Essex Property Trust, Inc. (NYSE:ESS) Q4 2023 Earnings Call Transcript

Essex Property Trust, Inc. (NYSE:ESS) Q4 2023 Earnings Call Transcript February 7, 2024

Essex Property Trust, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good day, and welcome to the Essex Property Trust Fourth Quarter 2023 Earnings Conference Call. As a reminder, today’s conference call is being recorded. Statements made on 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, Mr. Kleiman, you may begin.

Angela Kleiman: Good morning, and thank you for joining Essex fourth quarter earnings call. Barb Pak will follow with prepared remarks; Rylan Burns and Jessica Anderson are here for Q&A. I will start with the key highlights of our 2023 performance then discuss our expectations for 2024, followed by comments on the transaction market and our investment strategy. Overall, 2023 was a solid year for Essex. We achieved a 4.4% same-property revenue growth for the full year, which is in line with our revised guidance and 40 basis points higher than the original midpoint. Furthermore, we made substantial progress in reducing delinquency as a percentage of rent from over 2% in the first quarter, down to 1.4% by year-end. These are the results of the well coordinated efforts of our hardworking operations and support teams across the company.

Great job team, and thank you. Lastly, we continue to drive results to the bottom line, delivering a 3.6% year-over-year increase in core FFO per share, exceeding the high end of our original guidance range by $0.06. Turning to the fourth quarter, we deployed an occupancy focused strategy as market rents moderated generally consistent with typical seasonal pattern. In addition, we recovered a significant number of delinquent units starting in October. As expected, the subsequent backfilling of non-paying units during a seasonally slow period created a temporary headwind to net effective new lease rates, which averaged negative 1.7% for the quarter. On the renewal front, the positive trend continues with strong retention among our residents, generating an increase in renewal rates of 4.9% for the quarter, resulting in blended rates of positive 2.6%.

As we start 2024, leasing activities in our markets is steady. In January, new lease net FX rates improved by 150 basis points and concession usage decreased by half since the fourth quarter, and our financial occupancy sits in a solid position of 96.2%. Moving on to our outlook for the West Coast in 2024 as outlined in our earnings package. We expect the US economy and job growth to normalize in 2024, consistent with economists’ outlook of a soft landing. We forecast job growth on the West Coast to perform in line with the national average on the Essex markets to produce market rent growth of 1.25% on average. The consensus macroeconomic US assumptions and the quality of jobs are key considerations to our modest outlook. In 2023, the employment growth was largely concentrated in the service sectors, which did not yield meaningful rent growth.

We expect this dynamic to continue, and we currently assume hiring of highly skilled workers to remain muted as companies continue to evaluate their labor needs and priorities. While our base case scenario for 2024 reflect tempered growth, there are several factors that could support a more positive outcome. First, inflation could continue to move in the right direction, increasing the likelihood that the Fed will pivot from tightening to easing. Accordingly, the economy could gain momentum and hiring of highly skilled workers reaccelerate as cost of capital becomes more attractive. Second, the large technology companies implemented significant business and labor retrenchments at the end of 2022 through the early part of last year. Therefore, these companies are better equipped today to lead advancements and stimulate growth.

To this point, recent layoff announcements have been much smaller in scale with companies citing larger strategic plans to redirect talent and investments toward artificial intelligence projects, which we view as a long-term benefit for the West Coast. With low levels of housing supply in our markets, a modest increase in demand could accelerate rent growth. Despite uncertainties in the overall economy, we are confident in our market’s ability to navigate near-term volatility and to outperform in the long term. Our conviction is based on two fundamental factors, low housing supply and favorable affordability. Over the next two years, we expect less than 1% of total supply growth per annum, which enables us to generate positive rent growth in most environments.

Also, renting in the Essex markets is considerably more affordable than owning a home, and favorable rent-to-income ratios support a long runway for rent growth, especially in our Northern regions. As such, we expect the economic incentive to rent to persist and drive demand for multifamily housing. Lastly, on the investment market and our strategy. 2023 was a year of historically low transaction volume, primarily due to significant volatility in the capital markets. Although, we’ve seen interest rates decline throughout the fourth quarter, yield spread between buyers and sellers remain wide, ranging from approximately 25 to 50 basis points in our markets. And thus, we are not anticipating a significant increase in deal volume in the near term.

Lenders have generally been accommodating to sponsors extending debt maturities when feasible, and there are very few four sellers in our markets currently. Given the thirst of data points, there is less certainty in the transaction market. It is during periods of uncertainty that Essex has historically created significant value for our shareholders through external growth. As such, our investment team is proactively looking for acquisition opportunities to generate the best risk-adjusted returns. We expect Essex’s disciplined approach to capital allocation, strong balance sheet and deep market expertise will be key differentiators in creating long-term value. With that, I’ll turn the call over to Barbara.

