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

Hey, good morning and good afternoon, wherever you are right now. My name is Richard Hill. I'm Head of U.S. Commercial Real Estate Research at Morgan Stanley. I'm very excited that Essex Property Trust invited me to moderate this panel discussion. Maybe I can turn it over to Mike Schall to give a few prepared remarks on ESS, and then we'll just jump right into some Q&A. As a reminder, we will be taking questions over the webcast. So if you have any questions, please drop them in, in written form, and we will get to them at the end of -- at the end of our Q&A. So Mark -- Mike, maybe I can just turn it over to you.

Sure, Rich. Well, first of all, thank you for moderating the panel. I appreciate it. And joining me today is Angela Kleiman, our COO; and Barb Pak, CFO. And I believe Rylan Burns, who's Head of IR, is also here with us as well. Again, for those that don't know Essex, I thought I would start with a few introductory comments. We're an S&P 500 company. The company owns and operates more than 60,000 apartment homes in a unique footprint, essentially, all the coastal urban markets from Seattle to San Diego along West Coast. There are some unique things about these markets that you should know that we think generate among the highest CAGRs of rent growth of the U.S. And the things that drive that higher rent growth are job growth that is typically above U.S. averages for long periods of time, higher incomes than other parts of the U.S. and actually better income growth compared to most of the U.S. metros, and high-quality jobs are the key part of that. Obviously, we have the tech employers and motion pictures in Southern Californias -- in Southern California that produce jobs that are very highly paid, and that's what drives that. Also, the transition from a renter to a homeowner is more challenging in these markets. Our medium price home is generally above $700,000. That makes that a challenging process to become a homeowner. And all of that, I guess, I would say, is validated by our track record. Again, we're a dividend aristocrat, S&P 500 Dividend Aristocrat. We recently announced our 27th consecutive dividend increase in 2021. Current dividend payout is $8.36 per share per year, representing about a 400% cumulative dividend growth since our IPO in 1994. We've also generated about a 15% CAGR of total shareholder return from the IPO. So obviously, what we're talking about has worked very well over time. We are always focused on the balance sheet, and I can get into that in greater detail. And I thought as to operations, we spent the last year about -- talking about pandemic-related items. Now we feel like we have some wind to our back, and conditions are improving pretty significantly, and I'll just throw a couple of data points out there. While the April jobs report in the U.S. was generally pretty disappointing, it's notable that over 44% of the jobs that were created in April went -- came into California and Washington. And again, this is from an expanded reopening here on the West Coast. We also do a survey of the top 10 tech companies and how many job openings they have in our markets, and we found that these employers now have more job openings now as compared to the pre-pandemic period, and that's increased about 89% since the pandemic low. Also, California and Washington have both got very effective vaccine programs, and we're expecting a pretty significant reopening to the states, June 15, California; and June 30 in Washington. We also, as part of our presentation, have an update on recent operating conditions, and we increased guidance recently. And our rents in May were down 3.3% compared to Q1, which was down 9.7%. That's net effective rental rates, and so some good news with respect to operations. We finally feel like we're turning the corner and accelerating, and so we feel like we're in a pretty good position from that perspective. And with that, Rich, I'll turn it back over to you.

Yes, thank you for that. There's a lot to unpack there. Let me start with a question about revenue growth. Revenue growth still remains under pressure. It's certainly better than it was. I think you reported negative 8.1% in 1Q of '21. So there's clearly some headwinds from COVID-19, but I actually want to focus more on the positive, about how you manage through the past 15 months because I do think there is some misunderstandings about how you, as a landlord, managed through this crisis. So maybe you can just talk through how you managed it, specifically focused on your concession strategy, to maintain occupancies?

