Officiating sports reminds me of investing.
A successful official knows it’s impossible to get all the calls right. Much like investing, you’re going to be wrong sometimes. Every person will have a few blind spots. We strive to have as much of the information as possible, but sometimes the tape will show us something we missed.
Equity Residential (EQR) was one of our best calls.
We introduced EQR to subscribers of The REIT Forum on January 14, 2018 (green boxes on the chart is when we purchased shares):
After we extensively looked into EQR, we posted an article to subscribers letting them know our view. Thereafter, we bought shares on 1/25/2018 for $60.99, 2/14/2018 for $56.00, and 3/23/2018 for $58.04.
We nailed the bottom and continue to hold onto a position in the stock. In this article, we want to focus on 3 factors that are critical to a successful investment.
Factor 1: Balance sheet
We love REITs with a strong balance sheet. This is the first major metric we look at when evaluating REITs. We want to see a low multiple of net debt to EBITDA and a low level of debt relative to the value of their assets. In the absence of excellent estimates for the individual properties, we can get by using debt to total market capitalization. However we slice it, EQR looks very favorable on the balance sheet side:
We like to look at a REIT’s access to debt using multiple metrics. EQR demonstrates several of the metrics. We have a strong preference for REITs with an A- credit rating, or at least BBB+.
Factor 2: Long-term growth
The next factor is evaluating the long-term expectations for growth in revenue. Growth in operating expenses is often less important than the growth rate in revenue. That may seem silly, but we have found the demand side of the equation is critical. Apartments have generated excellent rent growth over very long periods of time:
The growth in apartment rent is exceptionally impressive given the decline in interest rates. Declining interest rates over the last few decades have made mortgage payments more affordable despite increases in home prices. One of the reasons EQR is able to continue growing is their occupancy rates:
The expectation for occupancy on the year is a strong 96.4%. EQR’s strong occupancy has come from low turnover and good demand. EQR is focused on high-density urban and suburban areas:
EQR has continued their re-entry into Denver.
Denver also enhances the diversification within the portfolio. It gives EQR a major market that is clearly not among the “coastal” cities that dominate most apartment REIT portfolios:
All of these areas have physical occupancy between 96% and 96.8%. The lowest area for physical occupancy was San Francisco at 96%. That could be attributed to usual seasonal moderation and pressure from new supply.
Most of the renewal rates range between 5% and 6%. New York had the lowest renewal rate at 3.9%. Rates in New York were expected to be down in the latter half of 2019 because of changes made in rent regulations. However, EQR believes the market in New York will benefit in 2020 from a reduction in new supply.
Factor 3: Management
The third factor is management. EQR has an excellent management team. They extend this expertise through the board room. The board of directors is often an underappreciated part of an investment. In fact, it is hardly ever mentioned in any investing article. Yet, the board of directors is responsible for major decisions such as authorizing a share repurchase program or the sale of a major part of the company.
EQR previously had a major transaction in which they sold a large portion of their portfolio. They used the cash to pay a special dividend:
If shareholders reinvested that special dividend, they gained a substantial increase in the volume of shares they own. Some investors will look at the slight dividend reduction that followed as a negative, but it was tiny compared to the size of the special dividend. If a shareholder simply invested their special dividend in buying additional shares, their income from quarterly dividends increased substantially due to the higher share count. This is a great technique for a REIT trading at a dramatic discount to the value of their assets. However, it is only viable if the REIT has a strong enough balance sheet to withstand such a large sale and special dividend.
In many cases, a REIT selling a large portion of their assets would need to focus on paying down debt. Sometimes that can be challenging. If the assets appreciated in value, the REIT may have a significant taxable gain on the sale. Since REITs are required to pay out most of their taxable income, an asset sale may require paying a larger dividend. How should a REIT handle that situation? They need to proactively protect their balance sheet. If they don’t have much debt relative to the value of their assets, paying out a special dividend is less of an issue. We can see how EQR managed their capital allocation throughout a 13-year period:
When developing new properties carried a higher embedded profit margin, such as 2013 and 2014, EQR allocated more capital to developments.
However, great management in REITs also requires limiting overhead expenses. That should make sense, but very few investors actually think about it. If you were buying an apartment and hiring someone to manage it, you would rather have a lower expense than a higher one (assuming equal skill). This is another area where large REITs can shine. They use their larger size to get more efficient economies of scale:
We need to highlight that the peer comparison only includes their peers among the “big 7” apartment REITs. The smaller apartment REITs will generally have materially higher levels of operating expenses relative to revenue. Wonder how we keep outperforming when picking larger REITs? Our investments are using more of their revenue to drive returns for shareholders, rather than to pay management.
“Risk” to EQR via interest rates
Investors occasionally lose faith in apartment REITs and allow the prices to drop significantly even if the company has a solid balance sheet. One of the factors that can correlate heavily with price movements in the short term is interest rates. When interest rates increase, many investors will sell some portion of their REITs under the idea that a REIT is similar to a bond. While both provide sources of income, an increase in Treasury rates would go hand-in-hand with an increase in mortgage rates. Higher mortgage rates make it more difficult for renters to purchase homes and thus would allow for more significant increases in apartment rents over the following years.
Equity Residential has several great characteristics. For a long-term investment, it meets our criteria. The company has a great balance sheet, has clear growth in revenue, and great management in place. There are some risks to the share price following the substantial run higher. Our top pick in the sector currently is Essex Property Trust (ESS). While we find ESS more attractive, we should highlight that both REITs are exposed to an increase in rent control laws – particularly in California. For ESS, that factor is more significant since ESS has a larger allocation to California. However, the rent control laws we have seen so far haven’t concerned us materially. EQR actively tries to educate the public:
As you can see above, EQR has succeeded in educating the public and policymakers. In November 2018, EQR helped beat Proposition 10 in California which would have allowed local governments to enact rent control. We believe that EQR will continue to see events coming and adapt accordingly.
While the big 7 apartment REITs carry relatively low dividend yields (from 2.68% to 3.42%), we expect them all to exhibit strong growth in FFO per share and dividends per share. Over the last two years, we’ve seen a very significant increase in price-to-FFO multiples and in price-to-NAV (net asset value) ratios. Consequently, EQR doesn’t have near as much upside as it did when we were hammering out the buy ratings in early 2018. However, we still expect the same level of long-term growth in rental rates driving FFO per share and dividends higher.
Equity REIT Terms
We use several terms when talking about equity REITs. It helps us communicate if we have the same definitions. Consequently, we put together charts to help investors understand several equity REIT terms:
Note: Our definitions and calculations shown here are simplified. We’ve eliminated tiny adjustments that are usually immaterial.
You’ll see Analyst AFFO is near the very bottom of the chart. If we want to start from revenue, it takes quite a while to get there. You don’t need to memorize this table, but it could help you as a REIT investor.
Each line provides the formula to reach the value listed on the right. You’ll notice that “Normalized FFO” and “Standard AFFO” are the same. This is the value that most management teams report as “AFFO”. However, we also have “Analyst AFFO” which adjusts for recurring capitalized expenses.
Note: To be even more precise, there are a handful of other non-cash adjustments going into Analyst AFFO. However, in most cases, the other non-cash adjustments have a fairly small cumulative impact. We didn’t think it was worth adding several other boxes to represent a very small adjustment.
The next two tables dive deeper into the definitions:
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Disclosure: I am/we are long EQR, ESS. 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.