2023-08-01 07:00:00 ET
Summary
- Most everyone knows that California is struggling.
- Ever since the pandemic, headlines have been dominated by negative news from California.
- The biggest trend is the migration from blue to red states, triggered by unaffordable housing and related issues.
- So, the picks in this article are my favorite Californian REITs.
This article was coproduced with Leo Nelissen.
As a European who’s a big fan of the US, I’ve always been fascinated by the American dream and the contribution of European immigrants in the past few centuries.
An interesting piece of information I came across the other day got me to write this article.
Did you know that the American dream is the slightly poorer cousin of the California dream ?
The iconic California dream was of rapidly acquired middle-class wealth, said Mathews—and it is “older than the American dream, which is a slightly poorer cousin of the California dream.” The American dream was a Puritan dream of modest wealth, accumulated year by year; according to historian H. W. Brands, the California dream—following the Gold Rush—was one “‘of instant wealth, won in a twinkling by audacity and good luck.’”
Interestingly enough, the same source I used for the quote above also notes that the California dream isn’t in great shape anymore (emphasis added).
“We are no longer a state of arrival,” said Mathews—and so “the dream is no longer to show up and do well.” Rather, it’s “to be able to find a way to stick it out here.” Paradise, in today’s California, is more like Survivor, where everyone is scheming a way to stay on the island .
While California is home to some of the world’s best universities like Stanford and the University of California Berkeley, the biggest and most innovative tech giants like Apple ( AAPL ), Alphabet (GOOG) ( GOOGL ), and NVIDIA ( NVDA ), and stunning natural beauty (I never forget my visit to Yosemite Natural Park), it is struggling – big time.
I want to highlight both the challenges and positive developments in California in this article.
Furthermore, I will discuss three REITs that focus on California which we've rated as Strong Buy, Buy, and Speculative Buy.
So, let’s get to it!
What’s Up With The Golden State?
Ever since the pandemic, headlines have been dominated by negative news from California. The biggest trend is the migration from blue to red states, triggered by unaffordable housing and related issues.
What used to be the California dream is now a challenge for a lot of people. The two Wall Street Journal headlines below are just an example of this.
According to the Wall Street Journal in June, the tech downturn on the West Coast has led to tens of thousands of layoffs and cost-cutting measures since the middle of last year. Janitors, teachers, restaurants, and dry cleaners in California, Oregon, and Washington are among the hardest hit.
The states' unemployment rates have risen above the national average, and average wages in tech-concentrated areas have seen significant declines, which becomes an even bigger issue when adding high inflation.
Hence, low-wage workers have been hit hard, facing reduced hours and lower pay.
On top of that, the state is dealing with a budget crunch. As reported by Bloomberg earlier this year, California is facing a deeper budget deficit than anticipated at the start of the year due to declining fortunes among its wealthiest residents, as well as tech layoffs and banking upheaval.
Governor Gavin Newsom projected a $32 billion deficit for the upcoming fiscal year, which is $9.3 billion more than he initially forecast. The state's previous budget cycle boasted a surplus of nearly $100 billion during better economic times. Note that a deal on the budget was reached, according to CalMatters .
The sinking revenues from the state's wealthiest individuals, who contribute a significant portion of tax revenue, have worsened the situation.
As a result of these headwinds, the state is dealing with a new challenge: Population loss.
Since the pandemic, California had two years of significant net negative domestic migration, which more than offset natural population increases and international migration.
That’s where the bad news ends.
Wells Fargo, which produced the chart above, came out with a comprehensive report diving into the details of the Californian economy.
The bank notes that while California’s labor force remains below pre-pandemic levels in metro areas like Los Angeles and San Francisco (because of net negative migration), the state's overall labor force has been steadily growing, reaching its highest level since the pandemic in June 2023, and the jobless rate has improved to 4.6% from its peak of 16.1% in April 2020.
The leisure and hospitality industry, healthcare sector, and educational services have seen notable increases in employment. The transportation, warehousing, and utilities sector also have been performing well due to e-commerce and domestic supply chain fortification. Please keep this in mind as we head toward the stock pick part of this article.
Additionally, California has faced inflationary pressures, but there are signs of easing. After reaching a peak in June 2022, inflation has moderated, and several factors, including declining food, automobile, and medical services prices, have contributed to this improvement.
In addition, the housing market has gone through some changes, including a decrease in home prices from their highest point, though they still remain higher than before the start of the pandemic.
The residential and commercial real estate industries have been impacted by low supply and increased interest rates.
While these interest rate headwinds seem to be persistent, Wells Fargo makes the case that California's economy appears to be on a positive trajectory, with real GDP growth and payroll gains indicating continued economic expansion in the near term.
However, challenges such as population decline and a potential national economic downturn may affect the state's economic outlook. Housing affordability also is likely to remain under pressure due to constrained supply, impacting the residential market.
