Equity Residential (NYSE:EQR) is an equity real estate investment trust (REIT) specialized in multi-family housing. It has targeted five key markets in the United States - Boston, New York City, Washington D.C., Los Angeles and San Francisco. It has some properties outside these markets (notably, in Denver and Seattle) but these five are its primary focus. In each of these markets, EQR owns properties that are well located both in terms of current marketability and long term competitive considerations. EQR is, thus, a paradigmatic play on the well-known real estate adage that what matters most is "location, location, location."
Dividends - Before going into more detail on operations, I think it is important for investors to have a clear understanding of the dividend situation. EQR has had a recent change in policy and it may have created some confusion. In 2013, EQR paid 40 cent dividends for the first three quarters and then paid a 65 cent dividend for the fourth quarter. EQR's policy has apparently been to pay 65% of normalized funds from operations (FFO) each year; it has implemented this policy by paying a relatively low dividend for the first three quarters and then using the fourth quarter dividend as a kind of "true up." Normalized FFO is legitimate here because EQR has engaged in major transactions which can distort quarterly numbers. It has recently completed the Archstone acquisition in which it bought up a big chunk of the former Lehman property holdings. Normalized FFO excludes the impact of one time transactions and isolates the performance of the property portfolio. Based on EQR's past policy of large fourth quarter dividends, it would be completely misleading to calculate the yield on EQR stock by taking the fourth quarter dividend of 65 cents and multiplying it by 4 and then comparing that number ($2.30) with the stock price (although this appears to be how the dividend yield has been calculated on Yahoo Finance). Instead, trailing dividends for 2013 totaled $1.85 and this number should be used to calculate trailing yield. Going forward, EQR has changed its policy and will now pay four equal quarterly dividends based on 65% of the midpoint of its estimated forward normalized FFO. In its most recent conference call, EQR has estimated normalized FFO for 2014 as between $2.83 and $2.85 per share. It has also estimated a revenue increase of between 3 and 4% for 2015 over 2014. Using the mid-point of that range (3.5%) and assuming conservatively that normalized FFO will grow proportionately with revenue, we get normalized FFO of $2.92 for 2015. Assuming that dividends are 65% of that number suggests dividends of $1.90 per share. Based on Wednesday's closing price of $ 53.79 per share, dividend yield was roughly 3.44% in 2014 and would be 3.53% in 2015.
The Properties - EQR has amassed a really amazing set of properties. In each of the five major markets it has targeted, it has properties in prime locations. I have looked at many REITs and, in my own, Washington, D.C., area, I frequently find a REIT which has property in the SMSA only to discover that its holdings are in Ashburn, Virginia; Germantown, Maryland; or even further away from the downtown. There is nothing misleading about this and REIT investors have to exercise due diligence but the "Washington market" is actually several very different submarkets and it is very important to determine location in evaluating investment. The advantages of holding positions in prime locations are enormous. First of all, especially in our area (but also in the other four major markets EQR serves), height limitations, zoning restrictions, historical districts, and the lack of available land make it very hard to add apartment capacity in prime locations. Thus, when demand increases, supply does not necessarily increase with it; instead, the only thing that can go up is the rents. On the other hand, in outlying locations, there is plenty of land and local officials are generally friendly to more development. Another advantage is that in a down market prime locations may be able to fill vacancies by lowering rents and inducing tenants in less desirable locations to "trade up." On the other hand, buildings in less desirable locations may simply develop high levels of vacancy. Finally, if you believe the recent data concerning income distribution, you are likely to agree that properties attractive to high income tenants are likely to be attractive investments going forward; these are exactly the kinds of properties EQR has. Their holdings are attractive to Yuppies (young urban professionals) and DINKs (double income, no children) households and are located in five markets with a concentration of young, high income professionals. Investors should visit EQR's website and survey the properties in each of its five major markets; you will find a Boston property in Beacon Hill, numerous properties in Manhattan, DC properties on Massachusetts Avenue, Connecticut Avenue, in Chevy Chase and in Bethesda, and Los Angeles properties in the highly desirable coastal area.
Valuation - EQR is estimating normalized FFO at between $2.83 and $2.85 for 2014. Using the mid-point of $2.84, EQR is trading at a P/FFO number of 18.9, well within the normal range for its sector. Making the assumptions set forth above and assuming a normalized FFO of $2.92 for 2015, we derive a P/FFO of 18.4 for the current year. I believe that EQR deserves a premium valuation because of the quality of its properties. It is true that some of this premium is "baked in" in the form of higher rents and occupancy and, therefore, higher FFO but for the reasons stated above prime locations have additional advantages not entirely captured by current income and therefore deserve a premium valuation. In this regard, a recent presentation by EQR places a value of $34 billion on its properties; this is well in excess of its enterprise value of some $30 billion.
Management - Sam Zell. Those two words should be enough. He has a well-deserved reputation as a savvy value investor with an uncanny ability to buy, sell, and operate real estate. The property portfolio reflects sound selection of desirable and well-located properties; this is confirmed by very high occupancy rates. The company has excellent management which should also suggest a premium.
Potential Problems - EQR has recently experienced weakness in the Washington D.C. market. This frankly surprised me because I generally assume this to be a strong rental market. Perhaps, the sequestration has created more problems that I imagined. At any rate, this is one soft spot in an otherwise strong story in terms of rent increases and demand. Another control I have is government regulation in the form of rent control/rent stabilization. The markets EQR serves include some which have had a history of meddlesome price controls. EQR does not appear to address this issue in any recent presentation and EQR seems to have been able to increase rents in response to demand. It would be helpful to have a detailed analysis of this issue.
Bottom Line - EQR is not back-up-the-truck-and-fill-it-up cheap at current valuations. However, its high quality properties and excellent management suggest that it should be part of a diversified REIT portfolio and I tend to put it at the head of the class among residential REITs. I am long EQR and will accumulate more if it does not run away from me.