By George Skoufis

The steady climb in homeownership rates, tepid job growth, and an unabated supply of new apartment units have combined to severely stress apartment owners. However, after spending nearly four years in the doldrums, the residential REIT sector is finally showing firm signs of stabilization. Capital flows to the sector have remained robust, which has helped residential REITs offset operating shortfalls with gains from property sales, the refinancing of higher-cost capital and fund development activity. Recently strengthened fundamentals support Standard & Poor's Ratings Services stable near-term outlook for the sector, while favorable demographics and trends in job and lifestyle mobility point to continued solid demand for quality rental housing over the longer term.

Despite this anticipated stability, residential REIT management teams may have to navigate carefully to avoid potential risks during the next cycle. Institutional capital flows could become less supportive of the sector, which would signal trouble for those REITs reliant upon proceeds from development sales.

Dividend coverage for most residential REITs remains negative after capital expenses; management teams might become complacent with regard to rebuilding previously strong dividend cushions as property markets recover. Finally, the high level of condominium conversions is likely to retreat, which would return product to the market as rental units (increasing competition) and eliminate a remarkable source of capital to “take out” REIT development projects, as well as a stabilized product (at relatively lofty prices).

Standard & Poor's–rated residential REITs collectively have nearly $16.5 billion (or roughly 19 percent) of rated securities outstanding. The rated residential REITs own or have interest in approximately 10 percent (on a unit basis) share of the overall multifamily housing stock.

Standard & Poor's Residential REIT Outlook
Company	Ticker	Rating/Outlook*	Rated Securities* (Mil. $)	Total Assets (Mil. $)	Top Three Markets (% of Annualized NOI)	No. of Prop.**	No. of Units**
Apartment Investment & Management Co.	AIV	BB+/Negative	1,024.3	10,330.5	DC (11.2%), LA/Long Beach/ Ventura (6.9%), New England (6.4%).	1,477	261,358
Archstone-Smith	ASN	BBB+/Stable	2,713.0	8,901.0	Greater DC (38.5%), Southern CA (20.5%), San Francisco Bay Area (8.6%).	196	65,975
Associated Estates Realty Corp.	AEC	B+/Negative	58.0	742.2	Central Ohio (17.9%), Michigan (17.8%), NE Ohio (13.2%).	110	23,973
AvalonBay Communities, Inc.	AVB	BBB+/Stable	2,060.0	5,065.3	Northeast (42.7%), Northern CA (22.8%), Mid-Atlantic (16.8%).	148	42,850
BRE Properties, Inc.	BRE	BBB/Stable	1,298.0	2,586.5	LA/Orange County (26%), San Diego (23%), San Francisco (18%).	96	26,833
Camden Property Trust	CPT	BBB/Stable	1,749.5	4,450.0	Las Vegas (9.7%), Metro DC (9.4%), Dallas (8.5%).	207	75,269
Equity Residential Properties Trust	EQR	BBB+/Stable	4,252.6	12,697.3	South Florida (7.1%), Boston (6.8%), San Francisco (5.8%).	939	199,510
Essex Property Trust Inc.	ESS	BBB/Stable	0.0	2,231.0	Southern CA (61%), Northern CA (22%), Pacific Northwest (17%).	121	25,281
Gables Residential Trust	GBP	BBB/Watch Neg	635.0	1,791.7	South Florida (23.1%), Houston (22.9%), Atlanta (21.6%).	249	64,298
Post Properties, Inc.	PPS	BBB/Stable	667.0	2,072.4	Southern CA (15%), Tampa (5.8%), Orlando (5.2%).	262	76,935
United Dominion Realty Trust, Inc.	UDR	BBB/Stable	1,642.8	4,354.0
*Ratings/outlooks and rated securities (which comprises debt and preferred stock securities) as of June 30, 2005. **Properties and units include communities owned/managed under JVs and those under development/lease-up. Note: Total Assets, Top Markets, No. of Properties, No. of Units are as of March 31, 2005

Improving National Conditions

The multifamily sector has shown a modest recovery on a national level, although the pace has been slow. Vacancy declined slightly, to 6.6 percent for the first quarter of 2005 from a high of 6.8 percent at year-end 2003, according to Reis data, and net absorption turned positive (by a slim margin) at year-end 2003 for the first time since 2000.

