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

Here we go. My name is Josh Dennerlein. I cover the residential REITs at BofA. I'm pleased to be here with Essex management team, CEO, Angela Kleiman; CFO, Barb Pak; and Rylan Burns, who has a new title, which we'll -- I'm sure we'll go through a little bit later. But with that, I'll pick it up -- or I'll pass it over to Angela, who can give a brief introduction on Essex.

Well, great. It's great to be here, and thanks for having us, Josh. You guys always do such a nice job on this conference. And it's good to see everybody here. Essex, for those of you who are not familiar with us, is an S&P 500 company, about $22 billion in total market cap. And we focus on West Coast, so California and Washington apartments and up and down the coast, close to major job centers. And we are a dividend aristocrat, which means we've grown our dividends consecutively for over 25 years. In fact, we just announced our 29th year of consecutive dividend increase. So very proud of that history. One of the reasons we've been able to do that is we've been able to grow our rent growth or compound CAGRs of rent growth outperformed that of the U.S. and primarily because where our markets are, we have the benefit of lower supply and being the key center of innovation with higher job growth and demand characteristics. And of course, combine that with higher income growth that all enters to our ability to outperform. We have an operations update, but I'll turn it back to Josh in case you want to kick it off with any questions.

Well, maybe [ catching on ] that operating update. I think it would be beneficial to kind of go through the nuances within the numbers you updated and just kind of how we should think about maybe the rest of the year.

Terrific. Thank you. So I'll flip it to Barb to talk about guidance and our expectations in a second, but we have a presentation that's published. And on Page 12, is our operating update. And so a couple of key highlights on our operations update. In the top box, you'll see that preliminary July and August same-store property revenue growth is at 2.4%. And so you'll see a natural deceleration from beginning of the year, which is what we had anticipated and forecasted for guidance. But the one other factor that's not shown on this page is that with our delinquency as a percentage of rent at about 2%, that is a key driver to this deceleration and why we're at 2.4% because without this delinquency, we would be in the 4% range of rent growth. And just to put a little finer point on that last year, July-August, delinquency as a percentage of scheduled rent was only 60 basis points. So fast forward to this year, it's at 2%. And the big driver is emergency rental assistance. So the reimbursement is no longer available to us. So if you're looking at apples-to-apples, gross delinquency has been improving since last year. However, because of the availability of the government reimbursement is no longer there, which is why delinquency is ticking up. So it's not that things are getting worse, but this is playing out as we expected. On the bottom box, you'll see our leasing rates. And so with August preliminary blended rates at 2.3%, you'll see that new lease rates have been gradually improving. So from Q2, it's 1%, now at 1.6% preliminary. So it's a slow improvement, but nonetheless, it's what we have anticipated. Renewal rates have been decelerating, which is also what we expected. So they're kind of moving in opposite directions going from 3.4% in the second quarter for renewal rates, now to 2.9%, and that's because we have forecasted market rents to be at 2.5%. And so of course, as we renewal, we're going to move toward that market rent. So once again, things are playing out as we expected. And the one last note on the new lease rates is that we do believe that the new lease rates is being tempered by delinquency overhang, which is leading to evictions. We're trying to recapture the nonpaying tenants, which is creating effectively additional supply. So in those kind of environments, what we're trying to do is preserve occupancy, which means we are not going to be as aggressive on pushing rents. And so this whole dynamic is playing out as we've expected. Barb, do you want to talk about our guidance?

Yes. So quarter-to-date, the results are in line with our guidance and our expectations. And when we did revise our guidance for the full year, same-store revenues, it was really what we had achieved year-to-date. We didn't change the back half of the year for a higher rent growth per se. So the guidance and what we're seeing right now is very much in line with how we forecasted on our second quarter call.

Angela, I just want to follow up on a comment you said about how the markets where you're facing the delinquencies, you're focused on preserving occupancy. I remember at the 2Q call, you mentioned, you were switching back to pushing rate versus like holding occupancy. Just kind of curious, is it like a micro situation that you're still holding occupancy. And how did that switch to pushing rate go?

Yes, that's a great question. This year is somewhat unusual for Essex. So normally, we push occupancy during the seasonal low, so that would be first quarter and the fourth quarter. And during the second and third quarter, we're pushing rate really hard while just holding occupancy flat. And we did some of that, and we talked about that on our second quarter call. And what happened subsequent to the second quarter call is that it's a good news, bad news. In that, the good news is we're able to make good progress on vacating tenants that are not paying, but in so doing, it created more vacancy. So you'll see that we are very nimble, and we're going to adjust between the pushing rents and pushing occupancy back and forth. And normally, it's not this much back and forth. But once again, this is an unusual year. And I do want to make one more note on this delinquency conversation because typically, it takes, say, 2 to 3 months to go through an eviction process. And because the courts are so backed up because you can't find more eviction law courts or judges, or eviction attorneys. And the entire market, not just Essex, we're working through these evictions. So it's creating a logjam. And so it's taking 9 to 12 months to evict a tenant, which is prolonging the whole process. And so we do see light at the end of the tunnel, but it is taking longer because of the volume. And so it's not a legislative issue. It's purely a personnel availability issue.

