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

Welcome to Citi's 2021 Virtual Global Property CEO Conference. I'm Nick Joseph with Citi Research. We're pleased to have with us Essex and CEO and Mike Schall. This session is for Citi clients only, if media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast. [Operator Instructions] Mike, I'll turn it over to you to introduce the company and the team, and then we can get into Q&A.

That sounds great. Nick, it's great to be here with you, and thanks, everyone, for joining. With me today is Angela Kleiman, our Chief Operating Officer; and Barb Pak, Chief Financial Officer. Pleased, obviously, to have them join me today. So Essex is an S&P 500 Dividend Aristocrat company. We own and operate over 60,000 apartment homes on the West Coast of the United States, the coastal, major metros from Seattle to San Diego. In our view, these are unique markets in that they have very strong demand drivers over time. Job growth on the West Coast generally exceeds U.S. averages, driven by the tech industries, which seem to be very well positioned at this point in time as the pandemic fades. The West Coast markets also produce less housing supply, although any supply amid the extraordinary job loss of the pandemic is problematic as we saw last year. And then finally, we have high cost of homeownership in our markets, which create a barrier to homeownership and an incentive to rent versus own. Largely because of these factors, we have a great track record. We just announced our 27th consecutive dividend increase currently paying $8.36 a share, which is about a 400% cumulative dividend growth since our IPO in 1994. And over that period of time, we've generated about a 15% CAGR of total shareholder return, again, over 26 plus years. We have a very strong balance sheet with about $1.4 billion in liquidity as of March 1 and less than $250 million in debt maturities in 2021 and 2022, and also a well-balanced maturity schedule. A quick update on current operations. The West Coast is beginning to open up from severe lockdowns over the past year. Partially because of these lockdowns, we've had a greater percentage of job loss versus the nation. We're seeing that changing now and have a few positives to point to. Certainly, the recovery in job openings at the top 10 tech companies, which dominate these markets and record venture capital funding in 2020 and a record number of IPOs. There were 480 in 2020 in the nation and 147 of them were in the tech industries and 90 California companies went public last year. So as we mentioned on the fourth quarter call, net effective rents have stabilized in the quarter, and that's continued into January and February of 2021. And that's my quick intro, Nick.

Great. Thanks. We're starting our session off with the same question. Coming out of the pandemic, if an investor were to choose only 1 real estate stock to own, what are the 3 reasons why they should invest in Essex?

Well, I think it goes back to the track record, #1. And there are 2 items within that. Exceptional total returns over the last quarter century. So again, the 15% CAGR of shareholder return over that period. And also, our focus on the dividend. We've grown the dividend every year for more than 25 years. And so that made us a Dividend Aristocrat, which obviously is a pretty big distinction in the REIT world. And I would add to that, it's really because of the job base and the dynamics of housing yield, limited housing production that make the West Coast grow faster. So -- and I'd certainly add the sort of the coattails of technology companies that tend to be here on the West Coast are the key reasons why someone should invest with us.

Great. Why don't we start on operations? You mentioned the operating update for the watching. There's an investor presentation for the numbers. But why don't we start at, I think it sounds like year-to-date you're in line with expectations, with renewals leading the way, new leases still challenging, but maybe you can talk about the sequential trends that you're seeing since the fourth quarter in January and February.

