Photo: Breba/Jupiter Images

BRE Properties aims for strength through development

By Jennifer D. Duell

A lot has changed since BRE Properties Inc. (NYSE:BRE) got its start managing apartments for Bank of America.

In 1970, San Francisco-based BRE owned and managed 27 properties in California, Colorado, Florida, Georgia and Illinois. The United States was home to 203 million people. Baby boomers were just entering the workforce and moving into their own places.

Today, nearly 305 million people live in the United States. Gen-Y is the main demographic group that BRE is trying to attract. And BRE owns 80 apartment communities with a total of 22,680 units, primarily located in California. It also has joint venture interests in 13 apartment communities with a total of 4,080 units.

Yet, one thing has stayed the same throughout that 38-year period: BRE continues to look to the future, anticipating changes in the market and positioning itself for growth. “BRE’s decision to concentrate its portfolio in California, its active development pipeline and its efforts to reduce expenses and improve efficiency at the property level prove that it’s a forward-thinking company,” says Mike Salinsky, a senior REIT analyst at RBC Capital Markets. “The company is positioning itself for the future.”

Exiting Non-California Markets

In its early years, BRE's portfolio was concentrated in California, which included office, retail, hotel and apartment properties. However, in the 1980s and 1990s, the REIT expanded throughout the western U.S., acquiring properties in Arizona, Colorado, Nevada, New Mexico, Utah and Washington. The downturn in the California economy in the early 1990s, particularly in Southern California, was one of the main reasons the company expanded. By 2000, 65 percent of the company's net operating income (NOI) came from California, while the remainder came from other markets.

From the tech bubble burst in 2001 through 2004, BRE's Northern California properties suffered tremendously—Bay Area saw market rents decline about 30 percent, according to Ed Lange, BRE's executive vice president and COO. The accompanying recession had a very big impact on the company, he says.

In fact, the tech wreck actually demonstrated the resilience of the California markets. "Even with all the devastation that occurred from 2001 to 2004 in the Bay Area, our average market rents for all of our coastal California markets still increased 5.5 percent from 1996 to 2007," Lange says.

When BRE reviewed market data from recessionary periods in the 1980s, 1990s and early 2000s, it found that apartment owners with assets in California came out of the downturns in better shape than other companies, Lange says.

Avenue 64, Emeryville at the foot of the Bay Bridge in San Francisco

"Regardless of which 10-year or 20-year period, coastal California markets generate rent growth two to three times the [consumer price index]," Lange says. "In normal economic conditions, California is a market that can generate 6 percent to 7 percent rental rate growth. There are very few regions in the country that can match that."

That's why in 2005, BRE's new president and CEO Constance Moore reaffirmed the company's California-centric strategy, focusing on development and operations. At the time, the REIT had just concluded a five-year recycling of non-core assets, and its next step was to outline its five-year strategy. "We wanted to take advantage of the strong demand that exists in California," she says.

In the next three to five years, BRE wants California to represent 90 percent of the REIT's NOI, with Northern California accounting for 30 percent and Southern California making up 60 percent. At the end of 2007, California accounted for 83 percent of the company's NOI, with Northern California representing 24 percent and Southern California generating 59 percent. Phoenix and Seattle account for the remainder.

BRE made a smart move in re-focusing its energy on California, analysts say. "You have to give management a lot of credit for picking these markets for investment," Salinsky says.

Analysts also vouch that most California markets have high barriers-to-entry—they're land-constrained and face stringent zoning and permitting processes. As a result, they're more insulated from overbuilding. "The coastal areas in California have historically produced more long-term value creation and revenue growth than most of the country," says Steve Swett, a REIT analyst with Keefe, Bruyette & Woods. "They're fairly well positioned to weather the downturn."

Better Than Expected

BRE's geographic concentration is one reason why its financial performance is so solid today, despite growing weakness in the multifamily sector, analysts note. "BRE's performance for the second quarter was better than expected," Salinsky says, adding that he raised BRE from a rating of "marketperform" to "outperform."

BRE's funds from operations (FFO) for the second quarter 2008 increased to $36.8 million, or 70 cents per share, up from $35.6 million, or 68 cents per share, for the second quarter of 2007. For the first half of 2008, FFO totaled $72.5 million, or $1.38 per share, compared with $67.8 million, or $1.29 per share, for the six-month period in 2007.

Renaissance at Uptown Orange is situated in the heart of Orange County, Calif.

Total revenues from BRE's continuing operations for the second quarter were $88.5 million, up from $81.8 million a year ago. For the first half of the year, total revenues from continuing operations increased 8.4 percent to $175 million, up from $161.5 million for the same period in 2007.

Same-store NOI also increased during the second quarter by $2.2 million, a 3.9 percent gain over the same period in 2007. Newly developed properties generated $1.9 million in additional NOI during the quarter, as compared with the second quarter of 2007. Of the 22,680 apartment units owned directly by BRE, same-store units totaled 19,357 for the second quarter.

In fact, 19,357 same store units produced a $2.2 million increase in NOI over 2Q07 and new development properties (1,140 units) produced a $1.9 million increase in NOI over the second quarter 2007.

At the end of the second quarter, BRE's portfolio was 94.5 percent occupied, matching occupancy for 2007. Average same-store market rent for the second quarter 2008 increased 3.9 percent to $1,495 per unit, an increase from $1,439 per unit in second quarter 2007.

