Equity Residential: Too Bond-Like Right Now

Our apartment REIT exposure has been through REITs focused primarily on student housing. Despite the overall portfolio’s outperformance relative to the MSCI US REIT Index (RMZ), our positions in American Campus Communities (ACC) and Education Realty Trust (EDR) have lagged the broader Apartment REITs. We did, however, underweight Apartment REITs so that the underperformance within the sector had a muted effect on the overall performance of the portfolio. We still like the student housing REITs, which had near misses on their 2017-2018 pre-leasing guidance numbers. Both ACC and EDR are down about 5% for the week.

That said, it may be time to reconsider some of the more traditional Apartment REITs, which we downgraded earlier this year after torrid outperformance over the previous few years. Let’s take a look at one of the largest REITs in the sector, Equity Residential (EQR).

Equity Residential

Equity Residential is an S&P 500 company. It is focused on the acquisition, development and management of apartment and multifamily residential properties in top U.S. cities/markets such as Boston, New York, Washington DC, Seattle, San Francisco and Southern California. We don’t take offense that they focus on coastal cities but have essentially ignored my hometown of Miami.

Equity Residential has about $ 21 billion in total assets and had about $ 2.4 billion in revenue over the last 12 months. It owns about 77,000 apartment units across 300 properties in the United States so at least when we want to evaluate the coastal cities, we can get a good idea of the market by analyzing EQR.

East Coast AND West Coast

The key points of Equity Residential’s business strategy are, as we mentioned, focus on the coastal markets where incomes tend to generally be higher than the national average and where renters want to work and live. The markets they operate in are those with the lowest vacancy rates over the last 15 years and with average rent growth of over 2.5% annualized over the last 20 years.

Its primary markets are Boston, New York, Washington DC, Seattle, San Francisco and Southern California, which includes San Diego and Los Angeles. Each of these markets has strong demand, constrained supply characteristics, and high occupancy rates, as we mentioned. None of those trends have changed – these are still some of the strongest rental markets in the US.

Besides being in some of these highest demand markets, EQR properties also have attractive characteristics. For example, compared to peers, EQR properties have higher Walkscores and a greater percentage of renter households within a 1-mile radius of its properties.

Furthermore, EQR has lower overhead expenses as a percent of total revenue than the apartment peer average.

Q2 2017 Results and Q3 Outlook

Equity Residential had strong and steady demand for rental housing in its gateway, coastal markets – leading to high occupancy, retention and renewal pricing despite elevated levels of new supply. The key points of Q2 2017 results were:

Earnings Per Share (EPS) for the second quarter of 2017 was $ 0.53 compared to $ 0.59 in the second quarter of 2016. Funds from operations (FFO) was $ 0.77 per share for the second quarter of 2017 compared to $ 0.90 per share in the second quarter of 2016. Normalized FFO for the second quarter of 2017 was $ 0.77 per share compared to $ 0.76 per share in the second quarter of 2016. EPS for the six months ended June 30, 2017 was $ 0.92 compared to $ 10.36 in the six months ended June 30, 2016. The difference is due primarily to $ 9.58 per share in higher property sale gains as a result of the company’s significant property sales activity in 2016 FFO was $ 1.53 per share for the six months ended June 30, 2017 compared to $ 1.37 per share for the six months ended June 30, 2016. Normalized FFO for the six months ended June 30, 2017 was $ 1.51 per share compared to $ 1.52 per share for the six months ended June 30, 2016 Q2 revenue growth of 2.1%, on a same store comparison, was driven by better-than-expected renewal rate growth and a 250 basis point increase in the percentage of residents who chose to renew with Equity Residential.

The decline in FFO was essentially attributable to the company’s disposition activities but shareholders still received a special dividend of $ 11 per share obtained from the proceeds of those sales. That data is not picked up in your traditional dividend yield calculation but it is part of the total return calculation. Over the last 1 year and 3 year period, EQR has returned 3.7% and 11% annualized, respectively. Sounds reasonable but it was towards the bottom of its Apartment REIT peers, in line with Avalon Bay (AVB), the other behemoth in the sector.

Now looking forward to Q3, the forecast was for FFO per share between $ 0.77 and $ 0.81 per share.

We hope that it comes out at the top end of that range, which would, at current prices, make the stock more attractive. Current FFO forecasts call for a slight increase after FFO dropped slightly in 2016. As the chart indicates, however, by 2019, FFO is still not at levels reached in 2015.

We like the company and the markets it operates in but it might be priced to perfection – or close to it. Analyst consensus estimates call for just a 3% price return (that’s the dividend) and even though I don’t give much credence to analyst estimates, I mention it to readers as another point of information.

The chart below maps out the P/CFO vs. potential return based on analyst estimates. As we mention at the beginning of the article, we own EDR and ACC, which are positioned at the top right of the chart – high return potential and trading at a premium to peers. On a growth-value continuum, they would be considered growth stocks. Equity Residential, on the bottom left, looks both pricey and boring.

Risks

The major risks associated with Equity Residential are:

  • Low occupancy or fall in the occupancy rate below 95% in the equity residential markets. High occupancy rates are a staple of the company and any shortfall could result in a strong pullback in the stock.
  • Resident retention in a challenging market due to new supply in lease-up. The company’s focus on resident retention mitigates this risk but its still there.
  • Concentration in six cities/areas in the US is a high-risk affair.
  • High rent locations, which are more affected by downturns in business.
  • If new supply increases in Equity Residential markets which have been enjoying less new supply in high density markets on an average i.e. 1.5% annually during 2001-2016;
  • Equity Residential enjoyed better returns in Q2 2017; as the percent of people in America, who choose to rent versus own, peaked now at a 50-year high. This may not continue.
  • Unfavorable changes in the global, national, and local economic and political factors affecting renting activities.
  • Reduction in demand for multifamily properties.
  • Increased competition from other multifamily properties and single-family homes (both as rentals and owned housing).
  • Costs of materials required for maintenance, repair, or development may be more expensive than anticipated, particularly in light of scarce labor and materials being reported by builders AND the recent damage caused by Hurricanes Harvey and Irma, which could drive up expenses.

The Bottom Line

Investors looking for a safe bet in the Apartment REIT sector may benefit, both financially (albeit, less so) and psychologically, from investing in EQR relative to some of the other less stable companies. It only pays a 3.1% dividend which is decent but not great, and there isn’t much growth expected in FFO over the next few years. EQR has been extremely successful in navigating the real estate cycle and we have no doubt it will do so again, but for now this stock is the equivalent of a coupon clipping bond – for some investors, that might be OK.

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Disclaimer: Please note, this article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It is intended only to provide information to interested parties. Readers should carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances.

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Disclosure: I am/we are long EDR.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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