2023-07-29 04:52:12 ET
Summary
- REIT investors have faced challenges in 2023 due to rising interest rates, e-commerce growth, and recessionary fears.
- Within the multi-family residential REIT space, AvalonBay Communities and Equity Residential have outperformed their sector, while Mid-America Apartment Communities and Camden Property Trust have underperformed.
- The geographic focus of these REITs, with some prioritizing coastal markets and others focusing on the Sun Belt, partially explains the performance gap.
- Among this divergence, I review the strategy and recent performance of Essex Property Trust, a West Coast-focused multi-family residential REIT and Dividend Aristocrat.
- While the fundamentals are sound, and the company can be a decent long-term holding, subtle differences exist and lead me to believe investors could be better off with other choices.
With rising interest rates, the continuous growth of e-commerce and work-from-home, and recessionary fears, 2023 has not been an easy year for REIT investors. YTD returns for listed real estate (VNQ) have disappointed, trailing the broader S&P500 Index. Despite a somewhat more resilient profile, being immune to the digital macro-trend headwinds mentioned above (but not the rising interest rates), residential REITs have also underperformed. However, performance within the peer group varies wildly.
A subset of residential REITs, spear-headed by AvalonBay Communities (AVB) and including Equity Residential (EQR) and Essex Property Trust (ESS), have performed well so far in 2023, at least outperforming their sector. Conversely, Mid-America Apartment Communities (MAA) and Camden Property Trust (CPT) have underperformed peers and VNQ.
Coastal vs. Sun Belt
With tech again ruling the markets, energy underperforming, and back-to-office mandates in place, it seems the reason for the performance gap partially lies in the different geographic footprints of these REITs. While AVB, EQR, and ESS prioritize Coastal markets, MAA and CPT have a Sun Belt focus instead.
Equity Residential Footprint
AvalonBay Communities Footprint
Camden Property Trust Footprint
Mid-America Apartment Communities Footprint
Investment Thesis for Essex Property Trust
Established in 1971, Essex somewhat differentiates from all the above, as it is the only name in the group focusing entirely on California (82% of NOI) and Seattle (18% of NOI).
While some readers may balk when seeing California, especially after reading the news regarding the state of affairs in SF , it is essential to note that suburban properties comprise 85% of ESS's portfolio. Some of the wealthiest communities in the world are and will remain in California, which alone represents the 5th largest GDP in the world.
The overall market economics in which ESS operates look attractive, with Essex's portfolio average rent-to-income sitting comfortably below 25% and the median household income strong at over $100k. Homeownership might be difficult, despite the abundance of skilled, high-income labor in these markets. The median home price in places like Orange County and Santa Clara is above $1 million, with a home price to median income ratio slightly above 8x.
ESS management highlighted in its last presentations and calls that, with home prices soaring and interest rates on mortgages skyrocketing, the high cost of homeownership will continue to favor renting. It is over 2x expensive to own compared to rent in Essex markets.
Indeed, also according to this article , the median rent of $2900 - $3100 in SF, LA, and San Jose is way cheaper than the monthly cost of owning, estimated in the 5k+ range. With an average rental rate below $2,600, ESS rentals fall below the reported median values for these urban metro areas.
In addition, Essex remains financially sound, with a BBB+ credit rating and a long history of raising dividends that places the company within the prestigious "Dividend Aristocrats" club. Net Debt to EBITDAre remains at historically low levels at 5.7x, a slight increase vs. FY22 but below the surge to 6.6x during the pandemic and comparable with FY19 level of 5.5x. The debt repayment ladder is well stretched, with no single year with repayments at over 14% of the total and 12.2% of the debt maturing beyond 2032.
The company continues to secure financing at relatively attractive terms and recently closed on $298.0 million in 10-year secured loans priced at a 5.08% fixed interest rate. The proceeds will repay most of the $400 million unsecured notes due in May 2024, yielding 3.875%, so the spread is approximately 1.2%, and the negative interest expense impact is limited to less than $5 million.
2Q23 Results
On July 27th, the company announced its 2Q23 earnings. It was an excellent report, with ESS beating consensus and reporting Q2 core FFO per share of $3.77 vs. $3.73 and $3.68 in the year-ago period. The company also significantly raised its FY23 guidance from the $14.59-$14.97 range to $14.88-$15.12, a roughly 1.5% increase at the new midpoint of $15.00 and better than the $14.85 consensus.
