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

All right. Great. I think we get started here. Thanks, everyone, for joining us for our session today with Essex Property Trust. Nick Yulico, I head up the Scotiabank U.S. research team. Very happy to have with us the Essex Property Trust team. I'm going to introduce -- I guess I'll turn it over to you, Angela Kleiman, President and CEO, to talk about the company and introduce the rest of the participants on the panel.

Terrific. Thanks, Nick. And it's great to be here. It's great to see everybody. On my left is Barb Pak, our Chief Financial Officer; and next to her is Rylan Burns, our Chief Investment Officer. We are excited to see everybody here in this May REIT. And just a brief background of Essex. We are an S&P 500 company and the only multifamily company focused in the West Coast markets. We have about 62,000 apartment homes with 255 communities across our portfolio. And this year, we are excited to celebrate our 30th year as a public company, and our team will be ringing the closing bell at the New York Stock Exchange. So that's going to be a lot of fun. Our track record that we are even more proud of is that we are the only multifamily REIT recognized as a Dividend Aristocrat. And in 2024, we announced our 30th consecutive year of dividend increase. We have generated one of the highest total returns among our all public REITs since our IPO with 13.8% CAGR. And the 3 key factors that contributed to these accomplishments are the markets that we invest in. So first of all, these markets are well below U.S. average with low level of supply, combined with incredibly strong demand drivers in industries that produce high level of job growth and income growth. So that all benefits the apartment business. Second is that we are known and have a track record as disciplined capital allocators. And lastly, we have a highly efficient operating platform. If you compare our core FFO per share growth to our peers, you'll see a notable outperformance and it is shown on Page 6 of our presentation. So moving on to just a high-level review of our current market dynamics. We publish on Page 15 of our latest operating performance. We're experiencing a steady improvement throughout our portfolio. And in May, we have generated a blended lease rate of 3.7%, which reflects a solid fundamental across the company. And with the exception of L.A. and Alameda, we're seeing pricing power and we're pushing rental rates. And as for L.A. and Alameda, we're continuing to deploy occupancy-focused strategy as we work through our delinquency units, and we have been successful in recapturing the nonpaying units. So that trend has continued to improve as well. With that, I'll turn it over to Nick for Q&A.

Great. So you mentioned some of the May and Q2 operating update so far. Maybe can you just remind us sort of where that fits in versus the guidance in terms of some of the rate improvement as well on the bad debt side?

Sure thing, Nick. I will talk about the market fundamentals. Barb will talk about delinquency. It's her favorite topic. And in terms of what we're seeing on the ground on our renewals and -- both our renewals and new lease rates are coming in ahead of our revised guidance and our guidance increase, which is fantastic news. We had originally anticipated that heading into the year, the broad economy will have a soft landing. That's what all the economists were forecasting. And so we could not disaggregate ourselves from that. But having said that, what has happened is that a soft recession did not occur. In addition to that, we're seeing strong job growth. Now it has not accelerated, but it has come in better than anticipated. And of course, with the backdrop of a low supply level, we really didn't need much job growth for us to be able to outperform our expectations. And so where we are sitting right now on the leasing front, the fundamentals are quite solid. And on the delinquency, Barb?

Yes. So on delinquency, it continues to trend favorably and has become a tailwind to our growth. So this year, we expect 80 basis points improvement in our growth just because delinquency, we're getting back those units and recapturing them. It was a big part of our guidance raise in the first quarter and for the full year. So we've already factored most of that into our numbers. And at this point, where we're at, we're at 80 basis points, we're assuming 1.1% for the full year. But keep in mind, the first quarter was 1.3%. So right now, we're generally in line with our guidance for the full year in terms of delinquency. We do expect to continue to recapture units as the courts are starting to finally get caught up. It took a year ago in L.A., it was taking 12 months to get a delinquent tenant out. Today, it's more like 6 months. But for us to get back to our long-term historical run rate, we're going to need to get to 2 to 3 months on the core eviction processing time. We're not there yet, but steadily making progress.

And you talked about the low supply impact really helping the portfolio right now. Any stats you can share on that, how your markets screen versus others? And then even within the portfolio where you may be seeing some supply impact?

