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

Welcome to the 11:15 AM session at Citi's 2020 Global Property CEO Conference. I'm Nick Joseph with Citi Research. I'm pleased to have us Essex and CEO, Mike Schall. The session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. For those joining us here today in person, to ask management any questions, please step up to 1 of the mics we have located in the center aisle of the room. If you're joining us remotely, simply type them into the question box on the screen, and they will come directly to us, and we will do our best to ask them during the session. Mike, I'll turn it over to you to introduce the company and any members of the team, and we'll get into Q&A.

Very good. Nick, thanks for having us. It's great to be here in person in good old Florida, and awesome, awesome conference as always. I want to introduce our people, Angela, Chief Operating Officer, Angela Kleiman; and Barb Pak is our CFO, to my left; and Chris Savvinidis. Chris, raise your hand, is heads IR for the company. By way of background, Essex is an S&P 500 company that owns and operates over 60,000 units in the West Coast of the United States, all the major metros from Seattle to San Diego. We recently announced our 28th consecutive annual dividend increase. And the dividend now has increased over 400% from the IPO. And it's notable that an investor that bought at the IPO and held their share now generates a 45% annual return on the dividend alone. COVID-19 has had a pretty significant regulatory impact on the company, and I think it's one of the opportunities going forward. There are challenges that we'll talk about more in terms of delinquency and a very significant part of our portfolio in Northern California has lagged the broader recovery, I think largely because of the severe shutdowns that we experienced early on in the pandemic. And so there are some indicators that are positive going forward, notably, in Northern California, the return-to-office process. And with respect to delinquency, we are owed about $77 million. And so delinquency will become a tailwind at some point in time. So overall, we expect significant very positive market rent growth on a net effective basis, and that average is 7.7% in our portfolio in 2022. Our view is that Northern California, turning to that, is our best-performing market over the longer term. And it's very significantly lagged during the pandemic, and an indicator of that is that rents in Northern California on a net effective basis remain below pre-COVID levels. So that's been a headwind for us going forward. But we think that's changing. Very recently, Microsoft, Apple, Google and Meta have announced returned to office programs using hybrid scheduling. So all those people that they've been hiring over the last couple of years remotely will likely return to office, given that they have -- got to show up at the office now. And as a result of that, we expect a positive impact on rental dynamics on the West Coast. Generally, the tech companies did really well in the pandemic in terms of their profitability and growing their business model. And their hiring has historically been a catalyst for our apartments, especially in Northern California and Seattle. The -- we've seen the number of open positions in the top 10 tech companies up about 71% from the prior peak in the first quarter 2020. So that gives you some idea of what the big tech companies are doing. They made very large commitments in terms of leases and growing their footprint within our markets as well. And so we track very closely what the tech companies are doing. And again, we think that, that is a catalyst going forward. With respect to delinquency, our long-term historical average delinquency is between 30 and 40 basis points. And you can see in our ops update in the package, and Barb and Angela can talk about this a bit more, but it's shockingly higher than even the early parts of the pandemic, somewhere around 2.75% to 3% of revenue. And so it's been a headwind for us. But again, we see that turning around when the state of California becomes more active at reimbursing us under the rental relief programs. So that's been lumpy. And I think that there -- the concern there is that there was such widespread fraud in the pandemic unemployment earlier in the pandemic. They're very concerned about fraud and so taking their time in terms of distributing funds. So we hope that, that will improve as time goes on. And it represents a pretty significant tailwind that when and if that happens. We published an ops update on Page 25 of our presentation, get into that probably in a few minutes. And with that, I'll turn it back to Nick.

Great. Thank you very much. We're opening each session with the same question. What are the top 3 reasons an investor should buy your stock instead of any other listed property company?

Yes. Nick, the first 2 of the 3 reasons haven't changed a whole lot over the past several years. One would be track record. We are one of the leaders in terms of total shareholder return over very long periods of time since the IPO. So I would throw that out there. We're a dividend aristocrat. We paid an increasing dividend every year now for 28 years and just announced our latest increase in the dividend. And then finally, a new item, which is I think there's currently upside represented by the return to office, especially in Northern California and given what's happened in the delinquency area.

Terrific. Angela, why don't we start with the operation update that Mike alluded to.

