Investor fascination with apartments as an asset class is interesting to me. For decades, apartments have traded at a material premium to other types of commercial real estate. Today, that premium spread is about 85bps when measured by cap rate, a slightly greater figure than the recent historical average. But perhaps more importantly, the sector is red-hot in the public equity markets. Interest is at perhaps all-time highs and, as I’ll get into later, many of the industry’s largest players likely trade at a premium to their net asset value (“NAV”). That includes industry stalwart Equity Residential (EQR). Despite its size and market-leading position, it’s tough to advocate a long position when shares trade at a premium multiple to funds from operations (“FFO”), cap rates have the potential to weaken, and the economic cycle is moderating. Perhaps there is no better signal of that than company action itself, with the company itself engaging in net disposition activity ($8,500 million in dispositions) over the past several years versus engaging in material acquisitions or development. It's tough to be bullish.
Equity Residential At A Glance
The bull case for Equity Residential, at least at a high level, is alluring. Founded by Sam Zell, the company has been a great long-term compounder of shareholder wealth. As perhaps the largest owner and operator of rental apartments in urban and high-density suburban markets, the company has unique exposure to areas of the industry that are currently in demand from renters. Unlike other areas of the country, lower new supply and better wage growth for prospective renters in its locales has kept property returns ahead of averages. Markets like New York, San Francisco, Seattle, and Boston all continue to attract a disproportionate share of higher-paying jobs, particularly from the technology industry. It isn’t just property values that have been moving upwards: same-store revenue growth has been as well. Coupled with a culture intensely focused on costs, what has resulted is perhaps one of the most well-run REITs out there.
*Source: Equity Residential, March 2019 Investor Presentation, Slide 7
Great companies, unfortunately, often come with steep price tags. Equity Residential is a great example of that, and while it is the industry leader on many metrics versus peers, one has to wonder about the value of buying up at these lofty levels. It’s also perhaps an unusual situation, as apartments as a whole have not been materially strong performers when it comes to same-store comp data. While apartment same-store net operating income (“SSNOI”) rebounded healthily from the Great Recession, the property class was one of the hardest hit and has not been a material outperformer versus other types of commercial property real estate. In fact, it is probably best described as just average in this regard.
*Source: Author's calculations using NAREIT data
Compared to consistently strong assets like manufactured homes, office which is having a bit of a late cycle surge, or industrial (not included above) which has been the strongest area of commercial real estate due to the growth of e-commerce, apartments just really aren’t all that attractive. I get the demographic trends pitch, but pretty much all commercial property types have some overwhelming trend to point to: health care and aging Baby Boomers, industrial and e-commerce, data centers and computing power growth, etc.
I prefer to look at the numbers. Importantly, while guidance from Equity Residential is for 2.25% SSNOI growth this year, this is not being driven by improving same-store lease pricing. Most major markets, such as San Diego, Washington D.C., New York, Boston, and Seattle all experienced negative net leasing changes in Q1, meaning rent for a new tenant versus the prior tenant has gone down incrementally. Instead, higher occupancy and higher rents on existing tenants were the driving force behind positive comps. Both of these drivers have their limits, and this is especially true for occupancy when it’s sitting at 96.3%. Achieving much higher than that is tough due to staggered building renovation and repair and maintenance during tenant turnover.
Am I reading too much into negative new leases? Perhaps. There is not a lot of turnover on an annual basis. But Equity Residential is raising a few flags as well on its own. Notably, the company had disposed of $8,500 million in assets since 2015 (much of which was returned to shareholders in the form of a special dividend) and has significantly slowed its development starts as “risk-adjusted returns decline and the cycle matures”. This management has made a name for itself for its deep understanding of the ebb and flow of apartment demand and has been one of the better property developers out there. Isn’t this a signal that a little bit of caution is warranted?
*Source: Equity Residential, March 2019 Investor Presentation, Slide 13
That view on where apartments lie in the cycle, which is being borne about by both comp data and management statements, is certainly not reflected in the share price. Equity Residential trades at 23.6x P/FFO based on its 2019 guidance, at the high end of its 10-year average. This is one of the steepest multiples among REITs.
There is no question here that the balance sheet is impeccable, that the company has unprecedented access to liquidity, and that fixed charge coverage is strong. However, with $1,850 million in NOI likely this year, Equity Residential also trades at an implied 4.7% cap rate, a 30bps premium to the nationwide metro average for Class A apartments (see CBRE data). Class B properties, which Equity Residential does own, trade another 75bps higher. I've harped on this often, but it just doesn't make sense to buy above NAV unless you see significant tailwinds for the property type and are willing to pay for top-tier management. The latter is true here, but I do not see the former.
These cap rates are nearly as strong as they ever have been (having come up recently due to higher rate fears), and it’s tough to make a case for stronger value. Remember, there are two ways that REIT investors can see returns over and above current cash flow that are not predicated on share price multiple expansion:
- Higher property values
- Higher SSNOI growth
Both are perfectly valid ways to see growth in the value of an investment. In my view, Equity Residential does not have a strong case for either. Management willingly admits that the cycle is near its end and that property valuations and comps are, at best, going to be low single digits from here. It's pretty clear to my eye that the valuation is full at best and overvalued at worst. It's just not the time to be considering additional investment.
In just three weeks time, I'll be at REITWeek meeting with the management teams of a dozen REITs individually and watching many more present. This is a treasure trove of data I'll be sharing with the Industrial Insights community.
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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.