CHUNYIP WONG
Dear readers/followers,
Equity Residential (NYSE:EQR) has been on my radar for a while and the only reason I haven't invested in the company to this day, was its similarity to AvalonBay Communities (AVB), which is one of my larger holdings. I published an article a couple month ago, highlighting some of these similarities and presenting my outlook for the company. Since that article, the stock price has barely moved (returning -3.5%), but the company has reported solid Q1 2023 results and I've done more research on their development practices. Today I want to share my findings with you and urge everyone to not miss out on a good buying opportunity.
Residential REITs vs Treasuries
I've seen many comments on SA from reader wondering why they should buy a residential REIT which yields 4% and has down-side risk when they could easily buy treasuries and lock a similar yield with no risk. And that's a fair question, especially with all the uncertainties we're now facing. Indeed you can get 4.4% from 2-year treasuries (orange line below) or 3.7% from 10-year treasuries (blue line below). And even more if you opt for short-term 3-month T-bills.
FAST Graphs
And the thing is that historically, other than during major bear markets, the dividend yield of high-quality residential REITs has actually been within 100 bps from the 10-year treasury rate. Let's take EQR and consider the period between 1995 and 2005 when the dividend yield averaged just below 6% vs 10-year treasuries at the time of around 5-5.50%. Same thing between 2010 and today, the yield has averaged closer to 3% with 10-year treasuries yielding about 2.5% on average. The only exception to this was the 2008 financial crisis during which the dividend yield spiked as high as 10%. We can all agree that was an anomaly and in hindsight everyone would have wanted to buy.
So one might argue that investing in treasuries has been just as good in terms of income as holding a residential REIT such as EQR. But this excludes one key variable - capital appreciation. Sure, the stock price has been very volatile over the past 30 years, but even after the 35% crash we've had, it has returned 320% on top of dividends. This is in contrast to treasuries which would have returned a grand total of zero capital appreciation.
As investors, our main goal is to beat inflation. If we don't manage to do that over a long period of time, we have failed. And it's nearly impossible to beat inflation with treasuries. This is why I'm advocating for investing in residential REITs, especially for income investors, and why I personally have about 25% of my REIT portfolio allocated towards rental apartments. The yields are very well covered and safe (many of these companies are A- rated, with a long history of increasing their dividends and low leverage) and on average track 10-year treasury yields. The potential downside which comes with volatility is only going to be short-lived and over a long period of time (10+ years), these REITs will offer substantial capital appreciation, at least equal to the return of the broader market which has averaged 8-10% historically. Residential REITs offer one of the best ways to generate income, while protecting yourself against inflation.
What's even better is that we're not buying these companies just anytime, but after a major selloff at significant discounts. These companies have very rarely traded at such meaningful discounts to their net asset values, but today you get to pick up prime REITs for 70 cents on the dollar.
Of course, none of us can time the bottom and we need to accept that. What we can do, however, is only buy the best of breed and calculate the value of these companies to make sure we have a sufficient margin of safety to protect against the downside and continue to buy slowly on the way down.
I'm fairly confident that this strategy will significantly outperform those hiding in treasuries waiting for even more blood in the streets. When things improve and credit comes back, those holding treasuries can easily miss the train as asset prices rise quickly and when their treasuries expire, they will have been left watching from the sidelines with no stocks left to buy at good valuation levels.
Equity Residential
With that in mind, let's have a look at EQR which is a prime candidate for a safe income oriented portfolio. EQR has a vast portfolio of 80,000 high quality (mostly A-class) residential apartments located across both coasts of the US. They also have a minor 5% exposure to growing markets (Denver, Atlanta, Dallas, and Austin) and aim to increase it to 10% over the next few years.
EQR's properties cater to a higher income demographic, with average monthly rent approaching 3,000 USD. As argued in my original article, I see their exposure to legacy markets as an advantage, rather than a risk and I encourage you to check out my reasoning there. All I'll say here is that the rules of the real estate game are simple: supply and demand.
EQR Presentation
Their balance sheet is amongst the best in the industry. There are only eight REITs that are A- rated or better. EQR is one of them. Non only that, but 95% of their debt is fixed rate and their leverage is very reasonable at 4.17x EBITDA (down from 4.38x last quarter). One thing to note is that they do have a debt maturity of nearly $900 Million this year, which could pose some refinancing risk. Luckily, roughly half of the refinancing risk has been hedged with ten-year forward starting SOFR swaps at a weighted average rate of 2.90% so I don't expect any major issue related to the refinancing of the 2023 facility. And beyond that, EQR won't really have to worry about debt repayments until 2025.
EQR Supplement
In terms of performance the first quarter has been quiet. The year-over-year numbers look great, but this was largely due to steep growth last year. In Q1 occupancy remained stable at 95.9% (up from 95.8% last quarter) and same-store revenue grew by 0.7% QoQ as FFO per share reached $0.85 per share. Still, I want to highlight the fact that cash flows have grown by double digits while the stock price has decreased by 35%, think about that. Going forward management guides towards Q2 FFO per share of $0.90-0.94 thanks to higher expected same store revenues and lower expected property damage from California rain storms. For the year the consensus is for 4% FFO growth and potentially 4-6% in the following years.
Long-term I think rental living will experience some tailwinds. On the demand side, as housing becomes less and less affordable, people will be forced to rent out of necessity which will lead to stronger demand and higher tenant retention. On the supply side, new construction in legacy markets on both coast is now near an all-time low, which will understandably result in higher occupancy and rents for existing landlords. I cannot see a scenario in which EQR would struggle to find tenants.
In addition to solid operational performance EQR has a history of recycling capital well and expanding/improving its portfolio via new acquisitions and developments. In Q1 alone, they sold a collection of 25-year old properties with 247 units in LA for about $135 Million at a cap rate of 5.3%. On the acquisition side, they spent $79 Million to acquire a newly developed property with 262 units in Atlanta at a cap rate of 6.6%. This translates to $288,000 per unit which management estimates is 15-20% below current replacement costs. Though these were small transactions, it's good to get some benchmarks for pricing which we can directly compare to the implied cap rate of 5.6% that the stock trades at today. In addition to this, the REIT currently has almost 3,0000 units under construction (mostly in fast growing markets of Denver and Texas) which it mostly expects to finish next year.
When it comes to development, EQR has a unique advantage compared to peers such as AVB in that it outsources the development to a third party. This means no internal development team leading to lower overhead. Also, this means no development risk and an increased ability to only construct new projects when profitable. REITs that have internal teams, on the other hand, may be pressured to work on new projects even when the time is not right, simply to give the team some work to be able to keep it (firing and replacing everyone is extremely inefficient and costly). On the flip side, EQR has to share some of the profit with the developer, meaning that it gets the buildings for slightly lower cap rates that a REIT with an internal team. Still I like this strategy in the current economic environment.
With what I've just showed you and following really impressive growth in cash flows of the past year, I see no reason to downgrade EQR. I will continue to value it at 20x FFO, which is slightly below the historical average and more than fair given the quality of this company. I'll keep my PT at $85 per share, leaving 41% of upside from today's prices in addition to a dividend yield in line with long-term treasury yields. Buying the stock is in my opinion strictly better than investing in treasuries, will give you double the dividend yield of a broader market index and should produce 10%+ returns over a long period of time. That's a no brainer BUY in my book.
