After a couple of years of scorching growth, the fire is finally starting to burn out for the housing market. The Federal Housing Finance Agency (FHFA) House Price Index reported a decline in prices during July, and apartment rents fell marginally in August according to an analysis by Apartments.com.
This decline in housing and rental prices is somewhat normal and relates to seasonality as prices generally peak during the spring shopping season and early summer. But some of it could be tied to a tightening economy and actions by the Federal Reserve. The Fed would like to see home price appreciation cool, which will help affordability. So where does this leave apartment real estate investment trusts (REITs) like Equity Residential (EQR 0.42%)?
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Equity Residential focuses on luxury apartment buildings for affluent tenants
Equity Residential is an apartment REIT that focuses on luxury properties in affluent urban areas. Its properties are concentrated in places like San Diego, the San Francisco Bay Area, Seattle, New York City, Boston, and Washington, D.C. These areas are characterized by exceptionally high prices for single-family properties, a focus on knowledge-based industries, strong job growth, and constrained housing supply. These areas are particularly difficult for a first-time homebuyer to purchase a single-family property in, which helps push these potential buyers back into renting.
The fundamentals of the apartment rental market are strong
The fundamentals of the rental market remain particularly strong, with the Census Bureau reporting that the national rental vacancy rate was 5.6% in the second quarter of 2022. This is the lowest rate for this category since the mid-1980s. While home prices have begun to decrease, rental inflation tends to lag home price inflation by about 21 months on average. Rental contracts generally reset once a year based on current market rates, which explains the lag. This means that rents will probably continue to increase even if house price inflation stalls out.
Rents are still rising at a healthy clip
Equity Residential is coming from a period of depressed rental inflation, which was due to the COVID-19 pandemic. During the pandemic, Equity Residential was forced to "buy occupancy," which means it found it made sense to offer tenants concessions like a month of free rent or upgrades in order to keep tenants in their apartments. These deals were made during 2020 and have largely rolled off and now rents are resetting back up to market levels. On the second-quarter earnings conference call, CEO Mark Parrell said that the average income for its residents increased 13% compared to a year ago, which means the residents can easily bear rising rental prices.
In the first half of the year, pricing increases worked out to be 10%, which is well above the 6% annual growth that would characterize a good year. So, even if apartment rents are declining marginally overall on average, all real estate is local, and it would appear not to apply to Equity Residential's portfolio, at least so far. The company gave an operating update at the end of August, and it said that rents had peaked for the year, which it attributed to normal seasonality. Rental growth was 11.8% for the month.
During the second quarter, Equity Residential updated its guidance for the year, increasing expected funds from operations (FFO) per share to a range of $3.45 to $3.55. At current prices, it is trading at just under 19 times guided FFO per share, which is historically cheap. The $2.50 per share annual dividend is easily covered by FFO per share, so there is no risk of a dividend decrease.
Overall, the market has remained strong for Equity Residential, and even if home prices decline, rents should continue to increase due to the normal lag. The marginal drop that Apartments.com reported may simply be normal seasonality and not an indication of declining rents going forward.
Equity Residential's stock has been beaten up a bit this year and has a dividend yield of 3.7%. Aside from the beginning of the pandemic, this yield is at the high point of its historical range. That suggests investors might want to take a closer look at this stock.
