This REIT’s price has not recovered from the March market rout, so it looks pretty undervalued. The shares have a current dividend yield of 3.86%, paid quarterly.
Essex Property Trust, Inc. (ESS)
From Investor Advisory Service
Essex Property Trust is a real estate investment trust (REIT) that owns 248 apartment communities comprising over 60,000 apartments exclusively on the West Coast. Its primary markets are Northern California (44% of net operating income), Southern California (39%), and Seattle (17%). About 90% of its apartments are in the suburbs while 10% are considered urban.
The high cost of living in these markets is currently a negative as remote working promulgated under COVID-related regulations has allowed workers to live in cheaper locales while retaining their high income West Coast jobs. While some workers may remain far from their jobs even after the COVID crisis subsides, an investment in Essex incorporates a belief that the West Coast will remain an attractive and premium-priced place to live.
The West Coast, particularly California, has unique and attractive characteristics for rental housing. Economic growth and median incomes are much higher than the national average. High costs of homeownership drive rental demand. High construction costs and zoning laws seem to have a greater impact on West Coast housing than many other places of the country, helping insulate landlords like Essex from the competition that should come when return on investment is high. Residential construction permitting in Essex’s markets is consistently below the U.S. average. The West Coast is a great place to own apartment complexes.
The market has historically awarded Essex Property Trust a premium valuation because it has been able to increase rents faster than elsewhere. The average rent for an Essex apartment is $2,400 a month. Yet, vacancy rates have typically only run about 3%.
Like most businesses, Essex was humming along until coronavirus worries changed behaviors. As unemployment rose sharply, some tenants could no longer afford their rent. Government stimulus and unemployment benefits helped, but didn’t go as far in Essex’s expensive markets. Turnover has risen and Essex has made concessions to help tenants afford their apartments and attract new tenants when vacancies occur.
Second quarter rent rose 2.5%, but declined 3.8% on a same-property basis. In addition, Essex set a high provision for delinquencies, implying that 75% of delinquent rent may never be repaid. Funds from Operations (FFO) per share fell 4.5%. FFO adds back depreciation to net income along with other adjustments for non-recurring items. Good real estate appreciates even though tax law allows depreciation expense.
Occupancy fell to 94.9% from 96.8% in the first quarter, but rebounded to 96.2% in July. Much of the increase in occupancy was due to reduced rents and other promotions. Essex has reduced its use of inducements, but occupancy continues to rise. Only its San Francisco market (4% of operating income) remains “challenged.” In several of its markets, rental conditions have returned to pre-COVID levels. The third quarter will still be impacted by some of its promotions while reduced rental rates will last longer. Conservative accounting appears to have front-loaded some of the pain, including aggressive reserving for delinquencies and reporting lease concessions (weeks of free rent) on a cash basis rather than averaging them over the lease term.
Reasonable debt levels and a modest 58% dividend payout rate help put a cushion underneath Essex Property Trust while its markets heal. A slight bounce back from its low share price this spring leaves it a rare bargain in a market that has become expensive once again.
The attractive characteristics of its markets suggest a return to the results it posted before COVID entered our vocabulary. A combination of its 12.5%-14.3% ROE (Return of Equity) and 42% earnings retention (one minus its 58% dividend payout ratio) implies FFO growth of perhaps 6% if it reinvests retained cash flow at the same ROE. Essex exhibits good capital management, lengthening debt maturities out to 30 years at a cost of less than 3% and occasionally buying back stock.
We, therefore, believe 6% FFO growth is a reasonable possibility. Five years of such growth could result in FFO/Share of $18.37. A repeat of the high price/FFO ratio of 21.8 could result in 84% appreciation to a price of 400. Add in dividends and the potential annual return could exceed 15% annually. We see the downside risk as 19% to 176, the low price during this spring’s market selloff.
Doug Gerlach, InvestorAdvisoryService.com, 1-877-33-ICLUB, August 27, 2020