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

Welcome to Citi's 2024 Global Property CEO Conference. I'm Nick Joseph here with Eric Wolfe with Citi Research, and we're pleased to have with us Essex and CEO Angela Kleiman. [Operator Instructions] For those in the room or the webcast, you can go to liveqa.com and enter code GPC24 to submit any questions. Angela will turn it over to you to introduce the company and team, provide any opening remarks, tell the audience the top reasons that investors should buy your stock today, and then we'll get into Q&A.

Great. Thanks, Nick, and Eric, and thanks for including us in this conference. You and the team always do such a terrific job here, and it's great to see everyone here for the Essex company presentation. I'm Angela Kleiman, the Chief Executive Officer; and to my right is Barb Pak, our Chief Financial Officer; and our left is Rylan Burns, our Chief Investment Officer. I'll just start with a brief overview of the company and provide a quick operations update and then turn it over to Q&A. Essex is an S&P 500 company and the only public multifamily REIT dedicated to the West Coast. We invest, develop, own and operate approximately 62,000 apartment units in the coastal markets of California and Washington. We have generated one of the highest total return of all public REITs since our IPO, and we have increased our dividend for 30 consecutive years. The key driver of our long-term outperformance is favorable supply/demand combined with our capital allocation and operating strategy. On the fundamental side, starting with supply, our California markets historically produced a low level of supply, well below the U.S. average. And that's primarily because of the lengthy and costly entitlement process. In addition, we have high cost of homeownership. So that creates a natural barrier and an economic incentive to rent versus own. And in fact, in our markets, the percentage of ownership versus rent is -- we have 55% of population to rent versus own and that's the reverse in other markets, for example. On the demand side, over the long-term, our markets actually have generated above-average job growth, even though we don't need a meaningful job growth to meet the demand -- to meet the housing supply. And as we all know, job growth is the key driver of housing demand. So those would be some of the key reasons still on Essex. And then lastly, our efficient operating model and disciplined capital allocation approach drives cash flow to the bottom line and enhances total return to our shareholders. And moving on to just a brief operating update, which is detailed on Page 15 of our presentation. Our markets are performing on plan with same-store revenue growth of 4.3% to start off the year. And this is a terrific start. I do want to caveat that 4.3% has a 1% benefit from delinquency. So year-over-year comp benefit. In March, it's going to reverse. So when you see a print for Q1 of around 3%, don't panic, it's exactly where it should be. We are well positioned heading into peak leasing season with strong occupancy and continued improvement in concessions. And eviction-related turnover is going to -- we anticipate that will lead to temporary lumpiness similar to last year, but at a much better trend compared to last year because of the progress we've made and that has continued in this area. And lastly, on our operating platform. We implemented our technology initiatives and property collections operating model since 2020 and have generated sector-leading operating margins. And that is shown on Page 9 of our presentation. It's also on our website. And we are going to continue to refine our operating platform and enhance other income opportunities and drive revenue to the bottom line and further improve efficiencies. With that, I'll turn it over to Q&A.

Great. That was helpful. You have another slide on here that shows the amount of NOI that ends up translating to FFO growth. And I thought it was interesting because when I think about Essex’s history, you have had a strong history of compounded FFO growth. So what would you think is going to be the sort of key to keeping that up in terms of peers are all sort of in a relatively close range in terms of same-store NOI growth. So how do you deliver better than average FFO growth going forward?

A couple of -- I think, a couple of factors that's contributing to this outsized growth in terms of FFO versus our fundamentals are very strong. And so the way we see our markets is, especially in Northern California, we have all the building blocks for our performance, starting with much lower supply. We're at a historically low supply. And when we attract permits, we don't see that changing. From an affordability perspective, it's at the best we've seen since we started tracking this metric. So affordability is kind of in the low -- so this is rent-to-income ratio is in the low 20% range. Long-term average is 25%. Peak is 30-some percent. So we have a lot of runway. If nothing else since COVID, income growth has been growing at a healthy 5% clip. And rent growth is still in Northern California kind of at par to pre-COVID levels. So that speaks to the fundamentals. As far as our operating efficiency, that's really the third leg, right? And with our -- we operate 9 to 12 properties as one business unit. So we generate a lot of efficiencies, and we have more to come on that. We only completed Phase I, what we talked about, and we provided -- produce about 200 basis points of margin improvement. The second phase, which includes additional technology improvements and the maintenance collections operating model that's going to provide even more operating efficiencies.

