Equity Residential Seems Overcooked
Equity Residential ('EQR')'s stock has ticked up by nearly 10% since the turn of the year, defying the odds as most believed the U.S. residential market would shed significant value in 2023 due to the disinflationary environment.
The Sam Zell-founded real estate investment trust ("REIT") is known to invest in mid-to-higher-end residential real estate within the United States, which has yielded significant returns to its shareholders over the years.
However, the question looms: Is Equity Residential ('EQR') still undervalued after its latest surge?
Understanding Equity Residential's Business Model
Equity Residential ('EQR') is an umbrella REIT, meaning its business model allows property owners to sell their units for a share in the REIT, providing owners with significant tax advantages.
Furthermore, the REIT is vertically integrated, allowing it to streamline its income statement by acquiring, developing, and managing prime real estate.
According to its latest publicly released data, Equity Residential ('EQR') owns 304 properties spanning over 80,000 units. Most of its assets are in high-productivity areas such as Chicago, New York, Washington, D.C., Seattle, San Francisco, and Southern Carolina.
Focus on Internal Rate of Return
A noteworthy feature of the real estate investment trust is its focus on the internal rate of return instead of the capitalization rate. The prior refers to the annualized cash-on-cash return generated during an assets holding period, whereas the latter points to an asset's going-in annualized rental yield relative to the acquisition price.
Many REITs get dragged into lucrative capitalization rates without considering the total returns. However, as shown by Equity Residential ('EQR')'s latest $135.3 million disposition in Los Angeles, which yielded an internal rate of return worth 8.7%, the fund emphasizes both value additivity and rental income.
Equity Residential's Capital Structure
Lastly, a salient feature of Equity Residential ('EQR') is its welcoming capital structure, which consists of 77.7% equity in the form of preferred and ordinary shares.
Sure, the REIT has debt on its books. However, approximately 93% of the burden is fixed, contributing to a weighted average cost of 3.6% with an average maturity of 7.8 years.
At face value, it can be said that Equity Residential ('EQR') can acquire throughout the interest rate cycle with relative ease as the REIT's capital structure conveys that little shortfall risk is present.
Recent Acquisitions and Dispositions
Let's delve into a few of Equity Residential ('EQR')'s latest acquisitions and dispositions.
Equity Residential ('EQR') acquired two properties during its second quarter, with the first being a $78.6 fully-leased residential building in Atlanta, which has a going-in capitalization rate of 6.6%. Additionally, Equity Residential ('EQR') acquired a $108 million, 287-unit property in Denver at a going-in capitalization rate of 5%.
Furthermore, and as alluded to earlier in the text, the fund recently disposed of $135.3 million worth of assets in Los Angeles. The assets generated an internal rate of return worth 8.7% and a going-out capitalization rate of 5.3%. More importantly, at 25 years of age, the assets were at risk of obsolescence, meaning the sale frees up capital for investments in higher productivity properties.
Interim Results and Future Guidance
Equity Residential ('EQR') affirmed its third-quarter and full-year guidance on Wednesday, September 6th.
According to the firm's management, rents will scale by approximately 5.5% to 6.25% by the firm's financial year-end, which aligns with the narrative shared in the fund's July earnings release.
Furthermore, the company's August update showed that same-store rents ticked up by 3.5% in the first two months of the firm's third quarter, while occupancy rose to 96% from the 95.9% recorded in Equity Residential ('EQR')'s second quarter.
Valuation and Dividend Profile
Although Equity Residential ('EQR') possesses robust fundamentals, its stock seems overvalued, and its dividend profile is relatively underwhelming.
Firstly, the fund has a $3.77 to $3.83 funds from operations guidance for 2023. If an absolute valuation is utilized, whereby the sector average price-to-funds from operations of 12.23 is multiplied by Equity Residential ('EQR')'s midpoint FFO guidance, the resulting figure would show that the REIT is overvalued by approximately 37%.
Furthermore, a relative valuation communicates that Equity Residential ('EQR')'s price-to-funds from operations ratio of 17.53 is within the 30th industry percentile, indicating further worry signs.
Another worrying sign for Equity Residential ('EQR')'s common shareholders is the dividend yield. The REIT's forward dividend yield of 4.12% is less than half of the 8.29% its preferred shareholders earn. Moreover, Equity Residential ('EQR')'s dividend yield sits within the 19th industry percentile, suggesting better income-based real estate investment opportunities exist.
Conclusion
Although Equity Residential ('EQR')'s robust portfolio provides much reason for optimism, key metrics suggest its stock might be overvalued on an absolute basis. Moreover, at a dividend yield of less than half its preferred shares' distribution, it is worth questioning whether the vehicle is set to provide best-in-class returns to its common stockholders.
This article first appeared on GuruFocus.
