Equity Residential: High Coastal Exposure Has Hurt Investors

Summary

• The Equity Residential, as the name implies, invests in single and multi-family housing, mainly on both US coasts.
• The article gives a brief overview of the US housing market as that drives construction costs and potential for increasing income from existing properties.
• That is followed up by a review of EQR itself. Despite the recent slowdown in the residential market, owning real estate is a good portfolio diversification asset.
• While EQR is expanding away from the coasts, there are other REITs already focused there that have outperformed EQR. At best, EQR is a hold hoping for better results going forward.
• Looking for a portfolio of ideas like this one? Members of Hoya Capital Income Builder get exclusive access to our subscriber-only portfolios. Learn More »

CHUNYIP WONG

(This article was co-produced with Hoya Capital Real Estate

Introduction

While my portfolio owns several REIT ETFs, I have only one specialized REIT, the Alexandria Real Estate Equities (ARE) which specializes in Life Science tenants. With all the talk about a housing shortage in the US, it made sense to start exploring REITs that focused on residential housing, which can also be divided into subclasses like single or multi-family, medical, manufactured homes, or senior facilities. My search started with Equity Residential (NYSE:EQR), which this article reviews. While EQR is expanding away from the coasts, there are other REITs already focused there that have outperformed EQR. At best, EQR is a hold hoping for better results going forward.

Why residential housing now?

There are the Econ 101 reasons: supply & demand factors as the next charts illustrate. Construction of houses and apartments in the US has been below trend lines since the 2008-09 GFC. A sub-issue is that the construction in entry-level homes (<1400sqft) continues to fall, increasing demand from renters as higher down payments and/or monthly mortgage payments leave more potential buyers looking for housing they can afford.

realtor.com vacancy rates

That construction imbalance is also reflected in the declining vacancy rates. This shrinking supply is pushing up home prices and rents! Another issue is what homes are available for first-time buyers.

For investors wanting to expand their REIT exposure, other factors come into play. Crime and continuing “work from home” rules add uncertainty to the future profitability of Office Space REITs. Potential changes to Medicare and Medicaid reimbursement rates would negatively affect income Medical Property REITs receive. Industrial/Warehouse REITs have benefited by more online shopping, which is easing, which could result in leases not being renewed. Consolidation and 5G technology could affect the REITs focused on cell towers.

While there are also negatives for Residential REITs, they might be best positioned of the various REITs after their recent pullback.

Equity Residential review

Data by YCharts

Seeking Alpha describes this REIT as:

Equity Residential is committed to creating communities where people thrive. The Company, a member of the S&P 500, is focused on the acquisition, development and management of residential properties located in and around dynamic cities that attract high quality long-term renters. Equity Residential owns or has investments in 305 properties consisting of 78,568 apartment units, located in Boston, New York, Washington, D.C., Seattle, San Francisco, Southern California and Denver.

Source: seekingalpha.com EQR

EQR is mainly focused on both coasts of the US, with a growing footprint in Texas, as shown in the following map.

s1.q4cdn.com: Investor presentation

They outline their strategy for success with these four focal points.

s1.q4cdn.com: Investor presentation

• Buy/Sell properties as the market dictates.
• Quality assets in high-cost markets.
• Maintain strong financials, lowering borrowing costs.
• Strong internal controls for managing the assets.

Cost of housing directly affects demand for apartments, thus rents and property values. EQR core holdings are in the high-cost cities, but that is changing!

s1.q4cdn.com: Investor presentation

Where EQR is expanding (the orange dots above) have two things in common:

• Much lower Price/Income ratios than the other areas EQR was in.
• Represent areas with growing populations.

Both factors should increase rents in these areas faster and see more property-value increases than the other areas where EQR owns real estate.

EQR distribution review

seekingalpha.com EQR DVDs

Dividend growth has been near or below 4% over the past decade and shorter periods, earning EQR the following grades.

seekingalpha.com EQR scorecard

Risk and return review

As EQR might replace some allocation to stocks, I added the SPDR S&P 500 Trust ETF (SPY) to this part of the review.

PortfolioVisualizer.com

Since EQR founding in 1993, it has produced a 10.63% CAGR, 99bps annually better than the SPY ETF. The risk data shows mixed picture. While EQR's Sharpe and Sortino ratios are inferior to SPY's, its Beta is much lower (.71 vs .96). As for Alpha generation, it was no contest: 5.31% for EQR; only .42% for SPY. Despite the ratios, it does appear EQR delivered for investors.

Location, location, location

Using a familiar response to what are the three most important considerations in real estate, here are my thoughts on why EQR has trailed other Residential REITs in CAGR that readers will see later. Most will continue to be headwinds going forward.