Yes, I'll do that, and maybe Angela or Barb may want to chime in here as well. But I would say this has been the most challenging period in my career, and I've been here a really long time. Some may say too long, something like 35 years, and I've never seen anything quite like this COVID period. The confluence of people leaving the state and work -- this work-from-home phenomena as well as all of the government regulations were an extraordinary burden on the company, and I got to give certainly Angela and Barb and really everyone a lot of credit for all that we did to react thoughtfully to the pandemic. And none of us have had this experience. And now we have, and now we know what to do and how to approach it. What we decided early on was to focus on really 2 things that we could control. One would be occupancy. And the other one would be let's hold on to scheduled rent, believing that this would be a relatively short period where we would go through this crisis mode and we come back on the other side. And so we thought that if we hold on to as much scheduled rent as we can or lease rate at high occupancies, that would probably minimize the damage that's stemmed by the pandemic. So as it turned out, you're right, out of the 8.1% decline in same-property revenue in Q1, only 3.2% was scheduled rent. So concessions were another big chunk, that was about 3%, and then obviously greater delinquencies that are tied to these anti-eviction ordinances and that type of thing. But the significance of that is that we thought that when demand returned to the West Coast, which is what we're seeing now, that we would see concessions abate relatively quickly and we'd be left with a highly-occupied portfolio with a nominal rent loss, and I think that's the position that we're going to be in. As to the reduction in concessions, we're really starting to see that happen. The April and May numbers are much better from the progress on concessions. As we started the year, again, we were turning the corner in Q4 and Q1 but pretty slowly, I would say, given pretty dramatic shutdowns in California and Washington at the end of the year. But we were at 2 to 2.5 weeks of concessions on average and the stabilized same-property portfolio in early January, and now we're less than a week of concession on the portfolio more recently. So made a lot of progress there. And again, it just -- it felt like the acceleration in April and May was very substantial. Part of the reason why we didn't increase guidance in Q1 is because we wanted to see a more significant push on the rents and concession side, and we saw that in April, May. And as a result, in preparation for NAREIT, we increased our guidance.

Great. Barb, or Angela, anything you'd like to add to that? So I do want to turn to the guide. I was going to ask you a question about why you didn't raise the guide, but that obviously changed on Friday night. Thank you for publishing after the close on Friday, by the way. I kid. Can you just maybe just elaborate a little bit more on the green shoots that you're seeing in April and May? And what gave you the confidence? I joke with investors that they're green shoots, and we think they're going to become green rocket ships in the second half of the year into 1Q of '22. But can you maybe just elaborate on what you are actually seeing? Because we're seeing it, too. We fully anticipate effective rent growth to turn positive in the coming months. But if you can maybe just drill down what positive trends you were seeing? And maybe why people are coming back to the markets as soon as they are?

Angela, do you want to take that, and I'll just chime in at the end maybe?

Sure, sure. Thanks, Mike. Yes, that's a good question, Rich, in that we also internally debated on -- about when and how and how much because the fundamentals in our markets actually were quite solid. And so the question is, when do we reopen? And when we had our earnings release, our markets were only at 50% reopened compare that to the rest of the country, and they were mostly already fully opened. And so it was important for us to be able to have better data and more visibility relative to once our markets are reopened, which is at this point, we're, at this point, about 75%. And in many other cities, more fully reopened. And you can see the question is, is it a shoot? Or is it a rocket ship? Well, what we were looking at, at that point in time or even in the past month is that we saw the trough, and so we saw that rents had turned. And sequentially, we're seeing positive trends, but it was pretty moderated just because of the reopening level. And over the past months, the numbers has actually moved more -- in a much better direction quickly. And we have our presentation on Page 22, that gives us sequential revenue growth. That shows where the new lease rates are. So from February to March, it's not very exciting, not a big change. But from March to April, there's a 2%, which is nice to see. But now from April to May, that's another 2%. And so we look at the new lease rates and, of course, concessions, Mike had mentioned that we used to be in fourth quarter, 2.5 weeks; last quarter, about 1.5 weeks; and now 1 week. And then the third piece is all this is happening during the time that we are maintaining occupancy, and so all the pieces are coming together nicely for us at this point.

