Peter Lynch famously said buy what you know. If there are certain products or services that you love then you should see if the company is publicly traded.
I don’t know if anyone truly loves their landlord but Glenn lived in his Essex owned apartment for 8 years. That’s his old apartment in Essex’s latest annual report.
The property used to be owned by BRE and then Essex purchased BRE which spurred Glenn to look into the company.
We like to invest in companies that own what we call trophy assets. We define Trophy Assets as assets with high replacement costs that act as a large barrier to entry for competitors. It’s one reason why we own railroad companies. It would be extremely costly and time consuming to replicate and replace their existing rail networks and port connections.
Multi-family real estate is much easier to replace than railroads but we view large multi-family real estate in and around major west coast cities as hard to replace trophy assets with a high-cost barrier to entry for competitors.
Dividend History
Structured as a Real Estate Investment Trust (REIT), Essex must pay out at least 90% of its taxable earnings to shareholders. The company has paid a dividend since its IPO back in 1994 and over the last 10 years Essex has grown their quarterly dividend at a compound annual growth rate of 7.23%.
They even grew their dividend during the Coronavirus market panic, eviction moratoriums, rent concessions, and concerns of a mass bay area exodus. To be fair it was a $0.012 per share raise but we expect more normal and meaningful dividend increases going forward as the West Coast rental market snaps back.
Dividend Safety
Dividend Safety for a REIT is different than the standard dividend growth stock. We kept the cash dividend payout ratio as a comparison, but the most important metric is the AFFO payout ratio.
AFFO stands for Adjusted Funds from Operations and you can think of it as a REIT’s free cash flow. We want a REIT’s dividend to be well covered by its AFFO. The long-term average payout ratio according to NAREIT is 69%. We want a ratio at or below that rate. It reduces the risk that Essex may cut its dividend during an economic downturn. Essex's AFFO payout ratio is 68% which meets our requirement.
Catalysts for Price Appreciation and Dividend Growth
Exclusionary Zoning
Exclusionary zoning is the use of zoning laws to exclude certain types of land use in a given community. Some common uses of exclusionary zoning laws limit multi-family buildings, set height restrictions, set mandatory parking space requirements per apartment unit, and set minimum lot sizes for single family homes.
Some exclusionary zoning laws may even ban multi-family units, or make the development of these units so costly that builders won’t build them at all or only build small higher income generating units. The end result: Housing supply cannot meet rising housing demand.
The images below are a snapshot of the communities around San Francisco Bay and part of Silicon Valley. Pink is where only single-family homes can be built and blue is where multi-family housing is allowed.
Image from Othering & Belonging Institute
Image from Othering & Belonging Institute
The San Francisco Bay area has its issues like all places but it is a desirable place to live with its access to the tech industry, high paying jobs, world class universities, good school districts, and a favorable climate.
Exclusionary zoning laws make single family homes expensive, multi-family apartments rare, and prevent new multifamily construction. This makes Bay Area apartment complexes trophy assets in a highly sought-after place to live.
Essex is the second largest apartment owner in the Bay area and Essex’s Bay area properties generate over 42% of its Net Operating Income.
NIMBY (“not in my back yard”)
California has a housing problem. There is too much demand chasing too few homes. California needs to build. Not just single-family homes but high-density urban multifamily complexes near public transportation.
But for most California homeowners the largest part of their net worth is in their home. They do not want to jeopardize that value. No one comes right out and says NIMBY. What they usually say is they are all for more housing and increased access to affordable homes but “this [insert name of the project] is not the right project.” And then they cite the NIMBY’s creed.
- It will increase traffic
- It will increase crime
- It will harm the “character” of the neighborhood
This is not to say new homes and apartment complexes aren't being built, but they cannot be built fast enough or at price points to match demand.
Existing multi-family complexes benefit from the high demand and low competition with low vacancy rates, higher initial rent, and consistent annual rent increases.
Housing Affordability vs Renting
Housing affordability in California is declining again.
A minimum annual income of $150,800 was needed to qualify for the purchase of a $817,950 statewide median-priced, existing single-family home in the second quarter of 2021. The monthly payment, including taxes and insurance on a 30-year, fixed-rate loan, would be $3,770, assuming a 20 percent down payment and an effective composite interest rate of 3.20 percent. The effective composite interest rate was 3.08 percent in first-quarter 2021 and 3.43 percent in second-quarter 2020. [emphasis added]
Declining housing affordability again increases demand for renting which decreases vacancy rates at apartment complexes and allows for consistent yearly rent increases.
Risks
Zoom Towns & Work From Anywhere
The biggest risk to Essex is increased competition for renters. This can come from increased housing supply, less people looking to rent, or a combination of both.
The structural systems currently in place regarding low housing supply prevent it from being a major risk. The bigger issue is fewer people looking to rent.
A major effect of Coronavirus, and most likely a lasting effect, is the ability to work remotely full-time. The more knowledge based the industry, like Bay Area based software focused technology companies, the easier it is to change over to remote work. With the ability to work anywhere, high salary tech workers can leave the costly Bay Area for lower cost Zoom Towns.
People did move out of San Francisco during the early phase of the pandemic and some moved out of California. But the vast majority of them stayed in California and within the Bay Area.
Southern California was the next big destination for people moving out of the Bay Area. Southern California accounts for 41% of Essex’s Net Operating Income.
Essex is the number 2 apartment owner in Los Angeles County.
The third largest in Orange County.
And the fifth largest in San Diego County.
And based on forwarding addresses given to Essex upon move out, residents overwhelmingly stayed within the same county or moved to counties where Essex also had a large presence.
The pandemic accelerated trends that were already in place and pulled forward future demand. The people that moved out of the Bay Area were already thinking about it before the pandemic. The pandemic was the catalyst to act.
But if the recent spike in people moving out of the Bay Area remains elevated, if young people do not want to move to major cities to start their careers and look for a marriage partner, if immigration doesn’t bounce back then Essex’s future economic value is not as high as we think it can be.
Rent Control
California passed a state wide rent control law. It is designed to protect renters from egregious rent increases. It is illegal for a landlord to raise rent higher than 5%, plus the local inflation rate, in one year.
If California passes a more aggressive rent control law or if local municipalities pass aggressive rent control laws, this will hurt Essex’s ability to grow and increase dividends. It may even force them to sell properties.
Rent control always sounds good in the short term but in the long run it would likely make problems worse. It takes supply off the market. Those in rent-controlled apartments stay put longer and it deters new construction. Rent control ignores the demand side of the problems and pushes prices higher for the units that are available.
But never underestimate politicians to forsake good long-term planning for short-term political gain.
Valuation
The value of a multifamily complex is often quoted in cap rate. Net Operating Income divided by Price. Think of it like the yield on a real estate investment.
On LoopNet large apartment complexes in major California cities have Cap Rates in the Range of 3-6%. Based on Essex’s 2020 Net Operating Income of $1.045 billion and their current Enterprise Value of $28.4 billion we arrive at a cap rate of 3.7%.
A 3.7% cap rate might not seem like a deal but you don’t have to manage the property. You have immediate liquidity. And you have diversification across 100s of properties in California and Washington.
Essex as a REIT and a consistent dividend grower is also a good candidate to be valued using the Gordon Growth Model.
We think Essex can grow its dividend by 5% per year post covid. We’ll use its weighted average cost of capital, 7.25%, as our discount rate. And using an annual dividend of $8.36 per share, our estimate of fair value is $372 per share.
Essex is currently trading at a slight discount to our estimate of fair value based on the Gordon Growth Model.