And maybe you talked about your update on operations, 4.3% same-store revenue growth, but call it about 1% of that is due to bad debt. I think you said bad debt is like 1.7%. So presumably, it would have been like 2.7% at this time last year. One thing I was trying to understand, though, is it -- it looks like in your guidance, you're expecting like low 3% sort of same-store revenue growth in the first quarter. So I guess I would think you'd need to come down to like 1.5% in March to kind of get to that number, which would seem to be a little bit more than just bad debt. So I guess I was trying to understand whether I was thinking about that correctly, if it's just bad debt or there's other things that would take you down to that level, but it seems like a big drop. So I don't know if it's just conservatism, but trying to understand what's embedded in that first quarter number?

Yes. No, that's a good question. It is primarily bad debt. So last year, in March, our bad debt was 1%. That's not what we've budgeted for the first quarter. We've assumed about 1.75%. And so we think we have a tail or a headwind in March on the bad debt line. So showing monthly numbers does lead to some lumpiness because the bad debt doesn't come in pro rata and ratably. And that's what you're seeing. We had a benefit in Jan-Feb. We have a headwind in March. So it will net out to 3% we've been for the quarter.

Got it. So it's -- okay, so you have a benefit and then you have a headwind, so it's like more like 200 basis points or whatever it is, it gets you down. Okay. Understood. And then in terms of market rent growth, it sounds like you're seeing sort of normal seasonality thus far. Is that fair? I mean, I think talking to some of your peers yesterday, they were pretty encouraged about what they were seeing in Northern California and in Seattle, much more so than what they thought they were guiding for. Obviously, they're going to give the caveat that it's early days, but maybe just help us understand sort of what you've seen so far in terms of the strength of demand, how that compared to your initial expectations? And sort of what the leading indicators are telling you about what the strength of peak -- [indiscernible] season might look like?

Yes, that's a good question. We have a little chart on Page 15 as well that shows how we're tracking relative to pre-COVID, the 3 years where things are pretty normalized. And we're a little bit on top of that right now, which is terrific, right? And -- but ultimately, we provided guidance. We guided to 1.25% for market rent growth. And that's not because where we have -- we see any cracks in the fundamentals or have concerns about our market. It's really driven by third-party economists' consensus, and we want to align to that because at the end of the day, we're part of the overall economy. And if the powers that we are forecasting a soft landing, we don't want to get ahead of that. And so in fairness to your question, if the economy outperforms, then we should outperform. And so far, the economy doesn't look like it's going to be a soft landing, which is why we're performing the way we're performing currently.

And so based on your guidance, one in the quarter, at some point, you're saying that line, the lines that you have here in terms of the market economic rent curve is going to start deviating and going beneath what you normally see from a seasonal perspective?

Well, it's pretty close. So what I mean is that line will then -- the peak won't be as high or if it peaks -- if the acceleration will be more extreme to end up getting to that 1.25% average for the year. And so the issue here is it's 2 months into the year. We're still not sure how the economy is going to play out. I think we see some terrific indicators, but there's unknowns, got some war out there, the election, I don't know what that means. I'm not smart enough to understand politics. But so far, from what we see is things are pointing to that. The fundamentals are good, and we're feeling good of our business at this point.

Maybe just one last question on it. If it were to follow a normal and just track that line and just terrifically track that line -- be an average type of year. What would that mean for market rent growth? Is that mean 1.25? Would it be like 2? I'm just trying to...

That sort of 3-ish...

Great. Okay. Nice. 3. On renewals, it's been tough to, I think, for people to track because there's a sort of concession burn off. It sounds like the concessions are going to be mainly burned off on the renewal side by sort of March, April. I'm just trying to understand, do you think that we'll start seeing the renewals kind of come down to like a 2.5% to 3% range once that happens or sort of stay closer to what you're reporting in February?

