2023-10-12 00:39:48 ET
Summary
- Shares of Essex Property Trust have held up well compared to other interest-rate sensitive peers, with a 3% loss over the past year.
- The company's exposure to the West Coast may be less of a negative than expected, as in-state migration trends suggest it can weather challenges.
- Essex's suburban asset base and the trend of hybrid work schedules can benefit the company, along with high housing costs pushing more people into renting.
- With a 4.25% dividend and moderate growth potential, high-single digit return expectations are reasonable.
Shares of Essex Property Trust ( ESS ) have held in better than some interest-rate sensitive peers over the past year, losing just 3%. Shares of the apartment REIT now yield about 4.25%. While at first glance its exposure to the West Coast may seem like a negative relative to Sun Belt peers, given migration trends, I think Essex may be able to weather these challenges better than many expect, making it attractive for dividend-oriented investors.
I also would note that while ESS has outperformed the likes of Mid-America Apartments ( MAA ) and Camden Property Trust ( CPT ) over the past year, it has lagged them over the past five years, with shares actually down during that time. Major cities and California saw more economic damage during the pandemic causing rents there to underperform the Sun Belt—hence ESS’s underperformance in 2020-2021, and then as the Sun Belt has cooled and legacy markets recovered, catching up to some extent. Essentially, we have seen shares converge.
This can be seen in rental data. Over the past six and 12 months, some of the hottest post-COVID markets, like Austin, Miami, and Orlando have seen some of the slowest rental growth. Markets that have done the worst the past three years have generally done better over the past twelve months. There is one notable exception: San Francisco, which has the slowest growth over the past three years and sixth slowest the past year. That market remains deeply challenged and colors many of the fears around CA.
With this backdrop, if we look at Essex directly. It owns 252 communities, which have 62,000 units. As you can see below, it operates across California and Seattle. Here, I think it is important to emphasize that it only gets 2% of its operating income from San Francisco proper, though Oakland will of course have a correlation. Essex is a California REIT, but it is not a San Francisco REIT, which is a critical distinction to realize.
Additionally, we typically think of apartment REITs as being largely urban plays, since cities tend to have denser living with single-family homes dominating the suburbs. Essex is an exception to this rule of thumb with 84% of properties suburban and just 16% urban. To the extent quality of life issues are pushing people out of cities (a reason why San Francisco has been a chronic underperformer), if it pushes them to nearby suburbs rather than out of state, ESS can benefit from this type of population flow.
I also believe it is interesting that in its September update, Essex listed return to office requirements for big tech firms.
Hybrid working schedules, which are becoming a norm across many firms, actually can be a net benefit for Essex’s portfolio. If you have to show up to the office a few times a week, you cannot easily live out of state. However if you do not need to show up every day, you may be willing to tolerate a longer commute—an extra 20 minutes is palatable twice a week when it may not five times a week. Hybrid work makes it easier to leave city centers for the suburbs, trading more commute time for quality-of-life benefits. Again, this trend is a net positive for Essex’s suburban asset base.
Additionally, suburban California is notorious for the high cost of housing, a problem only exacerbated by the dramatic rise in interest rises over the past two years. It costs 2.5x as much to own than rent in Essex’s markets, worse than other regions. This pushes more people into renting, and it keeps them renting for longer. This is a net benefit for Essex.
This brings us to the conflicting issues at hand: how many people live in California vs where those who live in California choose to live. The first is a headwind, well known at this point. As you can see below, from 2000-2016, CA grew in lockstep with the country, but since then it has decoupled lower with its population down about 500k from its peak (~1.25%). While this gets much of the focus, I see where Essex is positioned inside the state as quite favorable as explained above and expect its localized population trends to perform better. I do not believe its California address is reason enough to be bearish.
Importantly, this thesis is playing out in the company’s results. In the company’s second quarter , core funds from operation (FFO) rose by 2% to $3.77 as same property revenue rose by 4%. Alongside these results, it raised guidance for core FFO to about $15 from $14.78. Revenue growth will be about 40bp high to 4.38%. Scheduled rents rose 5.2% while delinquencies dragged 1.5%.
One challenging aspect of operating in California is that the eviction process is quite time-consuming. Fortunately, the company is working well through this process, and we are seeing delinquencies steadily fall. I would expect this trend to continue into next year as the past-pandemic rise in delinquencies is fully worked through the system.
With its September data in hand, we can see more recent results. These are consistent with the slowing that we know has occurred in the nationwide rental market as well as relative outperformance of these trends by Essex. In Q2, same-store revenue growth was 4%. This slowed to 2.4% in July & August. In Q2, new lease rates were up 1% and renewals were up 3.4%. In August, new leases ticked up to 1.6% whereas renewals slowed to 2.9%, for a blended lease increase of about 2.3%. According to ApartmentList , rents are running 1.2% lower than last year, nationally. In other words, Essex’s portfolio is outperforming the national average by ~350bps. Additionally, its occupancy is holding strong at 96.5%, with 3.5% of apartments vacant, that is about half the national average. Clearly, its properties do not have the desirability/migratory problems, plaguing other parts of the state.
At its current share price, it has a dividend yield of 4.25%. Its dividend has a coverage ratio of about 1.6x, giving the company plenty of room to continue its streak of 29 years of dividend growth. With about $15 in FFO, it has a FFO yield of 6.8%. For a company that should be able to raise rents at least as fast as inflation over time and modestly grew units, given my view CA’s suburbs should outperform cities, we should see about 3-5% growth over the medium, creating a path of steady dividend growth and high single-digit returns.
Now, of course, any investment has risks. My view is that its population trends within CA will insulate Essex from migratory movement out of CA. This has thus far been true, but if we were to see the pace of outflow from CA worsen, that could begin to overwhelm Essex’s localized tailwinds. Moreover, interest rates are critical to real estate valuation and discount rates used for future cash flows. If we were to see rates continue to rise, that will be a headwind for shares. If the 10-year treasury goes to 5.5%, I would expect apartment REITs in general to trade lower.
Importantly, Essex is not uniquely exposed to higher rates. About 95% of its debt is fixed rate . In July, it shrewdly borrowed to fund its 2024 maturity, meaning it will not need to tap debt markets to refinance any debt at higher rates until 2025—by which time rates may be lower. It only faces about $600 million in maturities that year, about 10% of its debt, making it manageable to roll even at higher rates.
Overall, Essex may not have the growth potential of my preferred REIT, Mid-America , but it does have better growth than one might think based on its location. With an 8-10% combined return profile given its dividend yield and ~5% dividend growth, based on underlying earnings growth and its strong coverage ratios, I view ESS shares are broadly fair value and suitable for dividend-oriented investors.
For further details see:
Essex Property Trust: California Exposure Isn't That Problematic