ABOUT THE EPISODE
BRAD THOMAS: Hello everyone. It's Brad Thomas with iREIT, and I'm back again with another CEO Roundtable interview. Today, I'm happy, and honored, and pleased to meet with Mike Schall. Mike is the CEO of Essex Property Trust - that ticker symbol is (ESS).
Mike, thanks for joining us back here after the second quarter results.
MICHAEL SCHALL: Hey Brad, it's great to be here with you. It's always a pleasure, and I'm happy to talk about the second quarter, and what's going on at Essex. So thanks for having me.
BRAD THOMAS: Great. Well, I just want to start maybe high level. Some of our audience may not be as familiar with Essex as we both are, and of course you're just outside of L.A. - I'm in South Carolina. But we know that Essex is basically a sharpshooter focusing currently on the West Coast. Can you talk just high level about the composition of your portfolio - just so the first-timers or newcomers might not be familiar with your business model?
MICHAEL SCHALL: Of course Brad. Yes, we operate about 60,000 - 62,000 apartment units in the seven major metros along the West Coast of the United States. Really, Seattle is about 10,000 units, and then Northern and Southern California. And we're an S&P 500 company. We went public in 1994 and have a pretty distinguished track record - which you've written about in the past. And so I've personally been here for 30-something years and seen a lot of things come and go. So we try to focus on these markets because we think they're different. Generally speaking, incomes, wages, etc., and rents, grow a little bit faster here. And, as I'm sure we'll discuss on the call, there are definitely some unique challenges in these markets, as well. So - is that good enough, Brad?
BRAD THOMAS: Yeah. And I was actually gonna maybe ask you another related question on that - is about Seattle. I know Seattle has been in the news quite a bit, in terms of the protests, and some of the political angst going on in that market. Can you talk a little bit about some of that volatility? Obviously, all I can see is what the media reports, and sometimes I don't know if it - I haven't been there - so kind of tell us what's going on there, in those markets.
MICHAEL SCHALL: Yeah. You know, Seattle, like all of our markets, are places - a nice place to live. You know, people generally view it as a beautiful city, and an attractive environment, overall. It has a very dynamic and growing job base, which has included more and more of the technology companies that look to Seattle as a lower cost, sort of “hub,” for technology-related companies, and therefore, employees. And technology is really driven by companies that have aspirations that use technology - and the number of people that are available within the market that provide those activities. So both Northern California and Seattle have that. And so it's been a very good market for us.
I think you're referring to the most recent civil unrest in Seattle. And you know, fortunately that's a very small part of Seattle. It's a place that they called the autonomous zone - the Capitol Hill autonomous zone, and "CHOP" is another acronym. So, we actually had one property in that area. And I give our community manager credit up there for reaching out to the protestors in sort of a positive way. And so we had essentially no harm done - and that was disbanded recently. So, we just moved forward there, but I don't want to get too focused on that, because our portfolio is really throughout the entire Seattle metro, which is a large metro - more than 3 million people.
And most of our portfolio actually is on what's called the east side of Seattle, which are the towns of Bellevue, Issaquah, Redmond, etc. And so we don't have, I would say, any huge concentrations of property. Again, our strategy is to go to the areas that support higher rent growth, and then have a diversified portfolio in these major metros. So we don't seek to have a huge concentration in downtown Seattle - or any other metro - but rather, have a variety of properties ranging from, let's say "B-" to "A" quality properties throughout one of these large metro areas. So that's the basic strategy.
And Seattle has done well this year. In the first quarter, obviously, pre-pandemic, it led our portfolio with 4.7% same property revenue growth, versus the total portfolio, which was at 3.2% in Q1. And since the pandemic, it remains one of the strongest parts of our portfolio. And so we're still very happy with Seattle, and I guess I would draw attention to the tech industries - which again, a lot of the tech companies are expanded in Seattle. Obviously, you have Amazon and Microsoft that are headquartered in the Seattle area. And both of them, because of cloud computing with Microsoft, and certainly Amazon's online distribution and sales capabilities are amazing - so those are probably companies that are actually benefited by the pandemic, ultimately. And even though they've slowed down a bit, I think that they will come roaring back, and do very well.
