Company Reports

The US REIT sector remains significantly undervalued, in our perspective. While the pandemic hurt REIT valuations in 2020, the recovery of fundamentals across most sectors combined with low interest rates led to strong total returns in 2021 and early 2022. However, despite fundamentals continuing to perform well over the past two years, with many REITs reaching historical levels of net operating income growth, the sector has underperformed the broader equity markets over the past two years. We believe that the cause has been the sector’s negative correlation with interest rates as income-oriented investors rotate out of the sector, higher rates lower the value REITs can create with external growth, and property valuations fall in line with higher rates. However, we don’t believe that higher rates significantly change our fair value estimates for the sector. Additionally, interest rates are down from the October 2023 highs, and REIT share prices have generally inversely followed the movements of the US 10-year Treasury.

First-quarter results for Essex Property Trust were slightly better than we anticipated, giving us confidence in our $290 fair value estimate for the no-moat company. Same-store occupancy declined 10 basis points sequentially to 96.3%, and average rental rates were only up 2.1% year-over-year, both of which are relatively in line with our expectations. However, the company benefited from fewer delinquencies and higher other income in the quarter, leading to same-store revenue growth of 3.6% that beat our 2.2% estimate. Operating expense growth of 5.0% was slightly higher than our 4.5% estimate, but the revenue beat led to Essex reporting same-store net operating income growth of 3.0% in the first quarter that was higher than our 1.1% growth estimate. The company reported core funds from operations of $3.83 per share, which was slightly better than our $3.70 estimate for the quarter.

We believe that there are several attractive opportunities across the US REIT sector for investors to consider. Following the recovery of many REIT sector fundamentals from the pandemic by mid-2021, we viewed the REIT sector as fairly valued through early 2022. However, the past two years have seen the rapid rise in interest rates and a slowing economy, which has led to major valuation declines across the sector. Our analysis of the REIT sector over the past 25 years suggests that the relative stock performance of REITs is negatively correlated with interest rate movements. The second and third quarters of 2023 saw large interest rate increases with the 10-year Treasury approaching 5%, which led to the sector underperforming. This occurred even as many REITs reported same-store net operating income, or NOI, growth at historical highs in 2022 due to high inflation. Higher interest rates, lower liquidity, tighter capital market conditions, and decelerating same-store NOI growth all led to a significant correction in the stock price for many REITs.

New single-family home sales increased 4% in 2023 to 666,000 units, as homebuilders capitalized on a dearth of existing for-sale inventory while also offering more sales incentives, cutting base home prices, and building smaller homes to improve affordability. By the fourth quarter of 2023, homebuilders began to pull back on sales incentives as the average 30-year fixed mortgage rate retreated from 7.62% in October 2023 to 6.64% in January 2024. However, mortgage rates have trended higher recently, and we now forecast the average 30-year fixed rate will be 6.50% in 2024, up from our previous forecast of 6.10%. Even so, that’s lower than the 2023 average of 6.81%, and we think homebuilders won’t hesitate to increase sales incentives if needed; they still enjoyed above-average gross profit margins last year with elevated incentives. As such, in 2024, we think new-home sales will increase 9% to 730,000 units and single-family housing starts will increase 4% to 985,000 units. However, we expect total housing starts will decline roughly 5% to 1,345,000 units due to a 23% decline in multifamily starts to 360,000 units, as there’s currently approximately 1,000,000 multifamily units under construction—the largest backlog in at least 50 years.

Essex Property Trust is the most geographically focused multifamily real estate investment trust, with a portfolio of high-quality multifamily buildings positioned entirely on the West Coast: Los Angeles, San Diego, San Francisco, San Jose, and Seattle. These markets should experience strong, long-term demographic trends like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger populations, which allows the company to maintain high occupancies and drive rent growth above the US average. Long term we expect the company's markets to see job and income growth above national average, which should continue to support above average net operating income growth, though some of these markets are experiencing near-term slowdowns. The company's solid internal operating outlook should be supplemented by its small but opportunistic development pipeline to create value for shareholders.

Essex Property Trust reported results for the fourth quarter that were generally in line with our expectations for the quarter, leading us to reaffirm our $305 fair value estimate. Same-store occupancy declined 30 basis points sequentially to 96.1%, below our estimate of occupancies remaining flat. Average rental rates were up just 2.4% year over year, though that is slightly better than our estimate of 1.9% growth. As a result, same-store revenues grew 2.9% in the quarter, in line with our estimate. However, same-store operating expenses were up 4.5% in the fourth quarter, leading to same-store net operating income growth of just 2.3%. Essex reported core funds from operations of $3.83 per share for the fourth quarter, slightly below our $3.96 estimate mainly due to a one-time impairment charge in the unconsolidated portfolio. Excluding that charge, core FFO results were in line with our expectations.

