Over the past few months, home price appreciation has stalled out and prices have begun to decline. Some of the hottest markets are experiencing the biggest drops. In a note to clients, Goldman Sachs reportedly recently said that some markets could see a 2008-style decrease of 25%.
Should this prediction cause concern for investors in residential property landlord Equity Residential (EQR 0.20%)?
Prediction: Prices could fall 25% in some of the more overheated markets
The Goldman Sachs note cited four markets in which prices could fall 25% from their peaks: Phoenix; San Diego; San Jose, California; and Austin, Texas. Goldman suggests that these four markets have become the most detached from fundamentals, i.e., prices increasing way faster than jobs and wages, during the COVID-19 rally.
According to the FHFA House Price Index, some of these markets have had incredible increases over the past two years, with Austin prices up 46% since the third quarter of 2020, Phoenix prices up 48%, San Diego up 33%, and San Jose up 18%. San Jose will undoubtedly be affected by tech layoffs, but its real estate has always been pricey.
Equity Residential owns property in some of these areas.
Equity Residential is a real estate investment trust that develops luxury apartments. Its main markets include Boston, New York, Washington, D.C., Los Angeles, San Diego, San Francisco, and Seattle, and it is expanding in Atlanta, Dallas, Denver, and Austin. The company focuses on markets that have strong demand for knowledge workers, high barriers to entry, and extremely expensive single-family detached housing. Its portfolio consists of 308 properties with 79,594 units.
Many of Equity Residential's tenants would conceivably be looking to move out of rental housing and into a house, but house affordability has decreased sharply over the past year due to rising home prices and mortgage rates.
Is the situation worrisome for Equity Residential?
While a decline in home prices could entice Equity Residential tenants to change from renting to buying, vacancy rates are low and competition for apartments is fierce. So things look solid for this landlord.
Also, a collapse in home prices likely would not mean Equity Residential would see the same thing happen to rents, at least not immediately. Rents tend to lag home prices by about 21 months. This is because rents usually reset once per year, and landlords generally don't raise rents for existing tenants by double-digit percentages; they tend to cap increases and then bump up the rent once the tenant moves. Equity Residential's rents have only begun to reflect the enormous home price appreciation in these hot markets.
And even if there were a rent collapse in the four markets that the Goldman Sachs note highlighted, it would not impact Equity Residential very much.
- San Diego represented about 4% of net operating income in the third quarter of 2022, so the impact of a real estate crash in this southern California city should be minimal.
- Austin is a developing market for Equity Residential, so the company is in the early stages of expanding there and does not pin any specific amount of net operating income to the market.
Another thing to watch
The price increases on new leases is declining: The company saw new lease changes (a measure of price change with a new tenant) decrease from 8.3% in September to 5.3% in October. Fall and winter months usually see slower growth. That said, it bears watching to see if this develops as a trend. There is a seasonality aspect to rent and home prices, and we are exiting the slow winter months. Given the lack of supply, rent declines seem unlikely, at last right now. The company is scheduled to report quarterly earnings on Feb. 9, so investors will have more information then.
On the plus side, occupancy remains strong. Equity Residential has forecast full-year 2022 funds from operations (FFO) -- an important metric for REITs that's similar to cash flow -- to come in between $3.52 and $3.54 per share. This means the company trades at 17.8 times projected 2022 FFO per share, which is reasonable, and with an attractive dividend yield of 4%. The stock is enticing and I'm not worried about how a housing crash would affect Equity Residential's earnings.