Today I want to take a look at a residential REIT Essex Property Trust (NYSE:ESS). The last time I covered the stock was at the end of July using their Q2 2023 results. I issued a buy rating because I believe that the California exposure of the company, while really heavy, is not a reason to be scared and actually brings an opportunity to invest when everyone is scared about people moving to Texas. This has not changed and there are many reasons, which I will get to, why this is still an advantage of ESS. However, since then the price has dropped by 7% so in this article I want to go over their Q3 results and assess how is ESS doing and still reiterate my buy rating as the company has been doing well on an operational level and I believe that it is still well positioned and can take advantage of the location of its properties.
First, a little background on ESS. They own around 62,0000 apartment homes in 8 major markets. 84% of their properties is located in suburban areas and 16% in urban. As I mentioned before their exposure to the Californian market is really significant with 42% of their portfolio being in Southern California and 41% in Northern California. The rest is located in Seattle. There are several reasons why this exposure can be beneficial to ESS.
1. California is the hub for technology and with AI on the rise this creates many new jobs which attract people to move to California.
2. ESS can take advantage of the small amount of new supply in their markets which is estimated to remain at 0.5% of the current supply in 2024. This is a result of high barriers to entry into the market as it is really costly and it takes a long time to process and authorize new projects.
3. Renting has become much cheaper than buying, especially in ESS’s markets, and it is now 2.6x more expensive to own a house rather than rent it which makes many people renters by necessity.
The same-property revenue has increased by 3.2% year-over-year and by 4.9% year-to-date. Though the growth has been slowing down throughout the year from 7.6% in Q1 and 4% in Q2. Still, their revenue growth is in line with the full-year guidance for 2023. The financial occupancy in Q3 was 96.4%, a 0.2% decrease from the last quarter. The small decrease is a result of improving delinquency in their apartment units. ESS was able to decrease long-term delinquent leasing from an average of 3.6% in 2022 to 2.2% in 2023.
The guidance calls for a core FFO of $15 at midpoint. The FFO for the last year was $14.97 which is at the bottom of the revised range for this year ($14.94-$15-06). Furthermore, the revenue growth is expected to be around 4.4% and NOI growth around 4.5%. At the same time, the operating expenses are expected to increase by 4%. Looking at these numbers, ESS is not doing bad at all. They are not growing at a really fast pace but we can see improvements nonetheless which only proves that their location is not a problem at this time.
The company is BBB+ rated and has a net debt to adjusted EBITDAre of 5.5x. Their weighted average interest rate is at 3.4%. They have quite a bit of maturities to cover in the next years however they have $1.7 billion in liquidity which should be enough to cover them for some time.
ESS has a strong history of 29 years of increasing its dividend. The cumulative growth since they IPOed has been 453%. With that, I don’t see a reason for this to stop and expect the company to raise its dividend. Especially since the FFO payout ratio is 62%. The current dividend is $9.24 per share per year which translates to a 4.2% dividend yield.
When I last wrote about the company it was trading at a P/FFO around 16x and I predicted it could return to around 18x. Today it is trading at 14.74x and the historical average is 20.13x. On an operational level, the company has not changed significantly and has delivered on its guidance so far however the growth seems to be slowing down a bit. I believe that the company can still get to that multiple but with interest rate hikes it might take longer than I originally expected.
By the end of 2025, I would expect it to return to 16.5x which would still leave an upside of around 12% from multiple expansion. Beyond that, I expect an FFO growth of around 3% per year which would leave us with an FFO of around $15.9 by the end of 2025. This combined could get us to a price of around $260 in this timeframe which would be nearly 20% of upside. Combined with the dividend this would mean a double-digit return of around 12%. While not the highest it is not a bad return either and I expect it to be pretty stable considering the company is not that high in risks which is why I rate ESS as a BUY.
Beyond the interest rate risk, the biggest one I see with ESS is the concentration risk in California. Obviously, nobody knows what will actually happen and it could not work out well for the company. However, the data available speak otherwise so far.