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

Great. Good morning, everyone, and welcome to our roundtable session with Essex Property Trust. Joining me today is Mike Schall, President and CEO; Angela Kleiman, Executive VP and COO; and Barb Pak, EVP and CFO. I just want to remind our audience today that you can participate. We appreciate the session to be interactive. Feel free to enter questions into the Veracast system, and I will ask them as long as I'm able to. We will first have a discussion on Essex, and then we'll get into Q&A. I'll turn the call over to Mike to introduce Essex. Mike, please take it away.

Very good. Well, first of all, Jeff, so good to see you virtually, I guess, and be part of the conference. So thank you for inviting us. So I wanted to provide a quick background on Essex and then talk a little bit about current market conditions and what we're seeing out in the West Coast. So by way of background, Essex is an S&P 500 Dividend Aristocrat. We own and operate over 60,000 apartment units on the West Coast, specifically the major coastal metros from San Diego to Seattle. We believe these are unique markets for a few reasons. Over long periods of time, job growth on the West Coast generally exceeds U.S. averages. That's really driven by the tech industries and perhaps the motion picture industry in Southern California, all of which have performed well during the pandemic and appear to be very well positioned as the markets recover. The West Coast markets also produce housing at a lower pace compared to many other metros and housing supply constraints are an important part of the Essex story. Muted housing supply and expensive single-family homes keep rental rates high and provide the incentive to rent versus own. As a result of these factors, our markets are among the highest or produce among the highest CAGRs, compounded annual growth rates of rent growth over long periods of time compared to other major U.S. metros. Yes, the proof of the importance of these factors is embedded in our track record, which I'll summarize. In Q1, we announced our 27th consecutive annual dividend increase, currently paying out $8.36 per share per year, represented a cumulative 400% increase in the dividend since our IPO. We've also generated about a 16% compounded annual growth rate of total shareholder return over the last 27 years as a public company, and that has handily outperformed major indices. We maintained a very strong balance sheet as part of our basic strategy. We currently have over $1.4 billion in liquidity. We refinanced about 1/3 of our debt during the pandemic. And in so doing, we lowered our weighted average interest cost by about 70 basis points to about 3.1% while also pushing out average maturities. We're now aggressively seeking acquisitions and development, a shift from selling property to fund commitments and repurchase stock at substantially lower prices during the pandemic. Now just like to provide a quick operating update on current conditions. The West Coast had fairly severe government shutdowns during the most intensive parts of the pandemic. I read earlier today that actually, the case growth in COVID cases in California is the lowest among the states in the United States. So that's a super important thing. Both California and Washington announced their full reopening in June 2021 and rents as a result recovered nicely this summer. Our survey of open positions of the largest tech companies now indicates that the open positions are 23% higher than the previous peak in the first quarter of 2020. So a big rebound in open positions among the large tech companies on the West Coast. A week or so ago, we announced that our August net effective rent growth, which is on Page 23 of our presentation, is up 17% from December and up 4.7% from the pre-COVID period. That's better than we expected given that we've recovered only about 56% of the jobs that we lost last year during the pandemic. The trajectory of rent growth is led by Seattle. It's up about 26% on a net effective basis from December, and Southern California leads compared to the pre-COVID period, it's up about 13.5% from March 2020. With respect to guidance, we haven't made a change to guidance as a result of the recent surge in rents, primarily because there won't be enough transactions to really move the FFO needle in 2021. However, that surge in rents has resulted in a large loss to lease, which is about 9.3% at the end of August, and obviously, that will benefit future quarters. So with that, Jeff, I'll turn it back over to you for Q&A.

Great. Thank you, Mike. Before we get into an operational update, can you explain today why -- I guess, 3 key points why an investor should invest in Essex Property today?