In other words, California is far from a dumpster fire. However, politicians need to be careful as the state has lost a lot of the attractiveness that made it such a powerful state.
So, the picks in this article are my favorite Californian REITs. All of these companies have top-tier management, assets that are in high demand, rock-solid balance sheets to protect investors (and the business) against financial risks like elevated rates, and attractive shareholder distributions with solid dividend coverage ratios.
Pick 1: Rexford Industrial Realty ( REXR ) – 2.8% Yield
In this case, I need to start by giving credit to Brad, who introduced this REIT to me. He covered this pure-play industrial REIT in an in-depth article earlier this month, which you can access here .
As I have close to 50% industrial exposure in my dividend growth portfolio, industrial REITs always are something that interests me.
In this case, we’re dealing with a company that mainly focuses on the Southern California infill market. With its $12 billion market cap and more than 44 million square feet of owned industrial real estate, it’s the biggest industrial REIT in California.
Based on that context, did you know that California is the biggest manufacturing state in the United States? Bigger than any state in the Midwest.
California is home to the biggest shipping port in the US and exported manufactured goods worth more than $130 billion in 2020. The state is known for aerospace manufacturing and pretty much anything related to that supply chain.
Furthermore, what makes REXR’s markets so special is limited supply. While SoCal is highly attractive because of its large market size, it’s not easy to build new buildings. It’s expensive, and regulations often prevent supply growth from accelerating.
As the overview below shows, REXR is less prone to industrial supply risk. It’s well below the nation’s average and miles away from the supply growth rates cities like Dallas and Atlanta are dealing with.
So, to reiterate, the company is serving a market the size of Germany without having to deal with significant supply risks.
This means strong pricing power.
The company has an average base rent of $14.71 per square foot. The peer average is $8.19. While one might make the case that it’s too high, the company enjoys an average same-property occupancy rate of 98.0%.
Close to 70% of its tenants operate in warehousing/transportation, wholesale trade, and manufacturing, which means that despite its focus on industrial REITs, its success isn’t completely based on manufacturing health, which is a good thing.
Also, despite this high occupancy rate, Rexford Industrial is well positioned for substantial internal growth. Assuming today's rents and no future rent growth, they project $165 million of incremental NOI (net operating income) embedded within their current portfolio over the next two years.
Thanks to a resilient market and strong pricing power, the company has grown its funds from operations (“FFO”) by 15% per year since 2018. FFO per share (which accounts for dilution) has risen by 11%.
Thanks to these numbers, the company has hiked its dividend by 18% per year over the past five years. The current yield is 2.8%, backed by a 70% payout ratio.
The most recent hike was 20.6%, which was announced in March of this year.
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Furthermore, the company enjoys a healthy balance sheet. It has a 3.7x net leverage ratio, $1.9 billion in liquidity, no meaningful maturities in 2023, and a BBB+ credit rating, which is just one step below the mighty A-range.
The company is trading at roughly 25x full-year core FFO estimates. While this is well above the sector median of 13x forward FFO, the median annual sector FFO growth rate of the past five years was just 2.4%, which means this valuation premium comes with more growth.
The current consensus price target is $62, which is 13% above the current price.
We maintain a Strong Buy rating.
Pick 2: Essex Property Trust ( ESS ) – 4.0% Yield
With a market cap of roughly $15 billion, Essex Property Trust is America’s sixth-largest residential REIT.
Established in 1971, the company has a focus on the coastal markets of California and Washington with a focus on superior long-term rent growth.
The company is a dividend aristocrat with a track record of 29 consecutive annual dividend hikes. It currently yields 4.0%.
This dividend is protected by a 62% payout ratio. The five-year average annual dividend growth rate is 4.6%. It’s not breathtakingly high. However, it’s consistent and above the average rate of inflation.
Just like Rexford, Essex benefits from limited supply growth.
Historically speaking, the new housing supply has increased by less than 1% (of existing stock) in California.
Having said that, the company serves Northern California, SoCal, and Seattle. California accounts for more than 80% of its NIO.
In its portfolio, it has 252 apartment communities covering roughly 62,000 apartments.
Looking at the statistics below, we see that despite a high average rental rate, the company serves renters with a decent rent-to-income ratio in markets with elevated home prices. When adding the impact of high rates, renting becomes attractive in these markets.
Adding to that, the company has a 96.6% occupancy rate, which has been steady. Furthermore, same-property revenue growth has rebounded by 6.2% through May, thanks to the company’s strategic use of concessions to favor occupancy.
Related to that, in 1H23, delinquency rates were 2.5% of the total rent. That number is expected to fall to 1.5% due to the ending of eviction moratoria in all of the company’s markets.
Not only does it have a solid portfolio of tenants, but it also reduces risks to shareholders by maintaining a healthy balance sheet. The company has a BBB+ credit rating with an interest coverage ratio of almost 600%. It has $1.2 billion of liquidity and a net leverage ratio of less than 6x (EBITDA).
