Essex Property Trust, Inc. (ESS) Earnings Call Transcript & Summary

Hi, everyone. Welcome to the Essex Property Trust presentation. Thank you for joining today. I'm Jeff Spector. I head the U.S., the BofA U.S. REIT team. And again, thank you for joining the Essex Property Trust presentation at the first virtual NAREIT. With me today is the Essex Property Trust management team. And I'm going to pass along the call to CEO, Mike Schall, who will introduce his team, and they will discuss some opening remarks, and then we'll get into questions. With that, I will pass it on to Mike.

Okay. Very good, Jeff. Thanks so much for moderating the panel, and thanks, everyone, for joining us today. John Burkart, COO; and Angela Kleiman, CFO, are also here today. And so I wanted to start with a few introductory remarks for those that may not know Essex. So by way of background, Essex is an S&P 500 company, and we own over 60,000 apartment units along the West Coast. These are the coastal urban areas from Seattle to San Diego. These are areas with significant housing shortages, estimated recently at somewhere around 3.5 million too few homes. And we note that this year that actually the supply trend is declining amid COVID-19. So nothing on the horizon appears to be making that shortage any better. Over the past decade, many of the fastest-growing economies in the country were located on the West Coast, especially the tech-oriented areas of Northern California and Seattle, which is most of our portfolio. Our belief is that the tech industry will continue to create value and wealth. And therefore, high-paying jobs, and they will draw as a result of that, many service jobs to the West Coast, so-called multiplier effect. We certainly expect to weather the COVID-19 storm well, although this has been one of the challenging -- most challenging periods of my career. I've been here almost 34 years and it's posed a number of very unique challenges, which no doubt we'll talk about in a minute. In terms of our track record, I think it's important to note that we, over our 26 years following the IPO in 1994, we've generated a 15.5% compounded annual return to shareholders over, again, 26 years. And actually, it was better last December. So the COVID-19 impact has hurt that number a little bit, but still very compelling. And it's also important to note that we are an S&P 500 Dividend Aristocrat, having paid an increasing dividend every year for the last 26 years. It's currently $8.31, which is about a 3.4% yield. Again, we've never experienced anything quite like COVID-19. It's posed a number of very unique and unprecedented challenges to the company, but I think we'd respond well. Initially in the crisis, we were given notice to shut everything down. On Tuesday morning, we were trying to figure out how to redo our leasing process, which was -- which took a tremendous amount of effort and was followed by a month or so of very little leasing activity, which we've made up for since then. So it feels like we're transitioning from playing essentially defense into offense as the markets reopen, and we definitely have seen a nice recovery in demand since that happens. The company has a very strong financial position and so we feel very comfortable on withstanding the downturn. We have over $1 billion in immediate liquidity and a variety of other capital sources. So with that, I was hoping to have John Burkart give a few comments, a quick ops update before we go to Q&A. John, do you want to take over from here?

Yes. Thank you, Mike. So the -- Essex has a presentation up on the web and our operations update starts on Page 15. The -- we're certainly feeling the positive impacts of the summer leasing season as well as the relaxed stay-at-home orders. We're seeing traffic as well as net applications increased significantly. As I mentioned on the first quarter conference call, we hit a low in early April and the graphs on Page 15 really show that, and they show the bounce back subsequent to that. So things are operating as we hoped, as we expected. On Page 16, we have a variety of operational metrics, including our delinquency. So our delinquency in April was up 5% on a cash basis, and that's now down to 4% in May on a cash basis. So that's going in the right direction. Another good thing there. As we look at leasing, our strategy, I mentioned on the call, we're commonly offering 2 to 6 weeks free in concessions on new leases. And you can kind of look at it in a sense of like a development lease-up, where we're providing the level of concessions to increase our absorption. That strategy is working very well. We've increased our occupancy 30 basis points to 94.7% as of the end of May. We continue to see challenges out in the marketplace. But overall, the market is working as we would expect. And we, again, are in chronically undersupplied markets. So adjusting pricing in effect creates demand and we're seeing the positive benefit of that. So we've been through different cycles in the past. This one is quite unique because of the COVID aspect of it. But at the end of the day, the fact of the matter is that we're supply constrained. We lack enough housing for the people out there. We do expect and we are seeing that an adjustment in price will improve our position. And so that's all going as expected, as I mentioned on the call. And with that, I'll turn it back to Mike or Jeff.

