SCHW - AvalonBay Vs. Essex Property Trust: Which Is The Better REIT To Buy Today?

2023-07-21 08:05:00 ET

Summary

• REITs are today heavily discounted.
• AvalonBay Communities, Inc. and Essex Property Trust, Inc. are two of the most popular REITs to buy today.
• But which one is the better opportunity?

AvalonBay Communities, Inc. ( AVB ) and Essex Property Trust, Inc. ( ESS ) are two of the most popular real estate investment trust, or REIT, opportunities in today's market. It is pretty simple to understand why.

Both companies are what you would typically describe as "blue-chip" companies:

• They own Class A apartment communities.
• Their rents are still growing at a good pace.
• They have strong investment-grade-rated balance sheets.
• Some of the best track records of all REITs, outperforming the S&P 500 (SP500) and other REIT sector averages ( VNQ ) by a long shot.
• But despite that, they are today heavily discounted after seeing their share price crash as if it was 2008-2009 again:

Some would argue that this is the best time since 2008 to buy apartment REITs because they have gotten so heavily discounted.

This has led many of you to ask me:

What's the best opportunity: AVB or ESS?

I will start by saying that I am bullish on both REITs, and so I don't have a strong preference.

But if I had to pick one, it would be AVB and there's a simple reason for it:

It is better diversified.

Both REITs are fairly similar in terms of balance sheet and management quality. Moreover, they both also trade at roughly the same valuation at around ~116x, an estimated 25% discount to their NAVs, and a 3.5-4% dividend yield.

The main difference is in the portfolio composition.

ESS is highly concentrated on the West Coast, and it generates a large percentage of its revenue from a single state: California.

AVB, on the other hand, is better diversified and owns assets in various supply-constrained coastal markets as well as Colorado:

ESS's concentration led to exceptional growth over the past decades as for a while, everyone wanted to live on the West Coast. The demand for apartments was growing rapidly even as the supply growth was slower than in many other markets because of the relative lack of available land and the more challenging permitting process / stricter regulations.

But things have changed.

You have likely heard this before, but there is now a growing trend of companies and people moving away from California.

Major markets in California have become very expensive for both businesses and individuals. At the same time, the homeless crisis has gotten a lot worse and crime has gone up. To make matters even worse, the state has one of the highest tax rates in the country, and there is a lot more red tape on business than elsewhere.

As a result, increasingly many companies are now moving to other states like Nevada, Texas, or Florida. Businesses go where they are treated best, and by simply moving to other states, they can materially increase their profits by reducing costs and taxes. You have probably heard about Tesla ( TSLA ) moving from California to Texas, but there are many other major companies. Here are just a few recent examples:

• Hewlett Packard Enterprises ( HPE ) , moving its HQ from California to Houston, Texas.
• Oracle Corp ( ORCL ) , moving its HQ from California to Austin, Texas.
• Co-founder of Palantir Technologies ( PLTR ) Joe Lonsdale and his venture capital firm 8VC, moving from California to Austin, Texas.
• Charles Schwab ( SCHW ) , relocating its HQ from California to the Dallas/Fort Worth area.
• McKesson Corp ( MCK ) , moving from California to the Dallas/Fort Worth area.
• Toyota ( OTCPK:TOYOF ) , moved from California to the Dallas/Fort Worth area already back in 2017.

Now, this does not mean that California's multifamily market is going to collapse or that ESS is a poor investment. As I said earlier, I am actually bullish on ESS.

But it increases risks because the outlook for California is more uncertain. There's also the growing risk of tighter regulations on rents and the real estate business in general. This risk is a lot greater in California than elsewhere.

AVB is less affected by this uncertainty because it is a lot better diversified, and this is the primary reason why I believe that AVB offers a slightly better risk-to-reward than ESS at this time.

If you are bullish on the West Coast and have a higher tolerance for risk, then ESS may make more sense for you.

But if like me, you feel uncertain about the West Coast, then AVB is probably the better pick since both companies are otherwise very similar and the difference in valuation is not material.

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