Equity Residential Properties Trust (EQR) — Q3 2023 Transcript

Thank you, Martin. Good morning, and thank you all for joining us today to discuss our third quarter 2023 results. As you can see from the press release and management presentation, the business continues to do well in most of our markets, with our East Coast markets outperforming our West Coast markets. New York, Boston, and Washington, D.C., comprising a bit more than 40% of our net operating income are all having very good years and are meeting or exceeding our expectations. Our target renter demographic remains well employed. Unemployment for the college educated is at 2.1%, with increasing pay levels and a continuing high propensity to rent, given elevated single-family ownership costs, low for-sale inventory and lifestyle reasons like delayed marriage and smaller families that favor our business. We're also seeing lower levels of new apartment construction in most of our established markets where we have 95% of our net operating income versus the Sunbelt markets, a pattern that will continue for the next several years. Consistent with this view throughout the primary leasing season, our pricing followed a trajectory that was pretty typical for a normal pre-COVID year. And as you can see in the management presentation, on par with our guidance assumption, the normal rent seasonality would return in 2023. We saw our portfolio-wide rents peak in early August and then begin to decelerate as we expected. However, we recently saw a deceleration in pricing in San Francisco and Seattle that was more pronounced than usual seasonal patterns. The main culprit here seems to be a lack of job growth for our target renter demographic. Michael will have more detail on this as well as the building blocks for 2024 that are laid out in the management presentation in a moment. In Los Angeles, we are working through the impact of a drawn-out process to normalize delinquency levels and to reduce bad debt. We continue to make good progress here, portfolio-wide bad debt before application of rental relief funds in the third quarter was about 1.3% as compared to 2.4% in 2022. But the process is uneven, and it is lengthy. Evictions are now taking six months or more in Los Angeles versus the two to three months prior to the pandemic. Given the underperformance in San Francisco and Seattle and the lumpiness and improvement in bad debt as well as the impact from the noncash write-off of a $1.5 million straight-line rent receivable in the quarter due to the bankruptcy of Rite Aid, which is a retail tenant of ours, we have adjusted our same-store revenue guidance expectation for the year to 5.5% from 5.875% at the previous midpoint. We have also adjusted our EPS, FFO, and NFFO guidance accordingly. Turning to 2024, the long-term health and outlook of our business remains positive, with favorable tailwinds that should support performance. While job growth expectations for 2024 are lower than 2023 levels, we'll continue to benefit from demand from a well-employed resident demographic. We think they are going to rent with us longer, given the cost of single-family ownership and powerful social trends like delayed marriage and smaller families that I previously mentioned. We also see a significant benefit from lower deliveries of new supply in our established markets compared to the elevated deliveries in the Sunbelt markets over the next few years. Switching to capital allocation. While the overall market remains quiet, we did have some activity in the quarter. We sold a 30-year-old asset in downtown Seattle during the quarter at a 5.4% disposition yield as we continue to lighten the load in the urban centers of our West Coast markets. We also continued to invest in our expansion markets by acquiring two assets in suburban Atlanta. One property was built in 2019 and was acquired from a large private equity real estate player. The transaction is a 5.1% acquisition cap rate, including the impact of the mark-to-market on some low-cost debt that we assumed as part of this transaction. This property is located in an upscale mixed-use development, though we acquired none of the retail with a resident base having high-paying jobs at the large education and medical employers nearby. The other asset we acquired is in Gwinnett County, with easy access to the I-85 employment corridor, and was acquired for $98 million. This asset is brand new and is still in lease-up, and we expect it will stabilize at a 5.4%-year two acquisition cap rate. The median home price in the desirable area where the property sits is $600,000 which, assuming a normal down payment in current interest rates, equates to an all-in housing cost at 2.5 times our pro forma rents. Median household incomes in the area and among our residents at the property are around $100,000, making rentership a good financial and quality of life decision. It is important to note that our 2023 acquisition activity was paid forward capital from our asset sales without incurring any dilution as we took a cautious approach to transaction activity given the pricing uncertainty and low volumes in the marketplace. We sold properties that averaged 30 years old, which we expect will have more capital needs and lower go-forward IRRs than the properties that were acquired, which were one year old on average. We are well positioned to further our portfolio diversification by taking advantage of acquisition opportunities that we believe are likely to arise from the substantial development pipeline that is delivering in our expansion markets over the next two years.

