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

Good afternoon, everyone. Thanks for joining us for my second panel in this room. Pleased to have Essex Property Trust with me. To my left is President and COO, Angela Kleiman. To her left is Essex Property, Executive Vice President and CFO, Barb Pak; and to Barb's left is Rylan Burns, Group VP, Private Equity and Finance. So I'll pass it off to the company for some opening remarks about Essex, and then we can jump into Q&A. As always, I definitely encourage questions. Don't be shy, my [ not ] calling someone. So -- but I have plenty of questions that you are actually shy. With that, I'll turn it over to Angela.

Well, great. Thank you, and it's great to be here. I think BofA does a terrific job hosting this conference every year. So we are delighted to see everyone and also to see business getting back to normal, which is really terrific. Well, I'll just start with a brief overview of Essex. Essex is an S&P 500 company and the only multifamily REIT dedicated to the West Coast. We invest, own, and operate about 62,000 units in coastal, Washington and California. And since our IPO, we have generated one of the highest total returns of all public REITs. And we have also been able to increase our cash dividends for 28 consecutive years. Now, what drives this out performance? We attribute that to long-term supply demand, favorable fundamentals in our markets, combined with our capital allocation discipline to maximize shareholder returns. So now moving on to just a brief operations update. We posted a presentation online. And so if you want to refer to details there, there's lots of good information. But I'll focus on Page 13 because that gives you a good sense of where we have been and where we are today. And I'll just start with the -- on Page 13 on the bottom table. We print a July, August year-over-year new lease rates of 11.6%. Now this 11.6% is a deceleration from the first half of the year at 20%. However, it is not because of any fundamental softness that we're seeing in our markets. I had discussed this on our earnings call that it is a tougher year-over-year comparables that's driving this. And just to give you a little bit more color, -- last year, in the first half of the year, we had negative new lease rate growth of 4%. In the second half, the -- we saw extreme acceleration to positive 13.25%. So fast forward that to this year, which is why this year in the first half, we have 20% year-over-year against a negative from last year the same period. And currently, we are at about 11.6%, once again, [indiscernible] against 13.25%. What we do expect is a continued deceleration so the second half of the year -- of this year will end up averaging about 7.5%. And -- so this is all happening consistent with our expectations. And in fact, this 11.6% is a little bit ahead of our plan. And so we see fundamentals remaining quite strong in our markets and especially with a year-to-date same-store of 12.4% avenue growth. So with that, I'll turn it back to Josh.

No. I guess maybe my first question was just -- it's the hottest topic, I think, with [indiscernible] just the job growth in your markets, especially with just what's going on in the tech community. Kind of, can you give us like an on-the-ground feedback on what you're seeing as far as job growth and then what's also going on with the tech community?

Yes, that is a hot topic these days. I think there's been quite a bit of a headline in recent months on deceleration relating to the technology industry. And it is a tale of 2 cities when it comes to technology. And you have the start-ups, which is getting a lot of headlines. And we typically expect the majority of start-ups to fail, and that is normal. So the -- on the flip side, we focus our due diligence on the largest 10 tech companies because they're the ones driving our economy and not just our economy, but the broader global economy. And when we look at the job openings and we actually comb through their posting to see where they're hiring, the levels of hiring is still higher than pre-COVID. So that tells us that -- and they were hiring throughout the pandemic. That tells us that while that industry will have -- will ebb and flow and when it comes to job hiring, it is doing quite well. And of course, with the demand and which we're seeing in our results, if we didn't have strong demands, we wouldn't have this kind of results. And on the demand side, if you look at trailing 3 months, we're at about 100 basis points above the U.S. Our job growth is at 5.2% average for our markets, and U.S. is 4.2%. So we see that tailwind to continue partly because, of course, we have the tech industry driving centers of innovation and wealth creation, but we're at about 93% recovery from pre-COVID level. So we're still in the recovery phase. So it's both of those factors.

That, 93% recovery that's across all of your markets...

That's an average for the -- for all of our markets.

How does [ it ] compare many across all your markets, I guess, Northern California [ is the ] weakest...

Well, let's see. In terms of -- I think I have the industry's information. And so -- if I look at Northern California, it's probably about the same like [indiscernible], let's say. On average, it's kind of in the 90-ish percent. So it's probably pretty close to the portfolio average with Seattle generally ahead and then Southern California depends on what pocket. It will bounce around a little bit.

And then tech gets a lot of focus, just given the West Coast, and I don't think West Coast is all about tech. I guess what are the other kind of industries that are adding kind of jobs in your markets and...

