Description

Using three metrics of valuation (FFO Multiple analysis, Cap Rate analysis and Replacement Cost Analysis) AEC is worth $15, $25 and $22 per share, respectively. Trading at a 40% discount to industry comps, 60% discount to replacement cost, with daily trading volume exceeding 100,000 shares, Associated Estates Realty (AEC) is extremely undervalued.


Company Description:

Associated Estates Realty is an apartment Real Estate Investment Trust (REIT) headquartered in Cleveland, Ohio. The company owns 77 properties comprised of 17,854 units, which span 10 states (52.7% Ohio, 18.8% Michigan, 7.3% Florida, 5.4% Indiana, 4.6% Georgia, 4.3% Washington DC, 3% Pennsylvania, and 3.8% of the units are in North Carolina, Arizona and Texas). In addition, the REIT owns partial interests in 4 properties totaling 1,239 units. AEC manages 28 third-party apartment properties consisting of 5,709 units and 1 commercial property.


Strong Second Quarter Results, improving fundamentals:

AEC beat Street estimate by 7c/share. They reported FFO of $0.29/share, up 93% YOY. Same store NOI was up 12.9% YOY. Management reiterated FFO guidance at the high-end of their prior guidance, $1.05-$1.10/share. The Street consensus was $1.00/share.

While AEC’s physical occupancy is a strong 92.6%, future earnings upside is likely as their economic occupancy is only 85.3%. The difference between the two is a function of “free rent” which is utilized to attract renters in a difficult renting environment. The percentage of “free rent” is steadily declining as AEC’s core market improves and now stands at just one month.

The company pays an annual dividend of 68c/share which translates into a current yield of 7.8% vs. the industry average of 6%. Using the company’s guidance the dividend is well covered by free cash flow (AFFO) with just an 87% payout ratio. This is dramatically different from last year when AEC’s dividend payout exceeded AFFO. AEC now has one of the best dividend coverage ratios in the Apartment REIT sector with the group on average sporting a rather lofty AFFO payout ratio of 109%.

Not included in any of my AFFO analysis are gains from asset sales which amounted to 50c/share in the second quarter alone. This gain was from the sale of a single property!! Bottom line – the book value of these assets is enormously understated compared to true market values (NAV).


Rising Interest Rates are good for Apartment REITs:

Apartment REITs have suffered the last few years as low interest rates encouraged renters to take the plunge into buying their first home. Additionally, low interest rates encouraged construction of new units as developers locked in cheap financing rates. Increasing interest rates should reverse this trend and increase apartment occupancies across the board.

While many people took advantage of low interest rates to purchase their first home, the less fortunate, (the unemployed and recent college graduates who may be underemployed in a difficult job environment) often couldn’t afford an apartment and essentially resorted to living with family or friends. An improving economy with job creation should lead to a higher rate of apartment occupancy.


The Comps:

Ticker Share Price FFO Multiple Imp. Cap Rate
AEC $8.80 8.0x 10.1%
AIV $32.14 11.0x 7.7%
AML $29.68 13.4x 6.3%
ASN $29.60 16.0x 6.2%
AVB $59.55 17.2x 6.3%
BRE $35.35 14.5x 6.6%
CPT $46.26 13.5x 7.2%
TCR $8.80 10.7x 7.9%
EQR $29.89 13.1x 6.6%
ESS $65.97 14.8x 6.3%
GBP $33.85 14.2x 7.4%
HME $38.45 12.8x 6.8%
MAA $36.99 12.2x 7.8%
PPS $28.75 15.3x 6.1%
SMT $25.82 14.4x 6.3%
TCT $24.97 13.8x 7.6%
UDR $19.79 12.2x 7.1%

Sector Average 13.4x 7.1%
AEC Disc. to Sector 40% 42.8%

AEC's Warr. Share Price $14.70 $24.92
Percent Return 67% 183%


FFO Analysis:

The average Apartment REIT trades at 13.4X 2005 FFO, a 40% premium to AEC’s multiple of only 8.0X. An increase in AEC’s multiple to the sector’s average implies a share price of $14.70 for a 67% return on the stock. The following chart illustrates AEC’s fair value at various FFO multiples.