Barb Pak: Thanks, Angela. Today, I will discuss the key assumptions to our 2024 guidance and provide an update on the balance sheet. Beginning with our outlook for 2024, a key factor to our revenue forecast is our market rent growth assumption. As Angela mentioned, the economic backdrop is expected to be muted this year, which is leading to below average rent growth for our markets. As a result, same-property revenue growth is tempered at 1.7% at the midpoint on a cash basis. The key drivers of our revenue growth are outlined on Page S-17.1 of the supplemental. Our guidance assumes delinquency of 1.5% of schedule rents for the full year, which represents a 40 basis point improvement to year-over-year revenue growth. We expect delinquency will gradually improve as we move through the year.

In terms of regional performance, we expect Southern California will produce our highest revenue growth at 3%, led by Orange County in San Diego. Northern California will be around 1%, and Seattle will be our weakest performing region, which is forecasted to be flat on a year-over-year basis. Moving to operating expenses. We are projecting 4.25% growth for the full year, which was largely driven by higher insurance costs. Although insurance costs account for a small portion of our total operating expenses, we are forecasting a 30% increase in our premiums, which adds 1.4% to our total same-property expense growth. The company remains focused on managing controllable expenses, which we are forecasting to increase 3% in 2024, primarily driven by higher wages.

In total, we expect same-property NOI growth of 60 basis points and core FFO per share growth to be flat at the midpoint compared to 2023. Core FFO growth would be over 1% higher, if not for the impact from two items related to our preferred equity platform. First, in December, we received $40 million in redemption proceeds, and we are forecasting an additional $100 million in redemption proceeds for this year. We anticipate redeploying the funds into new acquisitions, which tempers our near-term FFO growth, but is the best long-term capital allocation decision for Essex. Second, while our sponsors remain current on all financial obligations with the senior lenders, we changed the accrual status on two investments in the fourth quarter based on current market conditions.

Further, we’ve taken a prudent approach as to how we projected income for the remainder of the portfolio as part of our 2024 guidance. We will continue to evaluate the accrual status on each of our preferred equity investments every quarter as appropriate. Turning to the balance sheet. Essex is in a strong financial position with minimal financing needs over the next 12 months and ample sources of capital. Our leverage levels are solid with net debt to EBITDA at 5.4 times, and we have over $1.6 billion of liquidity available to us. We manage our balance sheet and capital needs conservatively to be well positioned to create value throughout the cycle, and we remain optimistic, we will see opportunities to invest this year. With that, I will now turn the call back to the operator for questions.

Operator: Thank you. We will now be conducting a question-and-answer session [Operator Instructions] Our first question is from Austin Wurschmidt with KeyBanc Capital Markets. Please proceed with your question.

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Q&A Session

Austin Wurschmidt: Great. Thanks. Just digging into guidance here. Can you share what your assumptions are for new and renewal lease rate growth are relative to the 1.25 market rent growth assumed and kind of how you’re thinking about the cadence of that through the year?

Barb Pak: Hi, Austin, it’s Barb. Yes. So we’re assuming 1.25 for new lease growth and renewals, we expect to be slightly above that at 1.75%. We do expect renewal growth will be in the first half of the year be above 2% in the low 2% range and then drift down to our market rent growth assumption of 1.25 in the back half of the year.

Austin Wurschmidt: I guess just following quickly up on that, what’s driving that really tight spread? Are there concessions burning off or anything that’s impacting, I guess, the spread between new and renewal lease rates assumed in your guidance?

Barb Pak: Yes. So I think if you look at January, you’ll see we printed 4.8% on new leases or renewals, but 50% of that is a burn-off of concessions, and so it’s not really a new market rent growth. And I would say, our philosophy on renewals is not to push them above market. We do like to, we want to price them appropriately. And last year, in 2023, we didn’t have a significant loss to lease. And so we don’t have a big spread differential between our new and renewals from last year that would carry forward into this year. So we think it’s priced appropriately.

Austin Wurschmidt : And if I can just sneak in one more. I recognize you guys report financial occupancy, but could you break out the impact from guidance around the occupancy change and then impact from concessions and maybe what market rent growth would look like on a net effective basis if you included the concession impact there? Thank you.

Barb Pak: Yes. So the concession piece on the occupancy and concessions, we expect concessions to be a 10 — or 10 basis point headwind to our forecast this year, occupancy to be 20 basis points. So we’re forecasting 96.2% for occupancy. So we don’t expect concessions to have a material impact to the forecast this year on a year-over-year basis.

Operator: Thank you. Our next question is from Steve Sakwa with Evercore ISI. Please proceed with your question.

Steve Sakwa: Yes. Thanks. I guess, good morning out there. I noticed on the delinquency slide, I guess it’s S-16, there was a big jump up in the delinquencies between the fourth quarter and January. And I know you talked about that overall trend getting better for the full year, I think, to the tune of 40 basis points. But just what color can you provide in January that showed that big pop?

Barb Pak: Hi, Steve, it’s Barb. Yes, this January, we’ve seen for several years now. It’s the post holiday. I think people are paying off their credit cards and whatnot. So it’s not something that we’re overly concerned about. We’re monitoring it closely. But we have seen this last year, if you go back and you look at our supplemental, we saw 190 basis points increase from Q4 to January. This year, we’re up 80%. So it is a lot lower than we were a year ago, but we’re monitoring it.