Sure thing, Nick. So we have a presentation on Page 25 that provides some additional color on what we're seeing in terms of our operating fundamentals. And you'll see that on Page 25, we share the revenue growth of negative 8.3% in January and February. And this is actually consistent with what we had anticipated and also consistent with what Mike just shared that in that net effect rents or revenues are generally stabilizing. But from a year-over-year perspective, what we have was a very strong January and February last year. In fact, the rent levels were some of the highest we ever had as a company. And so because of those year-over-year dynamic, we are going to continue to have these year-over-year headwinds for comparative purposes. And that we expect and we communicated this on the recent earnings call as well to kind of play through in the first half of this year. But what you will see here is that you'll see the occupancy has improved from 96.5% and to 96.7%., so from fourth quarter to the last -- in the last 2 months by 20 basis points. The other piece is really the cash delinquency. And you'll see that in our supplemental, which is now on here, but we have reported in the fourth quarter, cash delinquency was at 3.5%, and it's now 2.7% in fourth quarter and now slightly better at 2.6%. So we have an environment where occupancy is improving and concession is improving. So that's another piece of the market dynamics. On the bottom of Page 25, we also shared the operating statistics. And so you'll see that our blended lease rates are at negative 6.2%. But once again, those dynamics really reflect the strength of January and February last year. And last year, we were in a positive territory, almost 4% of the blended lease rates. And of course, naturally, this year, where we are today, we would expect a negative number. But once again, we expect first quarter year-over-year to be the toughest comp, slightly better in the second quarter. And so once we move the cadence, the third quarter will be generally flat and positive in the fourth quarter. And so that's the expectation of the cadence of our business.

That's really helpful. It sounds like from a portfolio perspective, it's generally in line with where you'd expect things to be so far. How about from a market perspective, are there any markets where you're seeing kind of stronger results or weaker results versus your expectations?

No. We haven't been surprised on the market side as well. And Mike, please chime in. But what we're seeing is the urban CBD that has been challenging. We expect that to continue to be challenged, both as Mike mentioned, we are starting to reopen the restaurants and some of these other amenities are starting to reopen. And so -- and then if you look at, say, L.A., we have fulfillment industry that's starting to come back as well. And so, so far, we haven't seen anything that has been surprising. Mike, is there anything else I should add or?

No. I'd just say it's been -- it's early days. And Angela said that, and I totally agree with her. Our lockdowns are ending. They were intensified in Q4, and that has the effect of slowing economic activity. And so we still believe really early on in the pandemic, we made this comment that the path of recovery will largely follow the jobs that we lost. So those jobs are concentrated in the inner cities. And again, they're typically in the restaurants, the services -- service sectors, entertainment, travel, hospitality, those jobs are concentrated in the city center. And so in effect, those are relatively low wage workers that have those jobs. And so when COVID hit, it really had very few choices. They can either move very quickly or stay protected by anti-eviction ordinances. And so as you start looking at that, those industries, is the demand for restaurants and entertainment different in a post-COVID world? We think not. So we see that as a natural benefit to what's going to happen here. As those jobs will come back, they've recently opened in some counties to outdoor dining only, but at 25% of capacity, typically. So again, a lot of those jobs are still on the margin and have been lost. The motion picture industry, which has decimated L.A. L.A. normally fares better in a recession than the tech markets do. But in this case, it really didn't because of the impact of COVID on the motion picture industry. Again, we don't see anything fundamentally wrong with the -- or bad about the motion picture industry. The demand for content, we think, will be very strong coming out of this. There are a lot of contract workers that are associated with the motion picture industry. They all left amid COVID and would be expected to come back to the markets. And then that leaves us with the tech companies, which we think, for the most part, they did extraordinarily well during the pandemic, and they are, I think, incredibly well positioned. We survey the top 10 tech companies. As you know, we've done that for many years. And we found after a pretty significant about a 30-plus percent reduction in open positions in the middle of the pandemic that we've recovered those openings. So the job openings of the top 10 tech companies are now nearing their prior peak, which was in March of last year. So obviously, that's good news. And because of the concerns about where those jobs are going to be hired, we've surveyed the different geographies across the country, and that's on Page 18 of our presentation. And once again, the vast majority of those jobs are on the -- in the coastal markets of Northern California and Seattle, once again. So we see a strong recovery in the tech jobs as well. And we feel very good about things. Again, it's off to a little bit of a slow start. I mean, we're stable, but we haven't seen a big push. But typically, the seasonality of the West Coast goes through Super Bowl Sunday, and with the COVID-related restrictions, maybe a little bit longer, but we're very optimistic that this unwinds nicely in the next several months.

