Avoid The 3 T's: Essex Realty Vs. Avalon Bay

Summary

• We'll be comparing two of the world's best multi-family apartment REITs to see whether one (or both) of these names make sense for investors to own.
• The primary risk that we see with ESS is its lack of geographic diversification.
• AVB's portfolio offers exposure to quite a few more markets than ESS's.
• Both ESS and AVB offer strong, safe yields, attractive valuations, high-quality portfolios and management teams, and above-average historical results.
• This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

If you've ever found yourself paying rent, you probably also found yourself wishing that you were the landlord, right?

It feels so bad to hand over a rent check every month, knowing that your hard earned money is building someone else's equity in the property that you inhabit.

Yet being a landlord is not exactly a simple or easy job to have.

There are taxes and maintenance costs (i.e., trash collection and toilet repairs) associated with owning physical property. Incidentally, that's what we call the 3 T's (taxes, toilets, and trash).

Source

There are tenant risks and periods of downtime in between them, meaning that the landlord has to foot the mortgage bill (the bank is not going to give a landlord a break just because they're in between tenants). And physical property is not a very liquid asset to own.

As the size of one's physical property empire grows, so do the problems, costs, and risks that might potentially occur. It's these problems, costs, and risks that drive so many would-be landlords into the REIT space of the equity market.

Sure, by doing so investors are not likely maximizing their return potential, but by passing along the responsibility of property management to well trusted and seasoned management teams, they're certainly making their lives much simpler and easier.

Life is short and stress is bad therefore, it oftentimes makes more sense to take the REIT route if you're interested in having exposure to real estate in your investment portfolio.

In this piece, we'll be comparing two of the world's best multi-family apartment REITs to see whether one (or both) of these names make sense for investors to own.

These two companies are Essex Property Trust (NYSE:ESS) and AvalonBay Communities (NYSE:AVB).

Essex Property Trust: Bullish Background

We've covered ESS several times in recent weeks. We've been very bullish on the stock. ESS is a dividend aristocrat with some of the best long-term total return metrics available in the entire market.

In short, here's a quick recap of why we view ESS as a blue chip SWAN in the REIT space:

• From ESS's IPO in 1994 to the end of 2019, the company produced compounded annual returns of 17% for shareholders.
• What's more, over this same period of time, the company has established a 26-year dividend growth streak and produced a dividend growth CAGR of 6.4%.
• This strong, long-term dividend growth growth was made possible by an 8.4% FFO CAGR since IPO.

That all sounds great, right? It certainly is. However, no stock is perfect and ESS comes with risks of its own.

Geographic Diversity

The primary risk that we see with ESS is its lack of geographic diversification. The company's properties are all located on the west coast of the United States, focused primarily in the Seattle metro area, northern California (San Francisco, Oakland, and Silicon Valley areas), and southern California (Ventura, Los Angeles, Orange County, and San Diego).

Source: ESS June Shareholder Update

Historically, ESS's focus on these geographic areas has led to its outperformance. Many investors may not even see the lack of geographic diversity as an issue due to the strong average income and job growth metrics that can be found in these areas which are anchored by large, cash-cow technology companies.

We continue to be bullish on ESS's focused geographic stance. In our recent exclusive interview with management, ESS CEO Michael Schall continued to express a high degree of conviction with regard to the strong long-term demand that he expects to see in those areas due to chronic underdevelopment and increased job demand.

However, we understand that COVID-19 is changing the way that the work place looks. It's likely that the work-from-home environment is here to stay. For instance, recently Facebook (FB) CEO Mark Zuckerberg commented on the changing environment and how it will effect his company in the short to medium term. In a live-stream video with his employees, Zuckerberg said:

We need to do this in a way that’s thoughtful and responsible, so we’re going to do this in a measured way. But I think that it’s possible that over the next five to 10 years — maybe closer to 10 than five, but somewhere in that range — I think we could get to about half of the company working remotely permanently.

This is a big change from his previous stance. For quite a while, the thought was that close proximity would result in close collaboration, which is why Silicon Valley has become the tech hub that it is today.

The Verge reports that up until recently, Facebook paid new hires a $15,000 bonus to live near its Menlo Park headquarters. But, as internet services, security, and global penetration increase, it's becoming clear to many in the big-tech world that connection via the internet is enough.

