UDR’s ‘B’ Property Exposure Leaves Shares Fully Valued (NYSE:UDR)

UDR (NYSE:UDR) has been a significant underperformer over the past year as higher rates weighed on real estate valuations, and the rental market has cooled significantly. Still, shares have rallied more than 20% from their lows as long-term rates have declined. While the apartment market is likely nearing a bottom, UDR’s valuation and real estate mix leave it unlikely to be a top performer in the sector.

UDR operates about 60,000 apartments across 21 markets. As you can see below, it operates across several markets. It primarily owns apartments in legacy markets like New York, Boston, and California, though it has also built a meaningful presence in the faster-growth Sun Belt. Over the longer term, given migratory patterns, I am constructive on Sun Belt real estate plays; however, the near-term outlook is more muddled as this positive backdrop has led to significant new construction, increasing supply, and weighing on rents.

Indeed, as you can see below, rental inflation has slowed significantly from its post-COVID surge. According to ApartmentList, rents fell by 0.7% in 2023, though the median rent is still up $250 from three years ago. The national vacancy rate of 6.5% is up from its 2021 low of 3.9% and is now in-line with pre-COVID levels.

Interestingly, Boston and New York were two of the top ten performing cities in 2023 as some legacy cities that underperformed in the aftermath of COVID have recovered and caught up, aided in part by lower construction levels. Strengths in these markets are a benefit to UDR. As you can see below, the Northeast has been immune to the fall in rents over the past year while the Sun Belt and California have weakened. The Sun Belt has reversed outsized gains whereas California has proven to be a structural underperformer since 2019, given negative migratory trends.

UDR’s Northeast operations help to insulate it somewhat from these trends, but its large West Coast and growing Sun Belt operations have felt some pressure. We can see this mixed bag in its financial results. In the company’s third quarter, UDR generated $0.63 in normalized funds from operations (FFO), up 5% from last year with same-store revenue growth of 5.3% exceeding its 3.4% expense growth. Revenue was up 5% to $410 million. Real estate taxes and insurance were flat in Q3 at $58 million while operating and maintenance costs rose by 7.3%.

UDR kept occupancy stable at 96.7%, and it is generating $2,939 in revenue per unit from $2,734 a year ago. That 7.5% growth has significantly outperformed the industry, aided by redevelopment efforts and strong re-leasing activity. As you can see below, resident turnover has been falling for the past six months, and the company has been pushing 4% renewal rent increases on its tenants, helping to support revenue.

While results are favorable year over year, we are seeing sequential pressures materialize, which is important when considering the trajectory for 2024. For instance, while annual revenue growth exceeded expense growth, relative to Q2, same-store revenue rose by just 2.3% while its expenses rose by 3.9%. Indeed, given recent softening in the market, it reduced Q4 guidance to a midpoint of $0.63 from $0.65. That would be flat to Q3’s results.

Now, on the bright side, the company has subsequently reaffirmed it expects to achieve the midpoint of its Q4 guidance with FFO of about $0.63 as same-store revenue growth is 2.25-2.75%. As such, I would expect Q4 results to come in line with guidance. The question will be the trajectory for 2024, and I view it as unlikely that UDR can generate much earnings growth.

We have seen the regional variances begin to impact UDR’s results. The West has underperformed with same-store growth of 3.9% while the Southeast was 6% and Northeast especially strong at 6.9%. The Northeast is relatively insulated from supply pressures, but UDR’s performance in the South has been quite strong. There are signs this may be weakening. While it is still generating 4% renewal rates, management has said that the pressure on “B” properties from “A” supply coming online and offering concessions has been “unprecedented.”

Essentially, new higher-quality markets have been coming on the market and offering such attractive concessions that customers in lower-quality properties have been able to trade up. In the sun belt, new leases for UDR are down 1.7% in A properties and a sharper 4.4% in B properties, as a result. As the impact of newly signed leases is felt in its financials, that will be a revenue headwind. Additionally, with this increased competition, I do question whether UDR will be able to keep passing on 4% increases to existing tenants without causing an increase in turnover. So far, it has kept occupancy solid with 96.8% occupancy in October, up slightly from 96.7% in Q3, but this has been aided by tripling its concessions to 1.5 weeks on average.

