Few commercial landlords will be spared by higher energy prices in the wake of Hurricane Katrina. But owners of Class-B apartment properties could be most vulnerable, analysts say, since their tenants are least likely to absorb rent increases to cover higher energy costs.

“As gasoline and other energy prices take a bigger and bigger bite of disposable income, the lower-end consumers will be less able to tolerate rent increases from a recovering apartment market,” says Karin Ford, a Banc of America Securities analyst.

Between mid-year 2004 and 2005, even as energy prices soared, the energy pass-through wasn't hampering rent growth. Data from New York-based Reis Inc. shows that national occupancy inched up to 94.6% over that period, and effective rents rose from $856 to $874 per month.

But with gasoline prices bouncing as high as $3.50 per gallon in some cities, oil stuck at above $60 per barrel and record natural gas prices pushing up the cost of heating and electricity, the kind of renters who live in Class-B projects are being squeezed. “Gas prices are nearing 3% of disposable income, a level which has in the past signaled a deceleration in consumer spending,” says Ford, who believes that this could jeopardize market expectations for 3% to 4% rental growth at a slew of Class-B apartment REITs.

Ford singles out United Dominion Realty Trust (UDR) and Apartment Investment and Management Inc. (AIMCO) as the two REITs that could be most at risk. She has cut estimated 2006 funds from operation (FFO) for United Dominion to $1.73 per share from the $1.75 per share she predicted in mid-August.

Another potential victim is Home Properties. The Rochester, N.Y.-based REIT has 42,000 Class-B apartment units scattered across the Northeast. Home Properties also absorbs energy costs for 70% of its renters, which helps fill its buildings. “We compete with mom-and-pop apartment owners, and that's how we stay competitive with them,” says Home Properties' vice president Charis Warshoff.

“A really cold winter will definitely affect our costs. But even before oil prices went up, we were exploring ways to shift more of the heating expenses to our tenants through energy surcharges on top of the rent,” she says. Home Properties has already locked in a contract for 18% of its full-year 2006 gas costs, leaving plenty of room to pay extra if prices rise this winter.

“If apartment owners suddenly begin passing along energy costs to tenants when energy is so expensive, that can easily make their properties less competitive,” says Nicholas Buss, a senior vice president at Pittsburgh, Penn.-based PNC Bank. He also believes that losing the ability to absorb rising energy costs for tenants in weaker markets could drive tenants to a competing property.

“The weakest local economies will be most vulnerable to rising energy costs because many of these tenants just can't afford to pay more rent,” he says.

Before Hurricane Katrina, Home Properties projected that natural gas costs for the 2005-2006 season would be roughly $8.60 per decatherm, the standard unit of measurement. But the cost of natural gas, which has risen in tandem with oil prices, was fluctuating between $12 and $13 per decatherm in mid-September.

Bear Stearns analyst Ross Smotrich estimates that higher heating costs will add $6.8 million to Home Properties' first-quarter 2006 expenses. Smotrich cut Home Properties' 2006 earnings by 7 cents, or from $3.05 to $2.98 per share.

“If you believe that higher energy costs will work their way up the food chain,” says Ford of Banc of America, “it wouldn't be that surprising to see Class-A tenants start to get pinched by these costs.”