Picture Perfect: Essex Property Trust has built its reputation by offering high-quality multifamily housing on the West Coast. Pictured (from top): Hillsborough Park, Monterra Del Sol and Coronado.

Essex Property Trust builds on what it has always done best: focusing on West Coast, supply-constrained markets
By Lorna Pappas

In a real estate market characterized by dynamic change, Essex Property Trust, Inc. stands out for its unwavering focus on its core strategy. The company has stayed the course since it went public in 1994 with a fixed operating strategy executed by the same management team focused on the same, distinct market segment: supply-protected multifamily housing on the West Coast.

The upside investment potential of supply-constrained markets is not a new concept, but it is a strategic opportunity first recognized and pursued in the multifamily housing segment by Essex, according to Keith Guericke, president and chief executive officer of this fully integrated REIT. "Supply-constrained multifamily housing has been our core business strategy since our initial public offering in 1994, and we haven't strayed since," says Guericke, adding that other companies subsequently jumped into the market.

Essex has remained focused only on this specific market segment, steering clear of risks on secondary opportunities, such as technology, which can result in huge, extraneous write-offs affecting the entire capital structure of a company. Its fixed marketing approach has affected Essex's strong results, Guericke states. Financial results reported in February 2002 indicated a 10 percent annualized dividend increase, representing its fifth consecutive double-digit annual dividend increase. Funds from operation (FFO) for 2001 increased 13 percent, while net operating income (NOI) increased 9 percent per share compared to 2000. Revenue increased 15 percent in 2001 compared to 2000.

Economic Research Is Key

Essex Property Trust acquires, develops, redevelops and manages multifamily properties with a concentration on the West Coast, primarily southern California, the San Francisco Bay area and the Pacific Northwest. The company has ownership interests in 92 multifamily properties totaling 20,762 apartments, with 1,274 units in various stages of development.

Driving the company's market allocation decisions is a well-established economic research model with which Essex develops supply and demand data specifically for assessing multifamily housing opportunities. The model helps Essex identify and discern the relationship in specific regions between job growth and household formation, and the supply of households, as it pinpoints markets with an imbalance in favor of demand on a projected basis. "Based on the results of this economic research model, we determine where rents and occupancy rates will go, then either increase our concentration within that market, or sell out and redeploy capital elsewhere," explains Michael Schall, chief financial officer for Essex.

Essex Property Trust, Inc. Headquarters 925 East Meadow Drive Palo Alto, CA 94303 650-494-3700 President and CEO Keith R. Guericke Core Markets San Francisco Bay Area, southern California and the Pacific Northwest Founded 1971 Went Public 1994 Ticker Symbol ESS (NYSE) 52-Week High $54.67 52-Week Low $42.28 The Essex on Lake Meritt

A two-prong investment strategy fuels company activities. The first is a constant monitoring of existing markets, sustained by the research model. As part of due diligence in an acquisition, most real estate companies examine the local market with in-depth evaluations, "but we take it several steps further by continuing the process of market research and economic evaluations throughout the ownership period," Schall says. "Our investment philosophy is to update and monitor economic factors and results on a continual basis to be sure our capital is working in markets with the highest yields."

For example, in the early 1990s, not all West Coast markets were recovering from the recession at the same time. Based on its economic research model, Essex identified in advance of competitors a recovery in the north, where a majority of its investments were in force when the company went public in 1994. Similarly, in 1996, Essex saw Southern California recovering and was in the area 18 months ahead of other investors, reaping the best deals.

The second part of Essex Property Trust's investment strategy is a rigorous evaluation of new markets to identify areas with characteristics that underlie rental growth, again supported by its research model. "Most multifamily housing companies don't talk about the single-family business," Guericke says. "The fact is that in every market in the country where single-family housing is relatively inexpensive, this segment competes head on with multifamily. In markets where houses sell for about $150,000, it's easier for renters to make a jump from multifamily to single family than those where medium home prices run $450,000."

"Thus, we're more focused on markets than on product," reiterates Guericke. "If given a choice between a shiny new asset where demand is low and a 30-plus-year-old property in the heart of Silicon Valley, we'll take the latter."

In comparing itself to leading competitors, Guericke says Essex Property Trust does not adhere to a bicoastal strategy, nor to as strong an emphasis on development. "We are different from other multifamily REITs in that we retain a targeted focus on supply-protected West Coast markets, and a firm balance between development and acquisition/rehab, with unique and strategic acquisition/rehab transactions," Guericke says. "In many West Coast markets, the best areas are those with older housing stock, perhaps 20 or 30 years old. We significantly upgrade the financial profile, amenities and living experience offered by these properties, then charge more rent. We successfully use this strategy in difficult-to-build areas like the West Coast to redevelop approximately 1,000 units a year, creating for us a strategically attractive niche."

Dealing With a Down Market

As Guericke maintains, you can't fix a market, and indeed Essex Property Trust could not overcome the challenges presented when in the fourth quarter of 2001 the U.S. as a whole lost 1.2 million jobs. With demand slashed in many of its core markets, same store NOI growth declined 3.6 percent in the fourth quarter compared to growth of 2.4 percent in the third quarter of 2001. Further weakening of the market in the Bay area also negatively impacted results, as did deteriorating conditions in Portland, OR as well as in Seattle, where Boeing announced 30,000 layoffs. Rents have declined in Northern California and occupancy is down 3 percent to 4 percent across Essex Property Trust's portfolio.

"If given a choice between a shiny new asset where demand is low and a 30-plus-year-old property in the heart of Silicon Valley, we'll take the latter."

