Mid-America Apartment Communities: Be Selective With Entry Points (NYSE:MAA)

Main Thesis & Background

The purpose of this article is to evaluate Mid-America Apartment Communities, Inc. (NYSE:MAA) as an investment option. The company is a “real estate investment trust that focuses on the acquisition, selective development, redevelopment, and management of multifamily homes throughout the Southeast, Southwest, and Mid-Atlantic regions of the United States”.

This has been a REIT I cover regularly because I have owned it for years. I reiterated a bullish rating on MAA back in October and needless to say I am extremely satisfied with its return since that time:

This is clearly a great move and one that was long overdue in my opinion. While see MAA deliver in this fashion is a welcome development, it has reached a point where I have begun to get more cautious. Yes, I still like the company and think more gains could be forthcoming. But there are some macro-forces that could pressure the broader equity market and real estate as a whole. This environment signals to me that a more neutral/hold view is justifiable, and I will explain this in detail below.

Why Caution? Market Under-Estimating Rates

I will start this review off with a macro-discussion about interest rates and investor expectations. While not necessarily specific to MAA, I believe this is fundamental to why I am moving to a more cautious/neutral stance on both equities as a whole but also income-oriented plays like REITs. The bottom-line is that investors have been anticipating a more dovish Fed by mid-year and beyond in my view, and that has pushed risk-on assets higher as a result. This is especially true for income vehicles like bonds and REITs by extension, as investors are not nearly as worried about inflation/higher treasury yields pressuring their returns.

What I am driving at here is I personally am of the opinion the market consensus is off base. I had similar feelings over the past 12 – 24 months when the Fed and politicians were pushing inflation as “transitory”. I was stunned so many people bought that line, and of course it turned out to be incorrect. I see a similar pattern emerging today with anticipating the Fed cutting interest rates. I don’t see that happening until mid-2024 at the earliest, and I don’t quite understand where the dovish sentiment is coming from.

For example, even after the Fed Chairman Powell reiterated they were not considering lowering rates, the futures market has not fully baked this in. I am referring to earlier this month when Mr. Powell was quoted in the February 1st press conference as follows:

it will not be appropriate to cut rates this year, to loosen policy this year”

Source: Federal Reserve

Yet, while the futures market sees a slightly higher path for rates going forward as a result, it is still anticipating a drop in the Fed Funds rate before the year ends. The expectation is rates will begin to decline by October or November 2023:

This just doesn’t seem to match the reality of what is going to happen in 2023. The Fed has hinted at raising rates further this year, and has not given any indication a rate cut is on the table for now. Chairman Powell has used language like “pause” and “assess” when determining what the next move will be after the rate hike cycle ends. This tells me there are not going to be immediate cuts – and why should there be? What sense does it make to raise rates continuously for 18 – 24 months only to begin cutting rates in month 25? Not much sense, in my view.

To tie this back to the discussion on MAA, this is not a knock on this REIT in isolation. But it could impact the Real Estate sector more broadly than other corners of the market. Even if it doesn’t, this dovish-hawkish disconnect could pressure equities and fixed-income across the board because investors have not come to terms with a “higher for longer” interest rate environment.

The conclusion I draw from that is one of more caution. With the market rallying in the short-term, such as MAA’s 19% pop, it makes a heck of a lot of sense to be more selective with entry points. While 2022 ended on a note of strong pessimism – suggesting a contrarian buy point for me – I am now starting to see the opposite. A bit too much optimism when it comes to rates and how the economy will handle them. For REITs that often trade inversely with interest rates, starting to downshift expectations looks prudent.

The Housing Market Does Support Rental Demand

The prior paragraph illustrates some of my concerns for MAA, fixed-income, and dividend-paying products as a whole. I do stand by those concerns, but there are positives for the apartment REIT sector in particular that balances out those headwinds. This is key to why I continue to own MAA to this day. So while I am advocating for some caution, this is by no means an outright “sell”.

