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Worried About a Recession? This Real Estate Company Is Not.

The economic theme of this year has been inflation and the Fed’s actions to bring it back under control. Along with rising inflation, we have seen rapid home-price appreciation, with prices rising 18%, according to the government’s FHFA House Price Index. This is good news for some apartment real estate investment trusts (REITs), especially Equity Residential (NYSE: EQR), which specializes in luxury urban apartments. 

Image source: Getty Images.

Equity Residential rents to the affluent

Equity Residential specializes in luxury rentals for young, affluent tenants in select urban areas. These cities are characterized by a high percentage of highly-compensated knowledge workers, strong job growth, and a shortage of single-family houses for sale.

The company has a presence in Southern California; San Francisco; Seattle; Austin, Texas; Denver, and the Northeast. All of these markets have experienced rapid home-price appreciation over the past decade. 

Funds from operations are rising smartly

Equity Residential recently reported its second-quarter earnings. Normalized funds from operations (FFO) rose 19% over the past year. Normalized FFO per share rose 24%.

FFO is the typical metric that REITs use to characterize their earnings. Generally accepted accounting principles (GAAP) require firms to deduct depreciation and amortization, which is a noncash charge. Real estate companies tend to have a lot of depreciation and amortization, which makes their GAAP earnings per share understate the cash the company is actually generating.

Its typical tenant has a lot of income and is less rent-stressed than most

On the earnings conference call, CEO Mark Parnell discussed the state of the economy. While inflation is a risk, especially if it begins to hamper job growth, so far the labor market remains quite strong.

Parnell mentioned that the income for the REIT’s typical tenant was 13% higher in June of 2022 than it was a year ago. These tenants are paying 19.8% of their income in rent, which is well below the threshold that has typically been considered comfortable. 

Equity Residential raised full-year guidance

In the most recent quarter, the REIT boosted its guidance for normalized FFO per share from a range of $3.40 to $3.50 to a range of $3.48 to $3.58. If you look at “same store” revenue (basically a way that companies measure apples-to-apples growth), the company sees it increasing between 10% and 11% this year. This is a function of strong occupancy, record resident retention, and pricing power. 

At the midpoint of the company’s guidance, Equity Residential is trading at 22 times normalized FFO per share, which is a reasonable multiple for a residential REIT. It pays a $0.625 quarterly dividend, which works out to a yield of 3.1%. This is somewhat on the low side for a REIT, but the company is expanding into newer markets, so it is reinvesting cash into the business.

The annual dividend of $2.50 is easily covered by the midpoint of the company’s $3.53 normalized FFO per share. Even if we hit a recession, the dividend is largely safe. Overall, the company is not worried about a recession given that rising home prices give it the leeway to raise rents, and its tenants are less likely to suffer financial distress if we do hit a recession. 

Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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