Right, right. Well, we're definitely seeing leisure hospitality, which is another key driver, professional services and, of course, the filming industry, which is meaningful in the L.A. area. So pretty much across the board, some construction, some wholesale trade, and transportation. But it's probably not a whole lot different than just U.S. average on the industries, both more oriented to professional services for us.

And then it sounds like over the last few weeks, I feel like we've heard a bunch of announcements for companies in the West Coast like asking people to come back to the office. Do you think that's beneficial to your portfolio, kind of neutral or just what's your take on -- for the company?

Well, absolutely, it's beneficial. I think, Barb, you have some good information on return to office?

Yes. So as you mentioned, there have been announcements, and they are actually bringing their employees back. And Apple just went from 2 days to 3 days post-Labor Day. And we are seeing it in traffic. Traffic has gotten much more congested in the Bay Area, more out-of-state license plates that we see that we haven't seen in years. And then in terms of our leases, the number of leases that we're signing from outside of our markets has increased. So in the first quarter, 20% of our leases were from out of our markets into the Bay Area. And then now that's grown to 30%. And so we are seeing that trend move up. And so it's definitely occurring. And we think it is a tailwind. We don't think it is all done at this point. We think people will continue to move over time. People are getting their life resituated. And so it will remain a tailwind for us over the near term.

And I guess one of the things like I think people are focusing on like Northern California, maybe just quality of life issues and then Seattle's [ going to ] extend. It sounds like some political changes that happened have started to get in the right direction. Like how much outboard is that, you think, to your portfolio? I mean you guys are more [ outboard ], so maybe it doesn't really matter, but...

Well, I would say that from a quality of life perspective, it definitely benefits our portfolio because we're primarily in the suburbs. And when it comes to kind of what you're talking about, the quality of life -- it's actually a CBD issue. So it's not just Northern California, it's the Downtown, all the Downtown, Downtown L.A., Downtown, San Diego because these areas, it's just tougher. There's more homeless, there's more crime. So tougher quality of life. And in the past, it had much higher supply as well, and that's still the case with Downtown L.A. So we had actually -- prior to the pandemic diverted our portfolio out of a CBD wherever, whenever it makes sense. And we do see that while, to your point, that there is a local acknowledgment that these things are challenging and needs to be fixed. It's going to take a long time. It's years and years.

Just any questions from the field?

In terms of operations, well, Seattle is we have -- we're mostly in Bellevue and Eastside. And so operations is incredibly strong in the Seattle market because you've got Amazon growing, demand for Microsoft and of course, lots of companies moved up there because it had a better affordability. And so that has continued. In terms of Northern California, San Francisco continues to be tough. We don't have a lot in San Francisco, fortunately. But the Bay Area itself is doing quite well. And when we look at our sequential growth year-to-date, so not year-over-year for year-to-date, both San Francisco -- I mean both Northern California, I should say, and Seattle leads the pack in sequential growth.

We hit a little bit on the demand side. Maybe turning to the supply. What's kind of in store for us in 2023? Or any kind of pockets you're watching?

Yes. I think the supply picture for us looks pretty good next year, and it's a function of what happened during the pandemic, right? Nothing -- no one was [indiscernible] nothing was starting because it didn't pencil. And so that's going to translate for us next year a reduction in supply in Northern California 40%, and then our total portfolio is down about 5%. So we see the supply picture looking good for us, not just next year, but the next few years because our level of permits that have been pulled have been pretty low because it is so difficult to develop in our markets. And especially Northern California, with rent growth lagging the rest of the nation, nothing has -- it's been more difficult to make the [ math pencil ] given the rise in construction cost. And so we see that as another tailwind for us. Next year, we don't need a lot of incremental job growth to cover the supply given the reduction we see next year.

What about Seattle specifically, that seemed like it was always like kind of a high supply market. I know it seems to be concentrated, but...

Yes. In that market, we do expect more supply next year, and it does ebb and flow, but it is a market that typically produces more supply -- and one of the reasons why we have a 20% allocation to that market is because the supply is a bigger factor in that market. But overall, the supply/demand fundamentals still appear good in that market.

And then just on the supply front, I feel like politicians in California was kind of talking about what is to help the affordability and get the supply going? Like anything that you're seeing or watching or concerned about?

