2023-05-01 06:30:00 ET
Summary
- Last week, the price of Essex Property Trust (ESS) stock had dropped to 57% of its 2021 high, more than most other quality apartment REITs.
- This stimulated me to take a preliminary look at patterns of earnings and valuation.
- I share why it would take a larger drop to get me interested.
It would be great to find another REIT I wanted to hold for upside as we come out of the current bear market. Having mentioned Essex Property Trust ( ESS ) a few times as a possibility, it was time to see whether to probe more deeply.
This work builds on my recent deep look at AvalonBay ( AVB ), which I have been closely following for a few years. I’ve also followed Camden Property Trust ( CPT ).
But in my view CPT got way overpriced in 2021 and has yet to come back to earth, relative to other apartment REITs. So they have not been the focus of much of my attention lately.
As it developed, some initial exploration into Essex convinced me not to delve deeper unless we get the much bigger market crash that some predict. Let me share why.
Also, despite the target price found below, any investment by me would call for a much deeper look at the company.
The Context for Essex
Essex is one of several long-standing, big, strong apartment REITs. They have some attractive features that are typical of this group:
- Credit rating of BBB+
- Well distributed debt maturities averaging about 5 years
- Nearly all unsecured, fixed-rate debt
- Low Debt Ratio
- High median household income ($115k)
- Low average rent-to-income (23%).
- The full mix of development, redevelopment and acquisitions.
- Strong long-term total returns
- Low dividend yield, amongst REITs
An additional aspect of Essex is that they are entirely focused on the West Coast of the US. This has kept many investors away, and likely has had some impact on valuation.
Price returns for ESS were strong from 2001 through 2014 (save for the Great Recession) but have been bumpy since:
Overall the ESS stock price increased at a 10% CAGR for the 20 years ending in late 2021. But last week it was priced at 60% of its 2021 high and is about at the pandemic low. The price seems to be rallying at the moment.
It would seem that the upside of 67% back to the 2021 high implies a good opportunity. Well, maybe.
Cash Earnings Growth
One aspect of the past two decades is that many REIT stocks saw their prices increase more than was economically justified. I explored this here , finding typical differences of 4% or more.
The available measure of earnings, FFO/sh (about which more below), increased at a 6% CAGR.
[This plot shows forward FFO/sh, which is what I could get TIKR to plot. I pulled earlier numbers, not shown here, from the 10-Ks. They support the long-term 6% CAGR.]
One can move these CAGRs a bit by selecting intervals, but not much if one avoids extreme cherry picking. Overall, the 4% difference mentioned above is intact. The economic value added by ESS operations was at 6% and the other 4% was from multiple compression.
It is worth noting that the 6% economic growth rate is excellent for a REIT. It lags AvalonBay by a bit, but still would place Essex in a small top group of strong growers.
So with today’s 4.4% dividend yield, one could expect total returns near 10% in a world with unchanging earnings multiples. More on that topic below.
Now FFO, or Funds From Operations, is a standard measure of earnings defined by NAREIT. But FFO is larger than cash earnings after all costs, which is what we really care about.
I looked at Essex while writing this article , finding that such cash earnings are about 85% of FFO. But the goal here is not to achieve high precision, so FFO is used below. It is trends that will matter, not exact values.
Earnings Multiples
I favor finding earnings multiples from discounted cash flow calculations. My preference is to do these for variable discount rates, highlighting their impact and the associated uncertainty.
On the assumption that the growth of FFO/sh at a 6% CAGR continues indefinitely, which it might, one gets this relation for the multiple of earnings as a function of discount rate. The orange squares show multiples of 25x, 20x, and 15x at discount rates of 10.3%, 11.3%, and 13%, respectively.
RP Drake
If you limit the duration of the earnings growth in your calculation, then the curve shown above moves down. But if you use actual cash earnings instead of FFO, increasing earnings multiples by 18%, then it moves up. For our purposes today we can look at it as a curve for FFO multiples.
To explain that 4% CAGR of multiple compression, earnings multiples have to increase 2.2x over 20 years. That’s in the ballpark of what happened, on average for REITs:
One can see here that most of the multiple compression occurred before 2007 (ignoring the temporary impact of the Great Recession) and during 2021. The early period is also when most of the drop in Treasury rates occurred.
Treasury rates (10 yr) have dropped a lot, from around 5% to around 2%. In terms of the model on the previous graphic, this correlated with a large change in discount rates for REITs, from about 17% to about 12%.
My comments about the NARET graphic are these. First, 2021 was a definite anomaly. It may have been the child of TINA, who is hopefully gone for good.
Second, the 2010s make it seem as though 17x, give or take a turn, is normal. But that is normal when 10-yr Treasuries are at 2% to 3%.
What will normal be for Treasuries at 4% to 5%? Just looking at the Excel graphic and assuming a constant spread, one would think perhaps 14x. But will the spread stay constant? I don’t think we know.
Third, a return to 10x seems unlikely to me unless we get very high interest rates. The view of REITs overall as investments has improved since 2021.
Wherever the new normal is, earnings multiples no doubt will continue to fluctuate with a full range of 20% to 30% and a period of a few years. With all this as context, let’s look at P/FFO for ESS.
Multiples for ESS
Here is what I could get TIKR to give me on this, with black showing P/FFO:
We see that through the 2010s P/FFO fluctuated about a median of perhaps 21x. Then it soared to 25x in 2021 but now is languishing near 14x. The question is what to make of this.
Here is what it seems to me we can say. One the one hand, if multiples return to their value from the 2010s, then there is 50% upside from 14x to 21x, perhaps with some fluctuations to higher multiples.
On the other hand, if multiples reset to the 14x suggested above, then the price will fluctuate from here with a mean that grows with earnings. That said, I think one can view 14x and the present price as low-end expectations for the mean of the fluctuating multiple.
Here is where this leads me.
On the one hand, if you buy ESS expecting 50% or more of upside, then your thesis includes an assumption (whether you know it or not) that discount rates and thus earnings multiples will return to the range they were in during the 2010s. If they do not, you could still fall far short of your expectations, despite outstanding operational performance by Essex.
On the other hand, if you buy ESS planning to exit after a gain of 20%, then you are assuming that, at minimum, the present price is a low point for the next upward, intermediate-term cycle. That seems a good bet to me, but still one could lose out if there were a further crash from here.
On the third hand, if the current yield of 4.3% meets your income needs, then ESS could be a sensible choice. The dividend yield is likely to grow over time at that 6% CAGR, more or less. Whether this would be the best choice amongst apartment REITs depends in part on your view of the West Coast.
As to myself, this is not where I want to be for upside positions paying yields that low. I want larger than 50% upsides to the earnings multiples from the 2010s. In my view we may only go partway back to those multiples.
Perhaps we will get that huge next crash that is popular with some authors. If the price went to say 11.5x or $170, then the upside to 14x would be 22% and more likely upsides would be 50% or more.
That price, $170, would provide a margin of safety worthy of Benjamin Graham.
For further details see:
A Brief Look At Essex Property Trust