Essex Property Trust, Inc. (NYSE:ESS) Q3 2023 Earnings Call Transcript

Essex Property Trust, Inc. (NYSE:ESS) Q3 2023 Earnings Call Transcript October 27, 2023

Operator: Good day, and welcome to the Essex Property Trust Third Quarter 2023 Earnings Conference Call. As a reminder, today’s conference call is being recorded. Statements made in this conference call regarding expected operating results and other future events are forward-looking statements, that involve risks and uncertainties. Forward-looking statements are made based on current expectations, assumptions and beliefs as well as information available to the company at this time. A number of factors could cause actual results to differ materially from those anticipated. Further information about these risks can be found on the company’s filings with the SEC. It is now my pleasure to introduce your host, Ms. Angela Kleiman, President and Chief Executive Officer for Essex Property Trust. Thank you, Ms. Kleiman, you may begin.

Angela Kleiman: Good morning, and thank you for joining Essex’s third quarter earnings call. Barb Pak and Jessica Anderson will follow with prepared remarks and Rylan Burns is here for Q&A. My comments today will focus on how we performed to date. Our initial outlook for 2024 and a brief update on the investment markets. Overall, 2023 has unfolded generally in-line with our expectations. We increased our same-property revenue and NOI growth in middle of the year, despite a challenging operating environment, with almost 2% of rent delinquent for the first nine months of the year. For context, this delinquency level is approximately five times our historical average. The unprecedented eviction protections enacted during COVID exacerbated by subsequent court delays has resulted in protractive exposure to non-paying tenants and uncertainty on timing of when we could recapture these units.

That said, we made considerable progress reducing delinquency as a percentage of rent, which is now at 1.3% in October, this improvement has naturally resulted in a temporary trade-off between rate growth and occupancy but has proven to be an optimal strategy to maximize revenues as we make progress towards normalization in our markets. Looking ahead to 2024, we plan to publish a more comprehensive outlook for the West Coast in conjunction with our full year guidance on our fourth quarter earnings call. For now, we have provided our initial 2024 supply outlook for our market on S-17 of the supplemental which forecasts total supply growth of only 0.5% of total housing stock. Unlike many other US markets, total housing supply in our markets is expected to remain at low level.

And we do not see a near-term catalyst for increasing housing supply growth in the Essex markets. This supply landscape also minimizes our risk to job growth relative to other markets, especially if we encounter a softer demand environment and will be a tailwind for Essex when the economy accelerates. While muted supply is part of our thesis, we also see conditions that could drive demand for housing. First, after a year of retrenchment, layoff in the tech industry appears to be slowing and return to office is gaining momentum, with percent of remote job hiring at the largest tech companies now in the low single-digits. Implying that once tech hiring resumes in a meaningful way, job growth will be highly concentrated near major employment centers.

Second, it remains to be seen, how the artificial intelligence industry will grow. We know that success in this industry will require immense scale and capital resources, and these types of companies are largely concentrated in the Bay Area and Seattle. Third, affordability, particularly in Northern California. Today, the Bay Aera is as affordable as we’ve seen since we began tracking this data, and we expect this will provide a long runway for rent growth. In summary, the combination of this potential demand backdrop and a muted supply outlook gives us confidence that the West Coast is well positioned to outperform in the long-run. Lastly, an update on the apartment investment markets. Deal activity slowed further in the third quarter, as interest rates increased sharply in recent months, compressing perspective returns and resulting in many buyers remaining on the sidelines.

We have seen several marketed deals not transact this year as sellers await a less volatile interest rate environment. There is little evidence to suggest transaction activity will pick-up in the near term as bid-ask spread remains wide. We have navigated through many economic cycles and our finance team has done an excellent job in fortifying the balance sheet, which positions Essex well for any environment. With that, I’ll turn the call over to Barb.

Barb Pak: Thanks Angela. Today, I will discuss our third quarter results, along with investments and the balance sheet. Starting with our third quarter performance. I’m pleased to report that core FFO per share for the quarter came in $0.03 ahead of our midpoint. The outperformance was driven by slightly higher revenues, other income and lower G&A expenses, partially offset by higher operating expenses. Most of the deals in the third quarter is timing related. As such, we are reiterating the midpoint of our full year core FFO per share and same-property revenue, expense and NOI growth. As it relates to operating expense [Technical Difficulty] which increased by only 1% due to the favorable outcome we received in Seattle. As we look to 2024, we expect operating expenses will remain elevated, primarily driven by non-controllable items such as insurance and utilities.