And what are you seeing, I guess, on the ground in terms of traffic trends or demand trends from a sequential standpoint? And then how does that play into your pricing strategy and the use of concessions?

Angela, you want to do that?

Yes. So we are seeing -- we look at net applications because that's a better indication because traffic, we could generate that, depending on how you want to market the assets. And we are seeing that applications up and we focus on maximizing revenues. And so we focus on our occupancy strategy. And so what we're seeing right now continues to essentially validate our expectations, which is we are in a gradual improving dynamic. We are -- our occupancy is increasing amidst the pulling back concessions and the market rents are stabilizing. And so all things are indicating the we're starting to turn.

Mike, you mentioned the -- kind of the large kind of companies on the West Coast and the dynamic nature of them historically. Everyone being virtual for the last year, obviously, the big topic is will people be more flexible in terms of where they work from or how often they're actually in the office in terms of commuting? How do you think about that in terms of kind of demand in California and Washington? And if those incremental jobs may ultimately be more remote versus where they were historically?

Yes. That's a million-dollar question there, Nick. So -- and all of us are trying to, again, adjust to the post-COVID world, and there's not -- we don't have a template. Again, never seen anything quite like the pandemic in my 30-plus years here at Essex. And so we're trying to be very careful. We try not to be idealistic about our markets, but go out and seek information that supports or conflicts with potentially so we can mid course correct if we're wrong about something. But what we see more recently more and more is most of the companies opting for a hybrid model. And actually, we have a slide on this, point 2 on Page 19, where we've provided the reported office opening dates for the major tech companies. And we tried to break lot of the major tech companies into a graph that shows quartiles that show what their expectations are going forward. And the winner in that is in this upper right quartile of that graph where most of the companies appear to be going toward a hybrid model. And again, this is not us. This is us trying to do research and trying to understand what these companies are going to do. But we see the hybrid model is offering a lot of benefits to the worker and still keeping the dynamic of, hey, we need to know one another, we need to act as a team, we need to trust the team members. Conquering complicated issues is best done with a collaborative smart group. And so I think those are the key arguments in favor of sort of the hybrid model, sometime in the office, sometime working remotely. And healthy amounts of both of those things. I think as I think about Essex and work from home, I think that we will also do a hybrid model. And I guess my chief concern about the hybrid model is whether you end up with a 2-class system. Those that show up in the office are more likely to be promoted. And those that are work-from-home mostly are not well-known and somehow are held back. And I think that, that is a key issue, which I don't think anyone has figured out a solution to. So our best estimate is that, and that has implications on portfolio strategy, and I would think that we would gravitate all things being equal, which they're not right now. Cap rates vary greatly between the city centers and the suburban markets. But all things being equal, I think that would tend to lead us to the high-quality markets where people want to live, good schools, low crime rates, high quality of life, some activities and proximity maybe to some of the entertainment of the bigger cities.

But do you think that kind of medium and longer term, I recognize this is an impossible question to answer today, but California has had very strong growth over the long term. Does this impair growth in California or in Washington and kind of benefit some of those other states where we've seen some population inflows?

Yes. Over my career, I've heard this several times, and certainly, the news media has picked up this, everyone's leaving California trend, and things are going to be fundamentally different. I think 1 analyst group went as far as to compare San Francisco to Detroit, which I think are incredibly different things, and I'm amazed that anyone would make that comparison. But I think that tech is here to stay and the dominance of the tech companies is, I think, hard to argue with from my perspective, and you can say, okay, well, where will the tech companies locate? Will they relocate vast parts of their operations to other places? I mean they will, on the margin, because they'll take the more typical corporate functions and probably move into less expensive areas. But the knowledge part of it and the innovation part of it, which is really what the West Coast has been extraordinarily successful at retaining. I have a hard time believing that, that goes very far from the West Coast. And as long as those core elements are there, and there's been, obviously, a tremendous amount of money spent on these corporate campuses in order to try to provide for all the needs of the worker from day care and all sorts of things that I suspect that it will remain. And so again, I've seen it -- I've seen this a number of times at the period after the .com period or the .com burst period where everyone's leaving California, again, in the financial crisis. A lot of the same headlines actually throughout both those periods of time. Both of them went out to be very, very wrong for the net result. I suspect that same thing will happen again.