Great. Thanks, Nick. We have a presentation, which has more details, but the operations update is covered on Page 25. But I will just give you a brief summary of where we are relative to our recent earnings. As of the fourth quarter, our rents compared to pre-COVID, so this will be March of 2020. For company-wide, we're up by 4%. But in February, we're now up at 8.2%. That's a significant increase. And that's primarily driven by Northern California. Northern California essentially has doubled the net effective rent growth relative to pre-COVID. And of course, the key catalyst is what Mike mentioned earlier, driven by the return to office, most of the large tech companies have announced a return-to-office plan. But just last week, they have actual dates attached to it. And so we view that as a continued strong momentum, which is why we also expect the Northern California to outperform for our portfolio. And given that it's a market that's already 96%-plus occupied, it won't take much to be able to deliver the results that we are expecting. We also covered our blended lease rates. That's a blended new lease rates and renewal rates. And in the fourth quarter, we're close to 14%. And right now, in February, we're about 16.7%. So once again, another strong indication. Having said that, I do want to caveat that with a year-over-year comparison dynamic in that January and February of last year was at our lowest lease rate point. And so that year-over-year comparison will be strong throughout the first quarter, and then it will taper off, but that's to be expected. And then the last piece I want to cover is where we are sitting on delinquency as of today. It has continued to decline or not to be as strong. In the fourth quarter, it was 1.6% of scheduled rent. And now we're sitting at about 3%, but that is really driven by the timing of emergency rental reimbursements. And currently, the state of California has only dispersed about 25% of the emergency rental relief program. So there's still a lot more to go. And so for us, we view that as more of a timing issue, now that there is something fundamentally problematic with our markets.

Great. Why don't we start with that delinquency. How much of that is driven by people that are currently living in apartment units that are just not paying for any reason versus past residents who left the portfolio, but still owed money that you're trying to get back?

Yes, that's a good question. It's primarily the current residents. And so we have applied for about 75% of our delinquency balance, and Barb has more details on that. But the majority of that, so 75% of that, 75% reflects the current residents.

Yes. Let me add just one more comment to that. The programs are set up so that the state is actually telling residents to apply for these benefits. So the state is advocating for more rental relief. And unfortunately, its disbursements are lagging the applications pretty dramatically. So overall, there was -- they've actually taken this off their website, but they're -- there were around $7 billion of applications in the State of California, and they had funded about $2 billion of that. So they're way behind and mostly at the lower income levels, the lower ratios of very median income. So we've seen that happen. I think that they're very concerned about, again, the widespread fraud and abuse of the system while they're advocating at the front end. And so we think that the cadence has to pick up, but we have no visibility into exactly when that is going to happen. And then the other piece of it is that the courts on the eviction side will not process an eviction if there's a pending rental relief application. So we are -- it's not like we have really any choice in the matter because the courts, if there's a pending rental relief application outstanding, the courts are just going to say, I'm not going to hear the case. So we're going to have to get through this period. And no doubt, it's a significant drag on FFO and our revenue growth. But we believe it's temporary, and we just need a little bit more time to work through these issues.

Who takes the lead on these applications? Does the resident have to file? Or are you filing on their behalf?

It's a combination of both. So for the current residents, they will go ahead and file. And for the past due residents, we do file on their behalf. However, they will still need to certify it. So it's a combination.

And is there -- as you think about the lag in terms of the application versus what's been disbursed, is there any risk to the funding of the program?

The -- there was around $46 billion appropriated by Congress. And of that, California's program was $4.6 billion initially. And so as I just said, applications are about $7 billion. However, there are certain areas that have been allocated a lot more funds than they need. And so there's a reallocation process going on. So we're still waiting for that to play itself out.

And how does it work in terms of your ability to either renew the resident when they're in process or to actually increase their rent if they're in process of trying to get rental assistance?

It sort of depends on where they are. If there's an anti-eviction ordinance, where we have in los Angeles and Alameda County, for example, we're not going to be able to evict for nonpayment due to a COVID hardship, and so -- and then -- but the statewide law that is -- it does not take priority over the local ordinances, unfortunately, but the statewide law changes on March 1, 2022 -- March 31, 2022.

And so how do you -- I guess, how do you think about this playing out? Is there an expiration to the current residents seeking rental assistance, as we think about March or April, as we continue to go, are they able to continue to file for forward months? Is there an expiration to the program?

