Is This High-Quality Apartment REIT A Buy?

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About: Equity Residential (EQR)
by: Ploutos Investing
Summary

Equity Residential REIT owns a portfolio of residential properties in six key coastal markets in the United States.

The REIT should continue to benefit from favorable demographic trends in its key markets.

In the past few years, management has done a good job growing its revenue while limiting its overhead expense growth rate.

The current rising interest rate environment may continue to weigh on its share price.

Investment Thesis

Equity Residential (EQR) is the largest apartment REIT in the United States. It owns a portfolio of residential properties in the six key coastal markets in the United States. In the past few years, management has done a good job growing its revenue while limiting its overhead expense growth rate. The REIT should benefit from favorable demographic trends in these major markets. It also has a unique dividend policy that ensures its long-term financial sustainability. However, its FFO growth rate may decelerate in the near term due to elevated supply in its key markets. In addition, the current rising interest rate environment may continue to weigh on its share price. I would prefer to wait for a better entry point.

Source: Investor Presentation

Reasons Why Equity Residential is a Good Investment Choice

Strategically Located in 6 Key Coastal Markets

Equity Residential’s core coastal markets include Seattle, San Francisco, Southern California, Boston, New York, and Washington, D.C. These areas do have several key demographic trends and conditions that are highly favorable for the REIT. These trends and conditions include a higher housing price over income ratio than the national average, a decreasing trend of homeownership rate, a change in lifestyle choices, etc.

Source: Investor Presentation

Source: Investor Presentation

Consistent long-term average rent growth and occupancy

The ability to consistently keep a high occupancy rate and grow its revenue are the two key indicators to evaluate a REIT’s ability to grow its revenue. Below is the chart that shows the long-term average occupancy rate and average annual effective rent growth rate in the past two decades. As can be seen from the chart, Equity Residential’s key markets such as New York, Boston, Seattle and San Francisco (shown in orange dots) generally have higher long-term average occupancy ratios and higher average annual effective rent growth rate than many other major cities in the United States. The REIT's funds from operations ("FFO") growth rate is positively impacted by this favorable rental market condition. As can be seen from the second chart below, Equity Residential has grown its FFO by a compound annual growth rate (“CAGR”) of 7.1% in the past three years.

Source: Investor Presentation

Source: Investor Presentation

Strong Operating Results and Excellent Cost Controls Over Time

Equity Residential’s management has done a good job increasing its revenue consistently while curbing its expense growth rate. As can be seen from the chart below, its revenue has grown by a compound annual growth rate (“CAGR”) of 3.42% while its operating expense only increased by a CAGR of 1.95% in the past decade. Its overhead expense as a percentage of total revenue is 90 basis points lower than its apartment REIT peers in 2016 (see second chart below). Management’s ability to control its expense has resulted in a 4.21% CAGR in its net operating income in the past 10 years.

Source: Investor Presentation

Source: Investor Presentation

Investment Grade Balance Sheet

Equity Residential has an investment grade balance sheet. The REIT has credit ratings of “A3“ and “A-” from Moody’s and S&P, respectively. Equity Residential currently has about $9 billion in total debt. Its total debt to adjusted assets ratio of 34.8% at the end of Q3 2017 is slightly better than last year’s 35.0% and in line with its peers. The REIT’s weighted average debt maturity of nine years is better than the average of 7.8 years of its peers (see chart below). This lengthy debt maturity years is advantageous as it reduces the risk of increasing its interest expense sharply in a rising interest rate environment. The company’s net debt to normalized EBITDA ratio of 5.7x is acceptable and much improved from the ratio of 6.8x back in 2013.

Source: Investor Presentation

Unique Dividend Structure

Equity Residential paid an annual dividend of $2.015 per share in 2017. The dividend is equivalent to a dividend yield of about 3.3% at today’s share price. Thanks to the recent decline in its share price, Equity Residential’s dividend yield is now slightly above its five-year average of about 3.13%. The REIT has a unique dividend structure where its annual payout ratio is about 65% of its funds from operation guidance. Although this means that its dividends do fluctuate year-over-year, the policy ensures long-term financial sustainability. The year-over-year difference is generally less than 10% in the past five years.

Chart

EQR Dividend Yield (TTM) data by YCharts

Some Concerns

Elevated Supply in its Key Markets in 2018

Despite favorable long-term demographic tailwinds, Equity Residential is facing some apartment oversupply in several of its key markets. Management noted in its Q3 2017 conference call that New York in particular faces a significant amount of supply (see chart below) and slowing job growth. In fact, several of its key markets also face elevated supply in 2018 as shown in the chart below. Besides New York, the markets with significant new supplies include Washington D.C. and Los Angeles. Given the fact that apartment lease terms tend to be shorter than other types of properties (e.g. office, industrial, medical properties), an excessive supply can quickly slow down Equity Residential’s revenue growth.

Source: Investor Presentation

Interest Rate is on the Rise

Beside elevated supply in the near term, Equity Residential also faces the risk of rising interest rates. This is evident in its share price lately. Shares of Equity Residential have declined by 13.5% since reaching its high in November 2017. In the past year, its shares have declined by nearly 3.5% whereas S&P 500 Index has increased by nearly 25%. If the Fed decides to accelerate interest rate hikes in the future, it is likely that shares of Equity Residential will decline further as bond yields will become even more attractive than REIT yields.

Chart

EQR data by YCharts

Investor Takeaway

Equity Residential should continue to enjoy favorable demographic trends in its six major coastal markets in the United States. The company has maintained a good track record of comparable FFO growth in the past few years. Its unique dividend policy ensures its long-term financial sustainability. Despite these positives, I'm concerned about the rising interest rate and the elevated supply in its key markets. Hence, I would prefer to take a wait-and-see approach and wait for a better entry point.

Note: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.