 2013. The time to buy real-estate-related assets is when you can buy them at a discount, and that just is not the case here. Shares of Equity Residential trade at more than 3x tangible book value. The stock rose sharply in the first part of 2012 but has fallen off the highs, so investors seem to realize that the party is over. The real danger here is that 94% of the float is owned by institutional investors, and the exits could get very crowded very quickly if they decide to sell.

I have been advising against owning Avalon Bay for some time now and even shorted it a couple of times, with mixed results. Again, it is not a bad company, but traders playing the demographic theme and asset allocators looking for apartment exposure have driven the stock to unsustainable valuations, in my opinion. Avalon Bay owns more than 58,000 units in some premier locations and is seeing rising occupancy rates and firmer rental markets. As wonderful as that is, Avalon Bay is not worth 3x book value and more than 50x earnings. Even if we use the more liberal funds from operations (FFO), Avalon shares trade at a multiple of 21. The shares yield less than 3% and are just not an attractive holding for long-term investors at this price.

The same condition holds true across the sector. Essex Property Trust (ESS) trades at 67x earnings and more than 3x tangible book value and yields just 2.9%. BRE Properties (BRE) trades at more than 50x earnings, and 2.4x tangible book value and yields just 3%. I found no apartment-related REITs that trade at a bargain, or even what I might consider reasonable valuation.

Apartments have favorable industry conditions with solid demand as a result of the wave of foreclosures. Rents are not rising rapidly but should gain in line with the economy at 2% or so. As the outlook for apartment REITs has improved, so has their popularity on Wall Street. Most of them have very high levels of institutional ownership. At the same time, insiders have been selling aggressively as prices have risen. The sector is priced for perfection and beyond, and most investors are wise to avoid them. Traders should be looking for an entry point on the short side, because this party appears to have reached its peak.

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