Nick, it's -- we can talk about what's out there. I mean our concern, obviously, is that these programs keep changing over time. And so I guess, we don't want to go too far out in terms of providing assurance because at the end of the day, we just don't know. I mean we're waiting for the government to do what it needs to do. And we're not sure whether some of these ordinances will be extended or not. And it's just too hard to predict. So I don't want to create any expectation. I don't want to get into the ground of trying to predict what's going to happen on something that's completely and totally out of our control.

And is this all -- or vast majority related to California or is there any Seattle delinquencies?

It's mostly California. So I haven't looked at Seattle delinquencies. Yes, very small. And really, it's mostly 2 counties in California. It's Los Angeles County, which is obviously huge, and Alameda County, which is the Oakland MSA.

Why don't we turn to kind of the return to the office. As you think about those large companies that have put out dates, you guys collect a lot of data. I guess the first question would be, are you seeing traffic start to pick up in anticipation of those return dates? And then the second part of the question would be where are those kind of employees living today right? Are they already in the area and so you don't see the housing demand? Or have they moved elsewhere and are now moving back to be able to do some level of hybrid?

Well, we don't know perfectly the perfect answer to that. But certainly, we think Southern California has done far better than Northern California. So certainly, there has been migration that we've seen from Northern California to Southern California. And so a lot more people, I think, live in there. But I think maybe take a step back for a minute here. So what I think happens is about every 10 years, there is a change in the rental cohorts and people approaching retirement. If that coincides with a recession, they tend to say, okay, it's time to move out of state, use my expensive California home as a source of retirement income and essentially go move somewhere else. So that happened during the pandemic. But at the same time, specifically because of the pandemic, something else happened that's pretty significant. And that is the shutdown of essentially everything related to travel and entertainment, shutdown of the restaurants, hotels, obviously, all the travel, airlines, all those things. That was shut down hard in California. And if you're one of the workers in one of those industries and your restaurant has just been shut down, you're effectively forced to go find somewhere that's open that you can find a job. So we think that, that was a very unique piece of migration that really would happen only because of the pandemic. And then, of course, the demand for those services is ongoing. So now we're bringing those people back. And so job growth as a result, Page 14 of our presentation, where we fell further in the pandemic from a job. We lost more jobs in virtually everywhere. It's now flipped around to where job growth is greater in the Essex markets than it is for the U.S. So we're starting to see the rebound, and that is probably just as important as the migration patterns. So what we would expect to happen is as demand increases from return-to-office programs, there will be movement of wherever those workers are. Mostly the tech markets were drawing workers from the high-cost Eastern metros. So we would expect to see migration of the people that were hired in those metros to California, back to California to take these jobs because now they have to come into the office 2 to 3 days a week. So I think that's a key part of what we expect to happen. And then that will have probably 2 impacts on Southern California because the people that move to Southern California to be in a beach community, let's say, amid COVID, they move back to Northern California, but then there will probably be other people that moved out of Southern California to Phoenix or Las Vegas that will move back to Southern California as well. So we think that the reversionary trade is sort of neutral on Southern California, positive in the tech markets.

And as you think about some of that employment growth, you mentioned some of the service industry. Does that impact your portfolio directly? Or is that more kind of a market benefit?

That's -- all this is market data. I mean, let me take a step back because affordability, job growth or demand, supply, we look at all those things on a market basis. Because it doesn't matter where you are exactly within the market. We tend to own everything from, let's say, a B minus property to an A property in the marketplace. So we're more concerned about the overall dynamic of the market rather than how it might affect A property specifically. So I'd caution everyone, everything that we do, all of our fundamental research is done on a submarket basis. And then we try to compare submarkets in terms of net demand over supply, let's say, and then deploy capital based on that. And then the finding actual properties or investments to make is a function, obviously, of how many transactions are occurring in the marketplace and how aggressively they're bid. So that's -- so our view is macro supply-demand, affordability. Those are the key metrics. And been trying to understand -- based on that, understand where to deploy funds.

And how does that play out from a market perspective of urban versus suburban, maybe given some of the quality-of-life concerns in some of the CBD?

Well, I think the CBDs have unique challenges. So -- and we, before the pandemic, we're selling CBD assets, notably 8Th & Hope in Downtown L.A., also in downtown San Francisco and a few others. So we have been active in doing that anyway. The draw into the cities was really driven by the global warming mandates. So try to put housing next to jobs. And we thought that early on, that was going to be the prevailing process of adding value. It's turned out to be different than we thought. And candidly, I think that the amount of homelessness and the lack of a long-term solution to the homelessness and then the exacerbated perhaps by the defund-the-police type of activity, has made the downtowns less desirable. And it was a relatively small amount of our portfolio, but it's become, I think, less desirable. And back to the initial global warming considerations, work from home and hybrid is probably just about as good as living in the cities when it comes from a global warming perspective. So I think there's now a new opportunity within global warming represented by the hybrid model.

