Company Reports

The REIT sector in the US offers many companies that should see relatively stable cashflow growth over the next several years. While the pandemic hurt REIT valuations in 2020, the recovery of fundamentals across most sectors combined with low interest rates led to strong total returns in 2021 and early 2022. However, despite fundamentals continuing to perform well over the past three years with many reaching historical levels of net operating income growth, the REIT sector underperformed the broader equity markets in 2023 and into the first half of 2024. We believe that is due to the sector’s negative correlation with interest rates, as income-oriented investors rotate out of the sector, higher rates lower the value REITs can create with external growth, and property valuations fall in line with higher rates. However, interest rates have fallen since the end of July, leading to a rally for the REIT sector. Still, we still view many of companies in the US REIT sector as being undervalued as the companies should continue to produce solid long-term growth.

Despite a rally over the past two months, we still view the US REIT sector as being undervalued. While the pandemic hurt REIT valuations in 2020, the recovery of fundamentals across most sectors led combined with low interest rates led to strong total returns in 2021 and early 2022. However, despite fundamentals continuing to perform well over the past three years, with many reaching historical levels of net operating income growth, the REIT sector has underperformed the broader equity markets in 2023 and into the first half of 2024. We believe that the cause has been due to the sector's negative correlation with interest rates as income-oriented investors rotate out of the sector, higher rates lower the value REITs can create with external growth, and property valuations fall in line with higher rates. However, interest rates have fallen since the end of July, leading to a rally for the REIT sector. We believe that US REITs will continue to see share price movements that are inverse of interest rate movements.

Equity Residential has repositioned its portfolio over the past decade to focus on owning and operating high-quality multifamily buildings in urban, coastal markets with demographics that allow the company to maintain high occupancies and drive strong rent growth. The company has sold out of inland and southern markets and increased its operations in high-growth core markets: Los Angeles, San Diego, San Francisco, Washington, D.C., New York, Boston, and Seattle. These markets exhibit traits that create demand for apartments, like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger people. The company regularly recycles capital by selling noncore assets or exiting markets and using the proceeds for its development pipeline or acquisitions, a strategy that has produced strong returns.

Second-quarter results for Equity Residential were relatively in line with our expectations, leading us to reaffirm our $79 fair value estimate for the no-moat company. Same-store occupancy improved 10 basis points sequentially to 96.4%, higher than our 95.9% estimate. Average rental rates for the same-store portfolio were up 2.5% year over year in the second quarter, in line with our 2.6% estimate, leading to same-store revenue growth of 2.9% that matched our estimate for the quarter. Meanwhile, same-store operating expenses were up 2.7%, which was below our estimate of 4.0% expense growth. As a result, Equity Residential reported same-store net operating income, or NOI, growth of 3.0% that was slightly better than our 2.5% growth estimate. However, general and administrative costs were about $6 million higher than we anticipated. Therefore, Equity Residential reported normalized funds from operations, or FFO, of $0.97 per share in the second quarter that came in a penny below our $0.98 estimate.

The US REIT sector remains significantly undervalued, in our perspective. While the pandemic hurt REIT valuations in 2020, the recovery of fundamentals across most sectors combined with low interest rates led to strong total returns in 2021 and early 2022. However, despite fundamentals continuing to perform well over the past two years, with many REITs reaching historical levels of net operating income growth, the sector has underperformed the broader equity markets over the past two years. We believe that the cause has been the sector’s negative correlation with interest rates as income-oriented investors rotate out of the sector, higher rates lower the value REITs can create with external growth, and property valuations fall in line with higher rates. However, we don’t believe that higher rates significantly change our fair value estimates for the sector. Additionally, interest rates are down from the October 2023 highs, and REIT share prices have generally inversely followed the movements of the US 10-year Treasury.

Equity Residential reported first-quarter results that were slightly ahead of our estimates, giving us confidence in our $79 fair value estimate. Occupancy in the same-store portfolio was up 0.5% sequentially to 96.3% in the first quarter. Combined with average rental rates increasing 3.4% year over year, same-store revenue was up 3.9% in the quarter, relatively in line with our estimate of 4.1% growth. However, operating expenses were only up 1.2% as payroll costs only increased 0.7% and utility costs fell 5.0%. As a result, same-store net operating income grew 5.2% in the first quarter, slightly better than our estimate of 4.2% same-store NOI growth. Equity Residential reported normalized funds from operations of $0.93 per share, a penny better than our $0.92 estimate and six cents better than the $0.87 figure reported in the first quarter of 2023.