Sure. Jeff, I guess, number one would be the recent rent growth and demand recovery that we're seeing on the West Coast. Again, we were a bit late to the recovery table, but it's now here. And the results that we're seeing currently, I don't think have been completely priced into the stock. So if you look at the amount of rent growth we have and where current cap rates are and do the math, I think you end up with an NAV well above the Street consensus. So I think that's an important factor in an investment decision. Also, we have continued muted supply for housing and the median price for-sale home is up between -- somewhere in the 19% to 20% range. And so that makes a transition from a renter to a homeowner more challenging and keeps people renters longer, which is obviously good for us. We believe that when you have increases in valuation, rapid increases in valuation, which we've had in the West Coast as cap rates have declined and really across the nation, the supply picture will change pretty dramatically and that will affect many markets, I think, greater than it will affect the West Coast. And then finally, I go back to the track record of performance in the things that I said in my intro, I think that we have among the best track record in the REIT universe. And so I think those are the 3 key points.

Very helpful. If I could ask maybe a few follow-ups on those points. I guess starting with the last one, track record. You mentioned in your opening remarks that Essex, it sounds like is trying to be more aggressive on acquisitions. You do have a history in downturns being opportunistic. Are you seeing opportunities? Or it's not necessarily discounting, opportunistic investing like you saw out of the world financial crisis, but bottom line, it's time to be more aggressive on acquisitions? I guess it's a 2-part question.

Yes. Let me address both of those. Yes, during the downturn, we repurchased about 2 million shares of stock at an average price of around $2.25 per share. And if you look at where the stock is trading now, obviously, it's had a big increase from that. So we thought that the best opportunity in the pandemic was to take advantage of that dislocation between what properties were trading for and what the stock is trading for. So as you know, cap rates went from somewhere in the low 4% range to the mid-3% range. So there was a big increase in real estate values. And then that disconnect disconnected with the stocks, stocks were going down while asset values were doing just fine. And so that set up that opportunity to repurchase stock. Now with the stock recovering, we're still in a position where we don't want to issue stock. And so that leads us to our co-investment business where we utilize institutional co-investment transactions in order to invest. And cap rates, again, have come down a lot, but I think the thing that's attractive is the amount of positive leverage. It's embedded in these transactions. So we're earning somewhere in the 3.5% to 3.75% cap rate, and we're positioning that with debt that's financed in the 2.5% range and our co-investment business is generally about 50% loan-to-value type transaction, so a little bit higher leverage on our balance sheet and you generate a lot of cash flow from that. That positive leverage, the impact of that positive leverage given that differential between cap rates and the underlying financing rate really drives the returns. And so we're interested in that, but not just acquisitions, I'd think development as well. We announced recently or we acquired a property that I think has been picked up in the media. We'll talk about it more on the quarterly call. But -- and we have some other potential development deals that we're working on now. So we're more active on both sides. Our history has been, as you say, to be active during downturns and because typically, things move fast in a recovery period. So if you look at our chart and when we do really well and where we set the stage for a recovery, it tends to be right in those early stages of the recovery process, which we're in now.

Very helpful. Just to confirm, are you still buying back stock? Is there still a buyback program in place? Are you paused at the moment?

Barb, do you want to handle that?

Yes. So we do have a buyback program in place that was authorized by the Board of Directors. And so that has remained in place. But at present, given where we're trading, we're trading -- we're not trading at a steep discount like we were a year ago where it was very attractive to buy back the stock. So we haven't bought back stock in the second quarter or in the first quarter of this past year. And so given where we're trading and given what Mike said about acquisitions, that would be the primary source of capital used today.

Okay. And then Mike, you mentioned as another key point, the disconnect on cap rates. I was just looking at my comp sheet, and it shows Essex around -- implied cap rate around 4, let's say, low 4s. I guess where -- I think you've alluded to it, where are cap rates today? And do you see them compressing further? Or are you saying that they're back to around -- and also if you could provide a perspective where were they pre-pandemic?

