BRE Properties Inc is a publicly traded REIT that owns, develops, and manages apartment buildings in the western part of the US.  As of FY 2010 year end, it owns 21,318 apartment units, and an 806 units development pipeline.  SF, LA, OC, San Diego and Seattle represent 88% of 2010 revenue.

I am recommending a short position in BRE as

1)      Even the "best case" scenario cannot justify the current price of $48.64

2)      The "limited new supply" theme is no longer true

Background : What happened in the last 2 years?

The apartment REIT sector has had a stellar rebound from the latest recession.  The Bloomberg US Apartment REIT index has returned more than 125% since March 2009.  The rebound is due to the following factors that are the direct results of the recent credit crisis:

• Close to zero interest rate has forced investors to chase yield and compressed cap rates (earnings yield of commercial real estate).  Therefore, net asset value (NAV) of all REITs is up.
• Higher demand - the marginal borrowers that could have qualified for mortgage loans before the crisis but now cannot and the owners who had their houses being foreclosed upon become renters
• Limited new supply - new developments were halted as the word "construction" became toxic in the commercial real estate world in 2009. 
• For a brief period in 2009 credit was extremely expensive for real estate companies.  The apartment sector was the exception as the GSEs continue to provide inexpensive financing throughout the crisis in their effort to support the residential real estate market.

Earnings model

The business model of BRE is very simple and hence earnings visibility is quite high.  Apartment units are rented for 9 - 12 month terms.  Revenue is determined by occupancy and rent per unit.  Major expenditures are property expense, maintenance capex, corporate G&A and interest expense.

In general, BRE's portfolio is of high quality, upper-scale apartment units located in supply-constrained area.  This can be confirmed through Google Map and its operating data.

Source: Form 10K

Source: Form 10K

During that time period, BRE has exited Denver and Salt Lake City, sold assets in Inland Empire, Phoenix and Sacramental.

As indicated above, BRE was able to maintain 94% plus occupancy and achieve rent/unit CAGR of 3.8% throughout FY 2004 - 10 through actively managing the portfolio.  These are impressive numbers as the downturn of 08 - 09 is included.

Earnings power in best case scenario

Revenue, in a best case scenario, is defined as 100% occupancy.  Assuming $1,500 rent/unit/month (up from $1,417 in FY 2010), 22,124 units (21,318 + 806, assume pipeline is finished and 100% leased), revenue would be $398.2mm.

Source: Form 10K, company supplemental

Source: Form 10K.  Defined as (preferred dividends + interest expense + capitalized interest) / average (consolidated debt + preferred equity liquidation value)

Now, assuming normalized NOI margin of 68%, normalized capex/unit of $1,710, BRE's operating FCF would be $212mm.  ($398.2mm * 68% - $1,710 * 22,124 units - $20m corporate G&A)

As of 1Q2011, BRE has $2.02B of interest bearing debt, assuming interest rate stays at the current level of 5.4% indefinitely (which is VERY unlikely) instead of the normalized 5.9%, FCF would be $212mm - $2.02B * 5.4% = $102.5mm, or about $1.36/share (75.44mm common shares/op units outstanding).

Valuation

First and foremost, real estate is a cyclical business and over the long term should track inflation.  Prime real estate in supply-constrained areas should be able to grow earnings at 1 or 2% above inflation.  For margin of safety, let's assume BRE can grow FCF/share indefinitely at 5%/year.  I believe a debt-free business with 5% earnings growth is fairly valued at 20x multiple. 

*Unconsolidated JV earns less than $0.1/share so it's immaterial.

BRE is highly indebted.  Its debt/best case operating FCF is $2,020/212 = 9.5x.  At $48.6, BRE is trading at 35.7x best case earnings.  Said differently, Mr Market is offering two AAA-rated companies - JNJ & MSFT - at 1/3^rd of the multiple of BRE.  I believe BRE is over-valued even at $27.2/share.

Catalyst

BRE has traded and stayed above $27 since Nov 2009.  Apartment rental rates and occupancy have been driven up in FY 2009 & 2010 due to higher demand and limited supply.  As the economy improves and house prices goes down, homeownership should go up that would lead to lower rental demand.  However, this is at least several years away.  So one can reasonably ask - why short now? 

The answer is the limited supply story has broken.  Please see below:

"Our fourth quarter results also showed another period of significant investment activity. We completed almost $500 million in development. We started construction on five new communities with a total capital cost of about $300 million...."

"our business plan calls for a significant increase in investment activity with overall investment levels up around 25% from 2010. We expect to start around 850 million in new development this year. Combined with 650 million in starts last year we'll have around 1.4 billion under construction by the end of this year, a level consistent with that experienced in 2005 and 2006 or during the middle of the last cycle."

AVB 4Q2010 earnings call

"With rents now increasing, we are pursuing development deals in several West Coast markets underwritten based on today's rents, development cap rates range from 5.5% to 6.25% or six and three-quarters, 7.5% upon stabilization..."

"Mike, one of your comments, I'm not sure I'm going to paraphrase it correctly, but you made it seem like you expect the development to come back fairly quickly like you did in last cycle, and that you were tracking  new development projects as a result, is that right?"

<A - Michael J. Schall>: That's exactly right. I mean, one of -- I thought there was commentary or question from one of the analysts in some of the other calls had talked about ...

ESS 1Q2011 earnings call

"we are commencing the development of a new community in Austin, Texas. Doing so, we are taking advantage of low construction pricing to put existing land into production at the leading edge of a new apartment cycle. Development will be our primary capital investment activity this year."

"There is development activity here and there, but it hasn't ramped up significantly. And bankers will take - they're interested in lending more than they were, but it's still relatively slow.  Now, my expectation is that development is going to ramp up as the fundamental picture continues to get better."

PPS 4Q2010 earnings call

Conclusion

Once the market realizes the supply of apartments are accelerating, BRE's multiple would contract.