Well, I think what the politicians try to do is balance -- and I believe they understand the need for supply and then balance that with public policy. And one of the legislation that was passed just for COVID was AB 1482, which essentially captures rent growth on renewals at CPI plus 5%, max at 10%. And to us, that's a reasonable policy because Essex had a self-imposed 10% rent cap on renewals since I've been there, so that's over 13 years. And it has not impacted our ability to drive growth or provide out sized FFO per share. And so with the political climate where it is since this legislation just got passed and they got passed with an overwhelming democratic majority, we don't expect a whole lot of changes. It's just nothing else just to let things settle. So I do think we're probably ahead of the rest of the country when it comes to legislation discussion when I talk about affordability and rent control.

Maybe just on the affordability topic. How is it kind of trending in [ the ] market?

Yes. So as we said in the past, Southern California, we've seen more upward pressure on affordability just because rents have grown more akin to the Sunbelt, 30-plus percent. And while wages have grown, they haven't quite kept up with rent growth. And so there has been some upward pressure on affordability. We're around 26% today. Long-term average, I think, is 23%. So we are above the long-term average in that market. And Northern California it is the exact opposite because rents have grown or basically back to pre-COVID levels, but incomes have grown that entire time. And so we've seen a reduction in the affordability metrics. And so we're around 21% today versus the long-term average around 23% and the historical peak of 29%. And so in Northern California, definitely not seeing any pressure there. And when I'm quoting these numbers, it's for the market, not for our portfolio. We don't look at it on a portfolio basis. We look at it for the market because renters have a choice to where they want to live. And so that's -- for the market, we don't see any concerns at this point. And even in Southern California, that's the market we're watching closely, but we're not seeing anything in our portfolio. That's alarming.

For L.A., since it does seem to be whole less affordable. Is that -- just given the rent growth, as they advance some strong rent growth or just like incomes are just not growing the staff.

So in Southern California, rents since pre-COVID are up 20% to 30%, in some markets even more. And incomes while they've grown, they haven't grown that to that same level, which is why you're seeing that affordability go up.

What's kind of driving that difference? Like why is L.A. like a gang buster market in Northern California, -- like is it just the political or tech environment or...

Well, let me just provide a little more color on L.A. Itself because it's a huge county. So Downtown, L.A. behaves very similar to any other CBD, Downtown, San Francisco, and Downtown, San Jose. And so that is not where we're seeing this 15%, 20%, et cetera, rent growth over the past couple of years. So it's really in the surrounding suburban areas. And the suburban areas has been a preference, right? It's a better quality of life. And with hybrid work, you have that ability to do so [ and ] the commuting time, while it's a little bit [ hot ] greater, it's still very manageable. And so when we're talking L.A. as a whole and the strength, it's really more directed towards the suburban L.A.

Any questions? No? Maybe turning to just the capital allocation. I guess where are you finding the best opportunities to create value to that?

Yes. I would say we can buy back our stock and sell an asset and create value today. That would be one of the ways. And then preferred equity is still very attractive for us. We like that business. We like it better than going and doing ground-up development. We think there is a better risk-adjusted return for our shareholders stepping in there versus on the ground upside. So those are the 2 areas we're focused on. The traditional buying asset, not going to work where our cost of capital is today.

Was [indiscernible] that you laid those out? Is that kind of your brain preference? Or is it...

No. It depends on [ where ] the capital is coming in and where we can find deals and where we can transact at. What we're not going to do is go and buy back a bunch of stock and hopefully we can sell an asset. We want to be certain we can sell as we don't want to lever up the balance sheet. We want to keep the balance sheet leverage neutral. And so we're -- we like to match fund everything because then we know what spread we're locking in and what value creation we've locked in for shareholders. So that's important to us as well. So it does depend on a variety of factors.

Okay. And can you remind us of just your preferred equity program, what kind of returns do you get? Do you need to scale it or kind of [ want to ]...

Yes. So we have -- it depends if it's a -- we have a variety of ways we price these programs. But on average, if it's a new construction and it's a development, it's going to have a higher return, north of 11%. And if it's a stabilized property, it's even -- it's lower, but it's moved up. So it's around 10, sub-10 in that zone. So we have seen more stabilized properties come to market more recently. And we're willing to step in and -- because we know the property, we know the sponsor, we know we know we can step in if we need to. And given where we underwrite to, we feel comfortable. I would say on the program, we have a Board-approved cap on the size of the program. It can go up to a little over $1 billion. We're not anywhere near that today. We're, I think, $600 million on that program. So we still have a lot of room and have continuously get redemption's because this is a 3-year typical life on this program. And well, I think it's a combination of things on the refinance front. Developers potentially were going to sell. Now they're going to wait it out and so they're taking another slug of debt to kind of bridge the gap until they can sell their asset or their construction loan came due, they're just refinancing to perm and taking out as like a preferred as well. No real distress, and we're not seeing distress. It's just really a function of where the capital markets have gone in the sales market.

