11/10/15
Short
ESS ($222)
Overview - Essex Property Trust (ESS) is
an apartment REIT based in Palo Alto, California. The company has ownership
interests in 245 apartment developments strictly on the West Coast (47%
Southern California, 32% Northern California, 21% Seattle Metro), in contrast
to more geographically diversified REITs. The company is highly concentrated in
“high end” apartments in geographies which have experienced huge growth in recent
years.
Performance - Since 2009, ESS’s stock price
has soared from $55 to over $220, increasing its market cap to over $14.7
billion. This has been fueled by a combination of improving real estate
metrics, job market improvement, and artificially low interest rates. These
variables are largely cyclical, and arguably due for reversion. While riding
these tailwinds, ESS effectively “doubled down” on the West Coast by purchasing
BRE last year for over $4.3 billion, probably overpay ing for a top competitor
in the midst of a cyclical high.
Above
$200, ESS is currently priced for perfection. Their properties are 96% occupied
while experiencing tremendous rent growth. Last Friday, The Company beat
Revenue, EPS, and FFO estimates, in addition to raising future guidance, yet
the stock still fell. If ESS experiences any slowdown in these key metrics, the
stock will certainly fall much further.
ESS
has been riding the West Coast gravy train for years and a top analyst at
Raymond James seems to agree that ESS is close to the top. “RJA believes that
all of the good news about West Coast markets are already baked into the
shares.”
Geographic
Concentration
- Looking closer at ESS’s properties, it’s easy to see why the company has outperformed
the market over the past six years. Each of their focus areas has outpaced the
national average in terms of rent growth. In San Francisco, the average
apartment rent has increased 91%, Los Angeles has increased 35%, and Seattle
has increased 57%. Granted these areas have experienced greater economic
prosperity than the rest of the country, these growth rates are simply not
sustainable. Real estate markets, like all markets, move in cycles. ESS has
asymmetrically positioned itself not only to benefit from this prosperity, but
also suffer from any slowdown.
Tech Bubble
Spillover - San
Francisco, which represents a large portion of ESS’s portfolio, has been one of
the hottest real estate markets in the U.S. over the last few years. The
re-emergence of the technology and venture capital markets has resulted in an
influx of high-earning renters to the area. ESS has directly benefited from
this external, cyclical market dynamic. Many industry experts are calling the
peak, including venture capitalist Mark Suster. A few weeks ago at Venture
Outlook 2016, Suster was quoted "our late-stage, privately held technology
market is clearly in a bubble… we’re doomed to repeat history. Boom and
bust."
The
current VC cycle has been fueled by non-traditional investors in search of
higher yields, given the low interest rate environment. Non-VCs led the vast
majority (78%) of funding rounds in the 80 $1 billion-plus companies in the
last 18 months. “When interest rates go up it's likely that non-VCs will stop
investing in startups so much and focus on more traditional asset classes
instead.”
An
article in Marketwatch last week also weighed in on the current bubble. “Only
12 tech companies went public in the first three quarters of 2015, the lowest
percentage of the overall IPO market since before the dot-com bubble formed.
Nearly half of the companies that did make it to Wall Street failed to live up
to their valuations, indicating that the late-stage venture investments of
recent years may have been overdone.” The Marketwatch bear case was summarized
with the following statement: “Wall Street just suffered its worst quarter in
four years, and many tech companies’ stocks have failed to live up to their IPO
prices; The next generation of hyped tech startups, while commanding
jaw-dropping private valuations, has been slow to go public; and layoffs have
begun at both heavily valued startups and their already-public older siblings.”
If
the Technology/VC market slows, which it appears to be doing, one would expect
occupancy rates and rent growth to also be affected. Jonathan Smoke, the chief
economist at Realtor.com, provided the following input. “Silicon Valley is one
of the markets that has the least amount of economic diversity… If tech
implodes there, the housing market will feel it.”
Apartment
Construction
– ESS has benefited from a lag in new multifamily construction in its focus
areas after the real estate crash of 2008. This supply constraint has led to
excess demand and exorbitant rent increases. As with any real estate cycle,
high rent prices attract new construction until the market falls back into some
semblance of equilibrium. Currently, there are over 135 developments
representing over 27,000 units recently completed or under construction in the
San Francisco area. In Los Angeles, there are over 161 developments also representing
over 27,000 units recently completed or under construction.
Raymond
James’ multifamily REIT analyst Buck Horne recently addressed the issue. “Horne
noted supply concerns, because new permits are up substantially in key Essex
markets of San Jose, Los Angeles and Seattle; he additionally mentioned a
higher cost of capital impeding accretive acquisitions moving forward.”
2015
has seen the highest level of multifamily construction starts since 1987. This
will help relinquish the demand crunch and, as often is the case with ill-timed
developers, eventually create an oversupply of units.
Leasing Cycle – Apartment REITs primarily deal
with short term leases, which are more sensitive to economic volatility. ESS
relies on a constant amount of high-earning renters to keep their occupancy
levels at 96%, while also relying on rent prices to progressively increase. Any
slowdown in this demographic would result in less demand, at more competitive
prices. When you couple this with the
new multifamily supply due to arrive, you have a dangerous cycle on your hands.
The short term leases would compound the problem in very short order.
Peer Comparison – Essex appears overvalued when
compared to its peers.
ESS
currently trades at 76x P/E ratio, while the overall industry average is 19x,
and close competitors like AVB and EQR trade in the low 30x’s.
ESS
currently trades at the highest P/FFO multiple of any major apartment REIT of
25.5x, significantly above the apartment REIT average of 20.1x.
ESS
currently offers a dividend of 2.8%, also below its peers and well below the
industry average of 4%.
Perhaps
the most accurate way to evaluate REITs is by Net Asset Value (NAV). Apartment
REITs have traded at an average discount
of 7% to NAV over the last eight months. Essex currently trades at a 2% premium, significantly higher than the
average and top of the peer set.
Sam Zell / EQR – Sam Zell, one of the great
real estate investors and ESS competitor, seems to think we are nearing a peak,
especially in the apartment space. He sold $5.3 billion worth of apartments
last week to Starwood. He called the previous real estate peak by selling $39
billion worth of properties to Blackstone in 2007. By 2009, the majority of
these units were underwater.
EQR
is using the funds to pay a special dividend, not pursue additional
acquisitions in the current market.
Anecdotes – Below are ancillary anecdotes
regarding the bear case for ESS.
Rent
Control – With the exorbitant rents pricing citizens out of affordable housing,
cities across the West Coast are considering rent control measures. This would
obviously be a worst case scenario for apartment REITs. Below is the ESS CEO
weighing in: “I commented last quarter that rent control is in ongoing
discussion in several West Coast cities. We continue to see plenty of media
coverage concerning the pace of rent growth and its relationship to income. The
city of Richmond California recently decided to pursue a rent control ordinance
although details remain in draft form.”
SF
real estate bubble - A recent article in Business Insider gave a telling example
of the current situation: “The couple who just bought a four-unit building in
what used to be a pretty scary block in the Mission — the kind of block where
you wouldn't have wanted to walk around alone at night unless you had your wits
about you — and is now renting the two-bedroom units out for $6,000 a month.
The owners got the money for the place by selling their successful startup.
Nearly all of the tenants work for startups or big tech companies.”
Conclusion – When you combine all the data
points and topics above, you see a pretty compelling case that the West Coast
is in a major real estate bubble. ESS is a pure play on this market that is
overvalued by every available metric, compared to its peers and other asset
classes. ESS is in the rare position of benefitting from multiple bubbles
simultaneously. When Sam Zell checks out, I’m not far behind.
