Battle Royale: AvalonBay vs. American Campus Communities

Real estate investment trusts, or REITs, can be an excellent way to get both growth and income in your portfolio. One area of real estate that has strong growth prospects in the years to come is apartment buildings. Let's take a look at two excellent, but different, apartment REITs and their respective target markets: AvalonBay Communities and American Campus Communities .

About the contendersBoth of these companies own and manage apartment communities, but their portfolios are rather different.

AvalonBay specializes in a variety of apartment properties, including garden/townhome style, mid-rise, and high-rise. The company owns 279 communities consisting of 81,606 apartments, all of which are located in six core markets. The basic strategy is to invest in apartment buildings in desirable markets with higher-than-average household income and high barriers to entry for other developers (think New York, Boston, and Southern California). In other words, these are markets with the ability to generate high rent, and grow rent quicker than most other markets.

Data source: AvalonBay.

On the other hand, American Campus Communities is a more specialized company, but with more geographic diversity. It invests in student housing properties, both on and off campus, located at major universities throughout the country, and currently owns 158 properties with 96,300 beds. The basic idea is that much of the existing supply of available student housing is either outdated or inconveniently located, and by developing housing solutions that meet students' demands, there is a huge underserved market to address.

Why invest in apartments?There are good reasons to invest in apartment properties, but they are different for both companies.

For starters, the demographic trends favor rental apartments. Homeownership data indicates that the U.S. is steadily becoming a nation of renters, with the lowest homeownership rate since 1967. Approximately 8.3 million new U.S. households will be formed by 2019, and it is estimated that 60%-70% of these will become renters.

In addition, U.S. job growth has been accelerating, especially in the 25-34 age group, which has a particularly high percentage of renters.

Data source: AvalonBay.

Finally, rental vacancies have been declining for years, and are at historically low levels, creating more demand.

Data source: AvalonBay.

For student housing properties, there is a largely untapped opportunity to modernize the nation's supply. American Campus Communities estimates there are 6.3 million students in its target markets, which represent a potential $400 billion market. And, so far this market is highly fragmented -- with the 25 largest student housing operators representing a combined 6.3% share (ACC is the largest).

Additionally, new supply is projected to fall in the coming years and enrollment at the company's target universities (flagship schools, enrollment over 15,000) is expected to steadily increase at 1%-2% per year.

Growth strategiesFor both companies, the primary method of growth is through development.

AvalonBay currently has $3.3 billion worth of new developments in the pipeline. It feels this is the best way to deliver shareholder value, as newly developed properties generate rents that are about 7% higher than pre-existing apartment communities. Even so, these new properties cost about 25% less than the value of AvalonBay's existing apartment units. In other words, by developing new properties from the ground up, the company is creating instant value.

American Campus Communities has traditionally grown through both acquisitions and development, but recently shifted its strategy away from the acquisitions market and strictly toward developing, for similar reasons to those of AvalonBay. Newly developed properties simply produce the most attractive returns for shareholders, as long as demand exists in the target markets.

Both companies also have significant capital "recycling" initiatives in place, which basically refers to the sale of unwanted properties with the intention of redeploying that capital in a more effective way. There are several reasons REITs sell properties. Maybe the property is worth more than the company paid for it, and feels it would be prudent to sell the property and put that capital to work elsewhere. Or, sometimes properties are sold because they don't fit into the company's vision of the future.

In the latest quarter, AvalonBay disposed of one of its properties for $99 million, resulting in a $35.2 million profit. American Campus Communities sold three of outs non-core assets for $32.1 million, mainly because they were older properties that no longer fit into the company's objectives.

Capital structureBoth companies have investment-grade credit ratings, with a slight edge to Avalon Bay.

This means that AvalonBay (theoretically) has better access to financing and at more favorable interest rates. Additionally, AvalonBay is less reliant on debt than American Campus Communities, with a debt-to-asset ratio of 22% versus 42.4%. AvalonBay has interest coverage of 5.8 times, which means that for every dollar in interest obligations, the company brings in $5.80. On the other hand, American Campus Communities is more highly leveraged, with interest coverage of just 3.2 times.

Now, American Campus Communities doesn't have a "dangerous" level of debt by any means, but this is definitely a difference worth noting.

Performance history and dividendsAvalonBay has a longer history to look at, and has produced a fantastic 16.8% average total return for investors over the past 20 years -- a remarkable level of performance to sustain over the long term. The company has steadily increased its dividend at an average rate of 5.3% per year, and with such a healthy capital structure, there's no reason to believe this trend won't continue.

As a younger company, it's tougher to make an apples-to-apples comparison here, but American Campus Community has shown signs of a promising future. The company has produced a 275% total return in the approximately 11 years since its IPO (12.8% annualized), and actually pays a more attractive dividend yield than AvalonBay (3.92% vs. 2.78%).

In addition, American Campus Communities has produced excellent growth, with net operating income (NOI) growth of 4.3% annualized and FFOM (adjusted FFO) growth averaging 7.3% per year. Both metrics are above the apartment REIT industry's averages.

Data source: American Campus Communities.

AvalonBay is the clear winner in terms of a proven track record of performance. However, I'm inclined to believe that American Campus Communities has the greater long-term potential simply because of the breadth and fragmentation of its market.

ValuationWhen valuing REITs, it's important to focus on funds from operations (FFO) as opposed to EPS, which doesn't provide an accurate picture of the money these companies actually make. Adjusted FFO, or AFFO, is an even more accurate measure of REITs' ability to pay dividends since it accounts for one-time charges among other factors, but the calculation for this metric isn't universal so we'll focus on FFO for an apples-to-apples comparison.

As you can see, American Campus Communities is the "cheaper" of the two. However, there are several reasons why AvalonBay deserves a premium valuation, including its record of profitability and dividend increases, healthier debt levels, and better credit quality.

The Foolish bottom lineBoth of these are excellent choices, but are appropriate for different investment objectives. AvalonBay is for investors who want to buy into an established, winning real estate business model with proven steady growth and strong returns. On the other hand, American Campus Communities and the industry it operates in are relatively young, but have massive growth potential if conditions stay favorable -- and are more appropriate for investors with a higher level of risk tolerance.

When investing in REITs, I tend to gravitate toward the experienced winners like AvalonBay, whose track record of market-beating performance is tough to ignore. So, while I consider AvalonBay the winner of this comparison, American Campus Communities certainly has lots of potential over the coming decades, and would also make a great addition to a portfolio focused on long-term growth.

The article Battle Royale: AvalonBay vs. American Campus Communities originally appeared on Fool.com.

Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.