Apartment construction is at its highest levels since the mid-1980s amid the well-publicized housing shortage There has been a divergence of late between single-family home construction and apartment construction. This is primarily due to affordability issues -- starter homes are relatively expensive to build, and mortgage rates are high. This is pushing some would-be home buyers into luxury apartments. You might think that would help apartment real estate investment trust (REIT) Equity Residential (EQR 0.40%), but that hasn't been the case.
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Equity Residential is a leader in luxury urban apartments
Equity Residential is one of the biggest developers and operators of luxury apartments in large urban coastal markets. It owns properties in Boston, New York, Southern California, San Francisco, Seattle, and Washington, D.C. It's also building a presence in Denver, Atlanta, Dallas, and Austin, Texas. The REIT targets markets with strong economic fundamentals and robust job growth. This ensures that its properties have strong bases of educated and highly paid potential tenants. Equity Residential also favors markets with tight apartment supply and very expensive single-family housing.
Equity Residential has benefited from rising home prices over the past several years. Nationally, home price appreciation stalled out in June 2022, according to the FHFA House Price Index. As a general rule, rent increases lag behind home price appreciation by about 21 months, according to a CME Group study published last summer.
Lots of new apartments are coming
That said, multifamily housing completions are elevated and are close to levels we haven't seen since the mid-1980s. The chart below shows completions for buildings with five apartment units or more.
Data source: YCharts. US Housing Completed: 5 Units or More
As the saying goes, "All real estate is local," so for Equity Residential, the most important question regards how many of these new units are competing with its properties. This is a function of both area -- Equity Residential's portfolio is coastal and urban -- and price. Management acknowledged on the earnings call that there is a high level of total new supply coming in the coastal markets that account for 95% of its net operating income.
The bottom line from the earnings conference call, though, is that San Francisco and Seattle are the REIT's weak spots. Although management does see "respectable" quarter-over-quarter growth, concessions are common, and its pricing power is muted.
The typical Equity Residential tenant is in good financial shape
On the earnings call, management also cited the tight labor market, and said it believes its average resident is in good financial shape. Rent-to-income ratios for new tenants are around 20%. Lease breaks for tenants who lost their jobs remain below pre-pandemic levels. For the typical Equity Residential tenant, the limited inventory of single-family houses at affordable prices is helping keep them in their apartments.
In 2023's first quarter, the new lease increase was 1.3%, while the renewal rate was 6.2%. The blended rate worked out to 3.9%, and it looks like April saw an uptick in new lease rates. Given that real estate prices nationally have been little changed for about nine months at this point, it is encouraging to see Equity Residential continue to report rent increases. Occupancy ticked up by 0.1 percentage point to 95.9%.
For the quarter, Equity Residential reported a 13% increase in normalized funds from operations (FFO) per share. REITs generally use the FFO metric to describe their earnings instead of net income. This is because depreciation and amortization are big expenses under generally accepted accounting principles (GAAP), but they are non-cash charges. Businesses don't write checks for them. As such, factoring them into the bottom line leaves the net income notably lower than the actual cash-flow-generating capacity of the REIT.
Equity Residential also increased its dividend by 6%. At current share prices, the company now has a dividend yield of about 4.2%.
Equity Residential's future will rest in part on the desirability of urban living. Given that work-from-home is now a common option for many professionals, highly compensated workers are less tethered to expensive urban areas. A tech worker, for example, might not be able to afford a starter home in San Jose, California, but remote work could allow them to find a home pretty much anywhere else. This issue and the growing supply of new apartment buildings will be headwinds for the REIT.