New-home sales have rebounded since the spring of this year as sales incentives and price reductions have attracted buyers who have fewer options in the supply-constrained existing-home market. That said, homebuilder sentiment data tells us that smaller builders remain cautious. Even so, we forecast single-family starts to increase by 3% in 2024, to 0.92 million units. However, we project this increase in single-family starts will be more than offset by a 24% decline in multifamily starts, to 0.36 million units. Multifamily construction has been robust for the past three years, but a record construction backlog and higher construction and financing costs have tamed developers' appetite for new multifamily projects.

Third-quarter results for Essex Property Trust were slightly below our estimates, though we didn't see anything in the quarter that would materially change our $305 fair value estimate for the no-moat company. Same-store occupancy fell 20 basis points sequentially to 96.4%, slightly worse than our estimate of flat occupancy growth. Average rental rates increased 3.3% year over year, in line with our 3.4% growth estimate. Combined, same-store revenues were up 3.2% in the third quarter. However, same-store operating expenses were up 4.4% as utility costs were up 7.0% and personnel costs were up 5.1%. As a result, same-store net operating income only increased 2.7% in the quarter, slightly below our estimate of a 4.1% increase. This led to Essex reporting core funds from operations of $3.78 per share for the quarter, which is 2.4% above the $3.69 core FFO figure reported in the third quarter of 2022 but $0.07 below our $3.85 estimate for the quarter.

Essex Property Trust is the most geographically focused multifamily real estate investment trust, with a portfolio of high-quality multifamily buildings positioned entirely on the West Coast: Los Angeles, San Diego, San Francisco, San Jose, and Seattle. These markets should experience strong, long-term demographic trends like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger populations, which allows the company to maintain high occupancies and drive rent growth above the U.S. average. We expect the company's markets to see job and income growth above national average, which should continue to support above average net operating income growth. The company's solid internal operating outlook should be supplemented by its small but opportunistic development pipeline to create value for shareholders.

The share prices of U.S. real estate investment trusts have fallen by approximately 30% from their 2021 highs because of higher interest rates and stress in some commercial real estate sectors. We think that the correction is overdone and the current valuations offer an attractive entry point for patient investors. Our core REIT coverage is trading at a discount of approximately 25% to our fair value estimate. We estimate that the average REIT within our U.S. coverage is currently trading at a dividend yield that is 126 basis points higher than the historical average. We see marked differences in valuation across different REIT sectors in the United States. For instance, the industrial sector is fairly valued, with stock valuations already accounting for future growth, but other sectors like offices, hotels, and malls are trading at attractive discounts.

New-home sales have remained resilient despite worsening housing affordability in recent months amid rising mortgage rates, with little relief in home prices in most markets. Year-to-date new-home sales through July were about even with the year-ago period, compared with a 22% decline in existing-home sales. The key to homebuilders’ relative success this year has been their ability to improve affordability by offering sales incentives, lowering base prices, and building smaller homes. According to the National Association of Home Builders, the share of builders offering incentives was 55% in August, up from 52% in July but down from 62% last year. One fourth of homebuilders reported lowering base prices by 6% on average. Homebuilders have also boosted production of speculative homes to capitalize on the tight supply of existing for-sale homes. Spec building also helps builders better manage construction cycle times and costs.

Essex Property Trust reported second-quarter results that were relatively in line with our expectations, leading us to reaffirm our $317 fair value estimate for the no-moat company. Same-store occupancy fell 10 basis points sequentially to 96.6%, but is up 50 basis points year-over-year and is better than our estimate of 96.0% occupancy for the second quarter. However, average rental rates improved 5.3% year over year, which is below our estimate of 8.1% rate growth. Same-store revenue was up only 4.0% in the second quarter as growth saw a negative 150-basis-point impact due to increased delinquencies, though that is because 2022 saw a $13 million benefit from the Emergency Rental Assistance program that has since rolled off. Same-store operating expenses increased 5.3% in the second quarter, slightly above our estimate of 5.0% growth, and led to same-store net operating income growth of 3.6%. Essex reported core funds from operations growth of 2.4% in the second quarter to $3.77 per share, a penny better than our $3.76 estimate.