"We have reduced our 2002 and 2003 FFO per share estimates for Essex by $0.05 to $4.55 and $0.10 to $4.80, respectively, erring on the side of caution with regards to the prospects for a recovery in apartment markets," reports David Harris, a REIT analyst with Lehman Brothers. Harris adds that Essex Property Trust's FFO growth this year will come from acquisitions, disposals, interest rate savings and expected reductions in G&A costs. "However, while Essex's West Coast markets are under pressure, longer term imbalances of supply and demand in California remain in the company's favor. Moreover, we believe the company's focused management team has delivered past impressive results and is likely to do so again when markets turn."

As employment does pick up, fewer jobs are needed for occupancy and NOI to increase in Essex's supply constrained markets, where new supply represents only about 1 percent of existing stock. During the West Coast's recovery, even a conservative rise in employment will cause occupancy and NOI to leap as the limited supply is devoured. Conversely, in markets such as Atlanta, where new supply of both single and multifamily housing represents 4 percent of existing stock, many more jobs are required to produce a similar increase.

In the last two months of 2001, Essex Property Trust closed on one transaction and acquired ownership interests in five single property partnerships that own 844 combined units in Southern California. These investments had little impact on fourth quarter results, but should have an impact on 2002 performance. Also in 2002, Essex expects to invest $150 million in acquisition/rehab activities—though this is half of what Essex normally spends for these transactions in a year—and another $100 million in development.

Essex Apartment Value Fund

In July 2001, Essex diversified its capital resources beyond the public markets by forming the Essex Apartment Value Fund, a joint venture between Essex and several institutional investors wielding an alternative investment strategy of acquiring, developing and managing assets in the company's core markets. The fund closed at the end of February 2002 with approximately $450 million in available investment capacity and nine different institutional investors (including Essex) with combined equity commitments of $250 million. With leverage of approximately 65 percent of the value of the underlying real estate portfolio, the fund may acquire or develop real estate up to $700 million.

Essex focuses on properties in high-demand areas like Monterra Del Sol in Pasadena, CA.

Guericke says that the fund gives Essex access to a selection of capital alternatives, enhancing the company's ability to shift its acquisition, development and disposition activities to markets that will optimize the performance of the portfolio, thereby increasing shareholder value.

Essex's partners in this venture are large pension funds and are among the most sophisticated organizations from a real estate perspective in the U.S., according to Guericke. "Under the terms we were able to accomplish, the strength of this fund is an endorsement of our management, our investment strategy and the opportunities represented in the West Coast multifamily market," he says.

Steve Sakwa, first vice president of the Merrill Lynch & Co. REIT research team, agrees with the advantages of the fund. "The creation of the Essex Apartment Value Fund is testament to management's ability to find high return-on-investment opportunities," Sakwa says. "In the current environment, the fund structure will provide Essex with a platform to boost its return on invested capital by combining a higher use of leverage [65 percent versus Essex's on-balance sheet debt-to-total market cap of 35 percent] and the potentially significant fees generated from managing the fund."

At the fund's closing, it had acquired seven apartment communities totaling 1,877 homes with an aggregate purchase price of about $190 million (excluding development expenses) and two land parcels where 368 apartment units are planned for future construction.

Staying With What Works

Some of Essex Property Trust's best management decisions have been ones of restraint. One of the company's most effective moves has been its decision to remain focused on its core business, without being swayed by potential opportunities that are accompanied by huge risks. Guericke says an example of this was the "dot.com technology initiative, which Essex saw as having no substance."

In addition, remaining geographically focused has proven to be very valuable. Notes Guericke, "We had several opportunities outside of the West Coast, such as in Las Vegas, where we could have acquired properties that appeared promising as well as inexpensive, but deferred to our economic research model that indicated the investment would go nowhere. We have and will remain focused on the West Coast.

"We are not trying to become a huge company," he adds. "We could have raised capital and expanded more aggressively, but decided it was more important to remain at a size and growth rate with which we could best control the quality of our acquisitions and earnings. That's more important to us than being big."

Almost every company adhering to slow and steady growth looks back to opportunities it may have missed, and Essex is no exception. In the mid to late 1990s, there was a certain growth potential that Essex did not capitalize on due to the concern of higher risk—a decision it reflects upon but doesn't necessarily regret. "Yes, perhaps we could have been more aggressive at this time, but unless we are absolutely certain about a transaction, we are very selective and conservative buyers," Schall says. "By being more aggressive, some part of our philosophy may have been stretched, with strong, steady growth dangerously undermined by risk."

Schall adds that Essex's strong financial performance is not due as much to its transaction savvy as to its foresight in sustaining very few low or non-performing properties—due in part to restraint at not jumping at seemingly "can't-miss" opportunities.

Future Building on Strong Past

The Essex management team's ability to execute key decisions for the company and its shareholders comes in part from its long history of working well together. In 1977, Guericke became CFO of a corporate group of which Essex was a part, and in 1988 took over the Essex organization. Schall has worked with Guericke for 16 years, while John Eudy, executive vice president of development, has been with Essex for 17 years, and Craig Zimmerman, executive vice president of acquisitions, has served the company for 18 years.

"Given its overall longevity with the firm, Essex's core management team has a thorough understanding of the marketplace, including buyers, sellers, brokers and economics, allowing us to move rapidly on strategic opportunities," Schall says. "The primary benefit of our history together is that we all understand and believe in the company's strategy. Investment decisions can be made quickly with few surprises in the approval process."

Going forward, Guericke sees the future being guided by a successful past, with the same management team executing the same operating strategy in the same tireless, focused manner. Guericke foresees 2002 as a tough year for the entire multifamily segment, but predicts a growth spurt for Essex late in the year, with at least a 10 percent annual growth for the periods thereafter. Since Essex has achieved that target every year since going public, it seems like a goal well within management's reach for 2003 and beyond.