A steady stream of new supply was readily absorbed in the robust economic environment of the late 1990s, driving apartment occupancy to a cyclical peak of nearly 97 percent by year-end 2001. However, demand fell drastically in 2002, as jobs and rental demand contracted, while new construction continued to flood the market with supply, which led to a dramatic decline in occupancy. New construction coming on-line has slowed modestly each year since. Demand, though sluggish, combined with the removal of rental product due to condominium conversions, has supported a return to relative equilibrium.

Deliveries this year should just meet demand, tempering prospects for greater absorption and a more robust recovery, absent meaningful job growth. Job growth has been tepid, negatively impacting demand for rental housing. Additionally, the steady climb in homeownership (due to the lure of historically low interest rates) continues to siphon demand away from rental product; this trend is not likely to reverse course quickly.

Asking rents have been modestly increasing, but have generally just kept pace with inflation. Concessions continue to eat away at rental rate growth, although Reis estimates that concessions as a percentage of asking rent declined slightly in the first quarter of 2005 for the first time in five years. Concessions, such as free rent, are likely to continue to decline slowly over the next few years, but are not expected to reach the very low levels seen during the last cycle.

Residential
# of REITs	27
Market Cap. (in thousands)	$51,830,035
Industry Market Cap. (in thousands)	$348,678,911
% of industry	14.9%
Yield	7.0%
YTD Total Return	13.9%
One-Year Return	43.0%
Three-Year Return	21.2%
Five-Year Return	15.8%
Average Daily Trading Volume (Shares)	5,906,715
Source: NAREIT. Data as of July 31, 2005

Condominium Effect Is Pronounced

Net absorption is expected to increase slowly and steadily over the next few years, but improvements could be vulnerable to a pullback in the condominium market, which has been reducing the stock of competitive rental product. The portion of multifamily construction slated for sale as condominiums continues to grow, and is expected to account for nearly one-third of total starts this year (up from 18 percent last year and 10 percent two years ago, according to Reis).

However, because the majority of condominiums (new and conversions) are concentrated in existing condominium markets (such as Florida and New York City), the risk of a pullback having a widespread effect is somewhat mitigated. Many of the rated residential REITs, including AvalonBay Communities, Inc. (NYSE: AVB), Archstone-Smith (NYSE: ASN), and Apartment Investment & Management Co. (NYSE: AIV), are selling product to condominium converters at very favorable prices. In addition, other REITs are developing in-house conversion capabilities through their taxable REIT subsidiaries, including Equity Residential (NYSE: EQR) and Post Properties, Inc. (NYSE: PPS).

Top Market Conditions Mixed

Performance is mixed and variable across the largest multifamily markets. The vacancy rate remains above 10 percent in Austin, Dallas and Houston despite high job growth and high net absorption, as low barriers to entry result in volatile vacancy rates in these markets.

Effective rent growth, net of concessions, has been strongest on both a percentage and an absolute dollar basis in markets such as Washington D.C., Los Angeles, San Diego and Orange County, Calif., all of which have relatively high barriers to entry and cost of housing. Conversely, rent growth has been materially weaker in many markets with less restrictive growth policies and more available land (such as Atlanta, Dallas, and Houston). While Austin has seen rent declines in recent years, rental growth has been comparatively strong over a longer time horizon (1990 through 2004). Looking forward, the markets with high barriers to entry and favorable prospects for employment growth are poised to outperform the national average.

Company-Specific Results Improved

Nearly all of Standard & Poor's rated multifamily REITs showed reported positive first quarter net operating income (NOI) versus the year-ago quarter, with strong revenue growth clipped by higher operating expenses. Aggregate same-store NOI reached 1.9 percent for the first quarter of 2005, up from a just break-even level the prior quarter. It has been a long, slow climb from the group's early 2003 trough in aggregate same-store results, which declined 8.5 percent that quarter.

Within the past few quarters, the apartment sector has stabilized nationally after spending nearly four years in a downturn. Vacancy has been decreasing, while effective rents have risen. More importantly, net absorption and completions appear to have reached equilibrium. Performance among the top multifamily markets remains mixed, with clear leaders and persistent laggards. However, the majority of Standard & Poor's-rated REITs have strengthened as indicated by solid same-store revenue growth and positive aggregate same-store NOI growth. Looking forward, the residential REIT sector is forecast to continue its slow, steady improvement, and for REIT management teams to effectively navigate through potential risks to capital flows and supply conditions during the next cycle.

George Skoufis is an associate director in the Real Estate Finance Group with Standard & Poor's.