Yes. Pre-pandemic, they were in the low to mid-4s, depending upon property quality and location typically driving that. And I think typically, the West Coast has had lower cap rates than the U.S. I think everyone's cap rates have come down and that positive spread or the lower cap rates of the West Coast are really no longer there. And I've been here for a long time, 35 years, never seen cap rates this low, but I also haven't seen interest rates this low. And so they are related to one another, and you can be concerned about how low cap rates have come although the offsetting factor is, again, the amount of positive leverage that are embedded in real estate transactions. And the way that the real estate industry looks at that positive leverage. So if I go back into the earlier part of my career, so cap rates were probably 7-ish percent in 1994 when we went public and interest rates were a little bit higher than that 7- to 10-year financing was more expensive than that. So we actually had negative leverage. We had higher cap rates but negative leverage in that period of time. And so things have come -- obviously, cap rates have come down a long ways, but interest rates have come down even further to where there's positive leverage embedded in these real estate transactions. And I think that's a super powerful force in apartments and in real estate in general. And so I would guess that I don't know if cap rates come down, they tend to be pretty sticky. They adjust to a certain phase and they stay there unless conditions change pretty dramatically. And so I think that I would doubt that if conditions remain as they are, the cap rates will change materially, we'll have to see what happens with the debt markets and some of the issues that are before us in the future. So I'm not predicting the future, but I think given where cap rates are now relative to interest rates and long-term financing, [indiscernible] comfortable spot.

Okay. And just to confirm, Mike. Where are Cap rates today? Did you say they're in the mid-3s?

Mid-3s. Yes. mid-3s.

Okay. One follow-up I had on the co-investments. Our team wrote a note months ago on the fund business, and Prologis has had great success with their funds platform, an open-end fund, leveraging lower -- third-party capital, lower cost of capital. Is that something you've considered or you prefer the co-investment? Just to confirm for the audience, is that more of a JV type of structure?

Yes. Let me provide a little bit of background, and then I'll have Barb fill in the details. So we use the co-investment business as sort of an alternate source of capital. So we're in a position where we don't want to use the company's capital. And currently, as I said before, we think the net asset value is substantially above sort of current consensus NAV. And so this would not be an environment where we want to issue a bunch of stock. And in fact, we believe that we're -- we believe arbitrage is the key part of what we do. In other words, like before, during the pandemic, where the stock was trading down and asset values were holding relatively steady, it would be a good time to sell properties and buy stock. Conversely, when cap rates come down and the markets rents have now recovered, if you do the implied calculation, the company's real estate portfolio is worth more than the stock price. In that situation, you don't want to issue the stock. You want to rely on another form of capital, which for us is our co-investment business. We've been doing this a long time as well. We believe it's fundamentally part of our overall strategy to be very careful about the relationship between the value of our portfolio and what the stock is trading at and not dilute our NAV per share is really the key there, try to remain accretive to NAV per share. And so the co-investment fills that void. So when the stock is disconnected relative to the real estate portfolio value, we have another source of capital because sometimes, especially early on in the cycle, which is fairly typical as we -- in the early phases of a recovery cycle, we see this disconnect and then we want to have our strong institutional platform to rely on to fund transactions going forward. So Barb, do you want to talk more specifically about our current program?

Yes. So [indiscernible] our current program is we have several large institutional investors that invest with us directly in each asset that we want a joint venture, and we have certain terms with those partners. But we -- and so we have a little bit of a different platform than Prologis where they're open ended and we're close ended in terms of our structure. It's worked well for us in terms of the value we've created for shareholders to promote income we earned for our shareholders over the years. And so it is something that we look to continue to do, and we have conversations with a number of large institutions, and they all really want to deploy capital in multifamily given the dynamics have remained very strong and values have held up. And so the appetite to invest in multifamily is very strong at this point. So we have had great success with it, and we'll continue to utilize it based on sources and of uses of cash.

And so to confirm, you're not considering right now and, let's say, expanding that business into an open-end fund similar to Prologis, you prefer your current structure?

Correct. At this point, that's correct.

And to confirm, are you seeing more opportunities in the marketplace, whether it's acquisitions or development opportunities? Is something changing?