AEC Price $8.80
2005E FFO $1.10
Discount/
FFO Multiple Warr. Price (Premium)
8.0x $8.80 0.0% AEC's current Multiple
8.9x $9.76 10.9%
9.8x $10.73 21.9%
10.8x $11.83 34.4% 10-yr Sector Average
11.6x $12.79 45.3%
12.5x $13.75 56.3%
13.4x $14.71 67.2% Current Sector Average


Cap Rate Analysis:

The average Apartment REIT trades at a 7.1% cap rate compared to AEC at 10.1%. A decrease in AEC’s cap rate to the sector’s average implies a share price of $24.92 for a 183% return on the stock. The following chart illustrates AEC’s fair value at various Cap Rates.

Discount
Cap Rate NAV To NAV
6.1% $33.80 74%
6.6% $29.03 70%
7.1% $24.92 65% Sector Implied Cap Rate
7.6% $21.36 59%
8.1% $18.24 52%
8.6% $15.49 43%
9.1% $13.03 32%
9.6% $10.84 19%
10.1% $8.80 0% AEC's implied cap rate


Replacement Cost Analysis:

I estimate the replacement cost for AEC’s portfolio conservatively to be over $60,000 per unit or $22 per share. This value I estimate from: site visits, discussions with management and looking at where comparable properties are being constructed (minus reasonable depreciation). The following chart illustrates at various share prices where you are buying AEC on a per unit basis.

Disc. Replace. Cost Per Warranted Share Price
Cost/Unit Unit Share Price Disc / Prem
23% $46,590 8.80 0% Current Share Price
21% $48,167 10.27 14%
18% $49,744 11.74 25%
16% $51,321 13.21 33%
13% $52,898 14.68 40%
10% $54,475 16.15 46%
8% $56,052 17.62 50%
5% $57,629 19.09 54%
3% $59,206 20.56 57%
0% $60,783 22.03 60% Replacement Cost


WHY AEC IS SO DAMN CHEAP!!

1. Small Cap equity, only Street coverage is Legg Mason.
2. Highly levered (bad in a market down turn – good in a rebounding market)
3. Until 2004 the dividend wasn’t covered on an AFFO basis and some investors feared a reduction in the dividend.
4. Management does not conduct earnings conference calls. My belief is management took a lot of heat when they had to cut the dividend in 2002 and just doesn’t want to be beat up.


CATALYSTS:

1. At least two other Street firms are considering coverage after AEC’s latest earnings release.
2. Realization from investor’s that the dividend is now much more solid and unlikely to be cut and may be increased as early as 2005.
3. Management is likely to change their policy regarding conference calls now that they are putting out solid, above expectations, earnings.
4. Rising interest rates and employment growth should further increase earnings leading to an even cheaper stock on a multiple basis and the chance for a dividend increase.
5. With the stock trading under $9.00 per share and worth at a minimum $14.71 on a multiple basis and $24.92 on a cap rate basis, AEC is not likely to stay this cheap forever. The replacement cost valuation on the real estate puts a real floor on the downside and the dividend yield of almost 8% allows you to wait the year or so it may take for AEC to be fully appreciated by investors.


Final Thought:

For those of you who think the real estate market in general is overvalued and that instead of AEC appreciating to the comps that the comps start to come down in value, I would recommend considering AEC for a pair-trade. An even dollar trade going long AEC and short almost any of the other publicly traded REITs would allow you to hedge your REIT exposure, participate in AEC’s upside and produce an immediate positive carry as AEC’s dividend yield is the highest of all the publicly traded REITs except for TCR.

Catalyst

Convergence of trading multiples to the mean.