2023-07-29 03:45:06 ET
Summary
- Essex Property Trust has a heavy exposure to California, resulting in a 33% drop in stock price, creating an attractive valuation.
- Demand for residential space in California remains resilient due to solid job growth and the high cost of homeownership.
- Q2 2023 results show solid growth, increased guidance, and a strong balance sheet, indicating the company is doing well operationally.
Essex Property Trust (ESS) is a residential REIT which holds properties in 8 major metropolitan areas on the West Coast. The company has a heavy exposure to California, which has scared many investors away, but I think this is exactly where the opportunity lies as it has resulted in a very attractive valuation as the stock price has dropped by 33% over the past year and a half.
Market Overview
When I say heavy California exposure, I mean heavy. 41% of properties are located in Southern California (mainly in and around LA), 41% in Northern California (mainly in the Bay area) and the remaining 18% are in Seattle.
We've all seen the headlines that say that California is dead and everyone is moving to Texas, but I'm not quite seeing it in the data. At the end of the day, everything comes down to supply and demand and from where I'm standing, the supply-demand dynamics seem to be quite balanced in California.
Sure, demand might be lower, but so is supply as construction activity has largely moved to faster growing Sunbelt markets. It's not all doom and gloom as the media would have you believe. In particular, there are two data points, that confirm my thesis of resilient demand for residential space in California:
- solid continued job growth in markets where ESS operates in line with the national average. This is important as people often go where jobs are.
ESS Presentation
Moreover, the job growth is likely to continue in the future as California remains the place to be for tech companies. This has recently been confirmed by AI funding which was four times higher in California than in the rest of the country combined. Texas might be in the news as the place to be, but I think it's more prudent to follow the money which suggests that California will be the long term winner.
ESS Presentation
2. the second reason is that it's currently more than twice as expensive to own than to rent which leads to many renters by necessity (simply because they cannot afford to own). This obviously has a positive impact on demand for rental housing and is unlikely to change anytime soon.
Q2 2023 Results
Recent results confirm my thinking, as Essex has reported solid growth and increased their guidance for the rest of the year. Same-store revenue results have been particularly impressive, as rents have increased by 5.2% YoY on a portfolio basis. It's true that delinquencies ticked up, as various moratoria ended, but a 4% overall growth is still pretty good.
Occupancy has remained equally stable, actually increasing YoY from 96.1% to 96.6%. This has led to core FFO growth of 5.1% YoY. I don't know about you, but to me that indicates that on an operational level the company is doing just fine and there isn't much to worry about.
Perhaps even more promising is the fact that management has raised their core FFO guidance for the rest of the year by $0.22 at midpoint to $15.00. That's about a 1.5% increase in guidance and if delivered will represent a solid 5%+ YoY growth for the company.
In the meantime, the company maintains a strong BBB+ rated balance sheet with reasonable leverage at 5.7x EBITDA. With immediately available liquidity of $1.6 Billion (as of June 30), ESS should be able to cover their debt maturities as they come due pretty easily.
Valuation
At $231 a share, the company pays a 4% dividend and trades at just under 16x FFO. Historically, it has traded closer to 20x FFO. That means that there's a fair bit of upside if the company can return to where it has historically traded and I believe that when the market sees that California is not going anywhere, the stock will return to that multiple.
Still to air on the side of caution, I will forecast the stock at 18x FFO which leaves about 12% of upside from multiple expansion. Add to that expected FFO growth of about 3-4% per year and a 4% dividend and you could easily see double-digit returns from ESS.
This is not the kind of stock that will make you rich, but it's also not one where you may lose half of your money. 10-12% annual return is still solid which is why I rate ESS as a BUY here at $231 per share.
Risks
If you're a regular reader of my articles, you know that I always talk about risks to my thesis. Beyond the obvious ones that apply to all REITs such as a potential recession and/or a continued increase in interest rates, the single biggest risk for ESS has to do with their geographical allocation. I don't have a crystal ball and I could be wrong about California. If job growth slows and tech companies leave the state in large numbers, the REIT could be in trouble and my forecast would likely not hold. So far though, the data I'm seeing is NOT indicative of this.
For further details see:
Essex Property Trust: Don't Mind The California Exposure