Equity Residential: A Property Giant, But Is It A Good Buy?

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About: Equity Residential (EQR)
by: Qasim Naeem
Summary

EQR is a multifamily housing apartments company with six major markets.

Management is really strong, chaired by Samuel Zell.

U.S. demographics strongly support the objectives of EQR.

Recommendation: hold, with a projected price of $66.58.

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Coming from Pakistan, it is a common mindset there that whosoever has the most land is the wealthiest. After I decided to start traveling and eventually landed in the U.S., I came to the realization that this is a global phenomenon and land is dear to many across the globe. Due to certain characteristics, such as its tangibility, it's an expensive asset to hold especially in the U.S. It is for this reason real estate investment trusts (REITs) come into play, which basically allow investors to buy some shares of the actual real estate underlying those REITs.

Among the many REITs that are being traded, I would like to talk about Equity Residential (NYSE:EQR), brainchild of Samuel Zell, one of the most refined real estate investors of the U.S. who has made it possible for this company to grow manifolds. If you want to buy an apartment complex in one of the coastal gateways of the U.S., consider buying some REITs and that dream might be realized.

Company Overview:

Equity Residential is a leading real estate company and a real estate investment trust formed in March 1993 in the U.S. that owns over 300 properties, which are composed of approximately 79,000 rentable units according to 2017 10K. It has the market capitalization of almost $27 billion making it the second largest REIT by market cap.

Business Model:

EQR has a goal of "maximizing the total return," which accounts for the operating income and the capital appreciation of the property holdings. To ensure maximum possible total returns, the company choose to invest more in the urban and high-density suburban area in the coastal gateway markets, which typically have high entry to barriers and a high demand for renting apartments because of the high costs of owning a house.

EQR's portfolio of assets is approximately divided evenly between the East and West Coasts. The West accounts for 56%, 26% of which is Southern California, and the East has 43% of the portfolio, 17% of which is Washington, D.C. The remaining 1% of the portfolio is contributed by Denver, which is a new market for EQR.

The company stresses keeping a balance between rental rates and occupancy as its operational emphasis because this balance contributes towards maximizing the total returns. To ensure consistency in occupancy rates, the company pays attention to residents' retention by providing them with the highest level of service through comfortable living. A very strong emphasis is laid upon providing convenience to residents by allowing them to manage their accounts and give feedback through the website.

There are different channels of capital inflow, such as retained cash flow, additional equity and debt, and sales of properties that facilitate acquisitions and developments, thereby furthering the goal of utilizing more and more land along with enhancing the company's market value.

What benefits do REITs offer?

REITs allow small investors to access the real estate market and gain a share of the benefits of these assets that were managed only by a few people and large companies. The business model of a REIT has a special tax benefit and their distributive earnings are excluded from the corporate income tax. Therefore, the investors only must pay the personal income tax, which is an advantage over other dividend-paying companies.

Besides the different tax structure that REITs have, they offer other perks such as providing a stable income stream to investors, ease of buying and selling the shares of REITs and allow both individual and institutional investors to diversify their portfolios without engaging directly into real estate activities. However, the most important benefit is that REITs must payout at least 90 % of their taxable income to shareholders giving investors faster return rates and more security over their investments. These companies are growing rapidly and are providing new investment opportunities, especially to small investors, which has led to a decent growth of this industry to a $3 trillion asset business.

There are different types of REITs in the market. EQR is developing its business as an Equity REIT, which basically means that it is a company that own and invest in property, and therefore offers the opportunity to invest in portfolios of real estate. In the case of Equity Residential, their main investment is towards residential property including houses, condominiums, residential buildings, etc.

Currently, Equity REIT has not had the best performance in the past few months, but compared with the general market, they have outperformed indexes such as the S&P 500, and Nasdaq. The leading REITs have been the large caps, with small-cap REITs having the worst results.

Although the results have not been the best for REITs, I believe it is a solid investment for those looking for some stable form of income which can come through REITs in the form of dividends.

Competition:

Some of the competitors of Equity Residential are AvalonBay Communities Inc., UDR Inc., Apartment Investment and Management Company, and Essex Property Trust Inc, however, some of these companies do not directly compete with EQR because of their investments in different property classes.

EQR does a great job in maintaining low capex vs. its main competitors such as Avalon Bay, Essex Property Trust, etc., which helps it accumulate greater funds from operations, which in turn translates into higher return for the investors. Also, in my opinion, it is creating a competitive advantage for Equity Residential as they are controlling their costs pretty successfully.

Another major point that I believe needs to be highlighted is the performance of EQR share over the previous years in comparison with its competitors as shown below. The stock has struggled a lot to generate returns in terms of stock price appreciation. But I believe that investors of REITs prefer earning dividends rather than generating major capital gains which might advocate for staggering stock performance.

5 Yr (Jan 02 2013 - Dec 27 2018) Stock Price Performance Source: https://finance.yahoo.com/quote/EQR/chart?p=EQR&.tsrc=fin-srch#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%3D%3D

Key Value Drivers:

I believe that three factors play a crucial role in driving the value for Equity Residential: U.S. demographics, quality of assets owned by EQR, and a strong emphasis on sustainable practices.

