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Morningstar | Lower-Than-Expected Growth for Essex in Third Quarter, but Long-Term View Still on Track

While the consolidated portfolio for no-moat Essex Property Trust grew less than we anticipated in the third quarter, the company's joint ventures outperformed our expectations to bring bottom-line performance in line with our assumptions. As a result, we are maintaining our $259 fair value estimate for Essex. Rental rate growth continues to be strong and met our expectations with 2.5% growth for the total same-store portfolio. However, while we expected flat occupancy, Essex reported occupancy of 96.4%, which is down 30 basis points both sequentially and year over year. This led to revenue growth of only 2.2% and net operating income growth of 2.4%, below our estimates of 2.9% and 3.3%, respectively. This is a significant slowdown from the first half of 2018 that saw revenue rise 3.0% and NOI rise 3.3%. However, management narrowed fundamental guidance with our 2018 estimates of 2.8% revenue growth and 3.0% NOI growth still within management's updated range. We had assumed that the fourth quarter would see some deceleration, but management stated that they expect fourth-quarter revenue will be up 2.9%, higher than our 2.2% estimate, and that offsets the lower numbers seen this quarter. The company's joint ventures produced 3.7% more net operating income than we expected, which led to core funds from operations coming in line with our expectations for the quarter at $3.15. Essex raised the midpoint of Core FFO guidance for 2018 by 3 cents to $12.56, which is within 1% of our estimate for the year with the difference being explained by a one-time charge for campaigning against California's Prop 10 in the fourth quarter. Despite some lower-than-anticipated growth this quarter, we think there is still is plenty of growth to be found in Essex's West Coast-oriented portfolio.

Essex provided a preliminary outlook for rent growth for 2019. Management believes that U.S. GDP will grow at 2.5% and see 1.3% job growth in 2019. However, it believes that the West Coast metropolitan areas where the company's portfolio is located will outperform these figures with job growth of about 1.8%. Shortages in construction labor will push some of the expected 2018 deliveries into 2019, which should make 2019 supply growth similar to 2018. However, the West Coast has seen lower supply than the rest of the U.S. and it believes most of Essex's markets will see 1% or lower supply growth. Seattle at 1.8% supply growth is the one major market that it sees with higher supply, but it projects 2.6% job growth for Seattle in 2019, significantly above the U.S. and even its own portfolio average. Job growth outpacing supply growth should lead to healthy rent growth of 3.1% for its total portfolio with a range of 2.3% rent growth for Oakland to 3.6% rent growth for San Diego and San Jose. This is all in line with our expectations of 2.9% rate growth for the total portfolio in 2019 with the tech and biotech markets being at the higher end, so we are encouraged that management's preliminary guidance lines up with our own outlook.

Management also stated that rising construction costs, including labor, entitlement, and financing costs, are compressing development yields to the point that it does not currently believe that the company will start any new development projects in 2019. While we assumed that the company would start $200 million in new development projects in 2019, we had assumed that yields would be compressed and as a result removing that assumption has no material impact on our fair value estimate. Longer term, compressing development yields and rising interest rates should limit supply growth, so as long as these markets continue to see job growth we would expect demand to drive healthy revenue growth for apartments. Overall, there was nothing in management's preliminary guidance that changes our long-term outlook for the company.