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We have recently downgraded our recommendation on Avalonbay Communities Inc. (AVB - Analyst Report), a leading multifamily real estate investment trust (REIT), from Outperform to Neutral as we anticipate it to perform in line with the broader market.

Avalonbay has Class A assets located in some of the premium markets of the country, such as Washington DC, New York City and San Francisco, where the spread between renting and owning is high. This enables the company to continually increase rents to fuel its growth engine.

Furthermore, Avalonbay’s assets are primarily located in in-fill supply-constrained areas, where there are very limited new apartment construction activities.

In addition, the company mostly focuses on developing properties for higher-income clients in high barrier-to-entry regions of the U.S. This safeguards the company from any short-term volatility in the market and provides a strong upside potential.

With a continued decline in the single-family homeownership rate across the U.S. and gradual improvement in the overall economy, apartment REITs have also performed strongly in first quarter 2011. We expect this sector to remain comparatively stable in the coming quarters as well, since renting has emerged as the only viable option for customers who could not get mortgage loans or are unwilling to buy a house at present.

However, a substantial number of apartment leases of Avalonbay are for a term of one year or less, enabling the residents to leave at the end of the lease term without any penalty. Consequently, its rental revenues are impacted by declines in market rents which affect its long-term profitability.

Moreover, Avalonbay has a huge development pipeline, which increases operational risks in the current credit-constrained market, exposing it to rising construction costs, entitlement delays and lease-up risk. As a result, although we remain bullish on the company on a short-term basis, we are skeptical about its long-term performance.

Avalonbay presently has a Zacks #3 Rank, which translates into a short-term ‘Hold’ rating. We also have a Neutral recommendation and a Zacks #3 Rank for Apartment Investment & Management Co. (AIV - Analyst Report), a competitor of Avalonbay.

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