Does that change affordability calculations, though, of suburban versus urban?

Affordability is interesting. It's actually more driven by where rents have grown. So if I just go back to pre-COVID rents to now, 3 Southern California counties, San Diego, Orange and Ventura County, have all grown their rents at least 25% from pre-COVID levels. Whereas Northern California is at about minus 5% and Seattle is about 0, so kind of breakeven. And so when you look at affordability, if you have a 25% increase in rents, you don't -- you didn't get a 25% increase in your compensation. So all those 3 markets, the 3 counties in Southern California screen affordable -- unaffordable from a rent-to-income ratio. Again, we do affordability on a -- using median rents and median income to trying to judge the entire county rather than a specific submarket. We think that's more relevant. And so those screen relatively unaffordable. And conversely, the areas where incomes have continued to grow in Northern California and Seattle and were still at or below pre-COVID rents, they screen affordable from that perspective.

What's the biggest growth opportunity that you believe the market is not giving you credit for?

I think we feel like we're maybe the last person to the dance in a certain sense. Because we have -- when you have almost 3% delinquency, that is an extraordinary challenge that it shouldn't be there, but that's clearly there. And the return-to-office in Northern California, and it's maybe not as quite as dramatic but significant impact on Seattle, the return of the technology employment areas is going to be the key driver of the company going forward, as it has been for the last 40 years. So we have the -- Northern California is, in our view, the best market for long-term CAGRs of rent growth compared to any major metro in the U.S. over 25 years. And so that is really disconnected and has created this opportunity. So I think that's there. And then the other part is even on the supply side, because of the COVID-related restrictions a couple of years ago, we expect supply deliveries in Northern California to decline about 50% in 2023. So if you get the confluence of these jobs returning to office and without a significant amount of supply, we think that, that has a very positive impact on us.

How are buyers underwriting these current delinquencies in the transaction market?

We're a buyer, obviously. And so we are dealing with this issue. We tend to believe that the world is going to get back to normal at some point in time. So the question is between now and that point that the world gets back to normal, which we're guessing at, what is the cost? How many dollars are lost during that period? And then we effectively subtract it or add it to the cost of the property in order to get a cap rate. I don't know how others are doing it, but that's how we do it. And we think that's a rational approach. We do believe that delinquency rates will return to normal once this is over. And typically, we're looking at somewhere around a year. But the reality, as I noted earlier, we don't really know.

And are you seeing any change to buyer appetite, just given the regulatory environment? I mean, putting aside kind of the near-term impact, does this change the medium and longer-term view of regulation in California?

Our view is that the regulatory environment, it swings like a pendulum. And so clearly, it swung further left than I would ever imagine, I have to say that. And that's pretty frustrating as an owner of apartments in a market that needs housing pretty desperately. It seems like they would be very welcoming -- the governmental agencies would be very welcoming to landlords, but we find exactly the opposite, which, of course, is the reason that there isn't a lot of development there. Because there are so many layers of costs that are embedded in what the government mandates are that you end up not being able to build. So I was actually asked recently by someone in Washington who's connected to the government. What do we need to do? What do we need to do to get more housing built? And I said, just there's plenty of developers out there. There's plenty of money out there at the right yield, but when you layer on affordability, the office buildings don't have to provide 20% of their space to charitable causes, right? That would be a pretty big impact on that. And the -- all the different fees that are layered on, California has CEQA, which is California Environmental Quality Act, which allows virtually anyone to object, on an environmental basis, which can include noise, traffic, any number of things. So -- and then every city approaches us and says, hey, we want 100% union. And we're happy with building a union, we just want to be able to bid out a property, a project against nonunion to kind of keep the pricing from going crazy. So it's all of these things that cause a lack of development and the shortage of housing that we have. And it's all part of the overall political landscape of the West Coast. And so I do think that there will be some movement back. The pendulum is swinging back because I think the mayors, I mean you actually see the mayors on TV of some of the major cities saying, listen, enough is enough, we're not going to let this heck go any further. And so that's, I think, the first step for a longer solution. Having said that, the one thing I haven't heard is a permanent solution to the homelessness. And homelessness, in some way, connected to crime.

