Buy EQR: where short term thinking leads to the “patient long”
In my career as equity analyst and Chief Credit Officer, getting the short term right was critical in both positions. For stocks, a great deal of money is invested on the basis of “making quarters”, or near term earnings estimates. There is logic to this: if the market is efficient, a change in earnings versus expectations should lead to a price response. However, the focus on the short term can lead to stocks that become mispriced relative to long term cashflows. As a result, “patient money” has the potential for outsized returns. I am excited to write about one such idea-the apartment REIT EQR-as a “patient long” idea in Seeking Alpha-a forum which includes investors that aren’t always judged in the short term. We are also excited to discuss the following:
- Income in an income desert. EQR’s earnings yield are at 10 year wides versus corporate bonds. We think now is a great moment to use bonds as a funding source for EQR for investors in multiple asset classes.
- An options strategy. We believe both short puts and a buy-write structure create a “paid to wait” means of investing difficult to do in the framework of many investors.
Apartments: why we believe problems are not long term
Apartment REITs have not participated in the strong broader performance of the stock market. EQR has fallen 31% year to date through the close October 7. There is a great deal of sense in this, as revenues have declined in the midst of COVID (more about this later in this writeup). However, we believe the issues are cyclical rather than secular for the following reasons:
- Long versus short term demand
We believe EQR’s share price EQR’s operating performance has been negatively impacted by an urban exodus due to COVID. Some have argued that this is a larger event related to Millennials aging into more of a single family home owner demographics (see JLL Chief Economist Shares His Millennial Exodus Redux, Mulitfamily Executive, by Ryan Severino, September 22 for more detail). Indeed, there is some truth to this, but we believe the outlook is more balanced. In Exhibit 1 below, we compare the U.S. population growth of 25-34 year olds (which we call the “prime renter” population) versus 35-49 year olds (which we will call the “kids at home” population most likely to own a home) from 1995 through 2025. We note the following:
· Growth in prime renter age is slowing….U.S. 25-34 year old population growth in the United States peaked in the middle of the last decade, and is expected to decelerate to negative growth midway through this decade.
· ….while growth in kids at home is at the highest level in decades, expecting to average over 1% through 2025.
Exhibit 1. Growth in renter age Americans is expected to slow…
Source: Bureau of Labor Statistics
Should we run for the hills? No. If the 25-34-year-old population was the key driver of rent growth, 1999 and 2000 (a 1.4% and 0.9% decline in 1999 and 2000 respectively) should have been terrible years for rent growth-they were not. In these years, EQR posted same store revenue growth of 3.5% and 4.6% respectively for its portfolio.
As such, the report of the death of apartments has been greatly exaggerated.
Rent inflation and GDP growth
If demographics do not drive rent growth, what does? The economy. The Census Bureau has terrific long term data on rent inflation (which is a component of CPI). Exhibit 2 below shows year over year urban rent inflation the last 30 years. Notably, Urban rent growth (the EQR portfolio is split 55% between urban and suburban) decelerated after the last three recessions, and appears to be following the same pattern now. As a result, we believe there is evidence that we are following a normal (although potentially severe) pattern of weaker cashflows during recessions. With the Federal Reserve forecasting GDP growth in 2021, the potential for apartment rent growth to recover is encouraging.
Exhibit 2….but the economy drives results more than demographics
Rent growth decelerated after the 90-91, 01-02, and 08-09 recessions
Source: Bureau of Labor Statistics
Where do the renters come from without an increase in people of renter age? Please note that in recessions, “doubling up” and living with parents can increase, while the opposite can occur as an economy recovers. Also, corporate housing can be an incremental driver of demand in strong economies (EQR on its 2Q earnings call noted that corporate housing loss has been a drag to performance).
The “Ivy League” argument why EQR’s markets will have steady demand over time
EQR’s markets are in the high cost coastal markets, with the largest exposure in San Francisco (19.8% of stabilized NOI), Los Angeles (19.1%) and Washington DC (15.8%) and New York (14.6%). According to Business Insider, for each of the eight Ivy League Schools, three out of the top four cities to live in were EQR markets. I believe there is too much critical mass for this constant annual migration of talented and well-educated to end.
- Short versus long term supply
We believe current conditions will lead to a supply response, which may already be starting. As seen in Exhibit 3 below, TTM housing permits show a dramatic change, where multifamily growth has collapsed and single family has accelerated. Please note this will take some time to impact new completions: the BLS estimates on average it is over two years between permit draw and completion. As a result, the actually number of units under construction according to the BLS is up x% on a year over year basis as of August. However, declining permits today in multifamily could lead to a supply response in 2023.
Exhibit 3. Multifamily permits have begun to sharply decline while rising for Single Family
Source: Bureau of Labor Statistics
Valuation: significant downside priced in
There are two ways to frame the value proposition for EQR:
- Versus bonds. One rule of thumb is to compare the EQR FFO yield-the inverse of the FFO multiple-versus the yield on corporate bonds. Exhibit _ shows this comparison over the past ten years. We make the following observations:
- The spread is big. The FFO yield spread to corporate bonds on the current share price is now over 600 basis points, roughly 500 basis points above the historical average.(see Exhibit 4)
- A large forward decline is priced in. Please note the calculation above uses the current share price on 2Q20 FFO per share (a common earnings metric used in REITs). When reviewing catalysts below, we will acknowledge EQR FFO per share is likely to decline before it increases. However, the bond comparison creates a prism to assess how much downside is priced in. To return to the historical average FFO to corporate bond yield spread, EQR’s FFO per share would need to fall 47%.