Great. Thank you, John, and thanks, Mike, for the introductory remarks on Essex Property Trust. Again, thanks for allowing me to host the call today. And now we'll get into about 20 minutes of questions. Mike, appreciated the quick introduction on Essex, but for those that are new to the story, and it is important, one of the top incoming questions we're getting on your sector. And as people think about the implications of COVID-19, which is hard to determine now but they're asking about regions. And Essex has strictly really been a West Coast-focused apartment REIT. Can you talk about that strategy? Have you ever thought about different markets? And how comfortable are you today with your current markets? Would you even think about entering other markets?

Yes, Jeff, that's a great question. And we have, from time to time looked at other markets. And they would be areas that we think are similar to Essex and the things that we think make Essex very unique. And again, there are a few other markets, mostly on the East Coast that satisfy more broadly some of this criteria. But we believe strongly and certainly the tech ecosystem. So that consists, obviously, of engineers, programmers, venture capitalists, intellectual property attorneys. And I mean in bulk, not just a few of them, but many of them. And because there tends to be like-minded companies, very innovative companies around these people. And the confluence of them with the right amount of capital, certainly, the venture capital industry has certainly changed the world in so many ways. And in so doing, it has created an enormous amount of wealth along the way. And the good thing about creating wealth is it also creates other types of jobs. So not just the technology jobs, it creates service jobs as well and the so-called multiplier effect. So in a nutshell, and George Marcus was -- he started this many, many years ago, looking for an advantage and look with respect to owning apartments and quickly focusing on the concept of research, which when it started in the early '80s, there was very little data. There's huge amounts of data today. A lot of it conflicting just by way of background, but at the time, there was very little data that was available. But he realized pretty quickly that this is a supply and demand business. And so looking at both parts of that equation, you want very vibrant, strong, wealth-creating companies on the one hand, and then you want to have some constraints to the supply of housing on the other hand. And where those 2 conditions exist, you end up with something that is pretty remarkable. And so I'd say if you look back, coming out of the great financial crisis, since then our -- I think our average is somewhere in the zone -- our average same-property revenue increase over the last 10 years is somewhere between 4.5% and 5%. Over the last 5 years, it's a similar number. More recently, as we've talked about on our various calls, affordability has become an issue, in that early on coming out of the financial crisis, rents were growing much faster than incomes and creating an affordability issue. Well, I think that, that is really flipping around right now. For the last couple of years, incomes have outgrown rents. And certainly, that's improved affordability. And then, of course, we have the COVID effect where rents are declining, and that should, again, help that ratio. And so I've seen throughout my career here of over 30 years, coming out of recessions are generally a pretty good period for us in terms of growth and opportunity. And I kind of expect that same thing to happen this time.

And just thinking about the concentration in your earlier remarks on the tech industry, clearly, it's been an area of strength in terms of your renter base or attracting tech employees to your apartment buildings. Can you talk a little bit about, I guess, your latest thoughts on the tech industry? How do you track the health of the tech industry to gauge your demand for your business?