Yes, Rich, maybe I'll add -- I'll take a little bit different view of this. So actually, on Page 21 of our presentation, we try to break out what's happened during the COVID period and what's happened more recently and so -- by Walk Score. And so the lowest Walk Score has done the best in the pandemic, and I think everyone knows that. And the highest Walk Scores are -- have done the worst. So the highest Walk Scores -- and give you a little bit of background. We're about 70% in the low Walk Score category in terms of our portfolio, so we don't have that much in these other categories. But the lowest Walk Scores have almost gone back to 0, come down about 4% and have already come back to about 0 on net effective rents. So we're in good shape there. The far that you go out from the main urban areas and the job -- the main job nodes, the more -- those areas have benefited. So for example, Ventura County has led our portfolio for the first time in 20 years about -- because people have moved into Ventura County given work-from-home flexibility and other similar items, and so that actually is a positive rent growth. I would say going forward that that's not likely to continue because I think part of the scenario going forward that we believe will prevail is that workers are going to have to be closer to the office. So it seems to us that the hybrid model is probably going to be the most prevalent out there. And so people come into the office, let's say, 3 times a week, which means that you're probably not going to want to live in Ventura County and try to commute into L.A. You're going to probably need to live closer. So we believe that the farthest areas will continue to be a little bit more attractive because there will be greater work-from-home flexibility going forward. It just -- if you get too far from the main urban areas, the commute is just going to be too long. So that's our view. The high Walk Score areas, we don't think that the city centers are -- we think they will continue to recover and do well, especially as all these service jobs that were lost come back into the city centers. And we think that we're making progress on that. I mean, essentially, those workers were, I would say, forced out. They were not high-income workers. These are the hospitality, the restaurant workers, et cetera. They were essentially forced out of the cities, given the jobs were -- the stay-at-home orders were issued. And so they were forced to go live with mom and dad and/or forced out of state and a number of other things. I think it will take a little bit longer for those people to come back. And -- but clearly, in our view, high-income workers want to consume these types of services, and so it's just a matter of drawing people back into those jobs, probably with the wages. So we don't know what that wage is that will take to draw those people back, but I think it's a longer-term recovery for the city centers. And the city centers also have, I think, a little bit of a larger issue with homelessness, and therefore, crime that is somewhat of a headwind for their recovery as well. So our view going forward is the cities that are in suburbia, suburban cities that are near the job nodes are probably the right place to be and will do the best. And so that's kind of our view of transactions going forward, is that we're going to try to focus on those areas.

That's a good transition to my next question. You mentioned at the outset that you have a differentiated strategy relative to your coastal pure set, given that you focus specifically on the West Coast. I also think the -- sometimes the market doesn't appreciate that you own a really attractive mix of Class A versus Class B and urban versus suburban. The idea that Essex Property Trust only owns downtown San Francisco, for instance, I think, is incorrect. So as you think about this, can you just maybe compare -- well, first of all, can you talk about what you're seeing in population migrations and job growth in your markets on the West Coast? I sit in New York City. And if you want to tell me -- if you want me to tell you what's happening with New York City, I can look out my window, but I don't have that insight into the West Coast market. So I think that would be really beneficial for me, I'm sure some other people as well.

Well, I think actually, there are some similarities, I think, between New York City and the West Coast cities. Because I think once you close down all of the services, restaurants and bars and other things, and we have the tech companies that are so dominant out here as well and they had these very unrestricted work-from-home programs that allowed their workers to work anywhere. So I think that, that really define what happened in the cities. And again, if you have low-income workers that are displaced, given work-from-home orders, what happens is they don't have a lot of money. So they can't afford to just stay in the city, so they're going to move elsewhere. I think that's what drove this migration. I think the statistic of California actually lost population for the first time in 50 years, or somewhere in that zone was part of that. So I think that these trends reverse, and I think you're already starting to see that. The tech companies are -- the reason why we have that program of monitoring the tech company open positions is so we have some insight into what they're thinking and what they're doing. And so the fact that their open positions are actually above the pre-pandemic level and it recovered from the low, about 80% -- almost 90%, that's a big move. I mean the tech companies want to draw people into these markets. We have -- on one of our slides, we make the point that more than half, I think around 55%, of the open positions are in an Essex market. So the concept of all these positions are going to be in some other market, I think, is probably overblown. Notably, there were some media reports about Apple's recent announcement that they're going to open a research park or -- in the research triangle of Carolinas. But in the same press release that Apple announced that, they also announced there would be 5,000 jobs in San Diego and 3,000 content jobs in the L.A. area and 1,000 jobs in Seattle, which would be heck of a lot more jobs than they're going to put in the Carolinas. So there's some part of this that's part of the news media, I think. But what we see looking at the data, and we do a lot of fundamental ground-up research, what we see is those jobs coming back. A lot of them are here on the West Coast. And again, if you get the high-income workers coming back, the services will just follow. Because high-income workers, part of what they want to do is spend their money on services, and so those service jobs will be here as well.

