Equity Residential (NYSE:EQR) Q4 2022 Earnings Call Transcript February 10, 2023
Operator: Good day, and welcome to the Equity Residential Fourth Quarter 2022 Earnings Conference Call and Webcast. Today's call is being recorded. At this time, I'd like to turn the conference over to Mr. Marty McKenna. Please go ahead, sir.
Marty McKenna: Good morning, and thanks for joining us to discuss Equity Residential's fourth quarter 2022 results. Our featured speakers today are Mark Parrell, our President and CEO; and Michael Manelis, our Chief Operating Officer; and Bob Garechana, our Chief Financial Officer. Alec Brackenridge, our Chief Investment Officer is here with us as well for the Q&A. Our earnings release is posted in the Investors section of equityapartments.com. Please be advised that certain matters discussed during this conference call may constitute forward-looking statements within the meaning of the federal securities laws. These forward-looking statements are subject to certain economic risks and uncertainties. The Company assumes no obligation to update or supplement these statements that become untrue, because of subsequent events. Now, I will turn the call over to Mark Parrell.
Mark Parrell: Thanks Marty. Good morning and thank you all for joining us today to discuss our fourth quarter and full year results and our outlook for 2023. 2022 was a terrific year for Equity Residential. We finished the year, as we expected, producing same-store revenue growth of 10.6%. We continued to see good demand during the fourth quarter, but certainly saw a return of seasonality to the business. Our strong 2022 same-store revenue growth combined with modest expense growth of 3.6% resulted in same-store net operating income growth for the full year of 14.1%. With continuing positive financial leverage, this led to a 17.7% increase in year-over-year normalized FFO. I want to take a moment, thank all my colleagues across Equity Residential for their hard work and dedication in delivering these terrific results.
In a moment, Michael Manelis will take you through our 2022 highlights and how we expect 2023 to shape up on the revenue side; and Bob Garechana will comment on bad debt and review our 2022 expense results and 2023 expense expectations, as well as recent balance sheet activities and then we will take your questions. We have provided guidance for same-store revenue growth at a midpoint of 5.25%, which would make 2023 another good year for Equity Residential and produce same-store revenue growth well above our long-term average. We do admit to finding 2023 harder to predict than usual. On the positive side, we go into the year, expecting a benefit from embedded growth of about 4.2% from leases written in 2022 and we also carry into the year and above average loss to lease, both of which will contribute to positive momentum for us, particularly in the first half of 2023.
We also feel good about the employability and earnings power of our affluent renter customer. There still appears to be plentiful employment opportunities for the highly skilled workers that formed the bulk of our residents as evidenced by last week's blowout January employment and job openings reports. We saw big increases in employment in the professional and business services category, a smaller gain in financial activities and only a modest decline in information services, all big employment categories for our residents. So far the announced layoffs at tech and some financial firms while certainly creating a negative environment have not manifested themselves much in the government's reported numbers, or thus far in our internal numbers.
We've only seen a handful of residents terminating leases early due to job loss. Possibly the impact is delayed due to severance and other factors. But it is at least equally possible that the workers in these categories are being quickly reabsorbed into the job market. Our renter demographic has proven resilient in the past, and we expect them to continue to be highly employable. As to renter incomes, according to the Atlanta Fed wage tracker, college graduates wages accelerated in the fourth quarter, outpacing wage gains achieved by hourly workers despite the higher base. Looking at competition from home ownership and new apartment supply in 2023, we also generally see a favorable picture. Homeownership costs and down-payment requirements remain high in our markets, especially relative to rents, making our product to better value.
According to the National Association of Realtors, for their affordability index to return to pre-COVID levels, one of three things will need to occur: The 30-year mortgage rate will need to decline to 2.6%; home prices to fall by 1/3, our family incomes to increase by 50%. This is all very consistent with our internal data, which shows the percentage of residents leaving us to purchase a home fell to 9.4% in the fourth quarter from 15.8% a year ago. On the apartment supply side, we expect 2023 national new supply to run at record levels. But we generally feel good about the direct level of competition that we will face given our market mix and importantly, the location of supply within markets relative to our properties. The Sunbelt markets, including the Dallas Fort Worth, Austin and Atlanta markets, in which we are increasingly investing and Denver, will see higher relative supply numbers in our coastal established markets and likely more impact, especially if that's coupled with a job slowdown.
