So it’s not surprising when he says Essex Property Trust, the Palo Alto–based, West Coast apartment REIT where he’s CEO, no longer has Eastern ambitions. He gets the question a lot, given Essex’s success in the high–barrier-to-entry markets of Northern and Southern California and Seattle, paired with its 2006 failed pursuit of Washington, D.C., metro player Town and Country, which eventually went to Morgan Stanley.
Now, after gobbling up San Francisco–based BRE in a $4.9 billion stock-and-cash deal that closed April 1 and eliminated Essex’s largest competitor in its core markets, it’s fair to ask the question again. As the largest apartment operator on the West Coast, and with the BRE portfolio in tow—making Essex the third-largest apartment REIT overall and earning it a berth in the S&P 500 for the first time—will Essex look eastward to join bicoastal operators such as Equity Residential, AvalonBay, and UDR?
In a word, no.
“For all intents and purposes, we’ve decided to stay focused on the West Coast,” Schall says. “We’ve found a good niche within the industry, and we’re going to continue to pursue that. We’re not going to try to be another bicoastal company that has more competition and less differentiation.”
Of course, a laser focus and disciplined approach are exactly the things Essex is known for. Founded in 1971 by multifamily savant George Marcus of Marcus & Millichap, the firm has grown to third-largest in the apartment REIT universe through a straightforward approach of systematic research and investment analysis that puts living, breathing boots on the ground in all of its markets to troll for the next undervalued opportunity. By the time the rest of the multifamily world started to key in on coastal, high–barrier-to-entry markets in the mid-2000s, Essex had already been doing exactly that for decades.
Those moves have not only earned Essex’s management a reputation as among the best in the business, but shareholders have been rewarded too, to the tune of a 2,355 percent total return since the firm went public in 1994. The average among its peers during the same period is less than a third of that, or 667 percent.
“Investors regard the Essex management team as one of the best, if not the best, in the apartment REIT group,” says David Bragg, an analyst at Newport Beach, Calif.–based real estate research firm Green Street Advisors. “One of the reasons for that is their ability to allocate capital so successfully.”
For instance, in the mid-2000s, when Southern California was hot and Northern California markets had cooled, Essex sold a southern portfolio to UDR and reinvested that capital up north.
“If you look back over the last several years, it’s clear that that allocation of capital out of SoCal into NorCal was very well timed,” says Haendel St. Juste, a REIT analyst with Morgan Stanley. “They timed it well ahead of the recovery, and, today, NorCal is a much stronger market.”
A Tale of Two Neighbors
It was that ability to allocate capital so effectively while coming up aces in development and operations, that finally helped consummate the BRE deal. Those were the differentiating factors that set Essex apart from the company it would consume, even though the two firms were founded within a year of each other and had largely always operated in the same markets: More than half of BRE’s holdings were within two miles of an Essex property when the deal was announced.
Yet, despite a shared geography and common birthrights, over the years, from a financial perspective, the companies grew farther apart.
“Both companies went public around the same time at around the same price,” says Alexander Goldfarb, a REIT analyst with Sandler O’Neill & Partners in New York. “But Essex’s stock price was eventually three times that of BRE’s. For two companies in the same market to have a 3X difference, it shows that whatever is happening at one is not happening at the other.”
As that gap widened, the two companies occasionally talked about potential deals. But nothing ever came of it, to the frustration of investors.
“For years, BRE had resisted change,” Goldfarb says. “It almost started to seem like change would never happen, just because it never had.”
And it almost never did.
In fact, just three months before the deal was announced on Dec. 19, Schall reported to the Essex board that he wasn’t optimistic that a potential business combination with BRE was possible.
“For most of the last 10 years, I don’t think that we could have been competitive in a bid process for BRE,” Schall told MFE in the days before the deal officially closed. “It wasn’t preordained, and it wasn’t something that was just likely to happen.”
Instead, it came about the way that nearly all of Essex’s deals have materialized: by knowing its markets and competition extremely well, while having ample access to capital, mixed with nearly constant persistence. This is the story of how that persistence finally paid off, after years of trying.