Thanks, Mark, and thanks to everyone for joining us today. This morning, I will review the third quarter 2023 operating performance in our markets, our outlook for the remainder of the year, and some views into 2024 that we included in our management presentation. We continue to produce very good results with residential same-store revenue growth of 4.4% in the third quarter driven by generally healthy fundamentals in our business and some improvement in delinquency, although not as much as we expected. The East Coast markets continue to outperform the West Coast. Demand and occupancy remain healthy, especially across our East Coast markets and absorption in our results in the Washington, D.C. market continue to impress. As I will discuss shortly, San Francisco and Seattle are experiencing more pricing pressure than we previously expected. Before I get to that, let me touch upon the October leasing spreads, new lease, renewal, and blended. The stats we published through October 27 captures almost all the month's activity, and as we mentioned, are consistent with seasonal declines outside of Seattle and San Francisco. New lease change is negative, which is normal for the month, and will continue to get more negative as pricing trend continues to decline for the balance of the year. In a normal pre-pandemic year, by the time you get to December, it is not uncommon to see new lease change be negative 4% or 5%. Given the weakness in our Seattle and San Francisco portfolios, we will likely be slightly more negative than that. Renewal rate achieved should moderate slightly, but remain relatively stable and make up more of the transaction mix. Put it all in the blender and Q4 blended rate will continue to moderate. In terms of the specific conditions on the ground in San Francisco and Seattle, as we stated previously, we have had little to no pricing power throughout the year. However, the peak leasing season did demonstrate an increased volume of demand and some moderation of concession use, which led us to what we initially thought could be the beginning of better stability. Over the last six weeks, however, these markets have slowed more than normal, which has resulted in larger price reductions than seasonally expected, characterized by both declining rates and increased concession use. This is most pronounced in the downtown areas of both markets, though there are other suburban pockets experiencing pressure like Downtown Redmond in Seattle. The uncertainty of back to the office from the big tech employers, combined with their slowdown in new hiring is keeping a lid on demand. In order for these markets to fully recover, we will need to see the vibrancy that comes to these areas when the offices are active, employment increases, and residents want to enjoy the city lifestyle and easy commute to the office. Both cities are making progress on improving the quality of life issues, and we are seeing signs that a few of the major tech employers are slowly adding positions back, especially in Seattle. However, the improvement in both these areas needs to accelerate in order to generate enough migration to these markets which will allow pricing power to return. While recognizing challenges in these two markets, overall, our business remains healthy. Even with these now muted expectations, 2023 is on track to deliver very strong same-store revenue growth with several positive trends that we expect to continue into 2024 and support our business. First, our residents remain in good shape financially with rent-to-income ratios remaining at 20% portfolio-wide. Resident lease breaks and transfer activities to reduce rent, often early indicators of resident economic stress remain below pre-pandemic levels and in line with seasonal expectations. Overall, the job market and our residents remain resilient, which we expect to carry into 2024. Our resident retention remains very good. Turnover in the portfolio remains some of the lowest that we have seen. Single-family home purchases continue to be an expensive housing alternative, especially in our established markets. In fact, only 7.5% of our residents who moved out cited buying a home as the reason in the third quarter, which is one of the lowest numbers we have seen since we started tracking the data back in 2006. At this point, we are not seeing anything to suggest that the overall turnover rate in the portfolio will not remain low. As I mentioned earlier, the demand side, generally, the employment picture, particularly for the college educated, remains solid and supportive of continuing demand into 2024. While the high-quality job creation machine in San Francisco and Seattle recently paused, longer-term fundamentals support the potential future growth. On the supply side, overall, we are favorably positioned, particularly compared to those concentrated in the Sunbelt. We should benefit from less direct competitive supply pressure in most of our established markets while D.C. will be about the same and Seattle will have elevated supply in 2024. When looking at new supply as a percent of inventory, there are significant differences between the overall Sunbelt and our expansion markets as compared to our established markets. The average new supply as a percent of total inventory in our established markets is around 2%, which includes the Seattle market at 4.5%, which is the only outlier both on an absolute percent basis and relative to historical norms. Meanwhile, the Sunbelt markets are forecasted at just around 6% and our expansion markets range between a low of 4% in Atlanta and a high of nearly 10% in Austin, which will result in pronounced supply pressure. This shouldn't be overly impactful for us since only 5% of our NOI is located in these expansion markets and, in fact, may present acquisition opportunities for us as financially stressed developers sell properties. So, putting all of these factors together, our overall revenue outlook for 2024 right now anticipates solid growth led by the East Coast markets. As you can see in the management presentation, our embedded growth going into next year is trending slightly above pre-pandemic norms and loss to lease is generally in line. With bad debt net, it is hard to predict the exact amount of tailwind from improvement, but our view is that we will continue to gradually work our way back towards pre-pandemic levels. The eviction process is taking twice as long as it did pre-pandemic, and this speed is not yet sufficient to both clear the backlog and allow for the new typical volume of evictions to be processed. That said, we see no decline in the credit quality of our resident and their propensity to pay. We continue to believe that we will see meaningful improvement in 2024. In addition to the tailwind from bad debt net, we expect to see some incremental lift from several of the operating initiatives that we have in place around renewals, parking, connectivity, and other income opportunities. Moving to expenses, which continue to trend in line, we would expect our 2024 same-store expense growth to be slightly below this year. We will feel continued pressure on the repair and maintenance lines with some of the new technology fees like Smart Home and Wi-Fi, although the comparison period from 2023 is pretty high, which will help offset some of that growth rate. Insurance is clearly in for another significant increase. And right now, we expect real estate taxes to be higher than this year, but nothing that will create too much overall pressure. Some of the growth in these expense categories will be mitigated by continued operating efficiencies in the payroll line being created from our centralization initiatives. Let me wrap up by saying that the apartment business continues to be good with favorable demographics driving demand and limited new supply in most of our markets. We will continue to enhance our operating platform to take advantage of the opportunities that the markets present while delivering a seamless customer experience to our residents. I want to give a shout out for our amazing teams across our platform for their continued dedication to their residents and focus on delivering these results. With that, I will turn the call over to the operator to begin the Q&A session.

