Sam Zell was 28 years old when him and his partner, Bob Lurie, created Equity Group. Today, that company is the Real Estate Investment Trust (REIT) known as as Equity Residential.

Equity Residential is one of the largest US publicly traded owners of rental apartments in Boston, New York, Washington DC, Seattle, San Francisco, and Southern California.

As of 2019, Equity Residential owned 309 properties consisting of approximately 80,000 units. They employed roughly 2,700 employees across Operations, Leasing, Finance, Acquisition, Development, and other supporting functions.

In this 10-k breakdown I will synthesize Equity Residential’s Investment thesis and financials.

Investment Thesis

Equity Residential’s thesis can be simplified in the following sentence: We believe that there’s a lot of people in big U.S. cities that need to rent apartments and we can serve those customers really well.

Currently, there are three groups of people that have a likelihood to rent apartments:‍

1. Millennials: 78 Million people born between 1981 and 2000 who are disproportionately renters.‍
2. Gen Z: 70 Million people who were born between 2001 and 2014 that are likely to be renters.‍
3. Baby Boomers: 76 Million people born between 1946 and 1964 that are showing a growing trend toward apartment rentals

How Equity Residential chooses markets

Equity Residential has historically went into larger cities across the U.S. When considering their entry into a new market, they consider the following characteristics of a region:

1. High single family housing prices
2. Areas that have growth of “knowledge workers”
3. Areas that have highly walkable urban and high-density suburban areas
4. High barriers to entry for building new apartments or creating new supply primarily due to land scarcity or government regulation

I was happy to read point #4 because it’s classic Sam Zell. One of Sam’s fundamental investment philosophies is supply and demand which he learned from buying Playboy magazine when he was 13 years old. In his own words from his autobiography, Am I Being Too Subtle? -

“On one of my walks I discovered a newsstand underneath the “L” tracks. It was 1953, and a provocative new magazine called Playboy had just made its debut featuring Marilyn Monroe on the cover. It sold for 50 cents. I bought a copy and thought it was terrific. So I brought it home to Highland Park, where it wasn’t for sale, and showed it to my friends. One of them offered to buy it. “Three bucks,” I said. After that, I started a little magazine import business and, in the process, learned a lasting business lesson: Where there is scarcity, price is no object. This basic tenet of supply and demand would later become a governing principle of my investment philosophy.

Financials

Revenue & Expenses

In 2019, Equity Residential received $2.7B of Revenue and incurred roughly $0.8B of property expenses. Below is the breakdown by city:

Same Store Properties are defined as properties acquired or completed that were stabilized prior to January 1, 2018 (not including properties sold)

Non-Same Store Properties includes all properties acquired during 2018 and 2019 not stabilized as of January 1, 2018 (including any properties in lease-up)

Capex

During 2019, Equity Residential spent $178 Million on improving the condition of their properties.

$99M was spent on Building Improvements which includes items such as replacing roofs, paving, building mechanical equipment systems, exterior siding and painting, major landscaping, furniture, and other similar items

$40M spent on Renovation expenditures which consistent of primarily renovating kitchen and bathrooms.

$39M spent on Replacements which includes items such as appliances, mechanical equipment, fixtures and flooring.

There are three beneficial aspects within Real Estate as it relates to the $178M Capex investment:

1. These improvements on the property are considered Capex and therefore can go “below the line” which doesn’t affect Equity Residential’s Net Income.
2. The Capex amount also has the advantage of Depreciation, which is a non-cash expense that reduces your Net income (therefore gives you a tax advantage). On points 1 and 2, let’s see how these improvements to the property affects the 2019 P&L. Below you can see that in 2019, Equity Residential was able to calculate a $831M depreciation amount. Remember, this is a non-cash expense. This is simply an accounting principle that calculates the useful life of Capex you have deployed at your property and then recognizes it as an expense on your P&L. Therefore, Equity Residential was able to reduce their Taxable Income by roughly $831M. This depreciation amount is not only from the $178M of Capex that was spent during 2019, but rather accumulated depreciation from Capex investments from previous years.
3. Furthermore, you will notice that the $178M that was actually spent on improvements during 2019 is not reflected on the P&L. As mentioned, this is a below the line expense which doesn’t affect Net Income. Not only has Equity Residential been able to reduce their taxable income by incurring a non-cash expense of $831M, but they’ve also haven’t been “harmed” from a tax perspective of their $178M Capex investment in 2019.

What happens from here?

My goal with this 10-k breakdown is primarily to present the information in a summarized way and not opine on what I think the outlook is for the company. But, I can’t help myself.

Given that Equity Residential’s portfolio is 95% concentrated in the largest U.S. cities I think it’s very clear that there are two paths that may play out:

Bear Case: The demand for rentals in these large cities drops relative to the demand we’ve witnesses historically. Equity Residential then has properties in their portfolio that they are unable to sell for their required return. They move too slow to acquire properties where there is higher demand such as suburban areas.

Bull Case: The demand for rentals in large cities comes back in line with what we’ve experience pre-COVID. Equity Residential is able to stabilize occupancy, pull back concessions, and continue to raise rents with their luxury properties. They continue to expand in the CBD and suburban areas of growth markets.

How do I think it’ll play out?

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It’s usually not a good idea to bet against Sam Zell.