The Surprising Upside on a Landlord REIT Trading at 40 Times Earnings

What has been a great investment over the past 15 years and will keep being great over the next 10 years? Housing.

Oh, wait . . . did you think I meant that overpriced, underwater albatross you’re calling your home sweet home? No, no. I meant commercial housing—in the form of real estate investment trusts that own a whole lot of apartments.

Among apartment REITs, the big daddy is Chicago-based Equity Residential (EQR). This is a company with a $29 billion enterprise value. It’s one of the largest realty enterprises the world has ever known. Its shares are trading at 40 times earnings.

And yes, I think there’s a case to be made that the shares look pretty appealing right now. As is typical for REITs, Equity Residential’s total return—that is, the return for shareholders who’ve reinvested its dividends—has blown away that of the S&P 500 in the last five years, as seen in a stock chart.

EQR Total Return Price Chart

EQR Total Return Price data by YCharts

…10 years…

EQR Total Return Price Chart

EQR Total Return Price data by YCharts

and 15 years.

EQR Total Return Price Chart

EQR Total Return Price data by YCharts

Naturally, it’s temping now to say that Equity Residential -- that all REITs for that matter -- absolutely must have peaked. One of my YCharts colleages recently reported that Morningstar, the venerable Chicago financial-data firm, considers REITs to be the “single-most overvalued sector right now.” That report made much of REITs’ high P/E ratios compared to other stocks.

I respectfully disagree with that analysis.

Equity Residential’s stock has beaten the pants off the S&P 500 thanks to a combination of its relentless efforts to grow profitably and treat its shareholders well along the way. I think the company has developed some pretty good habits over the years, ones that will serve its investors quite well in the coming decade.

Started from scratch back in the 1960s by Samuel Zell and a partner and taken public in 1994, the company now owns more than 400 apartment complexes in 14 states. These aren’t fancy, high rise-type apartments in glittery downtowns, mind you. They’re boring apartment complexes out in the burbs. You know what Sam Zell figured out? When it comes to collecting rent checks, boring is just fine. He’s a billionaire thanks to that insight.

Sometimes -- not always -- it’s a good time to buy some Equity Residential shares. Now is one of those times. Own this stock, hold it, collect dividends and wait for a pop in the stock price later.

The most important metric you must ignore -- and this holds true not just for Equity Residential but for all REITs that own properties -- is earnings per share. The problem with ordinary EPS when applied to real estate owners is that it massively understates their profitability. The problem is the enormous depreciation charges that generally accepted accounting principals oblige commercial property owners to count against their income.

GAAP rules assume that a $100 million commercial building will be reduced to an uninhabitable hulk in 39 years if its owner fails to spend $2.6 million a year on fix-ups. Obviously, that’s not true. Even a fastidious owner can spend a fraction of that amount on annual fix-up and keep the place looking dandy. And of course, in 39 years, even a marginally well-located commercial property is quite likely to sell for a hefty premium to its original price.

The most widely followed measure of REIT profitability is per-share “funds from operations,” or FFO. That figure ignores one-time gains or losses from property sales and adds back all depreciation. (If you’re a real stickler for depreciation, as many realty analysts are, you may be interested in a figure called “adjusted funds from operations, which adds back most but not all depreciation, to account for the annual fix-up budget.)

Equity Residential’s FFO last year was $2.41, and Sandler O’Neil analyst Andrew Schaffer projects the company will report $3.13 a share in FFO in 2012. So Equity Residential is trading at -- ta dah! -- 25 times trailing FFO and 20 times projected 2012 FFO.

Now, hang on. At a time when the S&P 500 is trading at 16 times trailing earnings, that sounds like an awfully pricey PE ratio, right? Well, that’s because you’re comparing it to the wrong thing.

REITs are an income play with a growth kicker. They should be analyzed primarily in terms of their ability to produce steadily rising income and, ultimately, rising dividends. So it’s not entirely invalid to compare them to growth enterprises like, Boeing, and the Coca-Cola Company. But you’re better off comparing them to utilities or, even better, corporate bonds.

Given the dependability and predictability of REIT earnings, it’s useful to focus on their projected FFO yield and how that stacks up against the income that mid-grade corporate bonds promise to pay you in the future.

Equity Residential’s projected FFO yield on Schaffer’s $3.13-a-share number is 5%. And that’s just a little a bit more than the yield being offered by Baa-rated corporate bonds. And that, my friends, is very important.

Moody's Seasoned Baa Corporate Bond Yield Chart

Moody's Seasoned Baa Corporate Bond Yield data by YCharts

It’s important because a generally good time to buy growth-type REITS is whenever their projected-FFO yields exceed that offered by Baa-rated corporate bonds.

Using my rule, for example, you were buying Equity Residential for the few years leading up to 2005. Then you laid off for four years -- by laying off, I mean holding, not selling, your shares. You started buying again for a few months in 2009. You’ve been holding the shares and reinvesting dividends since then. And you’ve done pretty well on your investment.

Moody's Seasoned Baa Corporate Bond Yield Chart

Moody's Seasoned Baa Corporate Bond Yield data by YCharts

So why else should you buy Equity Residential now? Why have others been buying in? Well, the company is profiting handsomely from Americans’ increasingly well-established distaste for home ownership. Schaffer expects a slip in Equity Residential’s FFO in 2013, to just under $3 a share. But overall, Equity Residential is in a very good position to benefit from the shift away from home ownership and towards rental. It should see steadily rising FFO over the next five to 10 years, which will translate to some long-overdue upticks in its dividend.

Schaffer is projecting the company will lift its dividends 12% this year and 9% next year. That should boost its dividend from its current $1.35 to about $1.60 a share. The stock’s yield, at 2.2% right now, is awfully stingy.

EQR Dividend Yield Chart

EQR Dividend Yield data by YCharts

But what that skinny little yield lacks in heft, it more than makes up for in safety. The $1.35 is amply covered by the $2.60 a share in cash flow that the company has available for distribution this year, according to most analysts. This is because Equity Residential’s cash flow is not overburdened by debt service. Equity Residential’s debts are less than 40% of its $29 billion enterprise value.

EQR Enterprise Value Chart

EQR Enterprise Value data by YCharts

There are REITs cheaper out there than Equity Residential. There are also some that look cheap but that I suspect are overpriced. I’ll share a name with you every week or two in the coming months.



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