Thanks. Good morning. Michael, could you elaborate on the October numbers for the new side? If we look at the implied change, excluding Seattle and San Francisco, the number only decreased by 30 basis points. This suggests that those markets experienced declines in the high single digits to nearly 10% in October, indicating that rents are down along with some concessions. Are we interpreting that correctly? I’m trying to understand what caused the market to decline so significantly, particularly in the urban core compared to the suburban areas.

Steve, this is Michael. So yes, you are thinking about it correctly. When you look at the October new lease spreads and you drill into Seattle, San Francisco, and I kind of put the expansion markets in there as well, they are running in the new lease change rate in the high negative single digits. If you drilled into San Francisco and Seattle, I'll tell you about 400 basis points of that is driven from the increased concession use. So, you can almost look at that negative 8%, negative 9%, and split it in half and say half is from increased concession use. The other half is from rate. Some of that rate decline is really a function of who moved out, when did they move in, but the rates are down about 2%, 2.5% in those markets on a year-over-year basis. And if we drilled in even deeper into there, it is heavily concentrated into those urban cores of both Seattle and San Francisco. But as I said in the prepared remarks, the suburbs aren't completely immune from it. When you went around San Francisco, we are using some concessions on the East Bay concentrated in Alameda. But when you look at the value of the concessions, we're up at like six weeks, call it, 55% of the applications receiving six weeks in Seattle and San Francisco, which is very different than what you see in the suburbs, which are running less than a month.

Great. And then just maybe a follow-up on the transaction market. Mark, you sort of talked about maybe starting to see some increased activity, particularly in the Sunbelt. I'm just curious where that transaction market is? Where is the bid ask? I know you're sort of maybe a little bit indifferent on cap rates based on where you can sell. But just how are you thinking about pricing? And how have you maybe changed your underwriting?

Steve, it's Alex. Over the summer, it seemed like things were stabilizing around a 5.25% to 5.5% cap rate. However, the last two months have brought significant changes. With the rise in tenure, the current market situation is quite unclear. While there are transactions being completed, they reflect pricing from the summer rather than now. We're all trying to navigate this uncertainty. There are only a few properties available for sale, and no one is certain what cap rate corresponds with what sellers are willing to accept versus what buyers deem as acceptable returns. Consequently, there is noticeable upward pressure on cap rates. We are constantly assessing pricing. As we've mentioned in previous calls, we closely consider replacement costs, and there may be some attractive opportunities. We believe that as time progresses, there will be increasing pressure to sell, leading people to adapt to a new market reality, especially in high supply areas, particularly for those with capital exposure or maturing debt. We anticipate more market activity as it stabilizes over the next six to nine months.