Located in the heart of the Uptown Urban Center, Essex’s 275-unit Expo Apartments resides in Seattle’s Queen Anne neighborhood. PHOTO: Mike Seidl
Years in the Making
Most investors would peg July 31, 2013, as the day bidding commenced for BRE. That was when investor John Litt of the long/short fund Land and Buildings blindsided the BRE board with a scathing, open letter detailing the firm’s underperformance and castigating it for rejecting his offer to buy it for $60 a share.
The significance of that date? Litt released the letter just hours before BRE’s regularly scheduled quarterly conference call with Wall Street analysts.
But BRE’s eventual sale to Essex had actually begun more than a year prior. In July 2012, Schall reached out to BRE CEO Connie Moore to discuss a possible business combination between the two companies. Of course, that kind of talk had occurred between the companies in the past, though SEC filings state nothing serious had been discussed for at least the past five years.
On July 16, the pair sat down in San Francisco and had the first real conversation that would lead to a deal. Schall said Essex would be interested in creating a combined company. Moore noted that BRE’s same-store revenue growth had underperformed its peers, but that she felt BRE’s significant development pipeline, which then included six communities coming out of the ground simultaneously, hadn’t been fully valued in the company’s stock price. She then pointed out that in past overtures, Essex hadn’t been willing to pay a premium on BRE’s stock price.
While the two executives didn’t come to any concrete terms at that meeting, a dialogue had begun. By the end of August, Schall had sent Moore a letter proposing a “merger of equals.” More importantly, though, he said that after evaluating BRE’s development pipeline, Essex agreed with Moore’s assessment, and said Essex would be willing to consider offering BRE a 5 percent to 15 percent premium on its stock price (then trading around $50 per share).
Yet, when Moore took Schall’s proposal to her board in September, it balked. The board concluded that Essex hadn’t actually committed to paying a premium, only that it was open to the possibility. It directed Moore to let Essex know it appreciated the company’s offer, but it didn’t think selling would be in the best interest of shareholders. At its October retreat that year, the BRE board instead decided to forge ahead with a strategic plan to increase the company’s value as its new developments came on line through 2015.
Meanwhile, Schall was not deterred. In December, he sent another letter to Moore, with an offer price of $53 per share. At around the same time, news reports surfaced that Essex had bought about $70 million worth of BRE’s stock. Then, Essex board member Janice Sears called BRE board member Jeanne Myerson to lobby for a deal as well.
When the two met, Sears confirmed the investment in BRE, noting that Essex held shares in a number of multifamily concerns. While unstated, the message was clear: Essex was intent on buying BRE, one way or another.
But at its December meeting, the BRE board decided it still wasn’t ready to talk with Essex and assigned chairman Irving F. “Bud” Lyons III the task of communicating the news to George Marcus, Essex’s chairman. He did, and Moore simultaneously sent a letter to Schall demurring Essex’s overtures once more.
Thus, the dance continued into 2013. By that time, Essex and Schall weren’t the only ones chasing BRE’s skirt tails. In April, a pension fund approached BRE, and in June, John Litt made a verbal offer of $60 per share, contingent on BRE entering into exclusive negotiations with him (BRE’s stock hit a low of $47.09 on June 21). Then, in July, another multifamily operator, referred to only as “Company A” in SEC filings, joined the mix. Moore scheduled a meeting with that company for Aug. 1.
But before that could happen, Litt’s letter went public July 31.
BRE’s response, via press release, was curt: “As we understand it, Land and Buildings operates an investment fund with less than $200 million in total assets under management, which has neither the capital capacity nor demonstrated transaction experience to execute an acquisition of BRE. Accordingly, Land and Buildings’ proposal received today does not evidence a viable opportunity for the Company to consider.”
It’s Just Lunch
Within two weeks, Schall managed to get what an increasing number of suitors were now after: a lunch date with Moore. At that meeting, he told her that although Litt had contacted him, as well, Schall wasn’t interested in doing business that way. He also made it clear Essex still had its dogs in the hunt, and even named a preliminary price that “started with a six.”