And so as you think about kind of buyer interest in the market, it doesn't sound like even with those kind of issues you've laid out, either cap rates or buyer interest has really changed.

Yes. Cap rates have remained pretty substantial. I'd say over longer periods of time, the West Coast has tended to have lower cap rates. And I think now it does not. So I think that's an interesting phenomena. And cap rates, I'd say, in general, are -- they remain pretty sticky. They don't change often. But when they change, they change significantly as they did during the pandemic. So I would say our average cap rate was in the low 4s, 4% to 4.25%, pre-pandemic. And it's gone to 3.5%, 3.5%, somewhere plus or minus. The range of cap rates is probably wider now given inherent uncertainty in the marketplace in terms of some of these issues, how do you underwrite delinquency, how do you underwrite a return-to-office type of scenario. And so I think that, that creates a wider spread in cap rates in the marketplace. But I wouldn't expect it, again, depending upon what interest rates do, I wouldn't expect any near-term significant change in cap rates.

And how does that play out into your kind of external growth opportunities, either on balance sheet or with JV capital?

Yes. The -- with respect to growth opportunities, I think you can look back at the last year of activity where we acquired $600 million of property, virtually all of it in a joint venture mode. So that would imply that we don't find the stock as being the best source of capital. And in fact, we would prefer selling property, let's say, to fund our component and then transacting in a co-investment or joint venture type of opportunity. Interest rates, still a lot of positive leverage in apartments. But if you take the transactions that are in the marketplace and you apply those cap rates in the underwriting to our portfolio, it's not accretive to our NAV and FFO, and therefore, we would probably pass on that.

You guys have repurchased stock in the past, too. So it seems like the stock is somewhat just in between where it's not accretive to do on-balance sheet external growth, but it also probably doesn't make sense to sell assets and repurchase shares.

Do you want to do that one? Barb, that one?

Yes. We have been opportunistic in the past, and we will look at our cost of capital and try to arbitrage the difference between public and private market pricing. And as you mentioned, we -- the last time we bought back stock was in early 2021 when the stock was in the low 200s. I think today, we're kind of in no man's land where at the stock in the $3.40 range where we are looking to grow, but using the joint venture platform at this levels.

What's your #1 ESG priority in 2022?

It's, I would say, focused on the E and really 2 specific areas. One is refining the data collection and analysis part of ESG. And then we're also installing a lot of solar installations as well.

We actually have a couple of questions on this topic, so I want to get to it. How is the Board thinking about succession planning kind of going forward?

It's an ongoing process, and it has been for many years. And so -- it -- the Board is interested in the development of executives from mostly the Vice President -- Director and Vice President level up. And it is a long-term process of evaluating each executives, individual sort of skills assessment and understanding their track to the next higher position and plotting what that means for the company. So it's something that we've done for a very long time. And I think it's robust process.

And then we do have a question specific to turnover in the portfolio, if there's an opportunity or if you believe it could decline further? Or will 2021 likely be the low point?

Want to do that one?

Which one?

Specific to turnover in the portfolio, so just residents leaving. Would you expect turnover to remain at these levels? Would you expect it to move up? Or have we reached the low of turnover? I guess it's somewhat tied to your delinquency as well.

Yes. We do expect turnover to reach our normalized level over time, but it's still going to take probably a couple more quarters to work that through, especially in Southern California, where we have very low turnover, historically low turnover, primarily because that's where we have the greatest loss to lease as well. And with a market that's over 96% occupied, there's a question of where are they going to go. And how -- given AB 1482, there's also a limit on how quickly we can increase or realize that loss to lease.

Great. And we do have our rapid-fire questions to end the session. What will same-store NOI growth be for the apartment sector overall in 2023? And this year, the average is about 12%.

Yes, somewhere probably around 7%. So we think it will remain strong.

Sorry, what was the number?

That's same-property NOI growth?

Yes.

Yes 7%.

Yes. Sorry, we can't -- it's harder to hear up here. Where will the 10-year U.S. treasury yield be a year from today?

That's a million-dollar question, isn't it? So our group, we kind of pulled the senior exec group here, and we came up with a range of 2% to 2.5%. And so we're going to have to say, 2.25%.

Then finally, will the apartment sector have more or fewer public companies a year from now?

You guys always trick us with that. There's not very many of us. So okay, I'll say fewer.

Great. Well, appreciate the time, as always. Thank you.

Thank you.