We believe that there are several attractive opportunities across the US REIT sector for investors to consider. Following the recovery of many REIT sector fundamentals from the pandemic by mid-2021, we viewed the REIT sector as fairly valued through early 2022. However, the past two years have seen the rapid rise in interest rates and a slowing economy, which has led to major valuation declines across the sector. Our analysis of the REIT sector over the past 25 years suggests that the relative stock performance of REITs is negatively correlated with interest rate movements. The second and third quarters of 2023 saw large interest rate increases with the 10-year Treasury approaching 5%, which led to the sector underperforming. This occurred even as many REITs reported same-store net operating income, or NOI, growth at historical highs in 2022 due to high inflation. Higher interest rates, lower liquidity, tighter capital market conditions, and decelerating same-store NOI growth all led to a significant correction in the stock price for many REITs.

New single-family home sales increased 4% in 2023 to 666,000 units, as homebuilders capitalized on a dearth of existing for-sale inventory while also offering more sales incentives, cutting base home prices, and building smaller homes to improve affordability. By the fourth quarter of 2023, homebuilders began to pull back on sales incentives as the average 30-year fixed mortgage rate retreated from 7.62% in October 2023 to 6.64% in January 2024. However, mortgage rates have trended higher recently, and we now forecast the average 30-year fixed rate will be 6.50% in 2024, up from our previous forecast of 6.10%. Even so, that’s lower than the 2023 average of 6.81%, and we think homebuilders won’t hesitate to increase sales incentives if needed; they still enjoyed above-average gross profit margins last year with elevated incentives. As such, in 2024, we think new-home sales will increase 9% to 730,000 units and single-family housing starts will increase 4% to 985,000 units. However, we expect total housing starts will decline roughly 5% to 1,345,000 units due to a 23% decline in multifamily starts to 360,000 units, as there’s currently approximately 1,000,000 multifamily units under construction—the largest backlog in at least 50 years.

Equity Residential has repositioned its portfolio over the past decade to focus on owning and operating high-quality multifamily buildings in urban, coastal markets with demographics that allow the company to maintain high occupancies and drive strong rent growth. The company has sold out of inland and southern markets and increased its operations in high-growth core markets: Los Angeles, San Diego, San Francisco, Washington, D.C., New York, Boston, and Seattle. These markets exhibit traits that create demand for apartments, like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger people. The company regularly recycles capital by selling noncore assets or exiting markets and using the proceeds for its development pipeline or acquisitions, a strategy that has produced strong returns.

Fourth-quarter results for Equity Residential were in line with our expectations, leading us to reaffirm our $87 fair value estimate for the no-moat company. Occupancy in the same-store portfolio fell 20 basis points sequentially to 95.8% in the fourth quarter. Average rental rates increased 4.0% year over year, relatively in line with our estimate of 4.5% growth, and thus drove the same-store revenue growth of 4.0% for the fourth quarter. Expense growth was significantly lower at just 1.1%, so same-store net operating income grew 5.4%, which was better than our estimate of 3.7% same-store NOI growth. The company reported normalized funds from operations of $1.00 per share, relatively in line with our $0.99 estimate and ahead of the $0.94 figure the company reported in the fourth quarter of 2022.

New-home sales have rebounded since the spring of this year as sales incentives and price reductions have attracted buyers who have fewer options in the supply-constrained existing-home market. That said, homebuilder sentiment data tells us that smaller builders remain cautious. Even so, we forecast single-family starts to increase by 3% in 2024, to 0.92 million units. However, we project this increase in single-family starts will be more than offset by a 24% decline in multifamily starts, to 0.36 million units. Multifamily construction has been robust for the past three years, but a record construction backlog and higher construction and financing costs have tamed developers' appetite for new multifamily projects.

No-moat Equity Residential reported third-quarter results that were mixed compared with our estimates, though we didn’t see anything that would materially change our $87 fair value estimate. Same-store occupancy improved 10 basis points sequentially to 96.0%, which is slightly better than our 95.9% estimate for the quarter but is 40 basis points below the 96.4% figure the company reported in the third quarter of 2022. Average rental rates improved 5.0% year over year, better than our 3.8% estimate. However, while the blended re-leasing spread was positive with rents 1.6% higher than prior rent terms, rents to new tenants declined 3.2% compared with the prior rent. Additionally, higher leasing concessions in the quarter reduced revenue growth by 40 basis points, leading to same-store revenue growth of only 4.1%. Same-store operating expenses were up only 3.1%, leading to same-store net operating income growth of 4.6% that was relatively in line with our estimate of 4.8% growth. Equity Residential reported normalized funds from operations of $0.96 per share in the third quarter, a penny better than our $0.95 estimate and 4.9% higher than the third quarter of 2022.

