The U.S. has a severe housing shortage. According to some estimates, there is an "underbuilding gap" of anywhere between 5.5 million and 6.8 million units in the country. The current shortages of labor and materials are increasing the costs of new homes, and the rapid rise in mortgage rates since the beginning of the year has had negative effects on affordability.
Many would-be buyers are finding themselves looking at renting as prices and borrowing costs soar. This is good news for apartment real estate investment trusts (REITs), especially Equity Residential (EQR -1.67%), which specializes in luxury apartments in urban areas.
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Renting to affluent young knowledge workers
Equity Residential builds and leases high-end apartments in urban locations like Boston, New York City, Washington, D.C., Southern California, San Francisco, and Seattle. It is expanding its presence in Denver, Austin, and Fort Worth, Texas. The company focuses on areas where single-family houses are expensive and there is strong employment growth, especially in highly compensated knowledge jobs. These areas generally exhibit strong apartment demand along with limited supply.
In the first quarter of 2022, Equity Residential reported a 13.2% increase in funds from operations (FFO) per share. REITs generally use FFO to describe earnings as opposed to earnings per share. This is because REITs have a lot of depreciation, which is an expense for generally accepted accounting principles (GAAP), but is not really an economic outflow. This charge isn't a cash expense, so it tends to understate the earnings and cash flows of the company. On the earnings conference call, CEO Mark Parrell said the company expected the increase in FFO per share to accelerate over the next few quarters.
The days of handing out concessions are over
During the days of the pandemic, many apartment REITs were forced to "buy occupancy," which means they were giving rent concessions in order to keep tenants in their apartments. Those days seem to be over, as occupancy is at 96.4% and turnover was the lowest in the history of the company. Tenants signed renewals at record levels with an average 11.9% increase in rent. These increases are accelerating into the second quarter as renewal increases rose 12.5%. Equity Residential is generally avoiding rate negotiations given the strong demand.
During the quarter, Equity Residential's expenses rose much slower than revenue. Apartment REITs tend to use a sizable amount of debt, and much of that was taken out during periods of low interest rates. Its average interest rate is 3.65%, and revenue is accelerating as rents are rising by double digits. This demonstrates its operating leverage and how the current inflationary environment is a positive for the company. Equity Residential was negatively affected by some bad debt expense as some renters chose not to make rental payments in order to get government housing assistance.
Equity Residential has a dividend yield of 3.4%, and has guided for 2022 normalized FFO per share to come in between $3.40 and $3.50 per share. This means Equity Residential is trading at a FFO multiple of 21 times. This is about right for a REIT, and the stock has underperformed the market this year, falling about 20% year to date. As a REIT, the company is never going to be a high-flyer, however its yield does make it worth a look for income investors, and the fundamental story of profiting from a real estate shortage should last for the next several years, at least.