Yes. Jeff, there are a few things that are changing. First, when you have the amount of change and dislocation or things are just so different today than they were pre-pandemic in terms of work from home, return to office whenever you have these disruptive forces, owners make different decisions. And so we will see more transactions, we think, in the future, and we're starting to see that now. After a dearth of transactions during the pandemic, the transaction markets are really picking up. And so there's more to look at out there. And I would say that the other piece of this is because of work from home and hybrid models going back to work, that we probably expand our geography to some extent. We believe people will likely tolerate a longer commute, for example. And so that may allow us to go a little bit farther out into the suburbs than we previously invested in. So that will also expand our geography. So the combination of those 2 factors, I think, will lead to a pretty robust transaction market. On the development side, you can imagine that if cap rates go from -- go down 75 basis points, that means that every development deal that was on the cusp of making sense financially is now an opportunity because its value. Its terminal value upon completion is much higher. So there will be more development transactions as well coming out of this. And I think this is true across the nation, every potential development site that was close to making financial sense given cap rate compression now works. And so now the question is how quickly can that supply come online. And I think this is, again, the differentiating factor on the West Coast that labor shortages and other issues get in the way of producing a lot more housing. And so I think that we will have a bit of a benefit here, both from the transaction side, looking at development deals, but also without the supply problem, let's say, a year or 2 down the road.

Okay. That make sense. You've talked about cap rates and decreasing nationwide. You've mentioned a few comments, West Coast versus, let's say, Sun Belt, some of the comparisons historically and today, the market, you're right, is pricing, all markets equally and you're presenting a case for the West Coast here. I know this is talking your book, but in 5 years from now, when we look back, do you feel people are chasing opportunities in the Sun Belt? Do you think they're missing it and that the real opportunity here is on the West Coast and maybe we can dive further into again your initial comments on expanding employment, tech, you potentially moving further out?

Yes. I think that the -- and I don't want to knock the Sun Belt, certainly, I'm not here to do that. I'm here to essentially comment on the opportunity that's here on the West Coast. I guess that opportunity would be driven by the fact that we're still -- rents are up 4.7% on average, and that varies by market to some extent. So we haven't had this dramatic increase in rent. And in my experience, when rents go up by a significant magnitude, people make different decisions. You saw this in the pandemic when San Francisco was shut down, all the restaurants, all the hotels closed, et cetera, many people moved out of San Francisco, yet, we say 96% occupied. How did we do that? Well, we own property in the better locations and there's a backfilling approach at a lower price. So people will backfill and keep those properties full and kind of setting us up for the recovery, which is with high occupancy already there when those jobs come back into the cities. The hotels need to be staffed. There's an opportunity, generally wealthy areas like to have restaurants and bars and entertainment and personal services. So as those people come back into the market, there's not a tremendous amount of availability. And so rents recover quickly, which is exactly what's happened. So I think what we expected to happen, I think, is occurring. And I think we're at the kind of early end of that trend and compare that to some of the markets across the country that rents were up 20%, wages are up 20%. So the portion of their paycheck that's going to rent has changed pretty significantly. And I think we're in a fundamentally different place by comparison.

Okay. Focusing on key employment sectors, technology, which you've discussed. Everyone is still asking the question, work from home, hybrid, Google had a big announcement at least in New York City today buying a building where their employees work and an option to buy. So it's still positive. It's a new building. The office to them is important. They discussed culture. I guess what are you hearing from your contacts in the tech industry? What are you expecting -- how are you expecting this to unfold over the next 1, 2, 3 years? And again, how will Essex benefit?

The -- yes, I think that we try to track the big tech companies very closely in terms of their announcements and what their expectations are. And what's happened is there are generally plans to go back into the office using hybrid employment model have been pushed back given the delta variant. And as I said earlier, I think California has the lowest case growth now in the nation, which is obviously a great statistic. And with that, whereas the tech companies have pushed back their office reopening programs, which I think has hurt the Bay Area specifically, I think that, that will change as we get into later this year or early next year. And -- but we're waiting for that to happen. And I think that, that will be the point at which we have better clarity on exactly what the tech companies are going to do and what portions of their workforce are going to be located in these large areas. I guess the point I would like to make, and we have a slide in our presentation that makes this point. They continue to invest in office space. So as long as they're investing in office space and kind of consistent with their public announcements about using the hybrid model to come back to the office. As long as we see consistency between that messaging and their transactions, the Google campus in downtown San Jose, for example, moving forward and some of these other large office investments, we think that, that signifies a commitment to the more urban areas, urban locations and consistent with the hybrid model. So I think even New York City, even though it's not an Essex market, the fact that they're buying the building in New York City is meaningful because they expect to have a significant amount of employees in that place. And again, given the hybrid model, they can commute maybe longer distances, but they're still maintaining their office-centric model a little bit different format, the hybrid format.