Equity Residential has repositioned its portfolio over the past decade to focus on owning and operating high-quality multifamily buildings in urban, coastal markets with demographics that allow the company to maintain high occupancies and drive strong rent growth. The company has sold out of inland and southern markets and increased its operations in high-growth core markets: Los Angeles, San Diego, San Francisco, Washington, D.C., New York, Boston, and Seattle. These markets exhibit traits that create demand for apartments, like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger people. The company regularly recycles capital by selling noncore assets or exiting markets and using the proceeds for its development pipeline or acquisitions, a strategy that has produced strong returns.

The share prices of U.S. real estate investment trusts have fallen by approximately 30% from their 2021 highs because of higher interest rates and stress in some commercial real estate sectors. We think that the correction is overdone and the current valuations offer an attractive entry point for patient investors. Our core REIT coverage is trading at a discount of approximately 25% to our fair value estimate. We estimate that the average REIT within our U.S. coverage is currently trading at a dividend yield that is 126 basis points higher than the historical average. We see marked differences in valuation across different REIT sectors in the United States. For instance, the industrial sector is fairly valued, with stock valuations already accounting for future growth, but other sectors like offices, hotels, and malls are trading at attractive discounts.

New-home sales have remained resilient despite worsening housing affordability in recent months amid rising mortgage rates, with little relief in home prices in most markets. Year-to-date new-home sales through July were about even with the year-ago period, compared with a 22% decline in existing-home sales. The key to homebuilders’ relative success this year has been their ability to improve affordability by offering sales incentives, lowering base prices, and building smaller homes. According to the National Association of Home Builders, the share of builders offering incentives was 55% in August, up from 52% in July but down from 62% last year. One fourth of homebuilders reported lowering base prices by 6% on average. Homebuilders have also boosted production of speculative homes to capitalize on the tight supply of existing for-sale homes. Spec building also helps builders better manage construction cycle times and costs.

Second-quarter results for Equity Residential were relatively in line with our expectations, leading us to reaffirm our $88 fair value estimate for the no-moat company. Same-store occupancy remained flat sequentially at 95.9%, which is slightly below our 96.2% estimate for the quarter and 80 basis points below the 96.7% figure reported in the second quarter of 2022. Average rental rates increased 6.4%, slightly better than our estimate of 5.4% growth, leading to same-store revenue growth of 5.5% in the second quarter. Meanwhile, same-store operating expenses grew 5.6% in the quarter, which led to same-store net operating income growth of 5.3%. As a result, Equity Residential reported normalized funds from operations growth of 5.7% to $0.94 per share, which matched our estimate for the second quarter.

Through the first four months of 2023 (typically viewed as the “spring selling season” for homebuilders) new home sales significantly outperformed existing home sales. Indeed, April year-to-date new home sales declined roughly 10% year over year compared to over a 26% decline for existing home sales. New home sales improved sequentially during the first four months of the year, and April sales increased 11% year over year, albeit on an easy prior-year comparison (April 2022 new sales were down 24% year over year).

No-moat Equity Residential reported first-quarter results that were relatively in line with our expectations, leading us to reaffirm our $88 fair value estimate. Same-store occupancy fell 50 basis points year over year but was up 10 basis points sequentially to 95.9%, in line with our estimate. Average rental rates were up 9.8% year over year, in line with our 9.3% estimate. As a result, same-store revenue growth matched our estimate of 9.2% growth. However, the first quarter saw operating expenses increase 7.2% year over year, the largest single-quarter increase in at least the past 15 years for the company. While real estate taxes and payroll expenses remain low, only growing 2.6% and 2.8%, respectively, in the quarter, utility costs increased 12.7%, insurance increased 14.3%, and maintenance costs increased 16.9%. As a result, same-store net operating income increased 10.2%, which matched our estimate for the quarter. Equity Residential reported normalized funds from operations of $0.87 per share, which was two cents lower than our estimate because corporate expenses for the year were more concentrated in the first quarter than we anticipated.

Equity Residential has repositioned its portfolio over the past decade to focus on owning and operating high-quality multifamily buildings in urban, coastal markets with demographics that allow the company to maintain high occupancies and drive strong rent growth. The company has sold out of inland and southern markets and increased its operations in high-growth core markets: Los Angeles, San Diego, San Francisco, Washington, D.C., New York, Boston, and Seattle. These markets exhibit traits that create demand for apartments, like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger people. The company regularly recycles capital by selling noncore assets or exiting markets and using the proceeds for its development pipeline or acquisitions with strong growth prospects, a strategy that has produced strong returns.

U.S. home sales slowed significantly in 2022 as rising mortgage rates and elevated home prices made homeownership less affordable for more Americans. By mid-2022, the average 30-year fixed mortgage rate had increased roughly 300 basis points year over year to over 6%. According to estimates from the National Association of Home Builders, this rate increase priced out more than 16 million households. We also think higher rates and general economic uncertainty caused some qualified prospective buyers to move to the sidelines. All told, 2022 new- and existing-home sales declined 17% and 18% year over year, respectively.