Essex Property Trust (ESS): Great Long-Term REIT With Some Near-Term Questions

Shares of Essex Property Trust (NYSE:ESS) have come down a long way during this tough period for REITs. A 40% retreat from last year´s highs means that shares are back to levels already seen around 2015.

The Business

Essex is a REIT which focuses on apartments along the West Coast, focusing on the acquisition, development, redevelopment, and management of multi-family apartment communities in what the company calls supply-constrained markets.

The REIT was founded in 1971, and it has gone public in 1994, focusing on key markets like California and Washington, although 80% of the asset base is located in California. Since its offering, the company has uninterruptedly paid out dividends, hiking them in a steady fashion since the public offering.

The company owns more than 250 apartment communities, measuring a total of 62,000 apartment homes. While average rents of $2,500 are quite steep, these houses are located at high-income locations with average rent-to-income levels only coming in around 25%. This comes as generally wealthy households are targeted, earnings at $100k or more, yet many of these households still find themselves in a tough place to buy homes which average around a million in these markets.

The long-term track record of the business is very strong as shares have ten folded from about $20 to $200 since the early 1990s, yet this understates the returns as the company has been paying out steep dividends, now paying out $8.80 per share each year.

Of course, there are concerns related to layoffs in the tech sector hurting the company more than the nationwide average, yet at the same time, long-term supply constraints and key fundamentals of both regions remain key drivers for the long-term business case.

Establishing A Base

Early in 2022, Essex posted its 2021 results. The company posted a net asset base of $12.2 billion, which given the nature of a REIT, makes up the vast majority of total assets. The company has taken a balanced approach, holding $6.2 billion in equity against a $13.0 billion total asset base. The company has an extremely balanced debt profile, with roughly equal installments due in the years until 2032.

2021 sales fell from $1.50 billion to $1.44 billion. Contrary to many REITs, the operating profitability of $530 million is relatively low in relation to gross rent, due to relative larger operating expenses of the properties. Including some equity from joint ventures, net earnings came in at $489 million, equal to $7.51 per share based on 65 million shares outstanding. Core FFO declined nearly 3% to $12.49 per share, with comparables being tough after a very strong 2020. The company guided for 2022 sales increasing by about 8%, with FFO seen up to $13.70 per share.

The company has seen a solid 10% increase in first quarter FFO to $3.37 per share, even as the asset base has been declining (based on book values), with growth in the results attributed to higher rental prices. Second quarter FFO even rose by 21% to $3.68 per share. Third quarter FFO rose by 18% to $3.69 per share, with FFO for the year now seen around $14.47 per share.

Compared to the end of 2021, total assets have fallen to $12.6 billion in the third quarter, down from $13.0 billion nine months before. The company has kept the financing structure largely intact, with $5.9 billion in equity supporting this total balance sheet, with equity ratios coming in just below 50%. With FFO trending around a billion, the FFO multiple has shrunken to 15 times, but this is hard to read into.

After all, Essex operates an REIT model with substantial depreciation charges which involved a real (previous) cash outlay. Subtracting $600 million in depreciation charges, earnings are only seen around $5 per share, translating into a sky-high 40 times multiple.

The 65 million shares now trade at $216, and even if they are down a huge deal from the highs, the resulting $14 billion equity valuation surpasses the book value of equity of less than six billion, marking still a huge $8 billion premium. This means that the asset base comes closer to $21 billion if we read into the market´s opinion.

With gross revenues seen around $1.6 billion a year here, operating expenses of properties trend at nearly half a billion, resulting in a cap rate around 5%, perhaps a bit steep given where interest rates come in here. This comes after shares are down $150 per share, nearly $10 billion from the peak already.

Concluding Remark

The truth is that now is not the time to become bearish, but while Essex has a great long-term track record, actual volume growth is not seen in recent years, as this is more of a capital return story based on riding current rents, which have risen a lot since the start of the pandemic. The company might benefit from rental growth as renting is really cheap to buying (amidst higher mortgage rates) yet average rents are high already which causes concerns amidst a slower economic growth and especially tech layoffs, which are often located in these areas.

Moreover, the REIT has a higher expense rate and states have even implemented rent control measures to offset the pain for residents, creating a potential painful situation for landlords such as Essex. A more than 4% yield looks very decent, amidst a reasonable balance sheet, yet while the long-term track record is great, the near- to medium-term performance has been a bit uninspiring, making me still not an aggressive proponent of the shares here.