Residential and apartment REITs in particular have some tailwinds. For example, high mortgage rates are pushing down affordability for home buyers. This may be well known, but it really is striking just how low the affordability index (for home buyers) has fallen compared to its 10-year trend:

The gist of it is that this boosts demand for rentals. Not just apartments, of course, but it does support the rental market overall. As home affordability remains at difficult levels for a lot of buyers, that means they will keep on renting. In fast-growing regions like the Southwest and Mid-Atlantic, that plays right in to the hands of MAA. Although MAA does not offer the highest current yields, the chances of capital gains are definitely present to boost total return.

Dividend Growth Projects Confidence

Another positive attribute for MAA has to do with the dividend. Again, while the yield isn’t “high” given where the Fed funds rate is and how persistent inflation has been, the growth aspect is quite attractive. Earlier this year, MAA paid out its first dividend of 2023 and that represented a 12% increase in what was paid out last year:

This is a key part of the reason why MAA has been a fixture in my portfolio. When I started buying it the yield was relatively high, and over the past five years it has seen reasonable growth too. Hard to argue with that pattern.

Higher Interest Rates Not A Micro-Problem

Another prudent reason for holding MAA has to do with the company’s debt structure. Management has done a good job managing what is a hefty debt load (in absolute terms, and in percentage to assets). While this is common for REITs, MAA is not at risk in the higher interest rate environment. Lower-rated companies are at risk if their floating rate debt and/or new issues charge too much in interest and that leads to earnings pressure. MAA is not in this boat, as the company has locked in almost all of its debt in fixed-rate issues with an average rate of 3.4% annually:

I see this as an important point because we are in an elevated rate environment and I expect that to be the case for at least another 12 months. This means that borrowers are going to be in a tight spot in they aren’t prepared. Fortunately, MAA is prepared, as it locked in its debt with a relatively cheap interest rate based on prevailing conditions. This tells me on a micro-level, MAA’s debt burden is not a red flag by any means.

The Housing Market Isn’t Changing Any Time Soon

A final thought on apartment REITs and their potential stems from the housing construction backdrop. My followers know I have favored MAA for a long time because I like the company’s geographic reach and dividend history. But it also stems from my desirability to own apartment REITs more broadly. This is because I see demographics in the U.S. supporting this sector. This includes citizens staying single longer / starting families later in life, a shift towards urban living by younger professionals, and a lack of affordable or starter homes across major U.S. metropolitan areas.

During the onset of Covid-19, we saw a bit of a housing surge due to people wanting to move away from cities and roommates. Since then, supply shortages, rising input costs, and a lack of skilled labor have brought housing starts and completions down to more normalized levels. For two years we saw permits and starts spike, but those have come down consistently in the past twelve months. it has reached a point where major housing data points are sitting near pre-Covid levels:

What I take away from this is the single-family housing market is not undergoing any type of radical change. We are seeing a normalized amount of building while the population grows and demand stays high. This demand is simply not being met, which means not everyone who wants a home is getting one. Is that a “good” thing? Maybe not. But it sure is good for the rental apartment and the investors who own that exposure. I see MAA as a primary beneficiary of this trend, as it has been for years, and there is nothing fundamentally changing that is going to shift my outlook dramatically for now.

Bottom-line

There is quite a bit to like about MAA and this REIT has indeed performed well for me over time. But I have concerns. The stock ticker has pushed markedly higher in a short time frame – that usually makes me cautious as a rule. Further, I believe the market is under-estimating the Fed’s “higher for longer” stance with regards to interest rates. If I am correct, income-oriented plays like MAA and others are likely to come under some pressure going forward.

What this adds up to is a hold mindset for me. I would look to add to MAA if we see some sharp down days or prolonged weakness in the share price. Given the gains investors have enjoyed recently it doesn’t make sense to me to keep rushing in buying here. Be patient, let the shares come to you, and keep a level head in the early stages of 2023. I think more volatility is on the way and investors with a long term view will be able to buy in to a quality company at a better price soon enough.