EUR 850.00 For Business Accounts Only

Morningstar | 2Q Results a Slight Miss for Essex Property Trust, but 2018 Outlook Improving

Essex Property Trust slightly underperformed our estimates for the second quarter, but 2018 guidance moved closer to our outlook, leading us to maintain our $259 fair value estimate and no-moat rating. The company's Los Angeles and San Diego properties were strong at 3.2% and 4.1% revenue growth, respectively, in line with our expectations. However, Seattle and the company's Northern California portfolio produced revenue growth below our expectations with actual results of 3.0% and 2.0%, respectively. The total portfolio saw revenue growth of 2.8% for the quarter, below our 3.4% estimate, and net operating income growth of 3.0%, below our 3.8% estimate. Despite being below our estimates, the West Coast markets continue to outperform the East Coast markets, leading Essex to outperform its apartment real estate investment trust peers for the quarter. Additionally, the company raised the midpoint of net operating income growth guidance for 2018 to 2.9%, closer to our estimate of 3.0% for the year.

Core funds from operations rose 5.7% year over year to $3.14, though this was $0.04 below our estimate. The miss appears to be from a combination of lower internal NOI growth and lower net external growth. While Essex sold a San Diego property for $132 million at a 4% cap rate, close to our estimate for the quarter, it did not acquire any assets in the quarter to offset the disposition. The company has not acquired any new properties this year as competition has pushed prices beyond what it believes is prudent, so it has reduced both acquisition and disposition guidance for 2018. We are glad to see that Essex hasn't chased deals and is willing to scale back external growth expectations if quality deals don't materialize. The company increased the midpoint of core FFO guidance by $0.09 to $12.53, only 1.1% below our estimate for the year. Despite the miss to our second-quarter estimate, we are encouraged to see Essex move closer to our predictions.

Essex continues to get a significant number of questions about California's Proposition 10 on November's ballot to repeal the Costa-Hawkins Rental Housing Act. A repeal of Costa-Hawkins is a potential major headwind for the apartment REITs, especially Essex, which has a significant portion of its portfolio in California. The law prevents local jurisdictions from implementing rent control on apartment units built after 1995 and mandates that the landlord resets the rent of a vacant unit to the market level once a tenant moves out. Many local jurisdictions (San Francisco, Santa Monica, Long Beach, and several others) want to set tighter rent controls to increase the number of affordable units as they are seeing the market rents price out the lowest-income portion of their populations.

Landlords like Essex have come out strongly against the repeal. They point to the fact that California has a major housing shortage and that new single-family homes are not being built because of lack of land and infrastructure along with California's recent push to focus on apartments in the state's Global Warming Solutions Act, which looks to reduce traffic and carbon pollution by putting high-density housing options near jobs. If the law were to be repealed, then development of apartments could effectively stop in those jurisdictions.

While there is some support from Democrats in the more progressive jurisdictions that formally instituted rent controls, we don't believe support for the bill is widespread. Outside of those jurisdictions, there is little support as voters won't benefit from the repeal and supporters of Costa-Hawkins are trying to educate voters on the negative economic impact to the state of repealing the law. The private market does not seem to think repeal is likely to occur, as there have been several acquisitions and dispositions in the jurisdictions that could be affected and the cap rates on those deals haven't changed over the past 12 months. If the market feared repeal were a realistic possibility, then prices for those assets would have dropped. While this is something that we and the apartment REITs will continue to watch, we haven’t adjusted our solid fundamental outlook for California yet.