In terms of supply in our coastal established markets, where we still have 95% of our properties. Our internal research indicates that new apartments delivered near to our properties create significantly more short-term pressure on our results. As we look at 2023's expected deliveries through that lens, new supply within close proximity to our properties in our coastal established markets is actually forecasted to be below pre-pandemic levels with only the Washington D.C. and Orange County market screening as delivering above average supply close to our properties relative to these pre-pandemic supply averages. And over the next decade, the significant net deficit of housing across the country sets us up for good long-term demand. We do, however, fully acknowledge that despite what was good GDP growth in the fourth quarter and full year and continuing strong employment reports, the Federal Reserve's rate actions are likely to pressure job growth and economic growth as 2023 progresses.
We took this into account in our guidance by assuming a lower rate of rental rate growth during 2023 than usual and a decline in occupancy. But whether there is or isn't a technical recession is of considerably less importance to us than whether job growth substantially declines and if so when. A decline at the beginning of our spring leasing season will be considerably more impactful than a slowdown later in the year. We also now expect that the elevated post-pandemic level of bad debt in some of our California markets does improve in 23 but at a slower rate than we previously hoped, as poor public policies encouraging delinquency continue. Bob will discuss all this in a moment. In sum, we make no prediction about a recession but have assumed some impact to our 2023 results from a job slowdown and flawed government policy and evictions, while continuing to see sources of strength in our business in the form of modest forward competition from home purchases and new apartment supply, the high employment ability of our residents even if the job market deteriorates from its current lofty levels, and the positive forward momentum from our strong 2022 results.
On the transaction front, there was not much activity in 2022 for us. We only purchased one deal and we sold three others, two in New York City and one in Washington D.C. We did start a handful of new developments. These were mostly in our Toll joint venture structure. As we head into 2023, the transaction markets remain unsettled, but we see higher than usual supply in the Sunbelt and Denver markets in which we wish to expand as hopefully creating buying opportunities for us later in the year. For now, our guidance does not assume any acquisition or disposition activity, but remain committed to our strategy of shifting capital out of California, New York and Washington D.C., and into our expansion markets of Denver, Dallas Fort Worth, Austin and Atlanta, as well as the suburbs and markets like Seattle and Boston, assuming appropriate opportunities present themselves.
And with that, I'll turn the call over to Michael.
Michael Manelis: Thanks, Mark, and thanks to everybody for joining us today. This morning, I will review key takeaways from our fourth quarter 2022 performance, expectations for 2023 and provide some color on the markets before I turn it over to Bob to walk through our financial guidance. 2022 same-store revenue growth of 10.6% was the best in EQR's history of nearly 30 years as a public company. Reported turnover for both the full year and the fourth quarter was the lowest in the Company's history, reflecting great demand that produced high occupancy and significant pricing power. In most of our markets, we had a supercharged spring leasing season with more robust pricing power that started earlier than usual in the year. Rents peaked in August, which is typical and then started to seasonally moderate, which is also typical.
The seasonal moderation was a little more pronounced than we originally expected and likely due to a combination of rents reaching such a high peak, along with less pricing power than expected as we ended the year. Given current uncertainty about the economy, including increasing layoff announcements, this moderation isn't surprising, though the January employment report that Mark just mentioned was very encouraging. Sitting here today, we have good occupancy with solid demand across our markets. Our dashboards and current leasing momentum continue to signal a normal spring. Let me take a minute and walk through the building blocks of our guidance range of 4.5% to 6% revenue growth. This is an updated look to what we provided in our third quarter management presentation.