We use all the traditional ways of tracking. Certainly, job growth is a key part of what we do. On the supply side, we do our own ground up research. Essentially, our research team, driving around and trying to survey apartment buildings that are under construction that will come at us. We've created something that's called a supply radar, which gives us a longer-term view of what's under construction and where the concentrations are within our marketplaces. And then we've done a whole bunch of things on the other side, on the demand side, too, from tracking venture capital. We are on almost every conference call for the last several years. We've talked about the open positions of the top 10 tech companies, public tech companies, all of which are located or headquartered in an Essex market and try to keep our eye on that, certainly, with respect to office construction because we need office space to bring more workers here. If we saw anything that would -- that interrupted the office construction market, that would be concerning. Now we can argue that COVID-19 may have an impact on office without affecting where people live or perhaps it affects both to some extent. But I guess the point is, we're always looking forward in terms of that research effort to try to determine what future supply/demand looks like. And then we would -- then we adjust the portfolio. We've been as much as 60% Southern California, and we're currently maybe just over 40% Southern California now. So we will vary the portfolio depending upon kind of that future outlook for supply and demand throughout our markets.

And I thought there was a very interesting slide in your presentation that was new information to me and my team. I think you pointed to some recent data that indicates there might be migration back into California from neighboring states. Can you comment on that?

Sure. And Mr. Burkart may have a comment, too, about this one. The purpose of that is, we, for many years, attract another piece of data, the U-Haul data. Well, the U-Haul data would indicate that the cost of renting U-Haul equipment to move out of California is much higher than what it costs to bring it back into California is suggesting a supply/demand imbalance. So we -- many years ago, we spent a lot of time on that. And we concluded that, that might be representative of the lesser skilled workers and lesser -- lower income worker. And we started using a variety of other data from migration data from LinkedIn, United Van Lines being more of a full-service mover, et cetera, and -- sort of to confirm these trends. And yes, so some of this was certainly indicating that some people are moving out of California. There's no question about that. That's no different from any of the last 20 years. But maybe the interesting part was the website hits from neighboring states looking for an apartment coming into California. And as we look at all the evidence, the -- our own internal statistics about where people are relocating, who's relocating out of the area, how has that changed over periods of time. We don't see anything that would indicate that there's been a dramatic shift in terms of where people are going, i.e., many more people leaving the area and a lot fewer entering the area. We see a more balanced approach. I think a lot of this is -- it's back to the jobs. And there's a quote on Page 19 that I would refer everyone to because I think this kind of captures the crux of this, which is the reason why people come here is they -- there are more jobs than there are higher-paying jobs here. And everyone makes more money. Yes, it is more expensive to live here, for sure. However, it's more about the balance between those 2 and also the quality of life considerations, which can include weather, schools, just overall livability. So we haven't seen anything that would indicate a -- preliminarily COVID-19 is a relatively new occurrence. But we haven't seen anything that would change our views about the markets that we're in at this point in time. And actually, in fact, I would double down on the tech part of it because it seems like if there is an area of the economy that has withstood this pandemic, it's probably the technology industries. Yes, they will slow down. And certainly, our top 10 -- the job openings at the top 10 tech companies have slowed down a little bit, but it still remains pretty strong. And so we think that the tech markets are still the place to be.

And just to make sure the audience is aware, a lot of incoming question that we get for you and your peers is just portfolio positioning, is this company -- does this company target A pricing versus B pricing, high-rise, mid-rise versus garden style, urban versus suburban. Can you just describe the Essex portfolio?

We can. And in fact, on -- there's a page in the presentation that tries to compare the Essex portfolio. So each of the properties are plotted on a graph, that's on Page 20. And so it will compare, for example, the rent in Downtown Seattle, $2,365 against each property in our portfolio and average rent within each one of them. And as you will see from that chart, we tend to be more suburban, more the medium price points, let's say, mostly the B quality product. And we just think that over time, that represents the best-performing sector. And certainly, when you -- when you're in periods of economic distress, I think that people make generally a more conservative housing choice because they're becoming concerned about that check that they write every month. And as a result, we think it's safer there. Notably, we've sold some new beautiful buildings in the downtowns. Masso was sold in Q4 in San Francisco, 8th & Hope the year before. So our movement has been to become a little more suburban than urban over the last couple of years.

Okay. And tying into that question, an important investor question is recession. And we know this time is different than prior recessions. But can you provide some information to the audience or at least discuss your thoughts on today versus prior recessions and the Essex portfolio?