The same-property portfolio still sees Q/Q increases, with both SoCal and NorCal segments reporting a 1.6% revenue increase. On the other end, Seattle recorded a mere 0.3% growth that would seem to confirm the cooling of shelter inflation. Another bullish point of the release was that the company now forecasts operating expenses to grow at about 4% year-on-year, down from 5% at the previous guidance and below the revenue growth. FY revenue growth guidance accelerated from 4% to 4.4%, and the combined effects determined that NOI growth is now seen at 4.5%, up from 3.6%.
Portfolio occupancy remained high at 96.6%, down 0.1% vs. last quarter, but still +0.5% vs. 2Q22.
Comparing Results vs. Peers
Essex's results were undoubtedly good but can and should be put in perspective since some of the peers also reported theirs. Mid-America Apartment Communities and Equity Residential also released their 2Q23 results, while AVB will do so on July 31st and CPT on August 3rd.
All three REITs performed well, with EQR raising core/normalized FFO guidance by $0.02 and MAA by $0.03, although these revisions were not as robust as ESS. Scrutinizing performance details more closely, we can see that ESS was not the group's best performer when comparing data on a Y/Y or Q/Q basis. MAA comped relatively high vs. LY but sees a more challenging outlook, while EQR provided the most bullish stance for the year's second half. Therefore, coastal markets' outperformance seems explainable by the forward-looking nature of the markets. Still, ESS's focus on West Coast appears to be the wrong one, with East Coast markets fueling the EQR's recent growth and looking more promising than the West Coast. While MAA now sees a core FFO improvement of only 0.44% for H2 vs. H1, ESS a 2.1% increase, EQR is seeing a whopping 8.8% growth!
And Value For All
Takeaway Message
With favorable long-term macro trends and the relative affordability of renting vs. owning, I maintain a moderately bullish stance on all apartment REITs covered here. With a long holding period and a buy-and-hold attitude, all these REITs should do reasonably well.
I do not think short-term fluctuations in Q/Q results should be the primary driver in choosing the best addition to one's portfolio. ESS has distinctive traits that may make the company a potential good pick for income and DGI portfolios. The company has a remarkable streak of dividend increases, a sound balance sheet, and a focus on wealthy communities in California.
Despite headwinds, the extensive base of high-income labor working for the tech industry is not going away, and places like Silicon Valley will continue to attract brains from all over the planet. With a NAV estimate for ESS is about $300 per share using a 4.5% cap rate and $250 using a more strict 5.0% cap rate, the company seems to provide a decent entry point, although I don't see the shares as wildly undervalued.
Essex Property Trust might be worthy of a BUY rating, with a target long-term total return in the 10% region if FFO/AFFO fwd growth can return to stabilize around 6%. However, I don't see a significant chance of an upward re-rating to enhance this return further, so ESS may or may not be a good fit for different types of investors. I will continue to monitor the name and might even add a few shares at some point, as its focus on the West Coast sets the company apart from its peers.
Despite the more challenging outlook for the year's second half, which may be causing the temporary underperformance of its shares, I continue to favor MAA over ESS for my DGI portfolio with a buy-and-hold strategy. Even if coastal market REITs have outperformed in recent months, there is no evidence that Sun Belt-focused REITs like MAA and CPT will continue to underperform operationally. MAA's 2Q23 results were still more than decent, and FY guidance comfortably outpaces ESS.
And Value For All
Also, leverage-wise, MAA is relatively better than ESS's. The company maintains a superior balance sheet with overall low debt and an "A-"credit rating from both S&P and Fitch. Because I view these REITs as buy-and-hold investments, I also put some value in assessing the past ten years' total return performance. From the below graph, MAA emerges as the clear winner and the only name in the group able to outperform the S&P500 and VNQ significantly.
Nevertheless, it appears that East Coast markets are set to outperform in the coming quarters, which is why EQR and AVB have significantly outperformed in recent months. AVB, which has the heaviest exposure, by no coincidence, is the name that has fared the best. Investors looking to further capitalize on this momentum might therefore prefer adding these names vs. ESS or MAA.
For further details see:
Essex Property Trust: Beat And Raise, But The Wrong Coast