Equity Residential Stock: Lack Of Supply In Legacy Markets Should Buoy Rents (NYSE:EQR)

Equity Residential (NYSE:EQR) has lost over 8% over the past year, significantly lagging the broader stock market. This has been more in keeping with declines seen across much of the REIT universe as higher rates and slowing rent growth have weighed on investor sentiment. Shares have returned -3.5% since I recommended buying last October. This has been more driven by a compressed multiple than poor performance, and I see shares as attractive today for income growth-oriented investors.

In the company’s third quarter, EQR generated $0.96 in funds from operations (FFO), which did miss consensus by $0.01, as Rite Aid’s bankruptcy weighed on results. While EQR is primarily a multifamily owner, the ground floor of its buildings often has retail space. Alongside this, there has been a slow recovery in bad debt expense as onerous foreclosure processes in California have allowed delinquent tenants to remain in units for longer.

Given these quarterly results, management revised guidance. For the full year, it now expects normalized FFO of $3.77-$3.79, reducing the top-end of the range by $0.04. At the midpoint, this is up 7% from last year, which is consistent with the ~6% growth I forecast in last year’s buy recommendation. The truncated top-end of the FFO range is because net operating income guidance was revised from 6.3-7% to 6.2%. This was half due to the bankruptcy of Rite Aid and slower improvement in bad debt and half due to weakening in San Francisco and Seattle, a more persistent factor to be concerned about.

EQR owns over 80,000 units across 305 communities. It primarily operates out of legacy metropolitan areas, as you can see below, appreciate New York, Boston, DC, and San Francisco. It is slowly expanding into the Sun Belt, eventually targeting 20% of earnings in these expansion markets. EQR operates upscale apartment buildings; its average tenant has $170k household income, 60% above the national average and is just 32 years old. Given their higher income, the average rent to income ratio is just 20.2% (~28% is a healthy level).

Its exposure to legacy markets has generally been seen as a headwind because population is generally growing faster in the Southeast, aided by migratory patterns. However, not all legacy markets are created equal. In fact, according to ApartmentList, Boston and New York have seen the 5^th and 6^th fastest rental growth over the past three years while San Francisco has seen the slowest. NY has proven more resilient than many expected, but San Francisco is clearly weak. Fortunately, most of EQR’s exposure here is suburban, which should mitigate the downside.

The challenge for all multifamily REITs has been that rental inflation has slowed. As you can see below, after surging dramatically after the pandemic, rent inflation is now running negative over the past year. EQR has outperformed this trend. In Q3, blended rates rose 3.1% with new leases up 0.5% and renewals up 5.5%. I would note this trend weakened in October to 1.6% as new leases declined 3.1%. Still, EQR is seeing rent growth vs the national reject.

Slowing nominal income growth and normalizing household formation patterns have played a role in this deceleration in rent. However, another major factor has been supply. Increased rental rates made new construction projects more attractive as developers sought to earn these rents. As such, multifamily construction has soared to record levels, though it has begun to tick down with new starts down meaningfully from their highs.

Now, as I noted above, the Sun Belt generally speaking has a more optimistic medium-term picture given the faster population growth. Developers have noticed this too, and much of this surge in construction has been in these high growth markets. There has been relatively little construction in the legacy markets EQR operates. This lack of supply has help to insulate EQR from supply pressures. As such, while rental growth has remained slow, it has stayed positive overall.

While growth has slowed, I would also highlight that occupancy finished the quarter at 95.9% and ticked up to 96% in October. These are high levels, speaking to the strong demand for its apartments. EQR has also enjoyed solid operating leverage as it has pushed up rents over the past two years. Last quarter, same-store revenue rose by 4.1% against 3.1% expense growth, increasing net operating income by 4.6%. Relatively modest expense growth has been aided by just a 2.5% boost in tax and insurance. Offsetting this, property management costs rose a more substantial 9.3%.

As we think about next year, there should be a tailwind from re-leasing to the 54% of tenants who renew. In aggregate, its leases are 0.8% below the market rate. This is substantially less than the 5.1% last year, which is why renewal lease rates have been strong this year. Still, this should preserve advance growth in 2024. Indeed, just based on where the company is exiting the year, if it does nothing else, growth should be 1.3-1.5% in 2024. This is consistent with slowing, but still positive growth.

Finally, EQR has a rock solid balance sheet. Even with higher rates, net interest expense fell 5% to $68.9 million last quarter as mortgage notes have fallen by $300 million this year. It has just 4.2x net debt to EBITDA. Its debt also carries an 8.3 year average maturity, and there are no material maturities until 2025, largely insulating cash flow from higher interest rates.

EQR offers a 4.5% yield, and it provided 6% dividend growth this year with a $2.50 payout. As we look out to next year, it is important to recollect that real disposable income is still rising, which should preserve rental growth. While the San Francisco market may remain weak, we are seeing stronger results in other key EQR markets, and supply in these markets should stay fairly muted.

I do expect growth to slow as there is less rent catch-up. One positive tailwind is that net bad debt expense is running at 1.27% from 0.5% pre-COVID, in part due to lengthy foreclosure processes. As these work through in 2025, EQR should be able to reduce bad debt expense and begin earning revenue on these units again. Even closing just half the gap could boost FFO by 0.4%. Given a 1.3% exit growth rate, 0.4% from bad debt expense, 1-2 unit growth, and assuming 1-2% rent growth, less than the 3% seen before the pandemic. EQR should grow FFO by 4-5%, given modest operating leverage.

Considering its strong balance sheet, I expect dividend growth to confront or slightly exceed FFO growth, or come in at 5-6%. With a starting 4.5% yield, that is an attractive combination consistent with a ~10% total return. Given the structural tightness in the housing market given the lack of construction last decade, I do expect rents to rise faster than inflation over time, enabling ongoing 5-7% dividend growth. At this price, income growth investors can buy a strong, safeguard company with double-digit medium-term return prospects. I continue to appreciate EQR. Absent a renewed rise in long-term rates, which would weigh on real estate stocks, I see upside in shares over the next year and would be a buyer up to $65.