How should we think about that returned to normal delinquency? Like how -- is this like a continued overhang for 2024? Or do we kind of get back to normal by the end of this year?

Well, it's a great question and one we don't have a crystal ball on. I would say, to get to normal by the end of this year is not likely, and it's not part of our guidance. We've assumed we're kind of steady eddy from here at 2% for the full year. I would say, we do expect this to be a tailwind into '24, just given where we're at, and we will continue to make progress. It's just an exact timing on when we get back to our long-term historical average is a little unknown. What I would say, though, is that we don't believe there's a structural change in the market to allow tenants to be delinquent and for us to be at 2% forever. I do think this court system, which Angela mentioned, is an issue, but we ultimately will get back there. It's just going to take longer than expected.

And then our strategy, obviously, focuses on the West Coast. And what gets you excited about those West Coast markets today? And what's really needed to get those markets to reaccelerate and outperform?

I'm going to have Rylan cover this, who is now our Head of Investments.

Thanks, Josh. Yes, when I look out the next couple of years, I am particularly positive on Northern California. And the reasons for that are pretty simple. The supply outlook is relatively muted next year. And based on new construction starts, should improve thereafter. This is a market where rents have not grown since pre-COVID and incomes have increased around 20% on average. So affordability as it relates to apartment costs are as attractive as we've seen in over a decade. The cost to buy a home now with mortgage rates where they are is around 2.5x more expensive to buy a home. So in terms of affordability and looking forward on the supply side, we feel there is a very attractive fundamental setup in Northern California. Tech has retrenched in the past year. Tech jobs were down year-over-year, and we have seen a stabilization in that submarket of the jobs, and they're stabilized and starting to pick up. And so I think with all of the excitement we're hearing on AI with venture capital still flowing into the space, I think that next leg of economic growth, which higher beta tech company should benefit from the whole industry. I think we can get back to a period where we've seen significant outperformance and catch up in Northern California being one market. But we feel pretty good about our fundamentals across all of our markets, Southern California continues to do well. The supply outlook looks relatively muted there as well next year. And then Seattle supply can be a little bit more volatile in the Pacific Northwest. But the underlying fundamentals, in particular, affordability remain attractive. So I'm not anticipating significant changes in terms of our allocation, which are, if you're not familiar, 40% Southern California, 40% Northern California, 20% Pacific Northwest. We don't anticipate major changes in the near term and are feeling pretty good about our relative and absolute fundamental outlook over the next several years.

Rylan, what's -- you mentioned the incomes in Northern California have jumped 20%, but the rents they haven't moved at all. What what's driving that? Why hasn't -- haven't the rents kind of kept up with income?

We had a State-mandated government shutdown in California, where people could not go to their office for 1.5 years. And I think most people are familiar that we've seen some migration during that time period. So probably shortly thereafter -- pardon me, during that time, these tech companies hired considerably. It was effectively a 100% remote because it was not in our markets. They could not be in our offices, followed by what we've seen last year with the rise in interest rates and a tech retrenchment. So Northern California, where tech is the major driver of employment, has had 3 years in a row of challenging fundamentals. As I mentioned, I feel like it's stabilized. We're starting to see job opening slightly increased. The percentage of job openings that are remote went from a 100% to 25% last year. They're now in the single digits. And we've also seen anecdotally, the work-from-home -- the reversal of work-from-home mandates in assets that are right next to, for example, South Lake Union, and we also have several assets that are near Meta's headquarters in Northern California. And the rent growth year-to-date in these properties is quite attractive at low double digits from the start of the year. So we're -- we know that as they start to bring more people back to the office, which it seems like they're finally serious about, we believe that's going to be a tailwind for our assets as well.

Where are we in the process on return-to-office across the West Coast?

Still very early stages. I believe many of you are familiar with the Kastle data and the office utilization rates. So it's still fairly early stages. But we track this in several ways. We're on messaging boards, trying to understand what the companies are actually telling their employees. And it feels like they're starting to actually take this serious. And we've been head fake several times over the past few years, and we do not anticipate hockey stick level growth where you're going to see a bunch of people rush back to our markets now that they've pushing people back. But I do believe it is a continued tailwind for several years as new college graduates, new hires are being asked to be in the office.

