The exponential rise in interest rates stunned many businesses as borrowing became more expensive. Companies in real estate like Apartment Income REIT Corp are taking a huge toll as mortgage rates rose from 3% in 2020 to around 7% this year. However, credit agencies still maintain their BBB rating despite the risk of nearing debt maturities that the company may not cover. For today’s FA Alpha, we will determine the actual creditworthiness of Apartment Income REIT under the lens of Uniform Accounting that credit agencies failed to recognize.
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Rising interest rates are a big problem for certain sectors that rely heavily on debt to grow.
One sector in particular is real estate, and in the public markets, that means Real Estate Investment Trusts (REITs).
With rising rates, the cost of owning a home was no longer cheaper than renting one in the U.K.
This situation effectively disrupts the arbitrage for those owning homes for their yield.
As interest rates have rocketed up in the past year, mortgage rates have been rising from below 3% in late 2020 to around 7% today. The same trend can be seen here in the U.S. as well.
That’s not true only for owners of individual homes, but also for many REITs that are financed by floating rate debt. REITs need to pay most of their earnings out to shareholders in order to keep their classification as tax-advantaged investments. Thus, to grow, they typically use debt financing.
As interest rates rise, so does the cost of funding new projects. Some REITs have made particularly strong use of floating rate debt, which is extra damaging in a rising rate environment.
One company that might get in trouble with the rising rates is Apartment Income REIT Corp (AIRC).
The company focuses on the ownership and management of quality apartment communities located in the largest markets in the United States.
AIRC is one of the country’s largest owners and operators of apartments, with 99 communities in 12 states and the District of Columbia.
Even though the company has a successful history, the current credit outlook of AIRC shows a far more concerning story with a lot of debt coming due and interest rate risks.
However, S&P still rates the company a BBB – which is investment grade, and implies a less than 2% chance of default.
Its rating hasn’t changed since interest rates started rising.
We can figure out if there is a real risk for this company by leveraging the Credit Cash Flow Prime (CCFP) to understand the company’s obligations matched against its cash and cash flows.
In the chart below, the stacked bars represent the firm’s obligations each year for the next five years. These obligations are then compared to the firm’s cash flow (blue line) as well as the cash on hand available at the beginning of each period (blue dots) and available cash and undrawn revolver (blue triangles).
The CCFP chart shows that AIRC’s cash and cash flows together will not be enough to cover its operating and financial obligations going forward.
Not only does the company not have enough cash flow to handle its obligations, but the debt maturities in 2026 also adds a lot of risk. REITs are typically able to refinance without much issue, but depending on where interest rates go in the coming months, AIRC may not be able to refinance in a constructive manner.
That’s why AIRC gets an HY2- rating from Valens, which reflects a much riskier credit rating than what rating agencies suggest.
It is our goal to bring forward the real creditworthiness of companies, built on the back of better Uniform Accounting.
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SUMMARY and Apartment Income REIT Corp Tearsheet
As the Uniform Accounting tearsheet for Apartment Income REIT Corp (AIRC:USA) highlights, the Uniform P/E trades at 21.0x, which is above the global corporate average of 18.9x but below its historical P/E of 79.6x.
High P/Es require high EPS growth to sustain them. In the case of Apartment Income REIT Corp, the company has recently shown a -52% Uniform EPS shrinkage.
Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Apartment Income REIT Corp’s Wall Street analyst-driven forecast is for a -696% and -99% EPS decline in 2022 and 2023, respectively.
Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Apartment Income REIT Corp’s $36 stock price. These are often referred to as market embedded expectations.
Furthermore, the company’s earning power in 2021 is below the long-run corporate average. Moreover, cash flows and cash on hand are below its total obligations—including debt maturities and capex maintenance. The company also has an intrinsic credit risk that is 120bps above the risk-free rate.
Overall, this signals a moderate credit risk and a high dividend risk.
Lastly, Apartment Income REIT Corp’s Uniform earnings growth is below its peer averages and is trading below its average peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research
This analysis of Apartment Income REIT Corp (AIRC) credit outlook is the same type of analysis that powers our macro research detailed in the member-exclusive FA Alpha Pulse.