UDR is particularly exposed to this “trade-up” dynamic because 44% of its units are “A” quality and 56% “B” quality. Despite this quality of real estate, it has a strong customer base with $160,000 annual household income (160% of the median in its markets) with an average age of 36. This consumer is likely able to afford to trade up with rents a bit weaker. Moreover, with interest rates coming down, there could be some competition with buying vs renting a home, especially with 69% of its properties suburban. This is likely less of a pressure in CA and NY than in the Sun Belt, given local affordability considerations.

Additionally, as noted above, we are seeing sequential expense growth exceed revenue, which may continue to pressure results. Its same-store operating margin of 69% is down from its Q4 2022 peak of 70.1%. In particular, UDR has done a very strong job of controlling tax and insurance expenses, with insurance costs rising more materially for others. I would expect this expense growth to be higher in 2024, which will be a headwind for FFO.

Of course, if rents accelerate meaningfully, that will lift most apartment REITs, whereas a further decline will be a headwind for the sector. With a soft landing appearing likely and the labor market firm, demand should be strong, even if somewhat lower mortgage rates are a modest headwind. The bigger factor is supply. As you can see below, apartment construction has surged, and the number of units under construction has hit a record, though it has declined modestly from its peak.

As these units are completed over the next six months, that incremental supply is likely to be a headwind for rental growth. However, once we get past the next few months of competition, the backdrop should improve considerably. Higher rates and a cooler rental market have combined to cause much more caution on the new construction front. In fact, new starts are down from 600k to 400k. Essentially H22023-H1 2024 is being weighed down by the buildings begun in 2021-2022, but as we get past Q2 2024, the lower starts should lead to slower supply and support a bottoming of the rental market.

Essentially, it is a matter of getting through this cyclical supply surge in coming months, and then the favorable long-term dynamics of a supply-constrained US housing market should enable rents to begin rising again, though not likely at the pace seen in 2021 and 2022.

While UDR is likely to see rental pressures in CA and the Sun Belt, particularly among its B properties, it certainly has the financial strength to manage through this period. In fact, during the third quarter, it repurchased about $25 million in stock. It carries $5.8 billion in debt with 5.7x net debt/EBITDA leverage. Interest expense rose by over 10% to $44.7 million in Q3, a little more than a $0.01 headwind. About half of this was due to its $200 million of incremental debt and half due to a higher average interest rate.

We are likely to only see modest interest expense growth because 95% of debt matures more than three years from now. Its debt is extremely low cost at a 3.37% average interest rate. As such, even if rates fall from here, when it refinances maturities, they will likely be at a higher cost, but this is not a material pressure until 2027

UDR also has a solid 1.5x dividend coverage ratio, and shares offer a 4.4% yield. Over the past five years, it has provided dividend growth of 5% with 13 years of growth. In 2024, analysts are looking for just 1% growth to $2.50 in FFO. Even if this materializes, I would expect UDR to raise its dividend somewhat more quickly, given its strong coverage and financial position.

Given some margin pressure, lower new lease rates, and potential slowing in lease renewals, I expect UDR’s same-store revenue growth to slow below 2% in 2024, which is likely to lead to $2.45-$2.50 in FFO. As the company reports earnings, it will be critical to track the variances between A and B property rental performance as well as whether it is slowing renewal rents further.

UDR is trading at 15.4x consensus 2024 FFO. By comparison, Mid-America Apartments (MAA) is about 14.7x 2024 consensus while EQR (EQR) is about 16x. A company like MAA is much more exposed to near-term supply challenges while having faster long-term growth prospects than UDR given its Sun Belt exposure while its legacy positioning leaves EQR with better near-term safety and slower long-term growth.

With its large California presence and potential for further “B” property underperformance as new supply comes online and seeks to find tenants, I fear that UDR is likely to experience more near-term weakness while its smaller Sun Belt exposure limits long-term growth prospects.

I have rated both EQR and MAA buys as I find the safety and growth each offers provide unique values to investors in this rental market environment; UDR finds itself hugging these two traits, and at over 15x FFO, I see limited room for upside, barring a further decline in interest rates. Its dividend is secure and balance sheet is solid, which is why I view shares as a “hold” not a “sell,” but for those investors looking for rental market exposure, there are better opportunities outside of UDR.