Times are tough for young Americans in the housing market. The COVID-19 pandemic pushed the Federal Reserve to cut interest rates to 0%, which touched off a bull market in houses. Real estate prices rose at a high-teens clip for a couple of years, which negatively affected affordability. At the same time, mortgage rates have increased dramatically as the Federal Reserve has raised rates. Finally, the student loan payment pause enacted during the pandemic is sunsetting in August. What does all of this mean for apartment real estate investment trust (REIT) Equity Residential(NYSE: EQR)?
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Equity Residential focuses on upscale urban tenants
Equity Residential is a REIT that focuses on apartments targeted toward upscale urban professionals. Equity Residential has its apartments in places like Boston, New York City, the San Francisco Bay Area, Seattle, San Diego, and Washington D.C. These apartments are largely targeted toward luxury renters, which are primarily younger, well-paid professionals in knowledge industries. This type of tenant is also more likely to have student debts.
The typical tenant for Equity Residential lives in a metropolitan area where there are barriers to construction and a scarcity of affordable single-family houses for a young person to purchase. Starter homes have seen a decrease in affordability over the past year since mortgage rates have increased so dramatically. This has probably helped Equity Residential keep tenants in their units.
The economic backdrop is still favorable for Equity Residential
The good thing for Equity Residential is that the labor market remains extremely tight, though we are seeing layoffs in the tech sector, which impacts pricing in some of Equity Residential's markets. The company is seeing strength in the East Coast markets, while there is weakness in markets like San Francisco and Seattle.
One major headwind for Equity Residential is coming late this summer. As part of the debt ceiling deal, student loan payments will resume after being halted for the COVID-19 pandemic. The average student loan payment is above $500 a month. Since the typical Equity Residential tenant is working in industries where compensation is high, they are likely to have outsized student loan debt. This could impact Equity Residential more than other apartment REITs.
As of March 31, 2023, the average rental rate for Equity Residential was just under $3,000, so an additional $500 a month will likely have a profound impact on tenant budgets. Equity Residential reported that their tenants are not rent-burdened, with an average of 20% of their income going to rent. That said, adding on student loan payments will increase the burden, and Equity Residential could see an increase in delinquencies.
The expected deluge of apartment supply won't compete with Equity Residential
While there is a housing shortage in the U.S., at least according to some estimates, the number of apartments under construction is at record levels. The chart below shows the number of five-unit apartments under construction.
U.S. Housing Under Construction: 5 Units or More data by YCharts.
These apartments under construction will eventually hit the market, and that has the potential to impact pricing power. That said, not all apartments are created equal; Equity Residential has apartments in specific markets and targets a certain type of tenant. If these apartments under construction are more affordable units in markets where Equity Residential doesn't participate, the impact might be negligible. In fact, Equity Residential said in a recent investor presentation that it isn't seeing much additional supply in its markets. Much of this supply is in the Sunbelt markets, so while the number of apartments under construction may appear alarming, all real estate is local.
Equity Residential is guiding for 2023 funds from operations (FFO) to come in between $3.69 and $3.79 per share. At current levels, Equity Residential is trading at 17.6 times 2023 FFO per share, which is a reasonable multiple for a high-quality REIT. The stock also has a 4% dividend yield, and the annual $2.65 dividend is well covered by the FFO-per-share guidance. While the student loan payment resumption will be a negative for the stock, it shouldn't amount to a major hiccup.
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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.