Sure, we can. We published an update as part of the earnings conference call for Q1, and it is actually replicated on Page 17 of the investor presentation. And so at the beginning of the year, we expected another very good year, and that changed rather dramatically amid COVID-19 and market rents were up about 3% for the first quarter, that was relatively good news. And we thought that a good start to 2020. The pandemic changed all of that. And we withdrew guidance along with all the other multifamily companies. And our preference has been -- it's first time ever, I think, that we've withdrawn guidance. And our preference is to provide what we can to the marketplace. And because our view, having been in these markets and done this for a really long time, probably has some merit. And so we published S-16 to the supplement, which is reproduced on Page 17. And it paints a much different picture than what we had there previously. So this scenario assumes that job losses for the year will be around 900,000 in the West Coast markets, that's 6.6%. And the production of housing will slow, but not enough, given the job losses, such that the average rent for -- the average rents, we think, for the year will be down 2.8%, so that's our best estimate. You can say, "Well, if you can't go that far, why don't just give guidance?" And the answer to that question is that there are a whole series of assumptions that are pretty difficult and challenging to quantify. And I'll give you an example. So within the 5% delinquency in April and 4% in May, given the government restrictions on evictions, how do we collect that? How much of that is collectible and what is the impact? How do we evaluate the bad debt, given that in our normal pace of bad debt is somewhere between 30 and 40 basis points? So -- and the longer that remains outstanding, that will probably less collectible it becomes. So that's one issue within the cadence of opening up and how that goes and second waves and all the other various parts of this to go in -- that would go into FFO guidance become pretty challenging to predict. So we provided what we could, that's on Page 17. And we'll see what happens. I mean it definitely feels better. John's Page 15, where we went through this period of time where we didn't lease anything as we were trying to limit interactions between potential residents and our staff, and we closed the leasing office and trying to do everything online, that took some time. So we're playing a little bit of catch-up, but we feel much better today than we did even a few weeks ago as it relates to the amount of leasing activity that's out there because it seems to have come back pretty strongly.

Okay. And before we get into just some further discussion on fundamentals and thoughts possibly post-COVID or implications on your sector portfolio. Slide 6 on your dividend growth, FFO growth historically, very impressive S&P Dividend Aristocrat. I'm sure a lot of people in the audience are asking the question about your distribution. Can you talk about, I guess, your -- at least your distribution policy? And does that -- should we tie that into kind of your thoughts around your balance sheet? I know you mentioned $1 billion liquidity. I'm assuming balance sheet strength and when the Board thinks about the distribution or the dividend distribution, it's tied together.

Angela, do you want to handle that one?

Sure, sure. No, that's an important question as it relates to financial strength and liquidity, especially in the current environment. So I'll talk a little bit about the dividend question that you asked. We -- in terms of just how we approach our dividend, the payout ratio is really a function of FFO growth. And for Essex, we've ranged -- we've always been relatively conservative in how we approach that. And so for the past 10 years, our payout ratio range around 60% to, say, high 70%. And at the beginning of the year when we raised our dividend for the 26th consecutive time, we had target a low 62%. And so even with the current environment, we certainly are well covered just from cash flow from operations. And on the call, I also discussed that as far as our funding needs for the whole year and frankly, most of next year, we are well covered. We already have all the funding that we need to invest in our business to run the company and for other external growth activities. And so with really not have funding needs anticipated and a well-covered dividend from cash flow, we certainly have a great position. But we also provided some additional information on Slide 25, or Page 25 of our presentation. And what that does is it shows the investors where we were prior to the great financial recession back in first quarter of '08 and where we are or most recently, as of Q1 in 2020. And I think a couple of key ones to point out is, we have the net debt-to-EBITDA back then heading into the Great Recession were 6.5x. Currently, we're below 6. And unencumbered NOI to total NOI, back then, we were only at 28%, and currently, we're 90% unencumbered. So not only do we have our funding needs covered and cash flow available for distributions on the dividend side, we also have a much stronger balance sheet this time go around as well.