So overall, we've found Seattle to be a very good market for us. We've been there for a long time. We've grown our portfolio there. And I think another key to this market is understanding all the submarkets - and it's really in the details - and it's a market that we understand very, very well.
BRAD THOMAS: Sure. Well recently, I wrote an article on Essex and referenced the L.A. market - and specifically the entertainment industry, which appears to be clawing back, somewhat. We've got "Wheel of Fortune" I think, is back filming now. But some of those - I think one of my wife's TV shows is not coming back. So I'm just curious, how do you see that entertainment sector within the L.A. market?
MICHAEL SCHALL: Yeah, I made comments on our recent Q2 call about L.A. and the entertainment business, and you're right: it was shut down. It's a very large part of Los Angeles, especially the Hollywood and mid-Wilshire area. And it has caused pretty significant dislocation in that market. I think I said on the call the unemployment rate in L.A. was 19.5%. So that is an extraordinary number. And it's - I think partially or a big part of that - is attributable to the entertainment business, and all the gig workers that that brings in - which of course, all have probably gone home, or left the area. So it has been an area that, over the long haul, has actually been one of the most consistent performers. And we look at the tech markets as really adding big growth - or alpha - to the portfolio. And Southern California is more like the United States, in terms of more diversified, etc. And this time, the pandemic has really tested those expectations, because L.A. is one of the most hard-hit of any of our submarkets within our portfolio.
But as you say, demand for content isn't going away. In fact, it's probably going to be pushed harder as a result of the pandemic - and people staying at home and wanting content. It has now been shut down - and it was a hard shutdown. I have spent some time looking at it, and the complications of trying to film things on a crowded set, amid a pandemic - is a big obstacle. And so it was shut down. It actually just recently opened up again. And as you point out - and I made some comments on the conference call - that it is starting to open up. The Screen Actors Guild, and some of the other organizations have developed a process for filming, amid COVID. And so, as you point out, it's coming back, but it's likely to be a slow, step by step process, from here on out. You know, again though, I mean, we have to look at this, I think, somewhat long-term, because if you have industries that are not going away - they're going to come back. And again, it seems like when I look at technology, I'm surprised at how challenged it's become in the tech markets. But at the same time, I feel very comfortable and confident that they will come back - as I do with L.A., and certainly the entertainment business.
BRAD THOMAS: Yep. Mike, I know we discussed this on the last call. You know, just the fact that this pandemic is certainly something that nobody has prepared for - certainly I would describe a Black Swan event - but now that we're in it, what steps have Essex and your company done, to stress test the portfolio in terms of demand - and what you're seeing out there, overall?
MICHAEL SCHALL: Well quite a lot, actually, Brad. So, you know, our board is a pretty engaged board, and so we are constantly sending them updates on what's going on with the portfolio, between regularly scheduled board meetings. And so, we have spent a fair amount of time stress testing the company. Initially, we didn't know what we were comparing it to, because no one's seen anything quite like this pandemic. And you know, obviously we had, I think about -14% job loss in our markets in April, and that has improved to about -10% by June. So pretty significant improvement there, but again, different from most other recessionary periods. So what we did with our board initially - and this will evolve over time - is we compared ourselves to where we were in the financial crisis and looked at, "Ok, how do we perform there? What are the balance sheet metrics? What do operations look like? How did we cover the dividend? And so, we spent a fair amount of time doing that, and talking to them.
Now in the financial crisis, market rents, over a couple of years, declined -15%. Our same store revenues declined about -3% in each year, in 2009 and 2010. So again, your reported results never catch up to market rents, because market rents decline and then they recover, and you have leases in place that buffer those changes. So, that's what happened. So we compare our balance sheet then, with having some idea of what could happen to market rents, evaluate our balance sheet versus a financial crisis, and we're in very much better condition now. And let me throw out a couple of things that will demonstrate that.