Yes. The -- we actually have concession burn off by the end of January. So what that means is that renewal rate of 4.8% in January about half of it is concessions. So you could say that the true increase is really, say, around 2.5-ish, 2.4. And February is coming in at 3.8. And so -- but we're talking -- we're looking at spot-to-spot, right? So for the rest of the year, we really don't have concessions until we hit the fourth quarter. And so it won't be a tail or a headwind for the rest of the year until, say, October. And ultimately, because renewals lag market rents, if we are assuming the market rent is going to average 1.25%, then that renewal rate is going to come down over time to match that 1.25, assuming the economy is what consensus has forecasted.

Got it. And so that 3.8%, I think, is the February number, that doesn't include really any impact of concessions?

No.

Okay. I think you said on the call that as part of your renewal strategy, and you just brought it up a second ago, which is that renewals eventually should just go down to your market rent growth level because eventually, that's where it's going to go. If you're not raising your renewals above market. It does seem like some of your peers maybe push above market as a strategy. I think EQR in the past have said maybe they go to like 3% above. Just curious whether that's like why you view only stay going to market, whether you're willing to build a gain to lease? If not, why not?

Yes. Well, I'll start by saying EQR, that team, they're smart operators. And every market is a little different. And so whatever their dynamics are may drive their behavior and their focus and which may lead them to be more focused on same renewal rates. For us, we -- our goal is total revenues. And to build up that total revenues, you have a couple of key components. The big one, of course, is your renewal rates and then you're net effective. You're pushing your new renewal, you're creating more vacancy, you're going to end up with lower new lease rates. So those are some of the dynamics. And in between, you can use concessions to try and optimize those numbers. And so for us, our overall strategy is to be market appropriate. What that means is we tend to send out renewal rates maybe a little bit higher and when -- if and when necessary, we'll negotiate because in an environment of a few percentages of growth, we don't want to push turnover. Ultimately, when you push renewal above market, we don't believe that's a long-term play because at some point, they're going to move out and then you're going to create a friction. And our view is that turnover costs on average, say, you want to be able to raise your rents by at least 6% -- 6% of your breakeven -- if you want to push -- take that turnover cost. So our view is you try to run a slightly higher occupancy and your market appropriate and the renewals, which then allows you to push a new rents better, a better position to do that. And we've had a 30-year history, how that optimize our total revenues and then ultimately flow down through the bottom line.

Yes. And then maybe on bad debt, it looks like you're expecting sort of 1.5 for the year, maybe then sort of low 1s to kind of get to your guidance starting out a little bit higher today, kind of like 1.7%. Is the right way to think about the potential upside there? If you're ending at low 1s, your guidance is 1.5. There's another, call it, 30, 40 basis points of upside for next year in terms of bad debt, assuming that you stay at the same levels that you're ending at?

Yes. I think it's a little early to talk about 2025. But I would say that we're moving in the right direction on bad debt. We continue to get back units. And the court systems, which has been the impediment to getting back our units is starting to improve. We're still not back to the 2 to 3 months that we need to, to get back to our long-term average. But for example, in Los Angeles, a year ago, we sat here, we still didn't have the right to evict. But today, we do. And a year ago, it took 12 months to evict somebody. Today, we're down to 8 to 9 months. So it's an improvement. Outside of L.A., we're at about 6 months. And so that shrinkage of time for people to be evicted is allowing us to get back our units faster and allowing for the improvement that we are seeing and expecting to see throughout the rest of this year. And then we think the courts will continue to -- the improvement in the court systems will continue throughout the year, which will allow for the tailwind to continue into '25.

And then for those tenants that aren't paying, I guess, what's the sort of average months that they've been delinquent. So you said there's 8 to 9 months, it takes to get them out sort of on average, have they been delinquent 4 or 5 months. I'm just trying to understand, usually, these things aren't like linear in terms of bad debt improvement. Usually, there's like a step function down. So I'm trying to understand if that could happen in the near term?

Yes. I mean it varies in terms of the average amount that -- or average length of stay that they've been delinquent. I think what we have seen is the number of new tenants coming in and then going delinquent has declined because they know the game is up. So when you could move in and know that you had a year free, you would see some bad behavior, but we're starting to see that abate, and that's also improving the bad debt as well. So net-net, we feel very good that we're finally on the last legs of this topic after 4 years, given what we're seeing in the court systems and the tenant behavior as well.