Thanks. On your bad debt, if the court process had been as quick as you thought, I guess how much more would have bad debt been down from the current 1.27%? And once you're through with the bulk of evictions and court proceedings, where would that take the bad debt?

Yes. Eric, it's Bob. So, had it kind of progressed as fast as what we would have thought instead of having, call it, a 1.27% in the third quarter, we probably would have been about 10 basis points ahead of that and would have trended closer? So, the trajectory that we were hopeful that we were going to get to. And what we're just seeing, as Mark mentioned and Michael also mentioned in their prepared remarks is that it's just taking longer, right? And so, as the residents are staying longer with us as they go through the process, we're incurring more bad debt overall. We do have excellent transparency and excellent visibility into who's where in the cycle. So, who's where in terms of where they are in court cases, who's awaiting lockouts and all of that stuff, but we don't have great visibility into when exactly those proceedings are going to occur. As Michael mentioned in his prepared remarks, going forward, we do expect that at some point, this will accelerate because the backlog from the pandemic era will be worked through, and that we, at some point, will be able to get back to that 50 basis points, particularly given the fact that the credit quality of our customer hasn't changed, but it's harder to swag where we're going to end up on a full year basis.

And Eric, it's Mark. Just to add to that. We certainly hope 50 basis points is where we end up. But I would say that the fact that in some of these markets, the process has been maybe more permanently elongated because of either right to counsel and funded rights to counsel in some of our markets and just general, more bureaucratic effort required to get through it, you may have folks, and that's what Michael was alluding to in his remarks. We aren't seeing more delinquency with our new residents. We're seeing what I'll call the normal amount. But usually, they'd be out in a month or two. And now it's just taking longer, and that means they're going to hit our bad debt reserve. They're still leaving. But I just think again, we feel like the credit quality has not changed from all we can see, but the underlying bureaucratic process and regulatory environment has and it may be that we end up pointing to something modestly higher than 50 basis points going forward, again, not because the customer changed but more because the process did.

First question is on the transaction market. It feels like private market pricing, particularly in the Sunbelt has been very slow to adjust to the reality of higher rates, but also declines in market rent. So, curious in recent quarters, have you considered setting a complete pause on these one-off acquisitions in the Sunbelt? Or are you considering that going forward until more distress flows through the private market?

John, it's Mark. I'll start by saying that we have been matched funding that. This year was quite modest for us, with around $350 million in buys and sells. Frankly, we have paused our acquisition activity. The deals you saw closed were priced back in early second quarter, with one going through a lengthy loan assumption process and the other having a drawn-out lease-up and closing process. So, we are not making any purchases at the moment. What you see in the release reflects ongoing activities. We may consider putting a few more assets up for sale as we always evaluate market conditions. We will continue executing our strategy of reallocating capital. However, before we decide to buy assets at the current prices, we plan to let the market stabilize a bit or look for favorable opportunities. Yes. Thanks, John. So, I'll give a little color on that. I'm not going to be able to be terribly specific because it is pending litigation and giving you a range is something I'm just not able to do. But we are the only ones facing these sorts of issues; both public and private competitors of ours in Northern New Jersey have these litigation concerns. In our case, the particular matter you're talking about in Jersey City, there was a ruling in our favor, actually a year ago, that these properties, these two towers were exempt from rent control by an administrative entity that administers these rent rules. The decision that was announced a couple of weeks ago was by a politically appointed board that overruled the bureau's original decision here, and we completely disagree with that. And we're going to go and litigate that in the courts and have our say there and try not to talk about it too much in the press except to say, again, we think whether it's in Northern New Jersey or elsewhere in the portfolio, we follow the rules of the road. We feel like we comply with, whether it's rental control rules or notice rules or whatever they may be in all these markets; those rules are complex. They're ever-changing. We've got a great legal team, a great operations team that follows up on all that. So, I don't have any sense of an overhanging doom, but I think this is another sign of just political pressure that's manifesting itself in litigation in some of these markets rather than in just going through the process of trying to influence your public officials to change the rental rules.