That's helpful. I wanted to maybe transition a little bit to the medium to long term, and I'm not going to go to a position where I ask you to guide by any means. But I am really curious about your econometrics. I actually think you have some of the industry-leading econometrics. I really like the macro forecast. For what it's worth, our economics team use your macro forecast in a lot of our macro forecasts. So keep it coming, please. But what do you think the most important drivers of rent growth is over the medium to long term? Is it job growth? Is it income growth? Is it new supply of apartments? How do you think about -- what are the biggest drivers?

Yes. I actually have to put a shout out to Paul Morgan, who was previously with Morgan Stanley and the research area. So Paul has done a marvelous job with data analytics at Essex. And it is, for the most part, the same factors that are so important. Job growth is certainly one of them. And high-quality jobs generally are more effective at creating households, which is what we really care about. Then maybe low-income jobs because especially when rents are high, people will double off or whatever in order to minimize their cost. But job growth is super important. I would say supply would be #2, and then income growth would be #3. And especially, as I think about an inflationary world, that income growth is super important to us. I would say in the Class B, where you don't produce more housing in Class B, it's impossible to do because you have lower rents and the cost to build is basically the same as in A, it's just not that different. So you're going to build an A, you're never going to build a B. And so the net effect of that is the Class B is probably the most supply-constrained of our entire area. The problem with Class B is it's super price sensitive. So people make a certain amount of money, and they will spend some portion of that on rent. And therefore, it's that ratio of rent to income that becomes the key variable in terms of where they live. If they can't afford to live in, let's say, Fremont, and they might move to somewhere that's a little bit less rent and commute a longer distance. That's typically what happens. So that's why we talk a lot about this rent-to-income ratio because it's so important for that Class B renter, and that Class B renter is most of our company, and so we tend to talk about them and focus on them. If they get higher wage growth given inflation, and what we're seeing is shortages of employees throughout our markets, perhaps exacerbated by the $300 supplement to unemployment insurance and -- because people are not taking these jobs and there's a lot of job openings out there, and that could lead to higher wages, which I think would be great for Class B apartments going forward. So I think those are the key drivers. One notable thing is we don't produce a lot of for-sale housing in California, and we haven't had -- if you -- we have a slide in our presentation that compares us to various other areas, but mainly because of global warming considerations that California is focused on creating high-density housing and putting that as close to the jobs as they can. And as a result of that, I think you don't -- we don't see the threat from for-sale housing that you have in many other markets across the U.S.

And so that maybe leads me to my next question, which about -- which is about supply versus demand. I think there's a lot of focus on the millennials, but Gen Y on the heels of millennials is actually just as big a population as the millennials. So you mentioned at the outset, we have a shortage of housing in the United States. Would you -- I mean can you elaborate on that? And what do you think that tailwind means for demand for rentership?

