Equity Residential's Implied Cap Rate, And Why It Matters

Jan Brzeski is a contributor to Seeking Alpha. The article below is a copy of what he posted on August 22, 2011. To access his article on Seeking Alpha, please click here.

I am a full-time investor and fund manager focused on non-traded real estate investments. Right now I am focused on investing in real estate loans with a nice margin of safety, but that fall outside of bank lending criteria and therefore offer much higher yield than one would expect.

Every now and then, I take a look at traded real estate assets, and frequently the results amaze me. Today, we'll look at Equity Residential (EQR). All analysis in this article is based on the latest quarterly report on the company's website. To see the source document, click here.

Before we go into the details, I'll tell you the bottom line: public market investors pay a huge premium for the liquidity that they enjoy. To my mind, they are paying far too much, especially if the goal is to have steady income and there is no compelling reason for the investor to be able to liquidate an investment from one week or month to the next.

How Much Cash Flow Do EQR's Apartments Produce? In this article, we are not going to analyze EQR the way Wall Street analysts do. Instead, we are going to analyze it the way experienced real estate investors do. And we are not going to be extremely precise about the numbers. A rough estimate will give us a good view of what is happening.

In the latest quarter, operating income was about $146 million. But that is after deducting $159 million of depreciation, which is not a cash expense. If we add back the depreciation, we see the approximate cash produced by the portfolio of apartments owned by EQR, before debt service, is $305 million. Annualizing that number, we have about $1.2 billion of cash flow from operations (roughly the equivalent of "net operating income" to put it in real estate terms).

What Does it Cost to Buy EQR? EQR's balance sheet shows about $10 billion of debt. According to Yahoo Finance, the market capitalization is another $17 billion (rounding). There is a bit of preferred equity, but it seems to be small enough to ignore for our big picture analysis. So the approximate enterprise value of EQR is $27 billion.

The Implied Capitalization Rate Now let's look at the implied capitalization rate of EQR. That is the net operating income of its portfolio of apartments, divided by the price we need to pay to own that portfolio. The answer is, $1.2 billion/$27 billion, or about 4.4%.

Does that represent a good cap rate or a bad cap rate? It depends on one's perspective, but a seasoned real estate investor would tell you that, given EQR's portfolio, which includes plenty of units outside of the coastal land-constrained markets, a 4.4% cap rate is mighty low.

In other words, those who limit themselves to investing in real estate via today's public markets may be overpaying by a wide margin, relative to what's available to those who are willing to cut out the middlemen on Wall Street and in REIT corporate offices.

I am not advocating buying any old apartment building... only pointing out that yield hungry investors in the public markets should take a look at the underlying numbers once in a while and compare what they can get on Wall Street with what is available on Main Street.

As I will outline in future articles, the best risk-adjusted returns for investors seeking yield from real estate today are not in the REIT universe, and they are not even in the universe of acquiring individual real estate assets (except for a small number of very special situations). Instead, the best risk-adjusted returns can be had from making short-term real estate loans. Currently, banks refuse to make loans on certain types of real estate transactions, allowing private lenders to earn higher returns than would normally be possible.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.