Through the first four months of 2023 (typically viewed as the “spring selling season” for homebuilders) new home sales significantly outperformed existing home sales. Indeed, April year-to-date new home sales declined roughly 10% year over year compared to over a 26% decline for existing home sales. New home sales improved sequentially during the first four months of the year, and April sales increased 11% year over year, albeit on an easy prior-year comparison (April 2022 new sales were down 24% year over year).

First-quarter results for no-moat Essex Property Trust were relatively in line with our expectations, leading us to reaffirm our $317 fair value estimate. Same-store occupancy improved 70 basis points sequentially to 96.7%, better than our estimate of flat growth. Average rental rates improved 6.8% year over year with the Northern California markets being a slight drag on performance, only up 5.3% in the quarter. While same-store revenue growth of 7.6% underperformed our estimate of 9.3% growth, same-store operating expenses were only up 4.0% compared with our estimate of 5.5% expense growth. As a result, same-store net operating income improved by 9.2%, relatively in line with our estimate of 9.8% growth. Essex reported core funds from operations of $3.65 per share in the first quarter, which was 4 cents better than our $3.61 estimate and 8.3% higher than the $3.37 figure reported in the first quarter of 2022.

Essex Property Trust is the most geographically focused multifamily real estate investment trust, with a portfolio of high-quality multifamily buildings positioned entirely on the West Coast: Los Angeles, San Diego, San Francisco, San Jose, and Seattle. These markets should experience strong, long-term demographic trends like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger populations, which allows the company to maintain high occupancies and drive rent growth above the U.S. average. We expect the company's markets to see job and income growth above national average, which should continue to support above average net operating income growth. The company's solid internal operating outlook should be supplemented by its small but opportunistic development pipeline to create value for shareholders.

U.S. home sales slowed significantly in 2022 as rising mortgage rates and elevated home prices made homeownership less affordable for more Americans. By mid-2022, the average 30-year fixed mortgage rate had increased roughly 300 basis points year over year to over 6%. According to estimates from the National Association of Home Builders, this rate increase priced out more than 16 million households. We also think higher rates and general economic uncertainty caused some qualified prospective buyers to move to the sidelines. All told, 2022 new- and existing-home sales declined 17% and 18% year over year, respectively.

Essex Property Trust reported fourth-quarter results that were in line with our expectations, leading us to reaffirm our $322 fair value estimate. Same-store occupancy sequentially remained flat at 96.0% in the fourth quarter, matching our estimate. Average rental rates in the same-store portfolio increased 8.1% year over year due to continued high inflation, leading to same-store revenue growing 10.5%. While high inflation also led to utility costs growing 13.5% and insurance costs growing 9.5%, other major operating expenses like real estate taxes, maintenance expenditures, and administrative costs all grew 3.3% or less in the quarter. As a result, same-store operating expenses only grew 4.0% in the fourth quarter, which led to same-store net operating income, or NOI, growth of 13.3% that was relatively in line with our 14.1% estimate. Essex reported core funds from operations, or FFO, of $3.77 per share, which was a penny better than our $3.76 estimate and 16.0% higher than the $3.25 figure that the firm reported in the fourth quarter of 2021.

After analyzing recent United States housing market data and industry commentary, we've made downward revisions to our near-term outlook for new residential construction, home prices, and repair and remodel spending.

Essex Property Trust is the most geographically focused multifamily real estate investment trust, with a portfolio of high-quality multifamily buildings positioned entirely on the West Coast: Los Angeles, San Diego, San Francisco, San Jose, and Seattle. These markets should experience strong, long-term demographic trends like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger populations, which allows the company to maintain high occupancies and drive rent growth above the U.S. average. We expect the company's markets to see job and income growth above national average, which should continue to support above average net operating income growth. The company's solid internal operating outlook should be supplemented by its small but opportunistic development pipeline to create value for shareholders.

Third quarter results for no-moat Essex Property Trust were slightly better than we anticipated, though we don't see anything in the quarter that would materially change our $322 fair value estimate. Same-store occupancy declined 10 basis points sequential and 40 basis points year-over-year to 96.0% in the third quarter. However, average rental rates increased 8.9% year over year, which combined with fewer rent concessions in 2022 led to same-store revenue growth of 11.4% in the third quarter that was slightly ahead of our 10.6% estimate. Same-store operating expenses only grew 2.7% in the quarter, resulting in net operating income growth of 15.4% that was slightly beat our 14.2% estimate. Essex reported core funds from operations of $3.69, 18.3% higher than the $3.12 figure the company reported in the third quarter of 2021.