Exhibit 4. EQR’s FFO Yield versus Corporate Bonds is at 10-Year highs
Source: company documents, Federal Reserve
- Net Asset Value (NAV, or the estimated breakup value of the company prior to transaction costs). We estimate the implied cap rate (net operating income/real estate enterprise value) or EQR is 5.6% using 2Q NOI annualized. This is attractive relative to reported cap rates on recent asset sales. We note the following:
- In 2Q, EQR itself sold two apartment properties for $384 million at an average cap rate of 4.4%.
- Please note on its 2Q call, EQR did acknowledge the transaction described above was negotiated prior to the COVID downturn. However, AIMCO (AIV), another apartment REIT, announced in September that it had contributed $2.4 billion of California properties into a joint venture at an 4.2% cap rate based on first six months 2020 NOI.
Similar to the bond comparison, forward EQR NOI will be worse than 2Q, but the 100+ basis point spread in cap rate leave a lot of room for error.
We are often skeptical of NAV comparisons as companies are not always incentivized to sell. We are heartened, however, that Sam Zell, the Chairman, was also the Chairman of Equity Office, which was purchased by Blackstone in 2007.
Apartments: when they should perform
The argument above supports a “buy and hold” view on EQR with an admonition there could be some gut checks along the way. However, we offer the following potential guideposts:
- Tax loss sales. EQR has fallen 31% year to date through October 5 and is below prevailing trading prices since mid-2018. As such, it is a candidate to be sold into the end of the year as individuals look for losses for tax purposes. As a result, the stock could be weak for technical reasons. However, this period could create a great entry point for long term investors.
- “Less bad” same store. In 1Q10, EQR’s share price increased 16%, outperforming the S&P and REIT index by 1,021 and 746 basis points. However, in the quarter, same store declined 1.2%. Why was the market so happy? Because there was a slowing rate of decline. EQR’s same store revenues had a peak decline of 4.7% in 4Q09, but improved to only a 2.9% decline in 1Q10 (see Exhibit 5).
Exhibit 5. EQR’s share price rallied in 1Q10 even as revenue growth was negative-but decelerating
Source: EQR company documents
Please note apartments are showing no sign yet that revenues declines are getting “less bad”. A key forward indicator is leasing spreads (the change in rents on signed leases versus the prior year). Leases signed today give a sense of forward revenues.
Recent leasing spread data has not been constructive. We note the following:
- EQR leasing spreads through July were not good…. In its 2Q earnings release, EQR noted blended July leasing spreads were negative 4.5%, and an even worse negative 5.5% after accounting for the use of free rent. This is versus negative 2.7% and 3.5% in 2Q without and with concessions respectively. On its 2Q call,
- ….while peer reports have given no daylight either. AvalonBay reported effective (including the impact of concessions) leasing spreads of 4.8% versus 3.1% in July and August of 2Q20. Urban spreads particularly worsened to 8% from 4.3% over the two periods-worrisome for EQR as a readthrough given it has a significant urban footprint.
Again, this data supports a long over short term argument. We do think conditions today will create “easy comps” in the future (the burn off of concessions was a major support of EQR revenue growth in 2010).
Options and investing in deep value without catalyst
Given the upside catalyst for EQR is potentially years away, and there is risk the stock could trade down in the interim, option strategies (such as covered calls and short puts) can be ways to enhance returns for options with maturities dated ahead of catalyst dates. We offer the following examples using April 2021 dates, which could be prior to widespread vaccine use. Please note option prices used are for illustrative purposes only:
Covered Call (own the stock and sell a call against the position): For illustrative purposes, assume an April 2021 $60 call is priced at $3 when the stock is at $55. There are two potential outcomes:
- The stock closes below $60. The $3 option expires worthless, adding $3 to the investor position.
- The stock closes above $60. The investor is forced to sell the stock at $60. However, the return would be 16% for a 6 month investment.
Short Put (sell a put): For illustrative purposes, assume an April 2021 $50 put is priced at $3 when the stock is at $55. There are two potential outcomes:
- The stock closes above $50: the premium expires worthless ($3 gain).
- The stock closes below $50: the option is exercised and the put seller is required to buy the stock at $50. However, the basis is an attractive $47 for a stock the investor wants to own on a long term basis.
We particularly like short puts as a “paid to wait” strategy as it is a good way to be “forced to buy the dip”.
EQR is the classic example of a stock I believe is undervalued due to a significant amount of capital investing on a “beat the quarter” basis. However, this creates outstanding value for investors with a multiyear horizon. I believe in a three year horizon, it is likely the U.S. will return to an expansion, while supply is abating. In this backdrop, EQR’s revenue growth will accelerate against easy comps and investors will be rewarded. We are most emphatic about this relative value versus fixed income and note tax loss sale period could be an opportunity to have a particularly attractive entry point for the stock. Finally, we think buy-write and short put strategies work well in a “paid to wait” strategy.
Disclosure: I am/we are long EQR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.