I guess if you step back from that, what we've seen over the last 4 years and kind of the concern around at least some of these cities and some of the local politics there and the quality of life. It feels like things have started to turn there. So just kind of curious your thoughts on the ground, how you're seeing that from a demand perspective and maybe some job growth and population flow back in?

Yes, that's a great question. We have some just high-level migration data in our presentation. But ultimately, in terms of quality of life, the downturns are still pretty challenging. It's still -- the climber is still high. It's homeless is quite pronounced there. And there's more to work through in the downtowns. But I do think the direction that are headed, there is a good start. The quality of life in the suburb has always been quite good. And in California, the vast majority of the large employers are in the suburbs. So that benefits our portfolio. But in terms of the demand catalyst, what we've seen is we have a slide that only talks about migration, but really want to look at population as a whole, but we just started with one building block is that for 2 decades, the average is net on migration for California when we're talking domestic. And if you layer on international, the net migration turned positive, once again, 20-year average 2000 to 2019. The reason that's the case and the reason that even during those periods, we've had fantastic growth is because you have the baby boomers for the majority over the past 10 years, the -- all migration has increased because their equity is mostly in their house. And so they'll sell their house, retire, and go somewhere else. And so that net migration number has increased. Having said that, that's not -- that's really not the key driver of our rent growth. We're see -- we're starting to see stabilized job growth. And with the tech trenchment now behind us, even the recent announcement has been letting go of a few people, but they're pivoting as many of them as they can to AI or other special projects. And so that tells us that demand is stable, and the openings of top 20 technology companies has been steady -- steadily increasing incremental. It hasn't accelerated that, but it's incremental improvement.

And then maybe just one other question related to kind of upcoming ballot and the potential repeal of Costa-Hawkins, I mean it feels like [indiscernible], I know we've talked about this for many years, over 2 years. But given population flows, maybe given kind of the current climate in California, is there more of a risk of the repeal coming up? And just your general thoughts on that?

Yes. We don't anticipate a greater risk. In fact, we see the risk lower now because when the first time it came around, it was following significant rent growth in our markets. We had a super majority of Democrats in legislature. And even in that environment, only 1 out of 58 counties in California voted in favor of repealing Costa-Hawkins. Fast forward to today, and now this is the third time -- the legislature is not in favor. They all understand that in a market where you have acute shortage of housing, that is just not the answer. And in addition to that, there has been several amendments that's been proposed trying to amend rent control over the past 6 months, they all died in the legislature. So that gives us a strong indication that we don't believe the risk is higher relative to the past.

And I wanted to ask about one of the things you brought up a moment ago, but the out migration. As you said, you're seeing relatively close in migration from international. It's pretty close to what you've seen over history, but the out migration is is bigger than what you've seen throughout your history. Is that driven by sort of like what I'd say, problem markets where the quality of life is bad? Or is that driven by markets where, as you said before, someone sitting on a lot of their home equity and home prices have moved up to the point where they can sell their home in California and go to Phoenix or somewhere else? Like what is it being driven by that higher out-migration number?

I'd just remind you that those are statewide statistics, and it's actually in Northern California through the same data, we saw a positive in-migration in several of our counties, the ones that you might think of as being more troubled in terms of quality of life. So the point of that slide for us is that it's improving from what we saw in '21 and '22. And we think even though international saw a little bit of a pickup in 2023, it's not back to its historical averages. And so what you really need is for these tech companies and the consultants and the finance companies are related to the major industry in Northern California, in particular, to start hiring again, which they haven't done a lot of them in the past 1.5 years. And as those companies return to growth again and start hiring again, that's where you're going to see the uptick in H1B applications and international in migration, which are typically renters to begin with. So I think that's a key catalyst that has not yet fully returned, but we believe will occur again in the future.