Just like Rexford, it has no major maturities in 2023, and it enjoys an average weighted interest rate of just 3.3%.
The company is trading at 15.6x forward FFO, which is a bit above the median sector valuation of 13.0x forward FFO.
The current consensus price target is $240, which is 2% above the current price.
We maintain a Buy rating.
Pick 3: Kilroy Realty Corporation ( KRC ) – 6.2% Yield
The third pick is the most speculative one, given the environment it operates in. It also has the highest dividend yield of the picks discussed in this article.
Kilroy doesn’t own residential apartments. It also doesn’t own industrial warehouses. No, Kilroy owns offices – the most hated property segment at the moment.
While the company does have exposure in Texas and Washington, it mainly caters to the Californian market, where it has more than 7 million SF of office assets in the greater Bay Area alone.
With a market cap of $4 billion and 119 office properties, the company is a giant in its industry.
The good news is that despite struggles in its industry, the company is benefiting from a strong tenant base. This is what I wrote in a KRC-focused article last month:
“These properties had 406 tenants and an overall occupancy rate of 91.6%. The percentage of leased space was 92.9%. The stabilized portfolio also included three residential properties with 1,001 units and an average occupancy rate of 93.5%. Almost 75% of its tenants are public companies.”
As we can see below, the majority of its tenants are public companies with investment-grade balance sheets. Even the private tenants are well-known corporations like Deloitte.
Kilroy Realty Corporation
On top of that, KRC has a major benefit: It has a very young portfolio.
The average age of its buildings is 11 years. The industry average is 34 years.
It also enjoys the best locations, like Kilroy Oyster Point , which is a breathtaking office park in South San Francisco currently in development.
The reason I’m bringing this up is that the industry’s best performers enjoy declining vacancies.
Prime real estate also comes with pricing power – even in this environment.
Looking at the chart below, we see that prices for prime real estate have remained stable since the pandemic. Non-prime rents have declined.
Thanks to these developments, the company was able to stick to its guidance, except for one adjustment related to general and administrative costs.
According to the company:
“In summary, our original FFO guidance for 2023 was $4.40 to $4.60 with a midpoint of $4.50 per share. While most of our underlying assumptions are unchanged, we are updating our range to reflect the one-time G&A costs of approximately $0.10 at the midpoint. This brings our updated range between $4.30 and $4.50, with a midpoint of $4.40. Were it not for the G&A adjustment, our FFO guidance would have been unchanged.”
With that in mind, the company has a well-covered dividend, which can even withstand severe headwinds in the high-quality office space.
The company’s 6.2% dividend has a five-year average annual dividend growth rate of 4.5%.
While that may not be very high, it’s decent for a yield this high. Furthermore, the dividend is protected by a 49% dividend payout ratio, which is below the sector median of 64%.
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Additionally, like REXR and ESS, the company enjoys a fortress balance sheet with a 5.7x leverage ratio, 95% fixed-rate debt, and no significant maturities until December 2024. It also has $1.6 billion in liquidity, with $330 million of this being cash on hand.
It has a BBB credit rating.
Valuation-wise, we’re dealing with a steep discount.
The company is trading at 7.9x forward FFO, which is a discount vs. the sector median and well below its pre-pandemic average of 15x FFO.
The current consensus price target is $38, which is 7% above the current price.
In this case, analysts are cautious, as nobody is yet willing to bet on the recovery of the office industry – especially because the Fed isn’t yet looking to cut rates anytime soon.
We give the stock a Speculative Buy rating.
Takeaway
California's allure as a land of opportunity has been facing challenges, with the iconic California dream of instant wealth now giving way to a more resilient dream of sticking it out amidst struggles.
Despite the state's current woes, it still boasts world-class universities, tech giants, and stunning landscapes.
Hence, we dove into California's economic outlook and introduced three top Californian REITs rated as buy, speculative buy, and strong buy.
* Rexford Industrial Realty: With a focus on the Southern California infill market, REXR benefits from limited supply, ensuring strong pricing power. The company has a robust balance sheet and steady dividend growth, making it an attractive choice for industrial REIT investors.
* Essex Property Trust : As a residential REIT dividend aristocrat, ESS focuses on coastal markets in California and Washington, enjoying limited supply growth and high occupancy rates. It offers a consistent dividend with above-average inflation-beating growth.
* Kilroy Realty Corporation : Although it operates in a struggling office space segment, KRC has a strong tenant base, a young portfolio, and prime real estate locations. The well-covered dividend and attractive valuation make it a speculative buy with potential upside.
While the Californian dream faces challenges, these REITs present promising investment opportunities in a state renowned for its innovation and wealth-building history.
Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
For further details see:
California Dreaming With These 3 REITs