So is that -- like I guess, from [ RC ], like what's the main thing we should be looking for? Is it just more return to office? Or is there some other metric we should be focused on to figure out why markets start reaccelerating?

I mean job growth, as we've always said, is a major indicator of housing demand. A lot of the jobs that have occurred in our markets year-to-date have been in the leisure and hospitality space. Health care has been a big driver. Once you start to see those tech companies start to hire again, once you start to see more, we believe, AI companies emerge in higher talent, again, they're all headquartered in the Bay Area, I think that would be a catalyst for not just those people that come in, but they have a positive multiplier effect on their ability to drive economic growth and bring more people into those markets. So we've seen the cycle play out several times over the past 30 years since the company has been public, and our view is that it's going to happen again.

And then just maybe thinking about your market mix, it's 40% Northern California, 40% South California, 20% Seattle, how are you thinking about that allocation going forward? Just given the comments it sounds like Northern California, you think it's got maybe some of the best prospects a little bit further down the road?

As I mentioned, I don't anticipate it changing much. One thing we are seeing on the transaction side is that those cap rates across all these markets are very similar. So it could change on the margin, especially if we were to see some differentiation where we can add value by trading into reallocating our portfolio. But for the -- by and large, for the next few years, I wouldn't anticipate a significant change.

And I just wanted to touch on Seattle, the supply, it feels like it's maybe the one market that has a lot of supply for your West Coast markets. Just kind of curious how competitive is that supply versus the properties you own as you look at it.

Yes, Seattle is -- has always been a terrific market for us, and it does mirror the U.S. a little bit more in terms of the supply profile, so it creates more volatility. Having said that, because it has strong demand drivers, it's a market that we've always liked. But we keep it at 20% for that reason. It can be lumpy. So supply, we anticipate in Seattle to be heavier in the second half of the year and mostly concentrated in the CBD. Fortunately, for us, our assets are mostly in the East side in Bellevue and those corridors. So there will be some impact but not as intense as being in the CBD areas.

Is there any markets that you look at? And then I'm not necessarily talking about geographically much more diverse than like the West Coast, but even within like the West Coast, are there markets that you find attractive and might check like a lot of the boxes that you look for in a new market?

Well, this is interesting because during the pandemic, definitely, the secondary and tertiary markets were very appealing. Having said that, with the reversal of return to office, we're seeing our market coming back to how it's been functioning normally. And so we do track about 37 submarkets throughout our own portfolio. And for us, we will lean in from time to time wherever we see dislocation or if there any opportunities.

Any questions from the field? Yes, Chris.

As I understand it, about a month ago, there were enough signatures [Audio Gap]

Sure. That's a great question. So the question is on the repeal of Costa-Hawkins. So the leader of that group is a guy by the name of Michael Weinstein, and so he comes back with different names. Having said that, what he's been able to do in the last 2 campaigns is get the repeal Costa-Hawkins and the ballot, and it's really an antigrowth initiative, and he uses his AIDS foundation funding for that. So what we would expect is that it's been -- it was overwhelmingly defeated last 2 times, every county except for one voted in favor of Michael Weinstein. And the governor has come out and said publicly that he was not supportive, so we don't expect that he would change his position. There is another initiative, and that's getting traction that's going to be on the ballot, which relates to your ability to use your funding source for these other kind of projects. And because what's happening here is using money that's earmarked for a particular charity to do something else completely different doesn't seem to sit right with the general population. So that's one path. And then the other path is we have always maintained our organization to address this issue. So they're working hard at the -- on the political and legislative side, and we will continue to do that, and we expect that we will win again.

Any other questions? Maybe just thinking about like the operating platform [indiscernible] operating initiatives. Is there anything technology-wise or just initiative-wise that you're really focused in on and you're looking to kind of roll out across the platform?

Sure thing. So I think many of you who know us well, have seen the terrific results from our asset collections program, which we rolled out across the company. Essentially, it's operating our properties because 70% of our properties are within 3 miles of each other. So we operate 10 to 12 properties as 1 business unit. So there's a lot of efficiencies when it comes to pricing and sales and administration to group those and so that's behind us, and we've generated about 150 basis points of operating margin improvement. And that shows up when you look at -- I think we have one of our slides in there on our controllable cost per unit and controllable expense increase year-over-year and we're certainly one of the better ones relative to our peers. And in terms of the next phase is to focus on the maintenance side. And so essentially replicating the asset collections model to the maintenance team. And the goal with that is not so much personnel change, but it's more focus on better vendor management, better churn efficiencies and in some of these other ways for us to improve our business. And the other initiative is on the revenue management side, we are -- we have rolled out our own proprietary management, which will allow us to have better visibility and amenity pricing and be much more -- and react even faster to the market dynamics. So we'll have better visibility on the top line as well.