Yes. I mean relative to the rest of the country, the West Coast has historically and continues to be a relatively slow and low housing supply market. So in terms of housing units as a percentage of existing stock, we have increased over the past several years, about 0.6%. So several of the sunbelt markets where you've seen significant 6%, 7% increases, it's having a significant impact on new rents, is one of the reasons why we've stayed on the West Coast and focused on our markets. As it relates to a short-term outlook over the next year or 2, the downtown markets in L.A. as well as in Seattle, some pockets in Redmond, will have a little bit higher supply. So we're watching those markets closely. But at a big picture, when you think about the U.S. broadly, the West Coast remains under house, and we don't envision that changing anytime soon. When you look forward a little bit at new permits, permits have come down in our markets, the vast majority of our markets. And so that supply picture, which has been a benefit for several years is going to improve as we look into '25 and '26.

And I think one of the other factors that's helping your portfolio, your markets is affordability. And when we look at -- I don't know if the stats you have to share as well. But in terms of renting versus owning, it feels like it's at that affordability benefit of renting feels like it's at one of its strongest points right now. How do you see that? How is it actually helping impact, whether it's renewals or new lease pricing?

Certainly is a meaningful contributor to our performance. So in our markets, it's over 2.5x more expensive to own than to rent. And so that -- and of course, these are compelling economics, especially it's most acute in the northern regions, in Northern California. And so the ability for us to raise rents is -- has a much longer runway because the tenants or the potential tenants are not faced with the income pressure, if you will.

Are you seeing that -- I mean, in terms of that benefit, is it -- are you seeing any change in your rental pool because of that? It's an idea that perhaps people are just going to be priced out of the market. And actually, it's the type of customer that historically wasn't priced out and now is being forced into the rental pool.

Well, in terms of our demographic distribution, it has not meaningfully changed because keep in mind, in the West Coast, the supply landscape has always been much tighter. And the average cost to own a home is over $1 million in our market, especially in Northern California. And this is -- these are older homes that still need some improvement. And so the profile of our renters have not meaningfully changed. It's just in terms of just the quantity or the number of demand that has been one of the factors that's driving demand.

One of the questions we get a lot about your company is how tech the job market is going to impact the portfolio. Can you talk a little bit about an update on tech job openings? I think you mentioned on the first quarter call that you kind of needed higher-paying jobs to pick up in order to see some re-acceleration of rent growth in Northern California, maybe the latest you're seeing on those trends.

Yes. Yes. Barb will touch on the job in a second, but just a brief background. We're seeing steady improvement, which is giving us strength to -- and pricing power. But in terms of acceleration, we would be a larger magnitude of job growth.

Yes. So what I -- what we're seeing on the ground is we track the top 20 tech employers and their open positions. And what we've seen since the trough in February of 2023 is a steady increase every single month in open postings. And so that is, I think, giving us some shadow demand in terms of new demand for housing and rentals. Then we're also seeing migration patterns reverse course, and we're seeing, especially in the Bay Area, total migration turned positive for the first time in 2023 that we haven't seen in many years, and that has continued this year. So I think those 2 factors and return to office are leading to the shadow demand that is allowing us to push rents outside of having robust job growth, which you're not seeing in the BLS numbers today. And what Angela is talking about is we really need to see that reaccelerate in a meaningful way for us to push rents aggressively, but there is a shadow demand that is occurring, that is giving us strength today that we didn't expect when we set our guidance early on in the year.

If we just go back to Los Angeles. It was -- there was a headwind to your new lease rate growth in the first quarter due to some of the delinquency backlog being worked through. How should we think about that impact just trending throughout the rest of the year in Los Angeles?

Yes, that's a good question because Los Angeles represents about 70% of our delinquency and L.A. and Alameda comprise about 25% of our portfolio. And so this overhang, we expect to occur this year, we do think that, that will quickly become a tailwind. What we've seen so far is excellent improvement on the delinquency side, which is essentially a leading indicator for our ability to push rents. In terms of L.A., for example, L.A. Alameda, if it weren't for the delinquency overhang, we -- our lease rates will be 100 basis points higher. And so that gives you a sense of where things potentially can be heading towards.

And is there any -- I mean I guess the backdrop here was that there was court issues, backlogs, I mean, any improvement in just the timing of being able to process delinquencies or I guess, evictions in the city?

Yes. It's an interesting phenomenon because last year, when eviction moratorium expired in L.A. and Alameda at the end of April, the entire state of California was processing this situation at the same time. Well, there's only so many judges and clerks to process the eviction. And so for us, we do not believe that this would be a permanent issue, which is what's been playing out. Now that it's improved, it's improved by 50% is now in about 6 months. And it's -- what we're seeing is a continued improvement, especially as the delinquency process occurs, it works its way through the system. We do think that at this rate, by, say, end of the year or early next year, the vast majority of the L.A. delinquency issue should be resolved or should be at the tail end?

