Equity Residential: The Private Market Says Buy (NYSE:EQR)


Like most multi-housing (fancy term for apartments) REITs, Equity Residential (EQR) shares have been battered thus far in 2020, falling 40% from its 52 week high. The market’s chief concern seems to be that megacities like SF, LA, and NY will see a population exodus as COVID/government restrictions imposed as a result of COVID make city living less attractive. While anything can happen in the short term, we firmly believe that cities are alive and well. As a long term investor, we view the current price as a great gift and are long shares of EQR.

Overview

Equity Residential (founded owns a collection of institutional quality apartment buildings in supply constrained markets with favorable long term characteristics.

While California has a few challenges, it is home to the 3 of the 10 largest (Facebook, Google, Apple) companies in the world by market cap as well as Tesla, Netflix, Nvidia (to name a few). Seattle has two of them (Microsoft and Amazon). There is long term structural income growth in these markets which supports housing prices.

A LONG TERM WINNER

While shares have been very weak in 2020, EQR has done very, very well for its shareholders over the past 27 years. For long term conservative investors, this is a company that belongs on your radar.

Demand & Supply – both are INCREDIBLY FAVORABLE

Why are we so confident in the sustained growth of megacities? To understand the value of US megacities, it is important to understand network effects and globalization.

Effectively, network effects and globalization make megacities (NY, LA, SF) physical two sided marketplaces. Lots and lots of people in a relatively small geographic area which create a perpetual virtuous circle. Consider:

1) Job market – attracts the best entrepreneurs/employers/employees. This attracts the best global talent. Wages/household income are high. People have money to spend.

2) Dating ‘market’ -lots of potential mates. Meet lots of people, pick the right life partner.

3) Because household income is high, everything is on offer: wide range of restaurants, concerts, museums, theatre, sports events (NY/LA have two baseball teams, two basketball teams, hockey, etc.).

4) International tourism and migration – Wealthy tourists from around the world visit megacities and spend a ton of money. It is tough to see it now but trust me…they’ll return. Few will fly from Japan, England or China to visit Flagstaff or even Phoenix. They will go to NY/LA/SF. Many of these wealthy tourists eventually become residents.

It is a virtuous circle. When the pandemic fear passes and it is time to open new restaurants, hotels, theatres in NY/LA/SF because that is where the people and the money are. It is that simple. I don’t expect to see people sporting I love Des Moines shirts anytime soon! I am confident in long term demand for tenancy in these markets.

Sure the economic disruption wrought by Covid will cause some to lose jobs and flee to cheaper locations. But they will be replaced, in many cases, by wealthier people from all around the world. These new residents will continue to demand goods (retail) and services (restaurants). This will create new jobs.

On the supply side, it is very difficult to build apartments at a price which makes economic sense (except for Class A or high-end luxury apartments with monthly rents of $4-5,000) in these markets. Limited land availability, zoning restrictions, and ever increasing construction costs make building challenging to say the least.

Further, as you can see above the cost to own in EQR’s key markets is very high relative to the cost of renting (50-70% higher average monthly cost). This is a pricing umbrella which limits the ability of renters to become homeowners, ensuring a stable source of demand (or limited alternative supply). Said differently EQR’s markets have true barriers to home ownership a sharp contrast with markets like Chicago, Phoenix, or Atlanta where the cost of home ownership is much more in line with renting.

Stable demand and limited supply bode well for rents and occupancy which gives us confidence in the sustainability of NOI over the medium and longer term (net operating income which is similar to adjusted EBITDA for real estate).

Balance Sheet

Equity Residential has a fortress balance sheet. It carries less than $9 billion of debt (vs. $21 billion market cap) so a loan to value (LTV) of just 30% (at market prices). This is in line with other large cap apartment REITs but is far below what is typically seen in the private market where LTVs typically range from 50-80%. Note that only 5% of apartments are traded as REITs – the rest is held by private market investors – we think public apartment REIT investors would be well served by paying closer attention to the private market. This point can not be over-emphasized – the private market (where 95% of US apartment assets are owned) is the real market.

This gives the company the flexibility to acquire additional assets or better yet repurchase stock (apartment REITs ESS and CLPR have recently initiated buybacks).

Valuation

While there are a number of ways to look at the valuation, we again take our cues from the private market. In the private market, institutional grade assets such as those held by Equity Residential have traded at 3.5-5% cap rates (a cap rate is Net Operating Income divided by the price of the asset) over the past 6-7 years. This information is readily available for free online from reputable sources like CBRE or JLL. Interest rates have come down, implying that when the world worries a little bit less about COVID, cap rates could compress further (look at what has happened to PE multiples for most stocks).

There is evidence that the private market is alive and well. At the epicenter of the crisis (and during the peak of the crisis), Clipper REIT refinanced a large Brooklyn property (Flatbush Gardens) at an implied 4.2% cap rate.

From Clipper REIT’s first quarter transcript (source Seeking Alpha):

We know from Clipper’s supplemental filings that the Flatbush property (Brooklyn) generates ~$19.5 million in NOI, implying a cap rate of 4.1% (=$19.5 million in NOI /$475 million valuation of the property). We know Clipper received a $329 million loan so that implies a loan to value of 70%. This is a very attractive financial structure which is commonly used in the private market to finance the apartment building acquisitions.

Source: Essex 2Q20 Quarterly Supplemental

Similarly and even more importantly, given EQR’s California exposure, peer Essex REIT sold two properties in San Jose at $534,000 per unit in June (shown above under dispositions). By using various rental sites (Zillow, apartments.com), making a few phone calls and estimating an NOI margin (NOI divided by rental income), I estimate that these properties were sold at at a cap rate of 4.3-4.4%. On both its first and second quarter conference calls Essex noted that private market values had held up well, noting flat to slightly declining values relative to the period prior to the pandemic. SimilarlyEQR management noted little change in the private market.

Source: EQR second quarter transcript (courtesy of Seeking Alpha)

I have had many, many conversations with private market participants over the past several months and have come to the same conclusion, fueling my enthusiasm for the shares.

If we assumed that Equity Residential traded at a 4.25% cap rate (midpoint), shares could trade back to $80-90. With ultra low interest rates (the 10 year treasury is a full 100 basis points lower than it was when CBRE published its 2H19 cap rate table), shares could shoot through the mark. Should shares continue to languish, it is possible we could see an activist or private equity group become involved and ‘broker’ the sale of some or all of it’s properties. In the meantime investors get to collect a stable and growing 4.4% yield.

Risks

The main risk is that the pandemic worsens and this negativity leads to a decline in the share price in the near term. We would not recommend this security for short-term investors. However for investors with a 3-5 year time horizon, we see limited downside with the room for substantial capital appreciation while collecting a 4.4% dividend yield.

Disclosure: I am/we are long EQR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: LONG CLPR

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