This has caused some to question whether the age-old system that ESS has relied on for demand is breaking. Ultimately, we have a hard time imagining that the high-demand areas like Seattle, Silicon Valley, and SoCal are going to see a mass exodus of workers anytime soon. However, COVID-19 has certainly presented a threat that was not widely present just a few months ago and investors should take heed.

This leads us to AvalonBay's portfolio, which is spread across the entire country.

• The New England region accounts for roughly 14.5% of AVB's portfolio, with approximately 11,200 homes in the Boston area and 1,400 homes in the Fairfield-New Haven area.
• Metro New York/New Jersey area accounts for nearly 19.9% of AVB's portfolio, with roughly 17,200 homes spread out fairly evenly across the Central and North Jersey areas, as well as Long Island, New York City, and suburban New York locales.
• The Mid-Atlantic region accounts for approximately 18.6% of AVB's portfolio. Of the 15,977 homes that AVB owns in this region, roughly 7,400 are in the Northern Virginia area. 4,040 are in suburban Maryland, 2,931 are located in Washington, D.C., and 1,562 are located in Baltimore.
• 15% of AVB's portfolio is located in Northern California. These 13,037 homes are fairly evenly distributed between San Jose, San Francisco, and the Oakland-East Bay areas.
• Roughly 21.7% of AVB's portfolio consists of homes in the Southern California region. The San Fernando Valley is the company's largest focus in No. Cal, with 7,759 homes. Los Angeles, Orange County, and San Diego represent the rest of the region with fairly evenly distributed exposures.
• 7% of the company's holdings exist in the Pacific Northwest region. All of these homes are in Seattle, Washington.
• And lastly, the company notes that roughly 3.3% of its portfolio comes from "expansion markets". This portion of the portfolio includes 1,332 homes in Denver, Colorado and 1,564 homes in Southeast Florida.

As you can see, AVB's portfolio offers exposure to quite a few more markets than ESS's. This spreads risk out a bit, with regard to specific job markets, local politics, and natural disaster threats.

Conservative investors may feel more inclined to own AVB shares because of this. However, the results that these two companies have produced in the short term, and over the long term results between these two companies speak for themselves.

Both companies collected roughly 95% of their rent in April. AvalonBay recently posted a May rent collection update, which included 94.4% rent collection (down from 95.3% in April).

We suspect that ESS's collection figure is likely to fall a bit as well, but ultimately, the multi-family rental sector is expected to be one of the strongest with regard to monthly rent collection data, moving forward throughout the COVID crisis.

Taking a step back and looking at longer term data, we see that both of these two companies IPOed in 1994. Since then, ESS has produced the aforementioned 17% compounded total returns whereas AVB has produced 13.3% compounded total returns. While there is nothing shabby about 13%+ annualized returns, it's clear that ESS has been the better investment to own over the long term.

Valuation

However, the past does not always signal future returns. We believe that both of these companies have stellar management teams that we trust to continue to generate strong results for shareholders. Highlighting high-quality companies/management teams is only half of the battle when making prudent investment decisions. The other half has to do with the valuation that the companies trade with.

Right now, AVB trades with a 17.4x blended FFO ratio, which is well below its long-term historic average of 21.1x. From the AFFO standpoint, we see that AVB is trading for roughly 18.9x its blended AFFO, which also represents a significant discount to its long-term average of 24.2x.

Source: F.A.S.T. Graphs

ESS, on the other hand, trades for 18.4x blended FFO, which is just barely below its long-term historic average of 18.7x. From the AFFO perspective, ESS trades for approximately 20.2x its AFFO, compared with its long-term average of 22.9x.

Source: F.A.S.T. Graphs

In recent years, we've seen ESS outpace AVB's bottom-line growth, posting annual AFFO growth of 9%, 6%, and 5% during 2017, 2018, and 2019, compared to AVB's 6%, 4%, and 2% performances during the same years.

Looking forward, the analyst consensus estimate also calls for ESS to post slightly stronger growth in the coming years as well, with expectations for 0% AFFO growth in 2020, 2% AFFO growth in 2021, and 9% AFFO growth in 2020, compared to consensus estimates for AVB's AFFO growth coming in at -3%, 1%, and 6%, over the same period of time.

In terms of y/y NOI growth, ESS also outpaces AVB, with 3.9% NOI growth reported in Q1 compared to AVB's 3% figure.

This higher growth rate is why ESS continues to trade with a higher multiple than AVB.