Leverage, to be simple - just on a percentage of total market cap - was about 35% in the second quarter of 2008, and that compares to about 29% last quarter. Average interest rate on our debt in the second quarter 2008 was 5.4%, and it's now about 3.4% last quarter. Obviously when you look at debt to EBITDA, that doesn't come into play. But when you're talking about dividend coverage, that's a major factor in dividend coverage, because our coverage ratios are so much different given the lower debt cost, then versus now. Back then, we mostly used secure debt, and so now most of our debt is unsecured - only about 5% of it is secured.
And finally, we went into this period - and again, none of us foresaw a pandemic on the horizon, but we just happened to be in very good shape in terms of our commitments. So, we have about $1.4 billion in liquidity, and that includes our $1.2 billion unsecured line of credit - many times what we had before. And as we look at our forward commitments to fund development pipelines and other commitments, we're fully matched with property sales that we announced last quarter. So I think we're in extraordinarily good shape, at this point in time.
BRAD THOMAS: Yeah. So in terms of your liquidity currently, how do you compare today in terms of that overall liquidity after the second quarter?
MICHAEL SCHALL: You mean compared to financial crisis?
BRAD THOMAS: Yes. Or just how you've - since we entered the crisis - how have you solidified your liquidity position, going into this current crisis?
MICHAEL SCHALL: Well, all of those things: essentially cleaning up our line. We just did a debt deal. We issued $600 million of 10- and 30-year paper, $300 million each. The 30-year unsecured bonds yield 2.66%. Again, $300 million. And we did a 10-year tranche: $300 million to yield 1.75%. In effect, that will repay all of the maturities through late 2022. And again, even though we don't think that probably that's going to be an issue - trying to just take off the table some of those risks was our objective in this. And then obviously having much lower financing costs going forward for a very long period, it's going to help core FFO - again, creating coverage for the dividend. So, we've done that.
But I guess more fundamentally, when you go back to selling - we sold three properties - I think we're the only ones that sold property amid the crisis. So these were actually contracted post-COVID. We sold three of them at nearly a small discount, let's say, representing the cashflow that was lost during the pandemic: you know, higher vacancy, more delinquency - estimating that cost and taking that off the top of the price. So a small discount to those asset values - and I think that's important because rather than relying on your line of credit, your funding, your match funding, your obligations going forward. And when we look at our forward commitments, again, to fund development - it's very nominal. You know, we don't have a big development pipeline taking all the debt maturities off the table.
So we're knocking them off one at a time, and trying to create a very stable balance sheet - because candidly, we don't know the course of the virus in the future, and all of us hope and believe that it will ultimately dissipate as a factor, but you know: we don't know. And so the thought was, "Hey, out of an abundance of caution, let's take some of these commitments off the table, and make sure that the company is well financed." And I would say that, hey - if there's a vaccine, or therapeutics continue to advance, etc., then we're still going to benefit from much lower interest costs going forward, for a long period of time. So, it seems like somewhat of a win-win type situation.
BRAD THOMAS: Right. So, I want to ask you a little bit about the business model. I know you touched on this, I think, in the latest earnings call, and that is: diversification. I know you've really centered on being this local sharpshooter on the West Coast - where that's always been a competitive advantage with the high barrier to entry business model. Is that changed? Is it as a result of COVID? And do you anticipate potentially looking outside of those core West Coast markets for other opportunities?
MICHAEL SCHALL: It's a good question. We go through a strategic planning process, which actually I'm right in the middle of, as we speak - my other job - we go through, with our board - and this is in September, and again in October - some of the key strategic issues that we face, as the world evolves. And every year, we have a list of potential other markets that we consider. And you know, we go through sort of the same analysis that we go through with our 30-some odd, submarkets on the West Coast that we're active in - with other major metros. And we're looking for a few things - and it's interesting, because if you boil down the United States into the things that really matter, as it relates to being an apartment company, it's all about wage growth. You know, you can't get higher rents if you don't have higher wages. And so, that's a very important factor. It's about supply and demand. So on the demand side, it's about job growth, and having properties that are in places where people want to live - good schools, low crime - all those factors that go into that.