• California Proposition #13: Dating back to 1978, this caps property tax increases to 2% until the property is sold, thus the tax burden is shifted to new construction, in this case to landlords like EQR who have expanded their California portfolio of holdings.
• Rent Control: While inflation and other real estate costs were increasing slowly, this was less of an issue but still critical; more so on the East coast where they have existed longer. While limiting rent increases benefits the tenants, landlords earn less and thus less willingness to build more units, which makes for calls to expand rent controls even more.
• High cost of living: The prior issue helps cause this occurrence, as does the high income tax rates in many of the West and upper East coast states and cities. A new Washington state tax on "income" already has one major Investment firm saying they are leaving the state. Silicon Valley and the Bay Area are experiencing the same exodus. It also means more folks need to share a home/apartment to survive, all of which cuts into demand.
• Population shifts: Both California and New York lost enough population that they both lost a US House seat after the 2020 census. Colorado and Texas, EQR's growth markets, picked up a combined three seats. This is being driven by three factors: the high living costs already mentioned, rising crime rates, and the ability to work remotely, which seems to be more "sticky" than the experts thought.

Portfolio strategy

While ETFs like SPY hold some REITs themselves, the allocation is usually very small: only 2.6% for SPY. Add a REIT like EQR helps balance out the rest of the portfolio. Another benefit is assets like EQR have is their small correlation factor to the US stock market, which should help dampen the bad times.

There are ETFs that focus on housing, one I recently found and it just over a year old, is the Residential REIT Income ETF (HAUS), which holds 25 assets like EQR, its #2 holding. I mentioned that only show there are lots of REITs covering the housing market; some widely, others more specialized. Using the Peers figure to Seeking Alpha, it shows five other housing-focused REITs.

seekingalpha.com EQR Peers

The next chart helps explain the title and rating.

seekingalpha.com EQR charting

EQR comes in 5th place since 1998; shorter timeframes looked the same. While EQR's apparent strategy of moving away from both coasts might increase performance, there are better performing REITs available already focused on those more promising markets.

While EQR is expanding away from the coasts, there are other REITs already focused there that have outperformed EQR. At best, EQR is a hold hoping for better results going forward. Knowing why to skip a REIT is as important as knowing which ones to own.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Comments

[ccking3]

Pretty strong results reported yesterday and solid outlook. The west coast is anti landlord but the positives are they are high barrier to entry markets and EQR’s renters are not likely to be losing their jobs nor leaving for Texas.

The stock is undervalued but the markets right now hate anything that they think have recession exposure. ARE is a steal and also reported a strong 1Q with a good outlook but investors apparently are convinced its going to face challenges from biotech funding issues and possible competition from desperate office space, both of which are likely not to happen or will have minimal impact.

[Retired Investor]

@ccking3 Thanks for sharing. Others readers agree. I own some ARE, down a ton, makes little sense.

[tensei]

@ccking3

yeah california and new york are great markets for the "go-getter" talent that are making $200k+ salaries that EQR caters to. It is not in the realm of possibility that they are moving to texas, alabama or some other low cost of city.

[Small pockets]

Sam Sell as top dog is same as to clone Warren Buffet for real estate. Besides Warren is not a Club Harley rider. Long Sam

[tensei]

EQR residents in NYC and California are not moving to sunbelt cities. A finance person making $200k-300k in NYC in an EQR apartment cannot find a comparable job anywhere in the United States, especially in the sunbelt....

[Retired Investor]

@tensei That assumes they cannot WFH. Plus, they could take a big pay cut and still be better off. I when I started in TX, I got paid 50% of what a fellow grad got from NYC firm. I had lower taxes, fraction of the rent, and 15 minute commute.

[tensei]

@Retired Investor

Again, I don’t think you understand the target market for EQR residents. They are people earning over $150k that want to big in a big city.

It doesn’t matter how cheap texas is, they are unwilling to move there as the clubs/restaurants/friends are not there…also the highest paying finance jobs are in NYC, biotech in Boston, tech in Silicon Valley… these are not your “I’m gonna settle for a second rate Finance or tech job at a smaller city” kind of people

[Retired Investor]

@tensei Not arguing that point, but people are moving out of costly cities, especially if their employer moves. Granted, I do not have data as to what income brackets are most effected.

[mliu76400]

It's be more useful to do a deeper comparison of the six you included at the end of your article. Thanks!

[Retired Investor]

@mliu76400 I don't think SA would allow too much depth on the others but all have been recently reviewed by others. Good question though, thanks.