A Dividend Aristocrat to Buy That’s 21% Undervalued and Yields 4%

It’s not easy to find cheap dividend aristocrats as the market hits new highs, but Essex Property Trust ESS fits the bill. This residential REIT with a West Coast focus is facing a short-term slowdown in rent growth, which led us to clip our fair value estimate after incorporating fourth-quarter results. Yet we expect Essex to experience solid long-term internal growth. We also think its balance sheet is sound and its dividend payout ratio is appropriate. We assign the shares a $290 valuation; they currently trade well below that.

Essex Property Trust is the most geographically focused multifamily real estate investment trust, with a portfolio of high-quality multifamily buildings positioned entirely on the West Coast: Los Angeles, San Diego, San Francisco, San Jose, and Seattle. These markets should experience strong, long-term demographic trends like job growth, income growth, decreasing homeownership rates, high relative cost of single-family housing, and attractive urban centers that draw younger populations, which allows the company to maintain high occupancies and drive rent growth above the US average. Long term, we expect Essex’s markets to see job and income growth above the national average, which should continue to support above-average net operating income growth, though some of these markets are experiencing near-term slowdowns. The company’s solid internal operating outlook should be supplemented by its small but opportunistic development pipeline to create value for shareholders.

Key Morningstar Metrics for Essex Property Trust

• Fair Value Estimate: $290
• Star Rating: 4 Stars
• Economic Moat Rating: None
• Uncertainty Rating: Medium

Economic Moat Rating

We don’t believe Essex has an economic moat. Despite the positive demand drivers for Essex’s markets and assets, intense competition for high-quality assets in strong markets drove up initial capital investments for the company’s portfolio. Additionally, high supply growth in many of the company’s markets and ever-present competition from alternative housing options keep rent growth in the low to mid-single digits. Essex acquired its portfolio at low initial cap rates, and the realized internal growth rate isn’t high enough to exceed the company’s weighted average cost of capital. We calculate that over the past few years, Essex has averaged an adjusted return on invested capital approximately 210 basis points below our 7.3% WACC. While adjusted ROIC rises over our forecast horizon as assets stabilize from recent transactions and developments, it does not exceed our WACC estimate, affirming our view that Essex’s portfolio should be assigned a no-moat rating.

Read more about Essex’s moat rating.

Fair Value Estimate for Essex Stock

Our $290 fair value estimate implies a 4.7% cap rate on our forward four-quarter net operating income forecast, 19 times multiple on our forward four-quarter funds from operations estimate, and 3.4% dividend yield based on a $9.80 annualized payout. Our rent, occupancy, and margin assumptions drive total company annual same-store NOI growth averaging 2.5% across our 10-year forecast. We expect continued acquisitions and dispositions as Essex recycles capital, repositions its portfolio, and improves the overall quality of its assets. We project $200 million in dispositions annually at an average cap rate of 5.0% and $100 million of acquisitions at 4.5% cap rates as the company looks to recycle lower-quality assets to fund the acquisition of higher-quality assets. Additionally, we expect Essex to continue to invest in new development and redevelopment projects at a 6.0% average yield.

Read more about Essex’s fair value estimate.

Risk and Uncertainty

The multifamily real estate market on the West Coast has benefited over the past decade from demographic trends such as a falling homeownership rate, the rising relative cost of single-family housing, and urban gentrification. These trends are driven by the tastes and desires of millennials, whose behavior may change as they age and acquire enough capital to own single-family homes. The reversal of these trends would negatively affect apartments, and this could happen quickly since most leases run for only 12 months. Demand for apartments in any market is sensitive to changes in the economic health of that market. A downturn in the tech industry would significantly affect the economies of Northern California and Seattle, as well as the fundamentals of Essex’s assets in these markets.

Read more about Essex’s risk and uncertainty.

Essex Bulls Say

• Essex’s portfolio benefits from strong job and income growth and limited supply growth in its attractive West Coast markets.
• Essex’s high-quality assets should see relatively consistent long-term demand from high-income earners and will likely see just a small hit to fundamentals from the pandemic, as most residents have not experienced job losses.
• Supply growth should be kept in check as rising construction costs and tighter lending standards should reduce the number of projects that are started.

Essex Bears Say

• The pandemic made millennials consider alternatives to urban apartments, including suburban apartments and single-family homeownership. This demographic has put off many major adult milestones but may finally be making the shift toward the suburbs.
• Given short leases and a competitive housing market, demand for apartments can be more volatile than many other commercial property types.
• Concentration in the San Francisco and Seattle markets leaves Essex exposed to the possibility of weakening fundamentals if the tech industry goes through a downturn.

This article was compiled by Susan Dziubinski and Sylvia Hauser.