At the same time, Keith Guericke, Essex’s vice chairman and former CEO, met with Lyons to further shepherd the emerging deal. On Aug. 30, Schall called Moore to reiterate the $60 offer and propose entering into a mutual nondisclosure agreement to start seriously discussing terms. Everything was looking to be in Essex’s favor.
Then the wheels came off.
Moore wouldn’t have it; she noted that her board’s next strategic retreat wasn’t until the end of October, and that she couldn’t enter into an exclusive agreement before then. Discouraged, Schall made a dour report to the Essex board that he wasn’t optimistic about a deal happening between the companies.
But then, seemingly out of nowhere, the BRE board did something it had never done before: It finally said yes. At its October retreat, after discussing its progress on its strategic plan to realize the value of its pipeline, the board came to the same conclusion investors like Litt and companies like Essex had been telling it all along: It was time to sell. Within a day of the meeting, the board opened up a formal process to invite interested parties to look at the company. Essex was at the top of its list.
In total, BRE solicited seven companies to peek under its bedcovers. Four of them, including Essex, signed nondisclosure agreements to do so.
But the other suitors ultimately walked away without making offers because they all wanted to cherry-pick. They only really wanted BRE’s premium growth properties, and none of them was willing to take on BRE’s laggards to do a deal. Nope, only Essex and Schall, the company and CEO with deep roots in BRE’s own California backyard, were open to swallowing the entire company whole. And why not? Essex had plenty of experience turning well-located but lagging West Coast properties into outperformers.
When the deal was finally announced Dec. 19, 18 months after Schall had reached out to Moore and years after the idea had first blown in the wind between the companies, the final price came out to $4.9 billion for BRE in a cash-and-stock deal that put BRE’s shares at $63.05 apiece.
Mike Stedman, head of commercial banking and real estate at San Francisco–based Union Bank, who has worked with and known Schall for 20 years, wasn’t surprised by Schall’s steady pursuit of BRE.
“He never panics,” Stedman says. “If he has a conviction around something that makes sense to him, it’s nothing personal. He’ll always be able to come back to the table and talk about making it happen. He’s a very humble guy, and that’s a personal attribute people want to do business with.”
All Grown Up
Now, with the complete assets of both companies under his command, Schall says he hopes to find more West Coast gold among them.
“Hopefully, we can leverage our strengths and the legacy of success that we’ve brought forward since the founding of the firm, in 1971, and apply that to the BRE portfolio,” Schall says. “They’ve always had some great properties, and we’re going to look for locational synergies to run the entire portfolio more efficiently.”
For the most part, investors have faith he’ll do just that.
“I think it’s a great outcome,” says Litt of Land and Buildings. “BRE underperformed its peers for many years, and it was either fix it internally or sell it to a best-in-class operator like Essex. I think Essex and Mike are going to be able to drive meaningful outperformance
from the BRE portfolio.”
But there is one sticking point. Last November, at Essex’s Investor Day, Schall told Wall Street that the optimum size of his firm in net asset value (NAV) was $10 billion or less, in order to retain the agility and focus that has been its hallmark. Now, the company has essentially doubled in size, to $15 billion in assets spread among 56,000 units at 239 properties. In hindsight, Schall says when opportunity knocks, you’ve got to at least answer the door.
“We were invited into this small group of people to bid for BRE,” he says. “It required us to re-evaluate and look at Essex in the context of a transformative transaction. We came to the conclusion that shareholders were better off pursuing this opportunity.”
He notes that the firm’s primary financial goal is still to improve cash flow and net asset value per share, and that it hopes to do so through the operational efficiencies that are unique to these overlapping portfolios.
“I think what’s different for us is we now have both size and significant scale, but within a more limited geography—really, in our own backyard—that we know so well,” Schall says. “I think that’s the other piece. By staying on the West Coast, it’s the area we know best. I think it’s where we can really continue to be nimble, identify opportunities, and act on them appropriately.”
If history repeats itself, that should be exactly what happens.
Joe Bousquin is a contributing editor based in Sacramento, Calif.