And then, finally, the substitution effect has to be under control. So it can't be easy to transition from an apartment to a home. So in the areas that have very inexpensive, single family homes: effectively, rents are capped, because as soon as rents rise to a certain level, people make a different choice and go, "Well, I'll just buy a home." And especially when mortgage rates are where they currently are, a lot of people are going to be exiting apartments - to "for sale" housing. That'll be less an issue - probably on the West Coast - than it's going to be throughout the rest of the U.S. And so, those are the basic ingredients.
If you take those simple principles, and you apply them more broadly across the U.S., you end up with not that many major metro areas, and you narrow the scope pretty clearly. And then it comes back to - so more fundamental research: what have the long-term increases in rents looked like over long periods of time? And why has that occurred? Given each of those factors I just described, what's going on within these metros, that cause their results - to be their results - over long periods of time? So that whole process is ongoing. We do it every year. We have for a long time. It's interesting, because this year, in the middle of the strategic plan, the first whole section is COVID-related. It's all the different reactions that people have had. And whether they're going to be temporary or permanent, to what extent that things are going to truly change, and how does this affect us going forward? So it's going to be a very unique year for our strategic planning discussion.
And we will once again go through other potential markets, because I'm pretty sure that, you know, boards are going to be more interested in looking at diversification - even though I would argue, I think if you put California and Washington together, I think you have the fifth largest economy in the world. So it's a big place, and there's 40 million people in California. And so, I don't feel like we're a huge part of any market. And California is also unique in that it's not about a few large cities, it's really many small cities. So yes, L.A. is very, very large, for example. And so is San Diego as a city - and San Jose. But beyond that there are many little cities that are their own discrete political units that sort of buffer the effect to some extent.
BRAD THOMAS: Yeah, well, of course one of the things that is of most interest to me, and I think a lot of my readers, subscribers, followers, and all of those watching this video - is the dividend - and really the extraordinary dividend history of Essex, which has, I believe is it 26 or 27? - I can't remember - years in a row.
MICHAEL SCHALL: Yes, 26, I believe.
BRAD THOMAS: 26 years in a row. So, you know, dividend aristocrat in those terms. And over the years, you've not only grown that dividend - I'm just looking now at the earnings or Funds From Operations performance, going pretty far back over the last decade: you've had some really nice earnings growth, obviously 2020 being that outlier year with this pandemic. You're not gonna obviously grow at the same rate we've seen the company grow over the last, really, two decades.
But consensus looks pretty positive as well, for us. We rely on our analysis, but also other analysts. I would argue that this analyst - that would be me - is most interested in that dividend, because the retail investor really resonates around that, and really depends on that. Just like you depend on the rent checks to come in every month, I know a lot of REIT investors, certainly on our end, the true retail investors - can appreciate that dividend being a significant part of that total return process. So how would you discuss your dividend today in terms of the safety of that dividend, and taking that 26-year track record into account?
MICHAEL SCHALL: Yeah. You know, we often discuss the dividend - and really - priorities. And I guess I would say that you don't get to be a dividend aristocrat, unless it's a major priority that's bought into by the board, the senior leadership team. And hopefully in our discussion, we've demonstrated a lot of the things that we've done proactively to make sure that the dividend is safe - because as you well know, and I'm a student of your writings - and hey, it's important to the industry, it's important to the company, and it's important to the shareholders, for sure. So we 100% agree with that. And so I think that balance sheet, and the basic operation of the company and the management team, having all those people aligned, and the basic concept of the company aligned around dividend safety, is a super important thing. So we look at this often, and we're generally - housing, again is a basic human need, and therefore I think inherently less risky than some of the other property types. I think that gives us somewhat of an advantage. And yes, that doesn't mean that we don't suffer in periods of recession and other dislocations like the pandemic - which in effect, is leading to a recession - but we try to manage that, and build around it, by using the balance sheet.