What are you seeing on the regulatory side, both as the market starts to normalize and the ability to raise rents and then also just on eviction specific to California and the ability to be able to charge rent for anyone that you haven't been thus far?

Yes. Well, we saw a bill passed recently in California, SP 91, and it had both good elements and bad elements. The negative element is it moved the goalpost for when tenants had to start paying rent, the tenants that were affected by COVID-19 when they had to start paying rent. The prior law was by January 31, 2021, they had to pay 25% of their rent -- at least 25% in order to maintain eviction protection and so that goalpost was moved from January 31 to June 30 of this year. So that's the not good news. So which means that there are a number of residents within the Essex portfolio that will go potentially almost a year without paying any rent and makes the likelihood of them maintaining eviction protection in June less likely, I would say. But then the flip of that bill was taking the allocated federal stimulus dollars, allocating it to resident relief in California, some $2.6 billion. And it's still difficult to tell because that process is still working its way through. It is not an existing process that the state and local governments had to distribute those funds. It is a new process. And any time you're dealing with a new process, I'm sure you're going to end up with confusion and some difficulties. So we're still working our way through that. I would suspect that, that will be a significant positive in terms of resolving some of this rent collection because our portfolio has -- is pretty widespread, but we have a lot of B quality assets, properties. And I would say that there are going to be many people within those properties that will be within the 80% of median income range, which was specified as 1 of the hurdles in the law. So I think it will be a net positive. And part of that loss, to be clear, is we would have to walk away from 20%, and the reimbursement would be 80% of rents for qualifying residents. So I don't know how far $2.6 billion goes in the State of California. So I can't tell you exactly what that's going to mean to us. That's going to have to work itself out here in the next couple months.

Maybe we turn to capital allocation. What's the best capital allocation opportunity today?

Well, we haven't changed yet. We are planning going forward -- most of the last year has been selling properties and redeploying in either preferred equity at a fixed rate type of coupon in the 10% to 11% range and then buying stock back. We bought back $269 million of Essex stock at $225. Part of that was really driven by this disconnect between what values were and -- what private values were versus pre-COVID period. So even though our consensus NAV came down at least 10% during the pandemic, we saw much smaller declines in market values. And I'll give you an example. So 1 of the properties that we bought our partner out on almost exactly 1 year ago, we have now sold and completed a transaction and the price that the buyer paid was about a 3% discount -- 2% to 3% discount to the actual transaction that occurred a year ago. So -- and that is in a market where market rents were down about 17%. So as you can imagine, in that case, so this is a real transaction on both sides, and rents down about 17%. So cap rates have varied dramatically between the suburban markets, which are maybe down a little bit. And then in the urban markets, given the extraordinary decline in rents, cap rates are much, much lower.

And from an asset earning perspective, is that pretty representative, do you think?

Well, I think it is. I mean, I think that the -- we'll have to see how the transaction market evolves here and so there are some unknowns going forward. These were motivated buyers for the most part, 1031 exchanges and that type of thing. So the breadth of the transaction market is still very light. And so you don't -- you don't have as great a certainty with respect to what the transactions are going to look like going forward when you have relatively few transactions. Our best estimate is, again, given work from home flexibility, I would think that the areas that are not super far out but closer into -- closer to the cities, but high-quality cities, low crime and good schools and that type of thing will be the winners going forward. Again, assuming cap rates go back to a normal relatively small band, they're super wide now between the suburban markets, which have had no rent loss and cap rates, let's say, around a 4 to in the urban areas where the cap rates are in the low 3s, but rents have declined pretty dramatically. So still a little bit early to tell, but it's a good market for us and that uncertainty creates transactions ultimately. So even though there's a dearth here, the uncertain times will mean that owners will come to different positions about where the winners and what's going to win and what's going to lose going forward, that leads to transactions. So we're gearing up for a more -- a better deal flow and for a robust transaction market here. I don't know when exactly that will occur, but I think it's on the horizon.

