UBS cuts apartment REITs on slowdown risk

Although apartments have trailed the broader REIT sector so far this year, "we believe prospects for continued slowing growth and potential risk of a recession place further pressure on the multifamily sector," the analysts wrote in a report to clients.

"There is also the pressure from the oversupply of homes and condos coming back on the market as rentals, which will likely increase as [adjustable-rate mortgages] reset now through 2009," they said.

The UBS analysts are also nervous that REITs have ramped up their development pipelines while multifamily permitting is declining. "With the risk of a recession, the yields on these pipelines may be lower than expected," they wrote. "We estimate yields have already come down 1% since last year."

Apartment stocks were among the worst performers in REITs during the years following the 2001 recession, UBS said. For example, apartment giant Equity Residential underperformed REITs by a wide margin from 2001 to 2004, but narrowed the gap significantly in 2005, or four years after the 2001 recession. Apartments tend to outperform as the economy begins to peak, but lag behind at other times, noted UBS.

"Apartments have had the best of all worlds in this past economic recovery. Occupancies recovered to 95% from 92% as rents rose and concessions burned off," the analysts said.   "Supply was muted as condo converters removed existing stocks and new multifamily was built as for-sale rather than as rental," they added. "Finally, the rapidly rising cost of home ownership finally caught up with fleeing tenants who realized that making a leap to own a home no longer made sense."