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Morningstar | Equity Residential Reports Solid 2Q; Guidance Raise a Better Match to Our Forecast

Equity Residential produced solid second-quarter results within our expectations, leading us to maintain our $64 fair value estimate and no-moat rating. The company reported same-store revenue growth of 2.2% while same-store expense growth was 3.2%, leading to same-store net operating income growth of 1.8%, slightly below our estimate of 2.2% for the quarter. However, the company raised its outlook for the year to be more in line with our forecasts. Our 2018 forecast for 1.5% NOI growth moves from the high end of the company's prior 2018 guidance range of 0%-1.5% to the midpoint of its revised range of 1.0%-1.8%. This change to NOI guidance is driven by increasing the low end of revenue growth guidance to 1.9% from 1.0% and reducing the high end of expense growth guidance to 4.0% from 4.5%. We think the company purposely set a conservative 2018 fundamental outlook to start the year so it would get the benefit of raising guidance midyear to more realistic growth projections and didn't run the risk of having to reduce guidance, had performance been off.

The company reported normalized funds from operations of $0.81 for the quarter, a 5.2% increase over last year's $0.77, driven mainly by organic internal NOI growth and the continued lease-up of the development properties. This beat our estimate of $0.80 by a penny, though that is primarily due to the company not reporting any dispositions in the quarter. The company raised disposition guidance for the year to $700 million from $500 million, slightly above our 2018 estimate of $660 million, suggesting that the dispositions will still occur but will be back-half weighted in the year. The company raised the midpoint of 2018 normalized FFO guidance to $3.25 from $3.22, slightly above our estimate of $3.24, to reflect its increased internal growth outlook but also to reflect the timing of dispositions.

One very encouraging sign in the quarter is that Equity Residential announced a new $409.7 million development project. The company started development of a 44-story, 469-unit apartment building in the West End neighborhood of Boston. Its development pipeline had shrunk from $2.8 billion at the end of 2015 and $2.0 billion at the end of 2016 to only $1.0 billion outstanding in the first quarter of 2018. Additionally, four of the seven projects outstanding in the first quarter had completed the bulk of their construction and would reach stabilization within a year. High levels of supply over the past few years combined with increasing construction costs, rising interest rates, and tightening lending standards has made the development pipeline hard to refill as projects have completed. While we would prefer to have seen $400 million in new development announced as a series of smaller projects, as that would reduce the risk from a single project and would show more evidence that the company can continue to fill the pipeline with some consistency, the size of this one project matches what we had assumed the company would be able to source over the next 12 months. We assume that Equity Residential can achieve a 6% development yield on the project, though we are worried about rising construction costs, particularly from rising labor and steel prices, so if we see the expected cost to complete the project rise over time we will adjust our development yields down to compensate. If Equity Residential can continue to find select opportunities like this one, then it should be able to deploy capital to accretively grow.