Did that roll out or it's in the process of rolling out?

That rolled out. So we're just starting to get implemented.

Okay. And what are kind of the early results that you're seeing?

Probably too early to tell just because right now, our revenue management platform is -- has a lot of noise between delinquency and occupancy and some of these other challenges. I think next year, we'll get better indication.

So next spring leasing. And then maybe turning to the capital allocation front, thinking about how you think about prioritizing like deploying capital in this environment.

Yes. I think for us right now, it's difficult to deploy capital accretively. I think you all know us very well. We are very disciplined in our capital allocation decisions and nothing has changed about that on this front. Cost of capital is very high relative to where transactions are occurring in the market. We can't make it work. And so, we haven't been aggressive at buying assets. I think, for us, where can we deploy capital? You've seen us sell assets, buy back stock. That could still work today depending on the right opportunity. And then we still like preferred equity. I think we're getting a very attractive return today on new preferred equity investments, although their volume is down quite a bit. And what fits into our box is -- doesn't necessarily -- there's not a lot of that right now. So we would love to be able to put more capital to work in various areas. It's just can we make the math pencil and really push results to the bottom line, and that's been more challenging over the last few years.

Given maybe where your stock trades and the private market cap rates, your thoughts on buybacks? And in the past...

We need a source of capital to do that. We've always been disciplined and done it on a leverage-neutral basis. And even today, where cash rates are, you can earn a pretty decent yield on cash. So we would have to decide if we were to sell an asset, whether it's better to buy back the stock or just even park it in cash. So it's something we're weighing and looking at. We aren't actively marketing any assets. We always are out there looking. We have a lot of contacts to see if there's anyone interested in buying any of our assets, but we're not actively marketing any assets today.

And then Rylan, what are you hearing from your JV partners? What is kind of their mindset as a private source of capital?

I think there are like many people anticipating some opportunities to emerge, given the moving rates. And so they are still working with us collaboratively. We're underwriting deals. The return expectations have increased in the past year or 2, understandably with the rise in rates. But we're not materially far off from where the transaction market is today to where I think you'd see several partner institutional non-REIT public investors looking to put capital work in our market. So just, again, trying to be patient, wait for the right opportunity and making sure that it makes sense for Essex. We're not going to do a deal just to do a deal. We want to make sure that we're -- we have a plan to grow and to grow accretively, leveraging our partners goodwill.

How do they feel about the revaluations in Essex stock?

I mean that's probably the #1 pushback I would get 9 months ago. The deal was like, well, why would we go buy at 5, we can buy your stock at a 6, and I said, I agree, please go buy the stock.

And then just -- what's trading today? Is there any indication on kind of pricing, kind of a sweet spot on a cap rate where people get more excited?

We're still seeing transactions close in the 5 and below range. And I think that surprises several people from the outside, given where rates are today. So the volume is down considerably. What you are seeing are 1031 buyers, unlevered buyers who are buying on a basis play that are still transacting. I do think those cap rates are slightly backwards looking, given the move-in rates we've seen this summer. So there is a relatively wide bid-ask spread, especially for the levered buyers who are looking for typically positive leverage within a year. But there are opportunities. As Barb mentioned, we were able to sell 2 assets, one at 4.25, one at 4.5 within the past year, and we continue to look for those opportunities where we can lock in our source of funds and go back. In the past year, we were able to buy back stock at a very attractive cap rate. That's where we're still seeing transactions. But again, with the kind of volumes are down considerably and going into the fourth quarter, I don't anticipate that changing materially until early next year.

[Audio Gap]

I think that's a great question. And it's almost like beauty is in the eye of the beholder because it depends on the investor. So for a foreign investor, they're pegging their return relative to other fixed-income opportunities. And so if they can get a little spread above the tenure, they're happy campers. In the U.S., it's really more of the -- looking at the real estate asset class relative to S&P 500 Index. And depending on the investor, somewhere around 100 to 200 basis points above the expected S&P 500 return. And that's how the world was. But keep in mind, in the '90s, REITs were still relatively a new asset class. And so I think that perspective in the sophistication of the companies that have survived since then have also changed that mindset as well.

Any other questions? Bill.