U.S. Demographics:

The current demographics of the U.S. strongly support the business of the company because the current U.S. population is comprised of more than 70 million Millennials whose tastes very strongly support the rental business. These young people want to enjoy the flexibility of living by renting a place to live rather than owning a house. This allows them to focus more on their other interests such as their careers, social lives, etcetera. Moreover, the company's properties provide quality living which is highly preferred by this age group.

Followed by this segment of the demographics are the post-Millennials, which will also impact the future of the company and they constitute a very strong population segment of the U.S. demography. Another major aspect that we believe will affect future demand is the lifestyle choices of the Millennials. They prefer to live in urban areas which are densely populated and have a very close proximity to activities that they enjoy. The decision of the company to have their properties in such locations will keep on driving the demand as I will discuss further.

Quality of Assets

Over the past years, the vompany has been transforming its asset portfolio by disposing of assets which are expected to underperform, most noticeably the Starwood transaction of $5.365 billion which helped the company retire $2.0 billion in debt making the transaction leverage neutral. This I believe was a very smart move by Sam Zell because he already said that the real estate market is oversupplied, and demand does not equate with that.

But the main goal of disposing of these assets in five locations of the U.S. was to move towards six coastal gateways, which are expected to generate higher growth in the long run. This also means that average rental rate can be increased, which in my opinion is possible because coastal markets can support gradual increases in rental rates. Greater rental rate means greater top-line growth, hence higher funds from operations.

Sustainable Property Developments

There is an in-house team solely focused on ensuring sustainable practices in property developments as well as their operations. This team implements energy-saving programs in the whole business to achieve reduction in energy usage. Due to these efforts, the company has won the 2017 Global Residential Listed Sector Leader by GRESB, which is an investor-driven organization assessing the sustainable performances.

It is due to these key factors that I believe that EQR has the potential to generate gradual returns for the investors.

Riskiness of the business:

In my opinion, the risk that might impact the competitive advantage of this business is the change in macroeconomic factors. In case a strong recession hits, that can be a major blow for the business because residents in the coastal gateway markets might lose jobs thereby not being able to maintain their income level. This might lead to lesser people leasing the luxurious properties of Equity Residential and the funds from operations can plummet.

DCF Valuation: Key DCF Assumption

Revenue Growth Rate; Growth Rate Estimate for 2018

2017

Q1

Q2

Q3

Q4

Total

Revenue

$604,100

$612,480

$624,122

$630,704

$2,471,406

Quarterly Growth to Q4

4.40%

2.98%

1.05%

2018

Q1

Q2

Q3

Q4

Total

Revenue

$633,016

$639,808

$652,867

$659,830

$2,585,521

Projected Growth Rate

4.62%

Source: EQR-Investor; www.sec.gov

To estimate the growth rate for 2018, I used the quarterly growth rate from 2017 and estimate the total revenue of 2018. Through this, I calculated the 2018 growth to be 4.62% which allowed me to estimate the growth rates for 2019-2023. For 2019, I maintained a conservative stance by lowering the growth rate to 4.00% followed by a further reduction of 0.5% for 2020 - 2023. The terminal growth rate estimate is 3.00%.

Discount Rate (WACC)

I used the five-year treasury bond rate of 2.89% as the risk-free rate. The average market premium for EQR from 2013 to 2017 is 4.45%. The adjusted beta is 0.671 for EQR taken from Bloomberg. Cost of equity of 7.49% was calculated through these numbers.

The average of the cost of debt was used which was calculated through the numbers taken from the 201710K. In addition, the effective tax rate we used was calculated by using the average effective tax rate for EQR from 2013 to 2017. The effective tax rate is 10.75%.

DCF Valuation Analysis

I analyzed the past five years (2013-2017) financial statements and valued the company through DCF valuation.

Summary of Projected DCF Valuation:

Source: EQR-Investor; www.sec.gov

Projected value per share of EQR is $66.58 with a WACC of 6.61% and long-term growth rate of 3.0%. As a REITs company, EQR needs to pay out at least 90% of its taxable income to keep the income tax minimal. This means REITs need to raise large amount of debt for their PP&E and they benefit a lot from their extremely low-income tax.

DCF for REITs generally focus on the FFO (funds from operations) and AFFO (adjusted funds from operations) of EQR. AFFO is the money left after reinvestment to maintain the REIT's existing properties available to equity investors. So, the present value of AFFO shows that EQR has $32,818,892.95 for their equity investors. This price is slightly higher than the current stock price ($66.06).

Conclusion:

Since EQR is in the maturity stage of business life cycle, they have maintained stable revenue, cash flow, and profits. Their locations have diversified their weather environment risks and financial risks from different coastal areas.

I believe that the investors should hold the stock. My projected price of $66.58 is slightly lower than the current stock price but I suggest a hold because there is not a very huge margin of safety for new investors taking a long position. For those who already have this stock in their portfolios, they can earn stable returns. The company is at a very stable stage with low risk/low debt, and they are making efforts on the sustainability front. The senior management team is highly experienced who have a very strong knowledge of the real estate market. They do not show any intention to bring about any major change to the structure of the company.

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.