In addition, the tax benefit we received in Washington share is not expected to repeat in 2024. However, it should be noted that we have done a good job over the past four years improving the operating efficiency of the platform, which has led to modest increase in our controllable expenses. Since 2019, our controllable expenses have increased around 2.75% annually despite elevated inflationary pressures and higher costs related to our delinquent units during this period. This favorable outcome is primarily driven by the rollout of Phase 1 of our property collections model. As always, we are continuously looking for ways to improve efficiencies within the platform in order to optimize our cost structure. Turning to investments. For the year, we expect preferred equity redemptions to be around $70 million as we anticipate being fully repaid on a $40 million investment in the fourth quarter.

As we look to 2024, we expect redemptions within our preferred equity book to be around $100 million. While we are actively looking for new deals to replace these investments, there could be a timing mismatch in terms of when we get repaid and when we can reinvest. We are finding there are still significant capital sources eager to invest in this portion of the capital stack, while at the same time projects with reasonable return expectations are becoming harder to find. We will remain disciplined in this environment, leaning on our deep network on the West Coast to source deals at attractive risk adjusted returns. Turning to capital markets and the balance sheet. In July, we closed $298 million in ten-year secured loans at a fixed rate of 5.08%.

The proceeds were used — will be used to repay our 2024 consolidated maturities. We were proactive in refinancing our debt early in today’s volatile rate environment, locking in favorable financing ahead of the recent acceleration in treasury yields. As such, the company is well positioned with minimal financing needs over the next 18 months. We are pleased that our net-debt to EBITDA ratio continues to trend lower and stands at 5.5 times today as compared to 5.8 times one year ago. With over $1.6 billion in liquidity, the balance sheet remains a source of strength. I’ll now turn the call over to Jessica Anderson.

Jessica Anderson: Thanks Barb. My comments today will cover our recent operating results and strategy, followed by an update on our delinquency progress and regional highlights. Operating results were solid for the quarter including same-property revenue growth of 3.2% on a year-over-year basis. We experienced a normal peak leasing season across all markets. Market rents peaked in August, at 6% growth year-to-date compared to December 2022 and has subsequently moderated by 10 basis points in September, which is consistent with typical seasonality. While we took advantage of opportunities to push rents during peak season, we shifted back to an occupancy focused strategy midway through the third quarter as we began to recapture a larger volume of units from non-paying tenants.

This shift in strategy tempered our blended trade-out rates in Q3 which were similar to Q2 at 2.1%. Renewal growth rates were healthy at 3% in Q3 and 5.3% in October, boosting our blended trade-out rates while new lease growth was muted at 1.2% for Q3, reflecting new lease incentives to backfill recently vacated non-paying units. Eviction related move-outs increased in September, allowing for improvement in delinquency as a percentage of rents to 1.9% in September and even further improvement in October to 1.3%. Several of our markets such as Santa Clara, San Mateo and San Diego have returned to delinquency levels close to the long-term run rate. Los Angeles and Alameda County remained elevated, but significant progress is also being made in these areas after protections expired earlier in the year.

As Angela mentioned, the improvement in delinquency will result in a temporary tradeoff with new lease growth and occupancy, which can be seen in our preliminary October numbers, but we view this progress, as a positive for the company. Consistent with our approach all year, we remain nimble and will shift our strategy as necessary to maximize revenue in any operating environment. Finally, I want to thank the Essex team for their diligent efforts this past quarter. They’ve been a major driver of the improvement we’ve achieved. Moving on to regional specific commentary. Beginning with Seattle, this market has performed as expected this year. Blended net effective rent growth averaged 0.5% for the quarter, improving 70 basis-points from Q2. Despite nominal trade-out growth, demand fundamentals were solid in Q3 and I’m pleased with the recovery of this market after a slow start to the year.

Market rents in this region were the first to peak in July on par with a typical year and we anticipate a normal seasonal moderation although higher levels of supply deliveries in the fourth quarter may have an impact on pricing. Turning to Northern California, blended net effective rent growth averaged 1.4% for the quarter, consistent with Q2. Market rents peaked in late August later than normal, an indicator of solid fundamentals in this market. Santa Clara was our top-performing market for the quarter as outlined on page S-9 of the supplemental. The ongoing return to office along with corporate housing activity contributed to these positive quarterly results. San Francisco and Oakland CBD, which account for a small portion of our NOI, have lagged the regional average.