What's the outlook for, I guess, redemption's on that program?

Yes. So we have $100 -- about $120 million, I think, redeemed to date that mostly happened in the first quarter. And then we expect, I think our guidance calls for $225 million for the full year. And we still believe that we'll be in that zone.

Okay.

So we still have redemption's expected for the back half of the year.

Is that -- I guess I'm asking just because the interest rate environment has changed so much -- it seems like it might be more to track cost of capital for developers.

We did take down our guidance. We did assume around $300 million of redemption at the beginning of the year. And because of the capital markets and the changes that we've seen, that has come down to the low $200 range, but we do expect that we'll still have some redemption's. And I think we have seen our pipeline grow more recently in terms of people coming to us looking for this alternative source of capital, more so than what we saw last year. Last year, we were getting taken out. Debt funds are very aggressive, and they were coming in and taking us out or stepping in at rates we would not step in at, and we weren't really being able to do much and source many deals, that environment has changed.

Okay. And then can you remind us kind of your history of stock buybacks and how you approach that program?

Yes. So we are a company that is not afraid to buy back the stock and sell an asset and take that arbitrage and create NAV and FFO per share. We did buy back during the early parts of the pandemic, a couple of hundred million dollars of stock, and we funded it with an asset sale. During the -- Great Recession, the Global Financial Crisis, we did the same thing. So we will -- if that's the way we can create value, that's what we will do while maintaining our balance sheet strength and structure, I think it does make us unique because we're looking to grow in all economic cycles, and we're going to take what the market gives us and try to make something of it because today, the market is not telling us to go by assets.

And then maybe just turning to the balance sheet. Could you go over your philosophy on managing it, kind of how you're thinking about this interest rate environment?

Yes. [indiscernible]. We don't have a lot of debt maturing near term. So that's number one. I would say though, we've always maintained a very conservative balance sheet structure. We know our markets are going to be volatile. So how do you weather through that storm is you have a conservative balance sheet. And you have ample liquidity, lots of access to lots of sources of capital. So you have financial flexibility in any environment. And that hasn't changed, and it won't change. And it's allowed us to raise our dividend every year for 28 years. Not many companies can say they've done that. And it allows us not to weather any crisis without having to issue dilutive equity. And so no major changes on the balance sheet side. We have limited near-term capital needs because we don't have much in the development pipeline. And then we have limited near-term maturities because we were very proactive over the last few years taking out debt. And so from a capital needs perspective, we're in a pretty good shape.

Have you guys thought about maybe widening kind of the aperture on maybe how you source funds like more JVs, more fund model or anything like that, just given what's going on?

I think we're always looking at different sources of capital. I think we have a pretty wide spectrum of sources of capital, like you said, the joint venture platform. And it's not just one partner, we have many different partners to go and look to if we were to go and buy assets. And then -- and we're not afraid to sell our assets if that's what makes the most money for our shareholders. So that's another source of capital that we can always utilize. And then on the debt side, we have access to a variety of capital sources, including Fannie and Freddie, which is unique for multifamily, right? Multifamily is the only sector that has access to that source of financing. So I think that is a benefit. We don't use it, but it is a benefit to the sector and others who do use it. So we like to have a variety of sources because at any one point, one of those sources may not be available, then we can pull from somewhere else.

Any questions from the field?

[indiscernible]

There have been -- I mean there have been -- deals are still happening. I would say cap rates aren't different than what we said on the second quarter call, around [ 4 for ] economic today. It's going in is slightly lower than that because of the loss to lease. But yes, deals are still happening, more so than what were happening kind of early on when things kind of shut down, but we are still transacting.

Yes.

[indiscernible]

Yes. I think more people -- it's a smaller bidder pool and less rounds of best and final and that has definitely changed. And you've seen that as a result, cap rates have moved up, right? Because when there was a lot of bidders in the tent, they would go to multiple [ best and final rounds ] and that has pulled back. But people are still needing to transact, and they need to do 1031 exchanges or they've raised capital, they need to put to work. And I do think multifamily is a good inflationary hedge. If we're fighting inflation, we get to reprice annually on our rents, and that does help cut down to the bottom line, right, with the rent route. So we've seen some upward pressure on cap rates, but not to the level that we've seen in our stock price.