And Mark, maybe just continuing that theme on the Jersey City. You and I have chatted before on the risks of tax-exempt deals and deals that have incentives that years or decades later could come back to bite. So, in thinking about this, do you still see the appetite for EQR to pursue deals, especially in politically charged municipalities, deals that have tax incentives as worth the longer-term risk? Or what's going on here is your view is, hey, when we underwrite these deals, even if we shave off a few points for the risk for the political risk, going after these tax incentive deals are still economically worth it?

Yes. Thanks for the question, Alex. I go up a level and say political risk. So, when you look at these markets, it's more about us managing political risk in these markets and our feelings about regulatory matters. In New Jersey, I think, is a market. We are rational capital allocators that is probably disqualified itself from material additional investment by us in terms of development or new asset acquisitions because some of these regulatory things are coming out of left field. They're really not the result of incentives, these particular ones, incentives on construction. What was done is these were placed in a state where for a number of years, they were exempt from local existing rent control rules. And that's what this whole discussion is about. It's not about sort of a 421-A type question, just to be clear, but I get your point. For example, in Atlanta, almost everything built there has a tax incentive. That tax incentive is really well understood. We priced it in there at the beginning. We understand the cap rate and we understand what happens at the end of the deal in terms of the incentive going away 10 years in or whatnot. So I guess it's more of an indicator of these different lawsuits of political risk and places that I think for us and for others, will be less attractive to allocate development capital or acquisition capital and places like Atlanta where you feel more comfortable with political risk, and it's just really an underwriting exercise to price the tax benefit in the deal that the city did with good reason to try and encourage affordable housing in that market or at least buildings that have affordable components.

And then the second question, by the way, Mark, just speaking of political risk, obviously, rents being down shoots a hole in the whole yield star litigation argument. So, I guess, yes, there is a positive at our third quarter earnings, but thinking about Seattle and San Francisco, those are two markets where the downtowns continue to suffer and have issues recovering. By contrast, the issues in the Sunbelt are really, there's a lot of supply this year, into next, and then that supply goes away. So, as you think longer term, it almost seems like the resolution of Seattle and San Francisco, to your point, is political, and it's unknown for the recovery, whereas the Sunbelt is known because you can see the product delivering and that there's nothing behind it. So, again, think about EQR and capital allocation, are you guys still comfortable in the belief that Seattle and San Fran downtowns will recover? Or at what point do you sort of throw up your hands and go, the traditional recovery isn't there, we have to think differently this time?

Yes, thank you for the great question. To start, I believe that the Sunbelt will experience significantly less supply in the next three years, but that doesn’t mean there won't be additional supply in the future. This trend has held true throughout various cycles. I want to provide some thoughts on San Francisco and Seattle before summarizing my views. It's essential for us to maintain a long-term perspective as we are long-term investors in these markets. Regarding San Francisco, this area has historically been one of the best-performing large markets in the U.S. for rent growth over long periods. It has high housing costs, substantial barriers to new supply, and often experiences significant job growth. Historically, it has been a highly desirable location for our residents, though recently that appeal has diminished somewhat. Proposition 13 helps limit real estate tax increases, which is our largest expense, so the market fundamentals remain strong. However, it is a volatile market, which is why we have indicated since 2018 our desire to reduce exposure. Volatility does come with its rewards; for instance, in the two years following the global financial crisis, our same-store revenues in San Francisco decreased by over 2% annually for two consecutive years. However, in the subsequent five years, those revenues increased by an average of 9% annually, indicating that our shareholders benefited from accepting that risk. I believe the job market conditions in San Francisco could improve quickly, especially with the expected growth in the artificial intelligence sector, although I acknowledge there is a prolonged recovery process in place. Our management team tends to be optimistic, and some indicators we observed mid-year suggested a recovery was imminent. We still hold hope for that recovery. Concerning capital allocation, we have decided to scale back our downtown presence, as demonstrated by the asset we sold in San Francisco this quarter. Despite this, we value our exposure to the tech industry there, as we still believe it remains the tech capital of the world. The situation in Seattle is quite similar; it has shown solid performance over time. In retrospect, we experienced an average decline of approximately 4% in that market for two years after the financial crisis but rebounded with over 6% growth annually for the next five years. The volatility there, too, brings potential rewards. Our current strategy involves shifting focus from downtown to the suburbs, and we intend to keep that momentum going, while still having faith in the Seattle market. Overall, both management and the Board have confidence in these markets. We do feel somewhat overexposed to San Francisco and have acknowledged this, particularly in regards to downtown areas. However, we believe that the demographic of high-wage earners – who are less susceptible to job loss from AI and automation – will experience significant pay increases and be able to manage inflation risks. We are directing our capital with this demographic in mind, and I share your eagerness to see improvements in these markets.

