No investment is without risk. Because of that, investors need to look at risk on a sliding scale and consider whether a particular investment has more than they're comfortable taking.
With that in mind, here's a closer look at how to measure the riskiness of Equity Residential (NYSE: EQR).
Digging into Equity Residential's business model
Equity Residential is a real estate investment trust (REIT) focused on owning a growing portfolio of apartment communities in major coastal gateway cities. Relatively speaking, that's a low-risk business. Apartments in those metro areas tend to benefit from reasonably steady demand and typically generate stable rental income, even during economic downturns. People need a place to live, which is why apartments tend to be very sound investments.
That was evident last year. While the residential REIT's normalized FFO (funds from operations) per share fell 6.6%, REITs focused on other property types like hotels or shopping malls saw a much larger income drop. Meanwhile, its results are improving this year as the pandemic subsides.
Analyzing the REIT's financial profile
While apartments are pretty stable investments, there are ways to amp up their risk profile. For example, apartment owners, like REITs, can use a lot of debt to fund developments and acquisitions. They can also pay out a large percentage of their income via dividends to shareholders. Either factor can limit a REIT's financial flexibility during a recession.
However, neither is a problem at Equity Residential. It has one of the strongest balance sheets in the REIT sector, with A-rated credit. Meanwhile, it has a reasonable dividend payout ratio of 83% of its normalized FFO. Those factors give the company a tremendous amount of financial flexibility, helping reduce risk.
Taking additional steps to reduce risk
Equity Residential takes an already low-risk business and makes it less risky by maintaining a top-notch financial profile. However, it’s not stopping there. The company has taken additional steps in recent years to reduce its risk profile.
First, it's further diversifying its portfolio by moving into fast-growing inland markets, including several in the Sun Belt region. This strategy will reduce its exposure to high-cost coastal markets that have come under pressure during the pandemic. It will also spread out some of its climate change risk since it's moving away from the coasts where rising sea levels are a potential concern. The company is even financing this move in a low-risk manner by selling some of its higher-risk apartments (e.g., older communities and those in regions with higher regulatory risk like California) to finance its acquisitions.
Second, the REIT is taking a lower-risk approach toward development. Ground-up apartment developments are higher-risk investments because the market can change dramatically between greenlighting a project and its completion. Equity Residential is working to offset some of this risk by forming a joint venture with homebuilder Toll Brothers (NYSE: TOL) to develop apartment communities. Toll Brothers will build the communities while Equity Residential will lease them up. Upon stabilization, Equity Residential can acquire the properties from the joint venture. This strategy reduces its development risk by sharing it with Toll Brothers.
One of the lower-risk REITs around
Equity Residential is about as low-risk an investment as you'll find. It operates in a lower-risk sector and takes a conservative financing approach. On top of that, it's making moves to further reduce risk by expanding to inland markets (which it's financing in a low-risk manner) and using a joint venture to cut its development risk. While none of this guarantees that investors in Equity Residential won't lose money during a period of market turmoil, it's a reasonably safe bet to produce positive returns over the long term.