So we talked about the balance sheet and compared it to the financial crisis. So I won't go back through that again, but maybe it would help us to go through maybe the income statement and just look at how that looked. And so in the first quarter, so pre-COVID - and we've withdrawn guidance for the rest of the year, because there's so many facets of this pandemic that we've never seen, and therefore we can't anticipate - which includes governmental actions, and eviction ordinances that are evolving, constantly changing vaccines, and stuff like that, which we have no ability to judge what's going to happen and foresee the future. So, we withdrew guidance. But let me go back to Q1. So we generated $3.48 in core FFO. You annualize that, it's about $14 in FFO. So our dividend is about $8.31. We're about 59% of the $14.
We've been through lots of recessions and lots of different things. I've been here since 1986. So we saw the S&Ls implode in the early 90s, we saw the dot-com boom/bust period. We saw the financial crisis. So we've been through a lot of things. There is nothing out there that would be so substantial that it would impact the dividend, in our opinion. I mean, again, you would have to believe that people just exit California, en masse, in order for that to happen. And the reality is, people are here for a reason, it's a good place to live for the most part. And you know, definitely it has its challenges, but you know, overall, people are here for a reason, and the tech companies aren't going away. You don't build a spaceship-type campus in Cupertino, like Apple did, and expect to move it anytime soon - and it's not. So that's going to anchor a lot of these tech companies - and the entire tech community is a unique phenomenon unto itself. So I just feel like the dividend is very safe. I feel like we have done several things: selling assets to fund our commitments, getting our debt maturities off - taking them off the shelf, keeping our commitments low in general. It's hard to imagine the dividend is at risk - at any level.
BRAD THOMAS: Yeah. Well, thank you for that. And I know another one of your - not direct peers - but certainly dividend growth peers: Federal Realty (FRT) - Dividend King - over 50 years of dividend growth, just increased their dividend. And I've said this a lot: "the safest dividend is the one that's just been raised." And that's a pretty meaningful word just to have that dividend growth, even if it's 1% or whatever modest amount.
The other line I like using a lot is a Howard Marks line, which is, "managing risk is what separates the worst from the best." And in terms of managing risk, I think we've covered a lot of this, but I want to ask you one last question, which - I've asked you this before on other calls, but I've got a lot - people always look out: "What's the next Black Swan?” And I know you've addressed this, obviously, and that's the earthquakes - and we just had a 5.5 earthquake here in South Carolina on Sunday. I slept right through it. That's pretty typical of me, but my kids felt it. But what's the way that your company kind of manages for that other, next risk, that obviously is - you're in that earthquake zone area.
MICHAEL SCHALL: Yeah, we are, and again, we haven't seen that Black Swan event - we've been through obviously many earthquakes, and we've had maybe a broken window. And I think part of that is because we do a lot of due diligence, and we've killed acquisition and development deals because of proximity to faults, and that type of thing. So we try to take it holistically.
And then on the building set, the higher the density is, the higher the building is - the more earthquake risk. So we carry about $200 million of earthquake insurance on those properties, recognizing that - go through this other process of plotting all the properties on the various fault lines and try to figure out where your maximum probable loss would occur. And then we buy insurance around that. So that's how we approach it. And I think it's a thoughtful process. Obviously, I gave a vast oversimplification of how we approach it, but those are the nuts and bolts.
BRAD THOMAS: Great. Well, Mike, again, I want to thank you again. Obviously, shares are still on sale. We're definitely pounding the table as well. We see that opportunity. Fundamentals really speak volumes for the deep value of Essex Property Trust, and a great job through this pandemic. And I really appreciate your time for this call. And I wish you all the best.
MICHAEL SCHALL: Thanks Brad. Hey, my pleasure. Look forward to seeing you soon.
BRAD THOMAS: You too. Thank you.
MICHAEL SCHALL: Okay. Bye bye.