Okay. And assuming that, that does happen, do you think all of the sort of submarkets that you're in will -- I mean, they're obviously not going to all equally benefit. But I guess my question is, are there still -- are there certain submarkets at this point, maybe parts of Oakland or others that you just had to say, this seems like a submarket that's not necessarily going to recover for whatever reason? Or is it -- and it's quality of life, some kind of issue that they can't be fixed as easily as just having job growth from tech companies? Like are their submarkets that you need to prune sort of remove those structurally, I don't want to say broken, but structurally lower demand markets?

I think you'll -- there are certainly some markets that are going to benefit sooner than others. I think historically, out Oakland and a lot of the high-quality development downtown Oakland is a benefit. And the reason there's been new development in that market because San Francisco, when it's really expensive, it's a relatively cheap place to live and still be able to work in San Francisco. So our working assumption is that, that would follow after a recovery in San Francisco and some of our Peninsula submarkets. There are still some material problems in some of these submarkets as it relates to quality of life, and that's not going to be fixed purely by job growth. You really need to see some improvement on the ground in terms of cleaning up the retail scape, helping with the homeless population. And so we're still looking for those signs. I think there's growing momentum, as Angela mentioned, to create improvement in these markets. It hasn't happened yet. So it's something that we're watching closely.

Been limited sort of transactions in your markets so far. I mean I don't know what you'd say in terms of transaction volume being down from peak. But what do you think it's going to take to see increased transactions? Is it really -- is it a function of the capital markets uncertainty? Or is it uncertainty around the fundamentals of the market, what's going to need to happen before we can start understanding where pricing is.

Yes. I think last year, the West Coast, along with the country, transaction volumes were down around 70%. To start the year, I don't see a material change. I think there's still a lot of sellers holding on our property, hoping for prices that they saw 1.5 years ago, whereas buyers on the margin, the secured buyer has a little bit -- as higher debt cost today is trying to figure out when they can get to positive leverage. Is that 1 year, 2 years or 3 years away. So I think you could see the market improve several ways or in terms of transaction volume, you could see if we get some clarity and visibility in terms of rate cuts, I think that would bring a lot of buyers back to the market. Conversely, we have not seen any distress or any material distress in our markets. But if some of those debt maturities were to come and create some pressure for sellers. That could be another reason to increase transaction volume. But as it stands today, it's very similar to what we saw the majority of last year, where there's a bit of a standoff between buyers and sellers. The fundamentals generally are fine, as we pointed out in the majority of our markets and in some cases, have been very, very strong. So it's kind of a wait and see before we see some more transaction volume.

And it sounded like in the call that you were saying that you might take some of the structured finance book, preferred redemptions, the capital that you received there and then sort of recycle it into acquisitions. Are you having success in that? Sort of where are you in the process of it, if the transaction market is so difficult? And you can't find those acquisitions, what will you do with the proceeds if you're able to -- if you're not able to put it back into your portfolio?

I think it is a more challenging environment versus a very liquid transaction market where you kind of pick off broker assets that come to market. So we're just asking our team to look harder to turn over more rocks to leverage our relationships in these markets. We have a concentrated focus. We have people that live and work in these markets and their job is to find deals. So it's not easy, but we are optimistic that we're going to be able to create some acquisition transaction volume when it makes sense, and we can create value for shareholders.

And you said in your deck that you stopped accruing on 15% of your investments for the structured finance book, given near-term maturities. Are those the same ones that you talked about on the call, the Northern California ones?

Yes. No, there's been no change since our fourth quarter update. The 3 we stopped accruing it in the fourth quarter, and then we're watching 2 others. We've reserved against it in the guidance, but we're monitoring to others pretty closely.

Got it. Are you monitoring simply because they have near-term maturities. I guess if the whole book had near-term maturities, would you be putting everything on watch? I mean, obviously, the longer time you have until maturity, the better things you get in terms of the financing market, obviously, they're going to hopefully be growing cash flow along the way. But I'm just -- you made it seem like you're putting them on simply because there's a near-term maturity there. Like what's the health of the rest of the book. And if it had a near-term maturity, would you be putting those on nonaccrual as well?

