Investing in Residential REITs? Start With This One

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Last year was extremely difficult for real estate investment trusts (REITs) that focused on apartments. The COVID-19 pandemic caused many tenants to lose their jobs, while eviction moratoriums prevented landlords from removing non-paying tenants. Vacancy rates rose as renters left for the suburbs and many apartment REITs turned to price concessions in order to maintain occupancy numbers.

Equity Residential (NYSE:EQR) was in that position. But it’s looking like things are improving for the whole sector, and Equity Residential’s stock has been a strong performer this year as part of the reopening trade. Investors are betting that people will rediscover the allure of the cities, and rents will appreciate. 

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Earnings this year are being affected by concessions last year

Equity Residential focuses on densely populated areas that are home to top employers in the knowledge industries. Renters here are highly paid, they tend to demand the best amenities, and they’re generally lower risk. All this plays to Equity Residential’s strengths; its properties are Class A, which is a term used to describe the newest buildings with the most amenities. And the areas it serves — the list includes Boston, Southern California, New York City, San Francisco, Seattle, and Denver — are generally characterized by extremely high single-family property prices, which means that renting is often more attractive.

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During the early days of the pandemic, many urban residents decided to flee to the suburbs, and this affected apartment performance. Equity Residential gave out a lot of concessions (typically free rent or amenities) in order to keep renters in their apartments. But on the first-quarter earnings conference call, the company disclosed that it has recovered about 60% of the pricing reductions it suffered during the pandemic. Equity Residential anticipates recouping all of these reductions by the end of the quarter ending June 30, except for a few markets. 

Since Equity Residential gave out so many concessions last year, earnings will lag the underlying recovery in business. The company is guiding for revenue in 2021 to fall by 6% to 8%, while net operating income will decrease between 11% and 13%. 

Pricing is firming, while it looks like wages are going up

Spring is the primary leasing season, and Equity Residential is seeing pricing firm up. Occupancy also increased to 96%, up from 94.4% at the end of 2020. Equity Residential is looking to increase its presence in Denver and other new metro areas that are increasing the number of knowledge jobs, such as Austin, Texas. We are seeing companies leave markets like New York City and San Francisco, two markets that are lagging. Properties in these cities have yet to recover lost rents and occupancy.

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The tight job market is also likely to lead to higher wages, which will support rent pricing. The Department of Labor just announced that the quits rate hit 2.7%, which is a record for the index. The quits rate, which is the number of people voluntarily leaving jobs, is a leading indicator of wage growth. As a general rule, an increase in the number of people quitting their jobs implies they are leaving to take a better job.

Equity Residential has been a stellar performer this year, rising 33% as of Tuesday’s closing price. It raised guidance at the end of the first quarter, and investors seem to think that will continue. The stock pays a quarterly dividend of $0.60, which gives it a yield of 3%. The company has guided that normalized funds from operations (FFO) will come in at $2.75 this year, which gives the company a multiple of 29 times FFO. This is somewhat high for a residential REIT, but earnings this year should be considered a special case due to COVID-19-related issues. While the company refrained from giving color on 2022 and beyond, earnings should return to normal. Despite the drop in FFO, the dividend is still fully covered, with a payout ratio of 88%.

Investors looking at residential REITs should find Equity Residential attractive, provided they can look past the blip in earnings this year.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.



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