Turning to Seattle. Your portfolio is a little bit different than some of your peers. Can you just talk about how it is situated in the entire market and relative to some of the supply where you said it's Redmond, Downtown Seattle. How are you sort of quantifying some of your exposure to the market?

Yes, happy to. So in Seattle -- and this is actually similar to our approach to investing in the West Coast. We're mostly suburban. And there's nothing else, if you look at where the major employers are in the West Coast, Apple is in Cupertino, Meta is in Menlo Park, Google is in Mountain View. These are all huge companies that are in the suburbs. So there are a couple of reasons. Downtown has more supply. The quality of life is much tougher. And of course, the key major employers are in the suburbs in our market. So for those reasons, we've always favored suburban markets. And as far as Downtown Seattle and Suburban Seattle, once again, it's similar. Our portfolio is more suburban-focused. Downtown is where the supply is concentrated. And there's a little bit -- there's pockets of Redmond, but it's still mostly Downtown.

Perhaps turning to the acquisitions market. Can you just give us a sense for what type of transactions you are seeing in your markets give a feel for cap rates?

Yes. The transaction volume remains relatively muted from what we saw in '21 and '22. So that has not increased significantly. The vast majority of cap rates continue to be in the 4.5% to 4.75% type range. The buyer pool this year is bigger and more diverse than it was last year. So the few deals that are being brought to market are generally very well bid, and we're seeing a very competitive bidding process for the assets that are coming to market.

So I think for some, that would surprise people that cap rates could be that way since mortgage rates, I think, would be -- secured debt would be higher than that today. So are these -- are they unleveraged buyers? How is -- how are mortgage rates factoring into this equation?

I think that was the case last year, primarily, where a lot of the bids you could discount and say, "Oh, that was a 1031 buyer or that was a large private individual that wasn't going to put leverage on there." They are still involved in the bidder pool today. But what I say has changed is that we're seeing a lot more private capital, institutional capital that is using leverage that have come back. And I think some of the factors include the fact that they've raised a lot of capital in the past couple of years and have not put it to work and are maybe feeling a little bit of pressure to come to work. I'd say the other impetus is that in several of our markets, I think people are aware of the improving fundamentals and the very attractive fundamental setup as it relates to affordability, supply and some of the improving rent growth. So I think those are some factors you're seeing where people are coming in and bidding below where debt rates are today.

And how much is also some discount to replacement costs factoring in difficulty building in parts of California specifically, how is that factoring into the transaction market as well?

That is a topic that's been discussed in the vast majority of deals. So I think there's a -- that is an anchoring point for many potential bidders. And then now with supply coming down over the next several years, yes, people are focused on replacement costs.

And then, I guess, just in terms of that how does this relate to the preferred equity book at the company opportunities to deploy capital? How are you thinking about that right now?

Yes. At a high level, I would say that there's been a lot of capital raised to invest in that area of the space. So we've been involved in the mezz and the pref book for a long, long history. It grew in 2016 when our development pipeline shrunk and this is a way for us to participate in new developments, but at a higher -- better risk-adjusted return. Now with the other participants raising capital, I'd say that's getting a little bit more competitive. And so we think there's better opportunities on the fee simple acquisition side. And so that's where we've really been focused in 2024. And so we still remain out there. We'll be opportunistic if we see opportunities to invest in the preferred or mezz part of the stack. But in general, at a high level, we're excited about where we might be able to buy on the acquisition side.

And in terms of affordability, legislation, rent control, right, some of that comes up a lot in -- particularly in California. Just give us an update about some of the latest potential policy out there that could affect your business?

Well, I think, for us, the benefit is that California has been on the forefront of that conversation. And so pre-COVID, legislation was passed, AB 1482, that essentially capped renewal rent increases to CPI plus 5% max of 10%. To us, that's an anti-gouging mechanism, and we have always operated with a self-imposed 10% cap since I've been at the company and even longer. So that has not impacted our ability to grow rents at all. What we're seeing some of the conversations outside of California and other states are probably a little bit more alarming. As far as the legislation coming ahead is that there's a [ valid ] proposal to repeal Costa Hawkins. And Costa Hawkins is essentially prohibits buildings that are built after 1995 to have rent control, and it also allows for vacancy to control, which is very important because that allows us to take a unit to market once a tenant vacant if it's a rent control unit. So this is the third time that essentially, what we view as an antigrowth group is trying to repeal this. And first 2 times, they were overwhelmingly defeated every county except for one voted in our favor. The legislature, especially the government is well aware that in a state where we have an acute shortage of housing, repealing Costa Hawkins is not the solution. And so we don't expect that there will be much traction. On that front, having said that, it is a noise that we have to deal with.

