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.