And you mentioned the opportunities on the preferred equity side. How large of a book are you comfortable with having there? If there's a proliferation of opportunities, do you have some self-imposed limits?

Yes. I would say that we aren't close to our maximum exposure set by the Board, which is around a little over $1 billion would be the maximum program size set by the Board. So we're not close to that. And I think what will happen here is we're seeing -- we've seen more preferred equity this last year. We had a very good origination year. It's slowing a little bit, as you can imagine, because if rents decline substantially, you start ending up with needing more equity in a transaction to make it work to get a construction lender, et cetera, and make our preferred equity work as well. So I think that it will be a little bit more difficult to originate preferred equity transactions going forward. But with markets recovering, I think that we would be in a position to transact more on an acquisition basis, maybe acquisition and a joint venture type of mode would be our expectation going forward. So even though the preferred equity might slow down, I think that, well, it will be more than made up for in transactions in some other form.

Great. I want to shift to ESG. What are your top 3 priorities to improve your ESG score over the next 1 year?

Yes. No, that's a great question. And we are, in general, spending more and more time on ESG as I think everyone is. And I think it's been a good experience for us. Early on, we were very focused on the environmental part, but the S and G part have been -- become more on focus. So I would say, as it relates to the environmental part, disclosures have changed pretty rapidly. It's an evolving process. So we feel like we're always trying to keep up with the new types of environmental disclosures. And so we are -- so I would say that, #1, we will strive to increase our disclosures and consistent with recent changes in criteria. And as our data source -- we don't have perfect data sources. They get -- they continue to get better in terms of resident utility usage and some other factors. So as we get better data, I think our scores will improve over that. On the S, the social score, we already have a very diverse workforce, and -- but we're going to continue to try to pursue, I'd say, diverse candidate pools in each of our region, be very aware of that. And again, I think we're already there, but we found that some of the -- we formed a number of affinity groups within the company and that they've had -- they've been very, very successful and people appreciate them a lot. And actually, anything that ties people back into the company is a good thing as far as we're concerned. So we will continue that. And then maybe on the G, we will expand our Board's involvement in our ESG initiatives in general. And we will -- in 1 particular place, and that's the cyber protection, cyber risk protocols and protection. So we will be asking the Board to do more within those areas overall.

Great. Well, I recognize we're coming up on the end here. So I want to make sure we have time for our rapid fire. 4 rapid-fire questions. When we were sitting physically together in Florida a year from today, what will be the 1 thing that will have surprised people the most about your business over the prior 12 months?

I think I alluded to this in the comments, but I think that they're going to be surprised at just how strong a recovery that we have. The tech markets, again, all the pieces of where we lost jobs, I think, are going to come roaring back. And so I think that people will be surprised at our -- the strength of our recovery.

What do you think your corporate travel budget will be in 2022 as a percentage of what you spent in 2019?

I think it will be down probably 35%, let's say, 1/3.

What will same-store NOI growth be for the apartment sector overall next year in 2022?

I would say around 5%, but I think that there you will have separation between the coastal and the middle. And I think the coastals, given that they got hit harder, will come back faster and will lead on the way back.

Great. And then finally, where will the 10-year treasury yield be a year from today? Today, it's roughly at 1.5%.

Wild guess is 2%.

Great. Well, I appreciate the time. Thank you very much, and hope you have a nice rest of the conference.

Thank you, Nick. I appreciate being here. Hope to see you in Florida next year.

Me too. Bye.

Bye. Take care.