Yes. I think there was a study done by Up for Growth. It was a consortium. I don't know if you saw it a few years ago. I think that they said that the U.S. was short by 7 million homes, something like that. And of that, I think California was in the 3 million home shortage range of the total. So California and Washington, to a lesser extent, were 2 key parts of that housing shortage. And it's interesting. I would say all we do is produce a lot of Class A apartments, right? We don't produce Class B. We don't know how to do that or it's not economical to do that. We don't produce a lot of for-sale housing. And so -- and whether we can produce enough A-quality apartments and what impact that has is pretty interesting. At some level, there has to be a transition because I would think that the Gen Y would want to own a home. And I think this is part of what's happening right now, is they want to own a home, start a family. They're at that phase of their life. And guess what, the baby boomers own those homes, and they're living longer and they're not moving. So you sort of have this demographic thing, where because people are living longer, they're consuming a house actually without consuming a job, which is exacerbating the problem. And this normal transition of -- from rental into for-sale housing is somewhat stymied by the fact that we don't produce -- I think we're 0.3% of stock being produced annually on the for-sale side. So we don't produce enough housing. Now this would all work out well if the baby boomers moved into the city, where the -- a lot of Gen X/Gen Y is living. But that's -- I think the benefit of that, obviously, would be they have elevators. And if you have mobility issues, you're better set up in the cities, and you have food and food options and entertainment options around you. The problem with the cities, I think, right now is just the greediness and the homelessness. And so that transition is important, and I don't see that happening, which leaves us with, I think, a shortage of housing really in the suburban markets. And that's kind of where we're focused.

Yes. I want to transition to one more maybe top-down topic that has a lot of implications from a bottoms-up perspective for apartments, and that's inflation. I can maybe argue that the markets are obsessed with inflation right now. But as you think about inflation, I have a 2-part question, first of all, what do you think about your ability to raise rents and apartments being actually a hedging into inflation or something actually does really well in inflation? And the second part of that, is there a silver lining with inflation, where supply actually comes down faster than people are expecting, supply of new apartments comes down because building costs go up?

We're definitely seeing the -- an impact from building costs going up. Of course, that won't be really seeing coming out the back side for a couple of years because what's in process is probably far enough along that general contractors have accepted that responsibility for costs for the most parts, and/or the build-out or the buyout of the construction process is already far enough along that there's not a lot of risk there left. But a couple of years out, I think that if you look at the deals that are being made right now, and we're seeing this in our preferred equity pipeline, that some of them are starting to have some issues. And the issues we've seen, for example, are general contractors carving out lumber and drywall cost increases out of their contracts because they don't want to take that risk. And if construction costs go up, then the amount of equity goes up in a development deal, all things being equal. And a lot of owners don't want to -- don't have or don't want to put more equity up in order to make their deals work. So I think we're starting to see some headwinds with respect to development going forward. Again, that's not going to help us this year or next year. But further out than that, I think that's potentially an issue. I agree with you. I think apartments do well in an inflationary environment, and I think especially Class B if I think of the drivers of pricing in the different categories. In Class A, it's really how much supply is being created and how many units of demand in Class A do you have. And then if you have too much supply in Class A relative to demand, you're going to basically make your B+ renter now in -- being able to afford an A apartment. So there is some transition between the classes as well, but it's mostly about supply and demand. And it's mostly about in Class A, typically a rent-up in order to generate the velocity of lease-up, they give away somewhere around 1.5 months to 2 months of concession. And as long as that happens, it doesn't really affect the stabilized communities all that much. So -- which leads us to Class B, which, again, is chronically undersupplied. It's just a matter of due incomes. Are incomes high enough to pay whatever the supply/demand outcome might be? And I think in an inflationary environment, you end up with more wage inflation, which allows the Class B renter to pay more in rent. And again, that's why our discipline on rent-to-income ratios and discussing that is so important to us because we are mostly Class B. So I think we do well. And the one caveat is, obviously, you need to have a balance sheet that's in good order. If you're highly levered and you're -- and you've got a lot of maturities, you're going to probably have some issues there. And I think Barb has done a very good job of positioning our balance sheet so we don't have very much in near-term maturities, and our debt is predominantly long term and fixed rate. And our total debt to market cap, somewhere in the mid-20% range, so low leverage. I think this is sort of an optimal formula for an inflationary market.

Great. Well, I have a lot more questions, but I'm going to stop it there in the interest of time. Thank you for spending 30 minutes with me today. That was great. Very insightful. And look, for anyone that has any questions about apartments, we publish a lot on them. We like them a lot right now. So please feel free to reach out to myself, and I'm sure the Essex Property Trust management team would always like to hear from you as well.

Yes, and thank you. Rich, thank you. Thank you, NAREIT. And thanks, everyone, for joining.