Higher leverage is essential for expansion
In order to fulfill the requirement of paying at least 90% of their taxable income to investors as dividends, REITs like Equity Residential (EQR) opt for higher leverage to expand their real estate holdings. This increases their interest expenses, thereby pressuring their margins.
However, REITs require expansion in real estate holdings in order to create additional sources of income. It’s extremely important for REIT managers to maintain an optimum debt structure. This efficiency depends on how well the REIT converts higher leverages to its advantage.
Equity Residential’s consolidated debt was ~$9.0 billion—lower than the previous year’s debt level of ~$10.9 billion. Over the last five years, Equity Residential’s total debt rose moderately from $8.5 billion in 2012 to ~$8.9 billion on March 31, 2016.
Equity Residential’s debt-to-equity ratio reached its high of 1.18x in 2012 in the last five years. Since then, it has fallen consistently from 1.03x in 2013, 1.05x in 2014 and 2015, and finally to 0.88x in 2016. The company reported a debt-to-equity ratio of 0.87x in 1Q17 ended March 31, 2016. The industry median debt-to-equity ratio is 1.07x.
When compared to its peers, AvalonBay Communities (AVB) had the lowest debt-to-equity ratio of 0.68x. It was followed by Camden Property Trust (CPT) at 0.82x, Essex Property Trust (ESS) at 0.89x, and UDR (UDR) at 1.18x. Equity Residential forms ~2.9% of the Vanguard REIT ETF (VNQ).
Reduced borrowing cost
Equity Residential’s effective overall borrowing rate for fiscal 2016 was ~4.5%, close to its 2015 level of ~4.6%. The weighted average years to maturity for its debt was 7.6 years in 2016 compared to 6.3 years in 2015.
Equity Residential’s interest expense spiked 8.7%, mainly driven by prepayment penalties and debt extinguishment costs. The effective borrowing cost on all indebtedness for 2016 was 4.68%, down from 4.72% recorded a year ago.
Over the last two years, Equity Residential has reduced the weighted average interest rate on its debt portfolio from ~4.6% in 2014 to ~4.4% at the end of 2016. The weighted average years to maturity for its debt was 8.2 years compared to 7.6 years in 2015.
In the next article of this series, we’ll have a look at Equity Residential’s valuation in comparison to its peers.