And then any update you could also just share in terms of the -- I mean, I think there already is in place a policy in California to mandate the creation of more housing over time. How is that being implemented? How do you see it affecting sort of your business, the overall rental market in California?

Well, we actually would welcome more housing, especially in the affordable component. I think it is a need for California. And it would not impact our business. And we actually believe that having a more balanced housing market is not a bad thing, generally speaking. It's good for new businesses, and it's more market friendly. And so we certainly would be more in favor of that. All the initiatives that has been approved over the past several years, I think, by Governor Newsom, I think he enacted 25 pieces of legislation, it really hasn't made a dent. It is just so difficult to build in California. It's expensive. There's a lot of requirements when it comes to sustainability requirements and et cetera. So even though there's legislation that makes it more easily to build housing. The cost side continues to be a prohibition.

We do have time for questions in the room. I don't know if anyone has any. I don't know how we're doing this, are we doing it by mic or in the back or now just yell. Anyone have a question? Yes, Seth.

Rylan, maybe you can give more detail on the cap rate and bidding trends across the markets or that those that are more aggressive, lower cap rates.

Yes. I think we've seen a lot -- a few more transactions in Northern California. When I think of Southern California, San Diego remains one of the more liquid markets given the strong rent growth that they've achieved over the past several years. L.A. has been very quiet. We saw 1 or 2 transactions earlier this year that I think is going to bring more product to the market. And then the Pacific Northwest has been relatively quiet. When I think about where the deepest and most diverse fire pools have been recently, it has been in Northern California, again, as I mentioned, where I think some of the fundamental setup is fairly attractive.

Any other questions in the room?

[indiscernible]

Question is just about climate risk and physical and transition risks...

Yes. We actually -- earlier in March, we announced that we committed to SBTI, and so we're waiting to get approval on that. In terms of the climate risk change, I think California has always been on the forefront of that conversation relative to the U.S. And given where we operate, we've always been focused on, we call resource management and sustainability. And thus, I don't believe our risk as it relates to that transitional climate change is as meaningful as a lot of the other portfolios out there. We have already essentially installed, for example, solar across the majority of our portfolio, we essentially had a focus on some of the other water conservation initiatives. When we build, we always build the green or better. And so I think we're in a better position than most.

Any other questions in the room? We didn't talk about interest rates yet. At this point -- and this wasn't one of the questions I'm saying, so it will be a current pull maybe. I mean interest rates coming down, is it even a benefit to your business at this point or not?

That's a great question. So interestingly, we're less than 30% leverage. So our cost of debt is not a meaningful risk. We have a sleep in that balance sheet. Barb has done a fantastic job on that front. And when we refinance, we tend to optimize that, the pricing. So what will help when rates come down is really a consideration on cap rates and the value of the company. And for us, it's really more of a perception. That's one piece, but that drives your cost of capital and that does have some of these external growth impact. So that would be the one benefit on -- in terms of the rates.

Yes. I was thinking about the other side, too, I guess, is that, I mean, at some point, you thought about it, at what point does have for-sale housing become affordable game, become a threat to the business? Has that sort of already train that left the station and you're just dealing with unaffordable housing market in California? For buying, not rent.

Yes. For our markets, it's always been unaffordable. And so even before the interest rate increase, our move-outs to home buying was like 8% to 9%. Now it's only 5%. So it just makes it that much harder, but it was already hard to begin with. So once again, that home -- for our population, we have over 55% of the population that are renters. The U.S. average is the other way. The U.S. average is 45% of renters. There's more homeownership. So our dynamics has always been very strong on that front.

Well, I think we're almost out of time. So we could do one more question if there's any final. Do we have another question now? Okay. Any final thoughts that you want to put to the audience?

Well, final thought. I do think that California is coming out of a recession. It's behind the rest of the U.S., primarily because of the owner shutdown. And so what we see is growth opportunities ahead of us, particularly in the northern region, which is why we pivoted our investment to focus in the northern region. It has the lowest supply, it has the low -- best affordability metrics. And of course, on the demand side, as Barb mentioned earlier, we're seeing increasing job hiring NVIDIA, for example, just bought a headquarter there, even though they're fully remote, but they spent $350 million to buy a headquarter there. General Motors just set up a headquarter in Northern California. 85% of artificial intelligence companies are headquartered in our markets. So we do see that compelling upside to our market in the foreseeable future.

Great. So I guess with that, we'll wrap. Thanks, everyone.