Pack Up, Move Out of Equity Residential

Equity Residential (NYSE:EQR), the largest publicly traded owner of multifamily properties in the U.S., hit a 52-week high of $63.88 back in July, only to fall back below $60 with the August pummeling of the markets. Shareholders have had a good run the past decade, achieving an annual total return of 9.8% — 795 basis points higher than the S&P 500 — and currently working on a third consecutive year of positive returns.

Overall, business is good for Sam Zell�s baby. The question is whether this success continues. That I don�t know. What I can tell you are three reasons you should consider selling its stock.

Funds From Operations

Real estate investment trusts use this metric to gauge the true profitability of its properties by adding back depreciation and amortization, which are non-cash charges, to its earnings. According to Equity Residential�s website, its stock price trades at 27.4 times FFO, about equal to its peers. At least from this perspective, its stock is not expensive.

Digging deeper into its earnings, however, we see that its second-quarter FFO per share was $0.58; unchanged year-over-year and two cents lower than the consensus estimate. This despite a 5.2% increase in apartment rents the past 12 months through the end of June. In such an ideal situation, you�d like to see FFO rising.

Making matters worse, it sold $1 billion in real estate in Q2, and that will reduce earnings further until it can replace those properties with new acquisitions, which will take time. As part of its Q2 announcement, it lowered full-year FFO between $2.40 and $2.45 per share. This pushed 11 analysts to follow suit, dropping the estimate for 2011 to $2.43 per share from $2.46. It�s possible these numbers will drop some more in the next couple of quarters. This likely will put downward pressure on its stock.

Cap Rate

For those unfamiliar with the term, cap rate is the rate of return from a real estate investment based on expected income. Private real estate investor Jim Brzeski recently wrote an article for Seeking Alpha that calculated Equity Residential�s implied cap rate, which is the net operating income of its portfolio of apartments divided by the cost to own them. For net operating income, Brzeski used $1.2 billion, which is the annualized figure based on $305 million in the second quarter. The cost to own is $27 billion, its enterprise value. Using these figures, we get an implied cap rate of 4.4%.

Brzeski believes this is much too low and that public REIT investors are overpaying for their real estate returns. I�d have to agree. Recently, I wrote about one of Equity Residential�s peers, AvalonBay Communities (NYSE:AVB), recommending investors sell the stock because it was too expensive. While I didn�t examine AvalonBay�s cap rate, I�m sure you�ll find it�s not much better.

Yield

Here we have one of the biggest apartment owners in the country, and yet its funds from operations are less than they should be. Further, despite obtaining near-record prices for the $1 billion in properties sold, it appears investors are paying an unreasonable premium for its real estate. All of this trickles down to shareholders who currently receive a yield of 2.3%, 71 basis points less than its peers and the worst return in a decade. With its stock trading higher than ever, income investors really should consider cheaper alternatives.