However, it is worth noting that AVB has a higher S&P credit rating (A-) than ESS (BBB+). AVB's long-term debt/cap rating is also lower, at 42% compared with ESS's 49%. These more defensive metrics should help AVB compete on a valuation basis - yet they don't, leading us to believe that AVB is irrationally discounted.

As we mentioned in our recent ESS focus ticker piece, we believe that ESS shares are trading for a fair valuation here in the 18.5x range. Yet, in terms of relative valuation, it does appear as though AVB offers the better deal. Whether you're looking at FFO or AFFO, AVB is cheaper head to head on a trailing basis, on a forward-looking basis, and on a relative basis when compared with its historical average.

Once again, this leads us to believe that more conservative investors may prefer the cheaper AVB shares.

The Dividend

But, what about the dividend? Landlords own properties because they want reliable checks coming in, right? We're well aware that the majority of REIT investors are income oriented investors and therefore, a safe and reliable dividend yield is paramount to the due diligence process in this space.

With regard to a reliable dividend, it doesn't get much better than Essex. The company has a 26-year annual dividend increase streak and while the company's yield is rather low, by REIT standards anyway, at just 3.4%, its annual dividend growth has historically been much higher than its peers.

This has resulted in fantastic yields on costs for long-term shareholders. However that is a backwards-looking metric, and being that ESS's bottom-line growth has slowed in recent years and will continue to do so because of the COVID-19 environment, we expect dividend growth to slow down here as well.

AVB has paid a dividend every year since becoming public, but its annual dividend increase streak is only nine years. While AVB's annual dividend streak may not be all that impressive due to a series of freezes, the company's long-term dividend growth CAGR certainly is.

Since its IPO in 1994 (the same year as ESS's) AVB has generated a 5.2% dividend growth CAGR. This is great, but not quite as nice as ESS's 6.4% dividend growth CAGR over this same period of time.

In the aftermath of the last two recessions, AVB froze its dividend. From 2002-2004, AVB maintained its dividend at $2.80/share. And, from 2008-2011, AVB maintained its dividend at $3.57/share. The fact that the company successfully navigated those choppy waters and continued to pay its shareholders leads us to believe that the company has the potential to do so again in this environment.

We've already seen many REITs cut and/or suspend their dividends during the COVID sell-off. Right now, the company's forward looking AFFO payout ratio is 75%, giving management plenty of wiggle room should rent collection data continue to get worse. With that being said, we don't expect to see AVB join the dividend cut/suspension list.

However, ESS's forward looking AFFO payout ratio is just 68%, giving that name even more room to potentially raise. ESS declared a 6.5% dividend increase in February of 2020, so it's not due for another increase announcement for quite some by. By next February, the company should have a much clearer picture of its forward-looking growth outlook, but either way, due to the strong dividend coverage and the strength of its cash flows, we wouldn't be surprised to see another mid-single digit increase in early 2021.

In early February, AVB posted a 4.6% dividend increase. While this figure trails ESS's, it still outpaces inflation by a wide margin and we find no issue with a 3.93% dividend yield growing in the mid-single digit range.

ESS wins the dividend growth and dividend safety battle here, but AVB does take the prize in terms of dividend yield. We find both dividends to be attractive and most importantly safe, meaning that either company could be well suited for a conservative dividend growth investor.

Conclusion

At the end of the day, we find both ESS and AVB to be attractive REIT options for investors looking for exposure to the multi-family apartment building space. When attempting to pick and choose between the two companies, with regard to which will be a better investment, the simple answer is, why not own both?

We realize that this is a bit of a cop out, but not everything in the market is a head to head competition. There doesn't have to be a winner and a loser. There are relative pros and cons to each company, but when comparing the two, we didn't see a glaring weakness or strength that really set one out apart from the other. As investors, we're free to partner with as many high quality names as we like.

Both ESS and AVB offer strong, safe yields, attractive valuations, high quality portfolios and management teams, and above average historical results. Both names have done a great job of collecting rent and growing their NOI during the beginning of the COVID crisis. And, we believe that both companies have situated themselves in market leading positions that make them blue chip, SWAN names to own.

By owning both, you will have exposure to real estate many of the best cities and strongest job markets in the country. And, you'll own stocks that appear likely to generate reliably increasing dividends. What's not to like about this?

Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

Analyst’s Disclosure: I am/we are long ESS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.