I'd like to get some clarification on a comment you made earlier in your remarks that it's not uncommon to see new lease rate declines of minus 4% to minus 5% by December. And given the weakness in San Fran and Seattle, that you expect you'll be slightly more negative than that. So, am I correct to read that you're implying that your entire portfolio, new lease rates that you expect to be minus 4% to minus 5% or potentially weaker? And then what does that sort of imply for these rates you're expecting for San Fran and Seattle by that point? Thanks.

Yes, this is Michael. To provide some historical context, when we refer to historical norms, I’m mainly looking at the years 2017, 2018, and 2019. Typically, in October, new lease changes would range from a decline of about 1.5% to 2%. In November, that would drop to around 3% to 4%, and by December, it would be about 4% to 5%. Currently, for October, we are seeing a decline of 3.1% due to the influence of San Francisco and Seattle and the significant concessions we're offering in those markets. As we look towards the fourth quarter, I anticipate our new lease change for the entire quarter will be close to a decline of 4%, but for December, based on current observations, we might see a drop of 5% or slightly more. Overall, for the quarter, I estimate new lease changes will be near a negative 4%. Renewals have remained stable and surprisingly perform better than expected, with net effective changes on renewal increases holding steady at around 5%. When combining these two factors, the blended result would be approximately 1.25%, give or take around 10 basis points.

Just wanted to touch base on the same-store CapEx, you increased it again to $3,600 per apartment unit. I looked back like a year ago, I think it was like $2,600 per apartment. Just kind of curious what's going on there? What are you guys seeing? And if there's any shifting from like same-store expenses into CapEx buckets or just rising costs?

Yes, you're correct. The increase was due to several factors that I will explain, but it is not related to reallocating expenses into capital. Instead, we began the year believing that investing in our portfolio was a more attractive use of capital than pursuing acquisitions or development, and we prepared a substantial budget. I typically account for some delays in construction, as things often take longer than expected, and our projects have remained on schedule during the first half of the year. We had an unexpectedly productive summer, which resulted in completing more work than anticipated. Additionally, we incorporated some return on investment projects, particularly solar panel installations that became available to us mid-year and promise good returns. We also dealt with some storm damage that extended into the third quarter, and we've accelerated the installation of smart rent technologies. Looking ahead, we anticipate returning to a more normalized spending rate next year, and again, this is not related to any accounting changes.

Yes. So, we are really quite pleased with our operating numbers. One of the things we talked about during this call is evolving our strategies in these marketplaces and looking through the lens of, like, for example, in Seattle and San Francisco. So, relative to new lease changes that historically have been relatively pure in nature, it's very much about like what's going on in that market.

Okay. Got it. So, if I could, as a follow-up to that, with your CapEx plan, are you anticipating any shifts from non-discretionary to discretionary? I know you mentioned earlier on other calls your balance sheet was solid, so are you keeping back still on that spending?

We have to think through how much of our CapEx goes into discretionary versus non-discretionary. I wouldn’t say we’re pulling back 100%, but we also want to make sure we don’t overallocate capital on individual projects if we can avoid it. As you expect, we’ll spread the costs out and look out into 2024-2025 to see how our financial situation develops.

So while we're looking for opportunities on single-family purchases as mentioned, we see stability in many of our markets, especially in the East Coast regions. Therefore, we'll continue to monitor market conditions tightly as we pursue growth on primary housing and residential housing to capitalize on trends in new construction.

Thanks, Jennifer. I want to thank everyone for their time and interest in Equity Residential today, and look forward to seeing everyone on the conference circuit over the next few weeks. Thank you.