This Undervalued Stock Is a Buy After Its Dividend Increase

Like most REIT stocks, Equity Residential EQR is undervalued: It’s trading 17% below our fair value estimate of $79. We expect this residential REIT to generate low but steady revenue growth over the long term. Equity Residential has averaged a dividend payout ratio of 70% of normalized funds from operations during the past several years. After its March dividend increase, this REIT offers dividend stock investors a forward yield of 4.1% plus stock appreciation potential.

Equity Residential has focused its portfolio on high-quality multifamily buildings in urban coastal markets with demographics that allow it to maintain high occupancy 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.

Key Morningstar Metrics for Equity Residential

• Fair Value Estimate: $79
• Star Rating: 4 Stars
• Economic Moat Rating: None
• Uncertainty Rating: Medium

Economic Moat Rating

We don’t think Equity Residential has an economic moat. Although it has a high-quality portfolio, the starting rents and annual rent increases the company achieves on its properties compared with its initial capital investment produce returns that are below our estimate of its long-term weighted average cost of capital. The portfolio should maintain its relative quality advantage as the company regularly makes capital improvements and redevelops to keep it competitive. However, there is intense competition for high-quality assets in strong markets with positive demand drivers, forcing Equity Residential to pay a high price for a portfolio with these features. Additionally, many of the company’s markets are experiencing high supply growth, and competition from alternative housing options keeps rent growth in the low to mid-single digits.

Read more about Equity Residential’s moat rating.

Fair Value Estimate for Equity Residential Stock

Our $79 fair value estimate implies a 5.1% cap rate on our forward four-quarter net operating income forecast, a 20 times multiple on our forward four-quarter funds from operations estimate, and a 3.5% dividend yield, based on a $2.65 annualized payout. Our rent, occupancy, and margin assumptions drive total company annual same-store NOI growth averaging 3.0% across our 10-year forecast. We project $200 million in dispositions per year with a similar amount of acquisitions each year as the company looks to recycle lower-quality assets to fund the purchase of higher-quality assets. We estimate Equity Residential’s net asset value to be approximately $85 per share. We use NAV as an assessment of the firm’s potential private-market value, essentially viewing the firm as a portfolio of assets.

Read more about Equity Residential’s fair value estimate.

Risk and Uncertainty

Millennials have been driving much of the demand for multifamily assets in urban coastal markets. But as this generation acquires enough capital to own single-family homes, or if tastes change significantly, trends could reverse and hurt demand for apartments. The company’s portfolio is sensitive to any changes to the economies of its core markets. If job growth slows or industries experience significant layoffs, then demand for apartments falls. Many of Equity Residential’s markets are seeing significant new supply, which will pressure operations and asset values.

Read more about Equity Residential’s risk and uncertainty.

Equity Residential Bulls Say

• Equity Residential’s portfolio of high-quality assets should see relatively consistent levels of demand long term from high-income earners.
• Equity Residential has a history of finding accretive development opportunities to bolster its growth prospects.
• While current supply deliveries are near peak levels, rising construction costs and tighter lending standards should lead to lower supply growth.

Equity Residential Bears Say

• The pandemic made many millennials consider alternatives to urban apartments, including suburban apartments and single-family homeownership. This demographic has put off many major adult milestones but may finally be making the shift toward the suburbs.
• The company’s development pipeline is shrinking, and increased construction costs and tighter lending standards will make it more difficult to fill.
• With several alternatives to multifamily housing and short lease terms, demand for apartments can be more variable than for many other commercial property types.

This article was compiled by Susan Dziubinski and Sylvia Hauser.