Photo by Sidekix Media on Unsplash
So first, we start with an embedded growth of 4.2% for 2023. This is slightly below the midpoint of the range we talked about in the third quarter of 4% to 5%, but mostly consistent with expectations and takes into account the additional concessions used in the fourth quarter. Next, we expect strong occupancy for 2023 at 96.2% which includes a continuation of low resident turnover but is 20 basis points lower than that of 2022. Finally, we're assuming blended rates in 2023 will average approximately 4% for the full year. This assumption incorporates capturing our 1.5% loss to lease along with approximately 2.5% intraperiod growth in rates. This intraperiod growth assumes a positive impact from less overall pressure from competitive new supply and acknowledges some potential headwinds for a softening economy.
For your reference, in a normal non-recessionary year, we would expect intraperiod growth to be about 3% to 3.5% with us capturing about half of that gain in same-store revenue. The first half of 2023 will benefit from the momentum we had last year, while the back half of the year faces tougher comps and could feel the impact of the economy, as the year progresses. The contribution of this blended rate growth to revenue will be approximately half, as we capture it over the 2023 leasing season. Add all of that up and the implication is revenue growth over 6%, which would be exceptional after a remarkable 2022. The midpoint of our guidance range however is 5.25%, which is lower because we do not expect bad debt net to return to pre-pandemic levels in 2023, and it continues to work against us this year, due to a lack of expected government rental assistance and the extension of the eviction moratoriums in both LA and Alameda counties.
Bob will go into more detail on bad debt net, including our assumption in his prepared remarks. The outlook I just described is based on a belief that, while the economy may be slowing, our business continues to demonstrate a number of favorable drivers and resiliency. As we have often said in the past, we focus on our dashboards while also acknowledging the headlines. While keeping in mind that this is very early in the year, when we look at our dashboards today, the portfolio is demonstrating sequential improvement in both pricing trends and application volume, as we would expect, which by all indications is a typical pre-pandemic setup for the spring leasing season. New York and Boston will be two of our top performers in 2023, after delivering strong results in 2022.
In San Francisco and Seattle, we are seeing good demand and sequential improvement in pricing with slight reductions in both the quantity and value of concessions being offered since the beginning of the year. Even with this modest improvement, the overall level of concessions are still elevated, resulting in weaker-than-anticipated pricing power. San Francisco and Seattle have been slower to recover than the other markets, but both posted really good revenue growth in 2022. Both cities have been balancing a combination of quality of life issues in their downtown, which are getting better and a delayed return to the office from large tech employers. In addition, there have been some layoff announcements from companies based in these two cities.
These layoffs are a direct result of excessive hiring during the pandemic. This excess was spread across multiple markets and countries, not just Seattle and San Francisco. The remote nature of work in tech during the pandemic along with these hiring sprees, likely means that the layoffs are more geographically dispersed than in prior periods. Both of these cities remain hubs of the tech industry and share an entrepreneurial spirit that will continue to incubate the next big idea, be it AI or other innovations we find changing our lives a decade from now. The midpoint of our guidance range assumes that these markets continue to improve modestly as we get into the spring leasing season but overall weakness persists, which is why our intraperiod growth assumptions for the company overall are somewhat lower than the typical 3% to 3.5% range.
If San Francisco and Seattle get some traction this year, that could have a significant positive impact on our same-store revenue growth as could a more rapid improvement in bad debt net, leading us to the higher end of our range. Reaching the bottom end of our range would require either rate growth to slow much earlier in the year than expected or occupancy to dip to the mid-95% range for a sustained period of time. And lastly, before I turn it over to Bob to discuss our guidance, I want to spend a minute on our focus on innovation. On the revenue side, we will continue to focus on other income items like Wi-Fi, parking and amenity rate optimization. We will also leverage data and analytics to create opportunities to expand our operating margin.
We have been a sector leader in limiting same store expense growth, and this is attributable to our team's willingness to embrace innovation and initiatives focused on centralized activities. We are driven to get the most out of the portfolio and continue to have great success in creating efficiencies in our sales and office functions. In 2023, we will complete the centralization of onsite activities such as application processing, and our move-out and collection process. On the service side, we will continue to leverage our mobile platform to create more opportunities to share our resources across multiple properties. I want to give a shout out for our amazing teams across our platform for their continued dedication to the residents and focus on delivering these terrific operating results.