So there's a variety of factors we look at. It is the time to maturity. So that's one factor. Where our last dollar sits today and where transactions are occurring. And then we look at the sponsorship. And all our sponsors have continued to fund additional equity. So none of them are in default with the senior lender, and they continue to plow money back in. But given what we know is coming from a refi perspective, whether they're going to put in money or not is something we're monitoring closely. We are in discussions with one of the sponsors. And so it depends on how those discussions go. And so the rest of the book, it really depends on what the rent growth has been in some of our properties since we underwrote them. That helps in terms of a refi and really where our last dollar sits. So it's a variety of factors we're watching. But no, the entire book would not be on nonaccrual if it was all maturing in '24.

Got it. And then on expenses, you had, I think, a 30% insurance renewal, can you just talk about how you -- I mean it's unpredictable, but that's certainly a big number, and I think your peers are seeing big numbers as well there. Just how you're thinking about that expense going forward, how much risk you're willing to take with your captive insurance. If you see these types of increases going forward, what can you do to mitigate them?

Yes. It is unfortunate. The 30% is pretty baked for 2024 because we were in the market in December of '23, and so that number is actuals. I would say what we did is we did look at our captive, we did look at increasing our first loss piece within the captive and what the premium reduction was, unfortunately, it wasn't enough to justify taking more loss with it for the captive. I would say where we're positioned better is we do have over $100 million in assets on the balance sheet, which was the premiums we would have paid to third parties that we funded via our captive that we can use to fund losses if there were losses. We have a great loss history, very minimal losses. I don't think our carriers have ever had a loss. And so I think that helps us versus somebody who's starting a captive new. And then hopefully, with the insurance market, we'll see reinsurers come in. That's really what we need to see. And given the premiums they're charging, at some point, you will see people come back into the market because they will have profitability. And when you see that flood of capital come back in, that's when you're going to see the premiums come down or the rate of increase come to a more normalized level, but we just haven't seen that yet.

And those securities, that just -- that sits on the asset side? Is there offsetting liability there in terms of -- I'm just trying to -- where that is on the balance sheet?

It's marketable securities, and it is just cap -- it's in a variety of funds and bonds and equity funds that...

Okay.

We have. And we have a long horizon because once again, it's run kind of -- it's an insurance company. And so it's the horizon of when you expect your losses and things of that nature. So there is no offsetting liability. It is the cash we would have paid a third party. We fund into our marketable securities every year, that's just grown over time.

Makes sense. We have an audience question. What percentage of the evictions are tenant hardship versus fraud? And then, I guess, maybe if I could add one on to that. I think you said that there's about $130 million of uncollected rent. At what point do you say now it's not worth the legal sort of trouble pursuing it, and it's just get rid of it. I know it's -- I don't think you're carrying on your balance sheet, right? But at what point, practically you say we're not going to keep going after it.

Yes. In terms of the eviction, it's -- the ones that have hardship, they would have reached out to us, and we always work with them to negotiate payment plan or work around there. We wouldn't just tick somebody out of hardship without any conversation. There is a percentage of fraud, but it's not a high percentage in our portfolio. There are unique buildings that have these issues. And once we catch the fraud and they may go on for a few months, but we remedy them pretty quickly and mostly relates to identity theft. And so we've been able to address those. And so it's not a portfolio y issue when it comes to eviction. I think the behavior is really -- that's been prolonged is really just the time it took to a bit. And there's only so many judges and so many clerks. And so you've got the entire State of California going through eviction. And that volume, that intensity has finally now decreased over time to a point we're starting to get manageable and that's what's driving the evictions and delinquency behavior.

And then on the $130 million really quick, we have reserved against all of that. There's no risk to the financials in terms of the revenue. And what we've done is we've hit their credit. We've got summary judgments, but we're not spending incremental dollars to go after them because it's the ability to collect is -- it gets lower as you go further out in terms of collecting that. So we're not incurring incremental dollars, if you will.

We have the rapid fire to end the session. What will same-store NOI growth be for the apartment sector overall next year in 2025?

I would just say 2% to 3%, but a wide dispersion.

Will the apartment sector have more or fewer or the same number of public companies a year from now?

We're going to say fewer just because the apartment sector is just more fragmented than any other industries.

And then what's the best real estate decision today, buy, sell, build, redevelop, develop or buy back shares.

Buy.

Thank you very much.