AvalonBay Communities: Undervalued REIT Yielding 4%

While companies with long histories of dividend growth, such as the Dividend Aristocrats, tend to get the most attention from dividend growth investors, each name in that index had to begin their dividend growth streak at one year. They then had to continue to grow its distribution every year before they qualified for membership in a dividend growth index.

It is for this reason that we also monitor stocks with shorter dividend growth streaks. Companies with at least five years of dividend growth are called Dividend Challengers. Dividend Challengers broadly have a strong business model, solid prospects for future growth, and a commitment to dividend growth.

One Dividend Challenger we think has a good chance to join the best-of-the-best dividend growth stocks is AvalonBay Communities Inc. (AVB).

Company Background & Growth Potential

AvalonBay Communities is a multifamily real estate investment trust (REIT). The trust has 270 apartment communities containing more than 73,500 units. AvalonBay Communities is also in the process of develop 18 additional properties that will have more than 7,200 units. The trust was formed by the 1998 merger of Avalon Properties with Bay Apartment Communities. AvalonBay Communities trades with a market capitalization of almost $22 billion and generated revenue in excess of $2.3 billion in 2019.

AvalonBay Communities’ key competitive advantage is that it focuses on owning and developing top-tier properties in major metropolitan areas such as New England, New York/New Jersey, Washington D.C., California, and the Pacific Northwest.

Owning properties in densely populated areas of the country gives the trust a rather large pool of potential customers, which helps to ensure that its units are mostly occupied.

The trust’s most recent earnings report is evidence of this strength. Despite the immense and unprecedent headwinds from the COVID-19 pandemic, AvalonBay Communities had 93.1% of its units occupied, which was just a slight decrease from the previous year. Average rental rates were more than $2,600 per unit, a 3.4% decrease from the previous year. Given the circumstances of the current operating environment, it is surprising that the occupancy and average rental rates weren’t lower.

While not every person in the trust’s metro area markets needs to own a home, they do need a place to live. This makes AvalonBay Communities’ apartments so attractive. They allow customers to live in highly desirable areas without the long-term commitment of owning a house.

This is one reason why AvalonBay Communities held up decently during the Great Recession. Funds from operation, or FFO, fell 18.5% from 2007 through 2009, but the trust returned to growth the next year. AvalonBay Communities’ FFO has increased every year since with a compounded annual growth rate of 8.9% over the last decade. It should be noted that much of this growth occurred in the early and middle parts of the last decade. Due to COVID-19, we do believe that trust well see a 5.8% decline in FFO to $8.80 for 2020. We believe FFO can grow at a rate of 3.6% annually over the next five years.

Image Source: Pexels

Dividend Safety & Total Returns

AvalonBay Communities’ business model has made it possible for the trust to increase its dividend for nine consecutive years. The dividend has increased with a CAGR of 6.1% since AvalonBay Communities began its dividend growth streak. The trust’s raised its dividend 4.6% for the 4/15/2020 payment. If AvalonBay Communities keeps to its usual schedule then shareholders can expect the next dividend increase announcement to come in early February.

Shareholders received $6.36 of dividends per share in 2020. Using our estimate for FFO, the payout ratio is just above 72%. REITs often have elevated payout ratios, but this is lower than many of AvalonBay Communities’ peers. The trust has seen its payout ratio decline from 92% in 2010 to 65% in 2019. The five-year average payout ratio is just 66%.

AvalonBay Communities has managed its dividend growth in a very prudent manner. We expect that the payout ratio will return to a more normal level once a recovery from the pandemic takes hold. Shares currently offer a yield of 4%, more than double the average yield of the S&P 500.

Using the current share price of $159 and expected FFO for 2020, AvalonBay Communities has a price-to-FFO ratio of 18.1. This is nearly in-line with our five-year price-to-FFO target of 18. Therefore, we believe changes in valuation will have a negligible impact on total returns through 2026.

Total returns for the stock would consist of the following:

• 3.6% FFO growth
• 4% dividend yield

AvalonBay Communities is expected to return a total of 7.6% per year over the next five years.

Final Thoughts

AvalonBay Communities doesn’t have the streak of some of the more well-known dividend growth stocks, but the trust has a very strong business model, good prospects for future growth, and has shown a commitment to dividend growth. Unlike many of its peers, AvalonBay Communities often has a very low payout ratio as well, which should enable the trust to continue raising its dividend for many years.