"BRE has done an admirable job in the past of managing its properties," Swett says. "They have produced results that are at least as good as peers in the markets in which they operate."

BRE's financial results reflect stable economic conditions in San Diego, San Francisco and Seattle, which represent 52 percent of the company's same-store NOI. Due to continuing job losses and an excess supply of single-family housing, economic conditions were weak in Los Angeles, California's Orange County region and the areas more inland, such as San Bernardino and Riverside Counties, which represent 41 percent of the company's same-store NOI. The REIT's properties in Sacramento also are suffering from weak market fundamentals.

Moore says BRE may reduce its exposure in San Bernardino and Riverside, but definitely will not exit the market. "The Inland Empire will continue to be a core market for us, but it is suffering right now," she says. Specifically, the REIT is looking at selling properties that are located east of Interstate 15, where barriers-to-entry tend to be lower.

Photo: Russ Fischella Connie Moore, CEO of BRE Properties, says that the company is taking advantage of the strong demand that exists in California.

Additionally, the REIT is in the midst of exiting Sacramento—a market that hasn't performed as well as others. Moore says Sacramento had achieved rental rate growth of 3.5 percent to 4 percent annually, but has been hit hard by single-family housing and excess apartment supply. "Sacramento tends to act more like a commodity market, and it's one that we pegged to exit along with other markets such as Albuquerque, N.M.; Salt Lake City, Utah; and Tucson, Ariz.," she says.

Moore says BRE's Sacramento assets have a valuation of $300 million and account for $143 million on the books. "I view Sacramento as a source of capital for the company," she says.

Recently, BRE sold the Pinnacle at Blue Ravine, a 260-unit property in Folsom, Calif., for approximately $40 million. In addition, the company had four Sacramento properties classified as held for sale. BRE also had one property in San Francisco for sale, as well as a property in Seattle and a land parcel in Northern California. In total, the REIT expects to realize $150 million to $200 million in proceeds from asset sales in 2008.

Strength in Development

BRE is taking the proceeds from its asset sales and reinvesting them in its development pipeline, which consists of close to 1,400 units under construction totaling $457 million in project costs, according to Moore. A large land portfolio is not part of the company's strategy, but it does have enough land banked to develop 710 apartment units with a price tag of $367 million. Construction is slated to begin in the second half of 2009.

BRE has one of the largest development pipelines of all apartment REITs, Swett says. "With that pipeline, it can create an above average earnings growth for the long-term," he notes. "The development pipeline is one of the company's biggest advantages."

Analyst Rod Petrik of Stifel, Nicolaus & Co. notes that development used to be one of BRE's weaknesses, but the REIT has spent the past five years building a strong internal development group and improving its development capabilities. "Development used to be a weakness that is now becoming more of a strength," he says, pointing to the pipeline the company has created in Seattle and Southern California.

Over the past several years, BRE has developed 14 new communities with a total of 3,885 units and a gross investment of $660 million. The return on invested capital for these communities has averaged about 8 percent, according to the company.

The Stuart at Sierra Madre Villa Pasadena, Calif.

BRE currently has five communities under construction, two in Southern California, one in Northern California and two in Seattle. In Seattle, for example, the REIT will soon complete construction on Taylor 28, a 197-unit project. In Los Angeles, construction is well underway on 5600 Wilshire, a 284-unit property that was expected to begin leasing in October. In 2009, BRE will break ground on the Wilshire La Brea apartments. The project, which includes 470 apartment units and roughly 40,000 square feet of ground-floor commercial space, is being constructed at a cost of $565,000 per unit.

"Wilshire La Brea is the big BRE project that everyone is looking at," Salinsky says. "The implied price per unit is very high, and the size of the project is very large. If the rent growth doesn't get there because of market conditions, well, let's just say it's a risky project under current economic conditions." However, he is quick to add that if the project is successful, it will "drive BRE going forward."

During the second quarter, BRE also began construction on Crossings at Santa Clara in Northern California just north of San Jose, Calif. The project, which is expected to begin delivering units in second quarter 2010, will feature 270 units at a cost per unit of $332,000. However, BRE has postponed construction on several projects including a 166-unit apartment community in Mercer Island, Wash.

Salinsky says BRE has increased its return thresholds on new developments by 75 basis points, with the REIT now looking for a 6.5 percent yield on current costs or a 7.5 percent to 7.75 percent return on a trended basis.

"All of BRE's external growth will likely come from development," Salinsky says. "While I think that growth will be slow in 2009, I think their portfolio is set up for above average growth in 2010 and 2011."

Salinsky points out that the implied cap rates on new development also create value. "One of the things the market is undervaluing today is new development," he says, adding that BRE's stock is trading at a 8.5 percent discount to the firm's estimated NAV of $53.70 per share. As of early August, BRE's stock was trading at a multiple of 17.7 times compared to the sector median of 19.1 times.

RBC Capital Markets has a 12-month price target of $55 per share, based on BRE's guidance for full-year 2008. The REIT recently adjusted its FFO guidance for the full year 2008 to $2.75 to $2.82 per share, from the previous range of $2.70 to $2.85. For the year, BRE anticipates same-store revenue and NOI growth to range from 3.5 percent to 4.5 percent.

"The valuation gap between BRE shares and Essex Property Trust (NYSE: ESS) and AvalonBay Communities (NYSE: AVB) is pretty attractive," Salinsky says. "After BRE has put together several solid quarters, it's a pretty hefty discount for BRE stock."