Angela, I know we only have a few minutes left, but I guess you mentioned external growth. And when you look at the strength of the balance sheet, and historically, Essex has been opportunistic in downturns. Do you think that could happen this time around? Do you see Essex being opportunistic?

Well, Jeff, this is Mike. Yes, we certainly do. I mean, there are inevitably more opportunities in downturns than just the status quo markets where everything is very predictable because right now, there's pretty significant uncertainty about what properties are worth in the marketplace. I noted on the conference call that there's probably a 30 to 60 basis point difference in cap rate expectations between buyers and sellers right now, which is, yes, pretty wide. And certainly, significant enough that could dramatically reduce the number of transactions that are out there. But having said that, the other piece of this is looking at the underlying financing rate and so -- and the other dynamic. So I'd say as it relates to direct development, we'll start there. There is a chance that maybe the contractors will -- their increases in cost will abate and maybe even decline a little bit, which will make us more interested in development certainly. I've noted on many conference calls in the past that with construction costs growing in the high single-digit range per year and the -- and rents growing at 3%-ish. That is not a happy thing for direct developers that sometimes can take 3, 4, 5 years to entitle a property and can be delayed well beyond that if things go wrong. So there could be some opportunity in direct development. We -- the preferred equity world, again, there's disruption there. Banks are likely to be less aggressive. That makes our niche there more attractive and appealing. And I think that probably the deal flow could increase in the preferred equity area as a result of that. And then we're going to probably cut back on redevelopment, I can say, a bit just because keeping price points down, again, during this uncertain period is probably the right thing to do there. In terms of acquisitions and sales, I mean, the -- how the public markets value our stock and how private market buyers, again, subject to the 30 to 60 basis point difference, how they value properties in the private markets seems pretty wide to us. And so whenever that occurs, we look for arbitrage or without taking additional leverage on, on a leverage-neutral basis, just making sure that if there's an ability to transact, to sell assets in the private markets, buy stock back or reinvest in preferred equity or other things, that's always something that we have done well, especially during times like this. And again, the 30 to 60 basis points kind of is a general concept. The reality is when you drill down into that, you'll find there are some motivated buyers out there. For example, 1031 Exchange buyers, et cetera, that have the need to acquire something. And so I would say that at this point, we're looking for the more motivated buyers. No doubt, we talked to a lot of people in the last couple of months, and we tell them all, "Hey, look at our balance sheet, we're not stressed." Many of them don't believe us, and they threw out a very high cap rate on buying property. And we say, "No, thank you." Because we don't -- as Angela points out, we're not in a position where we have to do anything. And -- but we want to be opportunistic and look at transactions. So if I think about acquisitions, completing acquisitions in our co-investment format, which is we own half and a large pension fund owns another half of the other half of the property, and we go get secured loan, which we priced one recently. I noted on the call was that 7-year loan, 2.75%, ended up closing at 2.55%. And so if you're buying something at a mid-4% cap rate with 2.55% financing for 7 years, that generates a lot of cash. And I don't see how you can have -- you can argue that there's going to be a huge amount of distress when you have that amount of cash flow coming out of a transaction. And in fact, I would argue just the opposite. It -- probably cap rates are going nowhere or perhaps they trend down a little bit as there's a little more certainty out there.

Okay. Mike, that's very helpful. I know we're 3 minutes past our time allotment, 30 minutes goes by very fast. I hope this has been very helpful for the audience. It's been extremely helpful to me and my team. I guess, Mike, any concluding remarks for the audience, 10 seconds, 30 seconds on just Essex and go forward?

Yes. Again, it feels like we've been through this incredibly challenging period and now their -- demand is returning and things are looking somewhat better. Obviously, we're concerned about second waves of economic issues and/or COVID issues. But we feel like we're -- we've weathered the storm, and we're well positioned. And thank you, Jeff, and everyone, for joining the call today.

Great. Thank you, Mike, John and Angela. Thanks again for joining the Essex Property Trust presentation today, and we wish everyone well.