Levered buyers...

Yes. Levered buyers have definitely pulled out, but there's still a lot of institutional capital that like this segment. They like housing. And unlike other sectors, people are going to need a place to live long term. And so there's still good demand dynamics for the sector.

Are you currently marketing [indiscernible]?

We are actively marketing.

Is there another question?

[indiscernible]

Okay. So are you saying that in a recession, we would not have a housing shortage? Is that your question?

[indiscernible]

Okay. Yes. Right, right, right. So I see what you're saying. I think in a situation where we already have such an acute housing shortage and with our supply, also the pipeline is very anemic. I mean, Barb talked about where our company portfolio-wide, the supply is down 5%. But Northern California is down over 40%. And so back to your comment, if we actually have a demand issue, right? So not a lot of jobs. Well, in order to absorb the supply coming, we don't need much -- we don't need much, compared to, say, other markets where there is significant supply coming. So on Page 27 of our presentation, when you have a chance to take a look, there's a good chart that illustrates kind of what -- how much demand do you need to meet the supply coming online equilibrium. You'll see that for our markets, pretty much [indiscernible] below U.S. average. I mean -- I think we only need like 1%, and that's just a drop in the bucket. So at this point, the portfolio is, in fact, very much well positioned for a recession.

Any other questions? I think we talked about just maybe expectations across your market for [ trend ] growth and kind of how you see that playing out [indiscernible]?

Yes, sure. Well, we -- as for expectations for rent growth, we expect that the Northern regions to continue to outperform the Southern regions. And it's primarily because the Southern regions have done so well. And Northern region is still in midst of recovery. And so predominantly Northern California and Seattle, I think they're probably going to be pretty much neck to neck in terms of the magnitude of outperformance and followed by Southern California.

Then one thing that I really think is topical at this time of the year is just maybe the build blocks for growth in the future. You put out an update on your locked-in same-store kind of revenue for next year -- or your earnings...

Earnings, yes.

Could you maybe walk us through that and then just to other building blocks?

Sure. We -- in the past, we have communicated how to look at loss to lease because people will point to [indiscernible] lease, which is during our peak of 10%, and that's really aggressive. And then -- but you don't want to look at the loss of lease in December because that's typically the lowest period of demand. And so it's normal that loss of lease will be pretty much flat or 1%. And so we tend to look at the September loss lease as a good proxy. It's not going to be a [indiscernible] science. But September loss lease, and we assume 50% [ churn ], so you take that you have 50% and that calculates the earning. So we printed once again on Page 13 of our presentation, a August loss lease of 7.6%. And so that leads us to interpolate somewhere around 3.5% to 4% earn-in for the next year, and that's the background. But a little more context on this 7.6%. This is a really strong number. Typically, our loss lease around this time is around 3%. So this is twice the level, which is why we're feeling quite good about our fundamentals.

And then...

[indiscernible]

It is just a 50% turnover.

[indiscernible]

Yes. Yes. It has been lower, but what we didn't want to do is use a pandemic number or long-term forecast. So we kind of reverted to the long-term average of around 50%.

Is there any external growth or anything else that's hitting going to 2023 that we should be aware of?

Well, we haven't given out 2023 guidance yet, and so we're still working through our pipeline. So more to come on that. And once again, as I mentioned on the call last time, I don't want Barb to kick me or kill me. So I'm not going to talk about 2023...

We're not prepared to tell you about all the building blocks for '23 yet.

Okay, I always have to...

Going to try. That's all good.

Maybe [indiscernible]. With that, I think we're actually right out of time. But we've been asking 3 rapid-fire questions, for all the management teams. The first one is, which of the following is the greatest macro challenge facing U.S. public REITs today? A, risk of higher rates; B, risk of a recession or C, the rise of private equity and non-traded REITs.

I'm going to go with recession. [indiscernible] I mean rates that actually [indiscernible] to income inflation is -- it doesn't hurt our rental growth as it increases wages and -- so I'm going to go with recession.

Which of the following is the greatest sector-specific risk, labor issues, supply or capital markets?

Supply, outside [ environment with ], sector.

Sector.

Yes. sector risk, yes. Supply.

Are you seeing any signs of weakening demand?

Definitely not seeing signs of weakening demand.

No. [ Have you passed ] -- just...

That was a clear no.

Thank you, guys.

Thank you, everybody. It was great to see you all.

Thanks, Josh.