Steve Sakwa: Okay. And then just, I guess, maybe on the DC or your — I guess, your pref book. I mean just as you’ve kind of gone through and scrub sort of some of the things you talked about a couple of the underwriting changes. Like just what risk do you sort of see out there on the kind of roughly $500 million you’ve got outstanding? And I guess, how are you sort of handicapping that in terms of any future write-offs?

Angela Kleiman: Yes, Steve, this is Barb. We take a prudent approach when we look at this. And there’s a variety of factors that we look at when we’re looking at our preferred book, where are we — where is our last dollar sit relative to the market today? What — what’s the maturity of our investments? And how much time do we have for the market to recover and really what is our sponsors doing? Are they continuing to put equity and can they continue to fund? So those are the factors that we’re looking at. I think we have fully handicap the issue that we see today based on current market conditions within our guidance. It’s a few assets we’re monitoring. But for the most part, the book is performing as we expected.

Steve Sakwa: Great. Thanks. That’s it for me.

Operator: Our next question is from Nick Yulico with Scotiabank. Please proceed with your question.

Daniel Tricarico: Hey, it’s Daniel Tricarico on for Nick. Barb, with respect to the improvement in new lease rate growth in January, which markets were the largest drivers of that change? And I know you mentioned the 50 basis point improvement from concession burn-off, but is the general market improvement largely in line with typical seasonality?

Jessica Anderson: This is Jessica. I’ll take that. With regards to the largest driver of the sequential improvement from Q4 to January, it was 150 basis points. We saw the greatest improvement in Northern California and the Bay Area. And a large part of that was concession burn-off. For the total portfolio, if you break down a 150 basis point improvement, 100 basis points of it is the improvement in concessions. So, we were averaging one week in Q4 and that’s a half a week for January. And then the other part of it, 50 basis points is attributed to rent growth, which is typical with what we would expect this time of year historically.

Daniel Tricarico: Great. Thank you. Angela, follow-up. How are you thinking about recycling capital from your future pref equity redemptions into acquisitions or other use? You talked about optimism I believe in your opening remarks around a growing opportunity set. Are you seeing anything specific in the market today? And I guess, along the same lines, how are your JV partners thinking about deploying new capital into acquisitions today?

Angela Kleiman: Yes, that’s a good question. As far as how we’re reviewing investments. And let me just give you a quick background on our pref equity book. The investment thesis for this vehicle was it was intended to complement development pipeline during a period where yields and interest rates were low and construction costs were accelerating at a significant higher rate than rent growth. So, you saw us leaning into this business when the 10-year fell to historical low. And in that environment, a 12% yield was relatively more attractive. The general market environment and the interest rate conditions today are very different. And so we view that there’s more upside to rent growth in our markets over the long run. So, the relative value is more compelling to focus on these simple acquisitions.

So, it doesn’t mean that we’re shrinking the preferred equity book intentionally, but rather that this book will probably drift lower as we look to acquisitions as a way to grow the company. And the reason is because if you look at the fundamentals in our market, it all speaks to more upside relatively speaking, from rent growth. So, especially in our northern region, we have much lower supply. Affordability metrics is in the best position we’ve seen since we started tracking this metric historically. And there’s — the rent has yet to recover, so still in the recovery phase. And lastly, there is a demand optionality. I mean if you look at the composition of the companies in our markets, the seventh largest — seven out of the 10 largest companies are located in our markets, and these are companies that have tremendous amount of wealth and looking — and have committed to infrastructure and investment deployments.

And so if you look at all the building blocks, it’s there and it’s right for acceleration once the economy shifts from a soft economy to a growth economy. And on the IRRs, Rylan, do you want to talk about the IRS?

Rylan Burns: Yeah. At a high level, I mean, we have several joint venture partners. We’ve been in this business for a long time and remain committed to us and our investment thesis along the West Coast. So there is demand there if we see the right opportunities. And we would expect we will see some opportunities in the next year or two.

Daniel Tricarico: All right. Thanks for the time guys.

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

Eric Wolfe: Hey, thanks. I think you just mentioned that you saw the largest improvement in Northern California between 4Q and January and your peer, just mentioned something similar on their call a moment ago. So I was just curious why you think you’ll see this muted rent growth environment throughout the year in Northern California, if you’re already starting to see signs of a recovery during the seasonally weak period.

Angela Kleiman: Hey, Eric, it’s Angela here. On Northern California, it’s really when we look at our market rent growth, it’s a — we do see potential upside. Having said that, that will require the tech companies to hire — to resume their hiring in a more robust way. And so our forecast is really a function of the general market outlook, because we cannot disconnect from what’s happening with the rest of the country. And in particularly, the North Cal region itself, it’s really dampened by Oakland because of the amount of supply. And so if you look at the 1.25% market rent, composition. First of all, it’s a narrow range, just given the overall economic environment. But our Southern California leads the portfolio and above that 1.25% and Seattle is a close second. But the drag is really Northern California, which is closer to 1%, so below that 1.25% average, and that’s because Oakland is well-below that 1%. So that’s the drag.