Oakland continues to be impacted by supply, which is expected to continue into 2024. Lastly, Southern California continues to be our top-performing region led by San Diego. Market rents in Southern California were last to peak in mid-September and blended net effective rates remained resilient at 3.7%, despite the headwinds in Los Angeles, our market most impacted by delinquency. In October, delinquency in Los Angeles was at 4.6%, reflecting a 2.1% improvement since the start of the year. We anticipate making continued progress on delinquency in Los Angeles and as such we expect rents and occupancy in this area to be more volatile in the near-term. In summary, we are encouraged by the improvement we are seeing on the delinquency front and expect continued progress, heading into next year.

As we conclude the balance of the year, we remain focused on preserving occupancy and positioning the portfolio favorably, heading into 2024. I will now turn the call back to the operator for questions.

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Q&A Session

Operator: Thank you. At this time, we will be conducting a question-and-answer session. [Operator Instructions]. Our first question comes from Austin Wurschmidt with KeyBanc. Please proceed with your question.

Austin Wurschmidt: Great, thank you. Jessica, you highlighted that you’ve shifted your strategy from pushing new lease rate growth to growing occupancy, due in part to the elevated move outs of non-paying tenants. But from what I recall, the guidance assumes both an improvement in cash delinquency and re-acceleration in new lease rate growth towards that high 2% range in the back-half of the year. So, I guess I’m just curious if anything else changed from a demand perspective that also contributed to that shift in sort of operating strategy?

Jessica Anderson: Well, just to emphasize, we are on-track for the year. And as mentioned in my prepared remarks, there is essentially a trade-out. We did expect delinquency to stay elevated above the 1.3% that we reported for October. So that is lower than we had planned although we had experienced the trade-out with occupancy and our new lease — new lease trade-out rate. So as far as demand goes, all of the markets are performing as expected as we move into the seasonal slow period and we’re encouraged by recapturing the non-paying units because it will position us well as we head into 2024.

Austin Wurschmidt: Got it, that’s helpful. And then can you just remind me — I know you guys report financial occupancy, but does that capture cash delinquency or is that figure more reflection of gross potential rent? Thank you.

Jessica Anderson: Financial occupancy does not include delinquency.

Austin Wurschmidt: Understood. Appreciate it.

Operator: Our next question comes from Eric Wolfe with Citi. Please proceed with your question.

Eric Wolfe: Hey thanks. Just curious what you think drove the decline in delinquencies in October sort of specifically versus, say, two months ago and — even a couple of months ago. Some of your peers started seeing it. Do you think that the improvement is sustainable going-forward?

Jessica Anderson: Hi, Eric, this is Jessica. Well, we’re definitely encouraged by the improvement that we’ve seen in October and there is several factors that are contributing to that. The first is, for all of our areas outside of Los Angeles and Alameda, protections expired in July last year and at the time we were reporting that evictions we’re taking in the range of 10 to 12 months and some longer. And so now that we’re a year, plus into those areas, we are seeing a lot of those units have made their way through the system. And in the move-up that we’re experiencing. As far as Los Angeles and Alameda go, those protections expired earlier in the year and those tenants are realizing that there are no more protections. There is no more emergency rental assistance.

So overall, the tenant sentiment has changed and there is a greater sense of urgency. So we are seeing increased move outs as tenants are realizing this. And as far as forward-looking, one month certainly doesn’t make a trend and we’ve seen some choppiness in delinquency as we’ve worked through it, the last couple of years, but we’re certainly encouraged by our recent results and we’re going to be monitoring that closely, and we’ll have more information on our fourth quarter earnings call.

Eric Wolfe: All right, that’s helpful. I guess leads to my second question which is around the — you dropping through new lease rates, the increased occupancy of non-paying tenants. I guess, how long would you sort of expect that process to take? And would you expect new lease rates to sort of go back up to that sort of 2.8% that you discussed on the last call or should renewals have to come down? Because, I think you also talked about renewals tending to follow new lease. So just trying to understand how long new lease rates will be depressed and if we should also expect renewals to come down to follow them?