If you want to invest more like a billionaire real estate mogul — and come on, who doesn’t — few are better to emulate than Sam Zell. Through his private investment firm, Equity Group Investments, Zell has amassed an estimated $5.1 billion fortune, building some of the largest real estate companies in the U.S.
Even better, Zell has refined his simple yet contrarian investing philosophy into what he calls “Zell fundamentals.” Today I’ll to dig into one of Zell’s real estate investment trusts, Equity Residential, using four of his investing criteria to show why it’s a fantastic business, but not a buy today.
4. “It all comes down to Econ. 101 — supply and demand.”
The $29 billion Equity Residential’s nearly 400 apartment complexes are focused in metropolitan areas like New York City and San Francisco — places that have more jobs and higher concentrations of people, which creates stronger demand for housing. Apartments are also the more affordable option in major cities. The median home price in Equity Residential’s core markets is $519,000. That compares to a national average of $220,000.
On the supply side, government regulation and dense populations reduce available space and increase the cost to build in these areas, which limits new apartment construction. These factors, along with strong demand, have helped Equity Residential keep its occupancy rates above 94% since 2007, and nearly double average rental rates over the same period.
3. “Understand the downside.”
It is easy to get wrapped up in the positives, but it is essential to look at all sides of the story. One risk for Equity Residential is high turnover.
Equity Residential’s leases average one year or less. This is a significant reason why tenant turnover has averaged 59% since 2007. This is in line with its peers, but it means the company is replacing its entire tenant pool — and then some — every two years. If the company is unable to replace tenants, its occupancy and earnings will fall.
Most important, turnover tends to increase during recessions. This can create cyclical returns as the company may be forced to reduce rents in order to maintain occupancy. Over time, Equity Residential has proven its ability to increase rents and keep occupancy high, but that may not be the case forever.
2. “The definition of a partner is someone who shares your level of risk.”
As a passive investor, all you can do is understand the upside and potential pitfalls. That is why you need insiders looking out for your interests — which is more likely if they have skin in the game.
Currently chairman of the board for Equity Residential, Zell directly owns 0.5% of the company, and has indirect ownership of another 2% (in shares owned by his spouse or in trusts, for instance). Focusing exclusively on direct interest, his position is worth roughly $145 million. Losing that wouldn’t sink a man worth over $5 billion, but it accounts for about 3% of his net worth, which should be enough incentive for Zell to keep the company in line.
1. “When everyone is going right, look left.”
Finally, Zell and his companies have made a habit out moving in the opposite direction of the herd.
At the height of the real estate market in 2007, Zell sold his office REIT, Equity Office, to Blackstone for $39 billion. In 2012, while the market was still in recovery, Equity Residential bought 60% of a $6.5 billion portfolio of apartments from Lehman Brothers Holdings, which was part of the liquidation of the failed investment bank. And last month, just as the market seemed to be firmly back on its feet, Equity Residential sold more than $5 billion worth of assets to Starwood Capital Group.
Unlike the examples above, Equity Residential is not a contrarian investment. The company is trading at 23 times funds from operation, or FFO — which is a key cash flow measure for REITs. That puts Equity Residential at the high end of its peers’ range, and equal to its valuation at the stock’s previous high in 2006.
Equity Residential has earned its premium price tag. The company is bigger and more established than it was in 2006, and the stock’s total return of 48% over the last three years has outperformed the Vanguard REIT Index as well as many of its peers. But given its high valuation, that view seems to be the consensus. If you want to invest like Sam Zell, that means finding good businesses, like Equity Residential, but also waiting for more opportune times to buy them, or using the stronger market as an opportunity to sell.
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