The current environment of rising interest rates and a weakening economy has not been kind to real estate investment trusts (“REITs”), but this has created some opportunities for investors. One in particular that is rarely on sale, but that is starting to look interesting at current prices, is Essex Property Trust, Inc. (NYSE:ESS). This REIT owns and operates high-quality multi-family residential properties in California and Washington state. These two states have strong job markets and high levels of population growth. These states also have high barriers to entry because it’s difficult and costly to build, as they have restrictive and lengthy entitlement processes.
Another thing to like about Essex is that it is an S&P dividend aristocrat with a 28-year history of increasing dividends. The company also has a long history of outperformance, but over the past year it has significantly underperformed both the S&P 500 Index (SP500) and the popular Vanguard Real Estate ETF (VNQ).
While there are headwinds, we are surprised at just how much shares have dropped, given that the company’s guidance for 2023 is not that bad in our opinion. We believe the secular tailwinds the company has enjoyed for a long time remain in place. Essex provided an initial forecast for 2023 market level rent growth, which it based on consensus estimates of third-party economists for the national economy with respect to GDP and job growth. Housing supply across Essex markets is expected to grow at 0.6% of existing housing stock with the greatest increase occurring in Seattle with a 1.1% increase. The company expects net effective new lease rents to increase 2% in 2023 with their California markets expected to marginally outperform Seattle. When combined with the earn-in, this results in an estimated revenue growth of 4.5% for 2023.
It is worth noting that the company’s revenue growth projection for 2023 is lower compared to peers, but it is based on a consensus of third-party economists and a mild recession scenario. During the last earnings call, there was an interesting answer provided by COO and future CEO of the company Angela Kleiman, where she details how they arrived at their 4.5% estimate.
So, on the earn-in for 2023, I think — if it’s okay with you, I wanted to step back and make sure we’re using a consistent definition. For us, the way we look at earn-in is we look to the September loss-to-lease, it’s not too hot and not too cold, and take 50% of that. So, in this case, September loss-to-lease was close to 7%, taking half of it would be about 3.5%, and that will be our earning, and we assume no market rent growth.
Now, what we’ve heard is there’s a question about 2023 revenue growth and how does the earn-in applied to that. And so what we’ve done in the past is explain that by saying, you take your earn-in and then we look at our 2023 S17 market rent growth and take 50% of that. So, that would be — the market rent growth is 2%, so half of that would be 1%. You add that to the 3.5% earn-in, that gives you a proxy of about 4.5% for revenue growth for 2023. And so, as far as the loss-to-lease, where we are is we’re about 2.5% loss-to-lease in October for the portfolio. And of course, it varies by region, but that’s coming from a loss-to-lease in September of 6.7%, so definitely a deceleration. But it is expected and loss-to-lease at this level for October is actually better than our historical patterns. Typically, around this time of the year, we’re at about 1% loss-to-lease and heading towards zero by year-end. So at 2.8, we’re feeling pretty darn good about the portfolio.
Market Dynamics
Essex’s markets are performing well, with the unemployment rate in each of its markets under 4%, with the exception of Los Angeles. San Francisco and San Jose are doing really well, currently in the mid 2% range. While there has been an uptick in initial unemployment claims in California and Washington State, they remain at low levels, especially when compared to other states.
There were some interesting comments from CEO Michael Schall during the earnings call. He said that they are seeing some opportunities in the market created by the current environment, but that despite talk of potential distress-related opportunities, they haven’t seen any yet.
Balance Sheet
The net debt to EBITDA ratio remains at a reasonable level of ~5.8x, and debt to assets is roughly 50%. The company has a solid investment grade credit rating, which allows it to borrow money on relatively good terms.
The company has ~$1.2 billion in total liquidity. The weighted average interest rate on its debt is 3.2%, and its debt maturity schedule is well laddered. For investors, this means that unless things get really bad, with property prices crashing or the debt market freezing, the company is unlikely to have trouble refinancing its debt on good terms.
Valuation
Based on the company’s 2022 full-year guidance, core funds from operations (“FFO”) is expected at $14.47, at the midpoint. This means shares are currently trading at ~15x expected 2022 core FFO, or ~17x when considering trailing twelve months FFO. This is a nice discount to the ten year average of ~18.9x, especially when considering that Essex shares rarely go on sale.
Essex is trading with a dividend yield of ~4%, which is similar to that of REITs like Equity Residential (EQR) or AvalonBay Communities (AVB). We like, however, that its net common payout yield is more than 1% higher, since the company is buying back shares. As a reminder, the net common payout yield combines the dividend yield and the buyback yield.
Risks
Among the risks to consider with Essex is that it is highly concentrated in the California and Washington State markets. The company is also likely to continue facing headwinds in the short to medium term from rising interest rates and a weakening economy. These risks are mitigated by a solid investment grade balance sheet, and positive supply and demand trends in the states where the company operates.
Conclusion
Essex Property Trust, Inc. is a quality REIT that is rarely on sale, and it is currently trading at what we consider to be an attractive valuation. While Essex Property Trust is not at a bargain level, it is certainly starting to look very interesting. We like its focus on high quality properties in the California and Washington State markets, which continue to exhibit positive supply and demand trends. There are risks to consider, such as the rising interest rate environment and the weakening economy, but we believe Essex Property Trust, Inc. shares are a solid “Buy” at current prices.
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