[Audio Gap]

Development underwriting is getting much more challenging in our markets. We have not -- we pulled back from development several years ago because it didn't make a lot of sense to us. And with the rise in construction costs for the past several years as well as debt yield -- debt cost today, we're seeing a material falloff in new developments, and therefore, fewer opportunities on new development financing. We're still seeing some opportunities for recaps or sponsors that are looking to take proceeds out of a stabilized property that we're evaluating. So the market remains open, rates are in the, call it, 10% to 13% range, higher for new developments. But it's not like it was in terms of previous years when you had a pretty -- still open development market. So it's a little bit tougher to put capital work in that space.

[Audio Gap]

That is an interesting question. So coming out of the '08 recession, in our markets, the expectation was, oh, there's going to be a lot of opportunities and massive dislocation. Well, I can tell you that in the West Coast, in '09, we didn't buy anything, primarily because so little gets built in our market to start with. And of course, we have Fannie and Freddie as a backstop when it comes to financing. Fast forward to today, I think, interestingly, there may be more opportunities because development deals that pencil at 3.5 cap rate that are -- 2, 3 years ago that are now in the midst of lease-up and refinancing, they might need some help. Having said that, massive dislocation once again in our markets. It's really hard to see that's happening. Having said that, we have a terrific balance sheet. Barb's done a great job. It's essentially anticipating all our debt and refinanced everything that's available, that's possible. So we have $1.5 billion ready for Rylan to do something with when an opportunity comes up.

Any other questions from the field? Angela, last time, I guess, we met in person was -- must have been in March. And I think the following Monday, you were especially taking on the CEO title. Just kind of curious, just anything internally that you've kind of done just maybe a little bit differently, outside things the same, but just kind of internally, are you running things differently and promoting Rylan again?

She's doing a great job.

Well, interestingly, I took over on April Fools Day. So that tells you now my mindset there. Fortunately, for us, we have a terrific business, good people on the team. And of course, Mike was at the helm for a long time, and he ran a tight ship. So there wasn't any issues for me to really address. So the focus has really been incrementally on the margin, how do we move the company forward and how do we grow, and how do we expand our talent pool, those kind of things, which have been -- our conversations ongoing. And so one of the minor changes that I made was on the management side and in promoting Rylan to run our investments. And we believe that this is a great time to do so because we're heading into the seasonal low for our business and with muted transaction volume, this is a great year to essentially look at our investment platform, figure out how best to enhance that platform, add resources to it. But what I love about Rylan and his background is, Rylan is very strategic. And so he -- so in looking for a business partner that can understand data analytics and capital allocation and all these other different nuances and how to arbitrage between the cost and different cost of capital and different type of investments and how to optimize it, I think he's a terrific business partner for that. And so that's the one big change that we made on the management side.

Maybe just toggling about like kind of thinking about as we head into 2024, could you remind us what your loss-to-lease is today and just like you're earn-in...

So our loss-to-lease is 1.6% through August. And we haven't disclosed our earn-in yet. I think it's a little too early to discuss that at this point. But we use our loss-to-lease as a proxy for where our earn-in will be in '24. And we'll know more in September, but we have peaked in terms of rents, and so we would expect that loss-to-lease to come down a little bit from here.

And just one thing on the loss-to-lease comment. As I noted earlier, relative to our new lease rates, our loss-to-lease has also tempered because of our occupancy push. And so normally, you will see a higher loss-to-lease But this year, once again, we're in a transitional year as we work through our [attritions]. So that's going to temper the loss-to-lease number. And you'll see that, but it's what we expect.

Is that because market trends are depressed or just...

No, it's because we're trying to maintain occupancy. So if you look on our current -- our print, for August, occupancy in 96.5%, with 2% delinquency, it's not really 96.5% occupancy. It's like 94.5%. And so in our effort to shore up occupancy and close the back door, our-loss-to-lease, which is the new leases that we're signing is going to be also tempered because we're willing to negotiate a little bit more or give a little more concessions to draw people from out of -- outside of our properties or even on the renewals. And so that tempers that new lease rate number.

So there's [indiscernible] percentage points of people who aren't paying. Okay. That makes sense. And then we're just about out of time. We've been asking all the management teams, 3 rapid-fire questions with 2 parters, so that's really 5. The first one being, do you believe the Fed has done a hiking, yes or no? And do you expect the Fed to cut rates in 2024, yes or no?

So yes, on #1. No, on #2.

Do you believe real estate transactions will meaningfully pick up by, a, the fourth quarter of 2023; b, the first half of 2024; or, c, the second half of 2024?

C.

Are you using AI today to help you run your business, yes or no? And do you plan to ramp up spending on AI initiatives over the next year, yes or no?

Yes and yes.

Fantastic. Thank you.

Thanks, Josh.