The location of a real estate investment trust's (REIT) properties can be a huge determinant in its success. For a very long time, Essex Property Trust (NYSE: ESS) has been in good markets. But the pandemic changed things for this apartment landlord, and not in a good way. Here's some things you need to consider over the next three years that will help determine Essex's future.
The West is the best?
Essex was founded in 1971 and came public in 1994 with a focus on owning apartments in California and Washington. It has three core markets: Southern California (40% of net operating income (NOI): Ventura, Los Angeles, Orange County, and San Diego); Northern California (43% of NOI: San Francisco, Oakland, and Santa Clara); and Seattle (17% of NOI). In many of the REIT's properties there is ground-level retail. The key across all of these markets is that they are densely populated, wealthy, and have high barriers to entry.
Up until 2020 this focus had been a great advantage, given the technology-heavy regions in which it operated were growing fast. The best way to sum that up is Essex's impressive 25-year streak of annual dividend increases, putting it into the Dividend Aristocrat realm. You don't achieve a record like that by accident. It requires a consistent and well-run game book. But right now it looks like 2020 may have upended the REIT's so-far successful approach.
The key is that office workers have increasingly been working from home. And one of the fastest adopters of this approach has been the technology companies that dominate the regions in which Essex operates. It hasn't been pretty, with every single city in which the REIT operates seeing year-over-year revenue declines in the fourth quarter. Overall gross revenues were off by 8% compared to the same quarter in 2019. That's a troubling picture and resulted in a 12.5% drop in core funds from operations (FFO). Simply put, if you don't have to go to the office, why pay sky-high city rents?
Turning things around
With that backdrop, the real issue for Essex over the next three years is getting its business back on track. Right now it is granting rent material concessions to get people into its properties. While that's good for occupancy, it's not great for its top or bottom lines. And the pain will linger, since apartment leases generally run for one or two years. In other words, the next year or two could be tough ones for Essex's business, and there's no quick and easy way to change that. It will take time for the leases it's signing to roll off.
However, there are positives. For example, between the third and fourth quarters of 2020 there was an important change in direction, with gross revenue up just slightly between the two periods. Six of the 10 cities in which it operates started growing again. Clearly, Essex isn't out of the woods just yet, but the worst of the hit could be over. The big determinant will be when people start to return to cities for work and play. That, unfortunately, will be heavily driven by the direction of the coronavirus pandemic. It is a material wildcard, but history suggests that big cities will eventually rebound. Just don't expect the bounceback to be quick this time around, with three years probably being the earliest that a recovery in Essex's business might come around.
Meanwhile, Essex is still expanding. The apartment landlord has three properties in lease up. One is roughly 90% filled, another 75%, and the third around 50%. It probably won't get the rents it expected for these apartments, but they do provide some top-line growth potential here. That said, at this point, Essex doesn't have any new construction planned in 2021. Moving cautiously is probably a prudent decision given the economic backdrop and the three properties it's trying to fill. However, management noted during Essex's fourth-quarter 2020 earnings conference call that it's still looking at development opportunities. It's highly likely that it will eventually start building again, which will result in continued long-term growth.
It'll get worse before it gets better
When you look at the big picture here, Essex Property Trust is dealing with material headwinds thanks to the coronavirus. Over the next three years, that will weigh on its business. However, it seems like the worst may be over even though the timing of a full recovery will depend greatly on the direction of the pandemic. But, even there, Essex is still looking to expand using the same successful approach it has used since its founding. All in, three years from now it looks like Essex will probably be in a better position than it is today, though financial results may spend much of that time in recovery mode.