And then going back to one of your original comments on one of the key positives on Essex today and why someone should invest. You talked about the -- how expensive it is to buy versus rent. I guess can we quickly discuss the new California law on single-family zoning. What do you -- I know it just passed, but what are your thoughts there? How should investors think about that?

There's -- the 2 laws that you're referring to, I believe, are SB 9 and SB 10, which were passed couple of weeks ago and waited for the recall election in California and the governor recently signed them. There is an ongoing battle essentially between the NIMBYs and YIMBYs, the yes in my backyard, the no in my backyard. And there's a back and forth play here that's happening in California. And so I guess, SB 9 and SB 10 were a win for the YIMBYs side who will seek to increase the density in the neighborhoods, the suburban neighborhoods primarily by adding an accessory dwelling unit. The significance of that, we don't think is material. California a few years ago passed a ADU, Accessory Dwelling Unit, law that allowed up to 3 units, and we haven't seen a lot of production of housing as a result of that. It's still very expensive. There's still a variety of mandates, setbacks, ingress/egress, et cetera, types of issues to resolve. And so we think that there will be marginal increase in the amount of supply, but of very low levels. California supply, if you look at -- we have a chart in our presentation. It gives you that historical precedent on supply, going back to 1990. California produces very little housing. And we don't think that this will be a meaningful addition to that. And I guess maybe 1 more factor, and that is there is a ballot proposition that is being proposed that would amend the state constitution to embed local land use and zoning laws at the local level. So the NIMBYs are fighting back. And I suspect that this will be an ongoing dialogue and challenging in California. Ultimately, we don't produce enough housing in California, and I don't think anything is going to change out.

I know we're almost out of time, but I do want to discuss San Francisco and San Jose a bit more. In your update, the update said that net move-ins to the Bay Area improved sharply during 2Q and continues into 3Q. I guess just can you talk a little bit more about San Fran and San Jose, and then we'll get to our quick rapid fire questions.

Angela, do you want to take that one?

Sure, Mike. Well, I think what has happened with both the Northern California is that it didn't drop in terms of -- as sharply as, say, Southern California, but it's starting to come back as well. And that's one of the reasons why both the Bay Area and relative to Southern California, if we compare it has rebounded a little slower on the rent growth side. And so when we were talking about the compared to pre-COVID rents or even at the beginning of the year, pretty much if you look at our various regions, Southern California and Seattle for the most part, they are all above pre-COVID levels. But the Northern California has lagged and that's part of the reason. And the other piece is really the where the jobs went. And so with Southern California, we have a large population of leisure and hospitality that just all the jobs are gone. And so they experienced that rebound much quicker. And if you look at where the jobs are at this time, California actually compared to, say, in Q1, got about over 40%, I think it was 44% of the job growth versus at the beginning of the year, we were only around 12%. And so that all impacts the move-in, move-out behavior and where the rents and how the rents rebound.

Move to our rapid fire quickly. First, which of the following is the greatest challenge facing U.S. public REITs today? A, fed action and higher rates; b, supply chain issues; or C, flows to nontraded REITs.

Jeff, what's the first one? Yes, I'd say the first one. But what is that again?

Fed action and higher rates.

Yes. I think worker shortages, fed action, inflation, would be our #1 concern.

Okay. Number two, over the next 5 years, which markets will outperform: urban coastal or Sun Belt? That's to everyone.

You know what we're going to say to that. I mean I would say it's interesting because there is a middle ground there. And okay, it's rapid fire, so I'm not supposed to quantify it. So I will say the urban markets, urban coastal.

Even I can get that answer. And last, for your company's office plans post pandemic, will you have no change from pre-pandemic; two, leave it up to teams; three, offer hybrid; or four, go full remote?

We plan to do a hybrid approach.

Great. Excellent. This -- we could continue for, I'm sure, another half an hour. This has been excellent. Thank you so much to the Essex team. And of course, if anybody has follow-up questions, feel free to email me or Barb directly. Mike, Angela, Barb, thank you very much.

Thank you, Jeff. Really appreciate being here.

Thank you.