With that I will turn the call over to Bob.
Bob Garechana: Thanks, Michael. Let me start with bad debt, which should round out our thought process on same-store revenue guidance, followed up with a little commentary on same-store expenses, normalized FFO and the balance sheet. As Michael mentioned, the midpoint of our same-store revenue guidance assumes a 90 basis-point reduction in revenue growth due to the impact of bad debt. As we mentioned during last quarter's call, the biggest driver of this drag is the lack of rental relief payments in 2023 relative to 2022. Specifically, we received a little over $32 million in rent relief in 2022 that isn't in the numbers in 2023. And while we ended last year with more residents paying their rent than when we started the year, a trend that we would expect to continue, our forecast doesn't assume this will be significant enough to offset this lack of rental assistance.
Unfortunately, recent delays in lifting eviction moratoriums and slow processing within the courts led us to this more cautious forecast that reflects a more modest improvement coming later in the year than we had initially hoped for. We're hopeful that this caution might be unwarranted, in which case we could achieve the top end of our guidance range. But for now, we still expect delinquency to return to pre-pandemic levels, but more likely in 2024 than in 2023. Turning to expenses, I'm proud to report that in 2022, we once again continued to execute on our strategy of using technology and centralization to reduce exposure to labor pressures. Same-store payroll expense growth was negative for the second year in a row, and even when combining payroll with repairs and maintenance, a line item with significant labor exposure and product inflation, growth was below 3% for the second year in a row again.
Combine that with low real estate taxes and we were able to deliver industry low expense growth. For 2023, the midpoint of our same-store expense guidance is 4.5%. This forecasted growth rate is about 100 basis points higher than what I just described for 2022 but well below both inflation and our revenue guidance, meaning we expect 2023 to be another year of operating margin expansion for the Company. Of the four major categories of expenses, repairs and maintenance and utilities should grow at a pace slower than 2022, while real estate taxes and payroll should be faster. These latter two categories face challenging comparable periods given 2022's remarkable performance in addition to the following drivers: For real estate taxes, we expect municipalities will recognize the great strong income performance for multifamily in 2022 and as a result take a more aggressive approach to assess values and rates.
Total tax growth should be around 4%, up from 1% in 2022 with California continuing to benefit from Prop 13 at the low end of growth and expansion markets like Colorado, Texas and Georgia towards the higher end. These expansion markets are a small part of our same-store portfolio and the expected growth is consistent with what we underwrote on acquisition. For payroll, we expect 2023 growth to be around 3.5%, up from the decline of 2% that I just mentioned in 2022 and still well below typical wage inflation. We believe we can achieve this target through our continued discipline around staffing and optimization of our workflow. Turning to normalized FFO, page 2 of the release provides a detailed reconciliation of our forecasted contributors to NFFO growth.
Our midpoint of $3.75 per share includes a $0.01 of forecasted casualty losses from the California rainstorms that we mentioned in the release, and results in over 6% year-over-year NFFO growth, a very solid year for the Company. Finally, some comments on our planned financing activity for 2023 and the balance sheet. We mentioned in the past that we have an $800 million secured debt pool coming due, most of which needs to be refinanced in the secured market later this year. The current rate on the pool is 4.21% and the maturity is in November. The pool is very financeable, given it is roughly 50% levered and covers debt service nearly 2 times. We have favorably hedged more than half the treasury risk on the financing and would expect to be able to refinance later in the year at a 5% rate or better, which is also incorporated in our guidance.
After that, the Company has no maturities to speak of until June of 2025. We have low floating rate exposure, the lowest leverage in our history, significant debt capacity and ample liquidity supported by our recently recast revolver that will support our future capital allocation activities. With that, I'll turn it over to the operator for questions.
To continue reading the Q&A session, please click here.