Equity Residential Properties Trust (EQR) — Q4 2018 Transcript

Thank you, Mary. Good morning from the Polar Vortex and thanks for joining us to discuss Equity Residential's full year 2018 results and outlook for 2019. Our featured speakers today are Mark Parrell, our President and CEO; Michael Manelis, our Chief Operating Officer; and Bob Garechana, our Chief Financial Officer. Please be advised that certain matters discussed during this conference call may constitute forward-looking statements within the meaning of the federal securities law. 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. And now, I'll turn the call over to Mark Parrell.

Thank you, Marty. Good morning, greetings from chilly Chicago. It’s negative 21 degrees right now, with a minus 50 degree wind chill. Although the weather is quite cold, our business feels quite strong and we will take a few moments to discuss it. We’re pleased to have delivered same-store revenue growth at the top end of our original guidance range, as well as solid normalized FFO growth in 2018. We had strong momentum in the fourth quarter, and 2019 has started well. Now admittedly, December and January are months with a seasonally well volume of transactions. Strong high-wage job and income growth in our markets, combined with positive demographics and a consumer preference for a rental lifestyle in our highly desirable cities, has created a supportive backdrop for our business in spite of elevated levels of new supply. Recent announcements regarding Amazon HQ2 and Google’s continued business expansion reinforce our belief that the urban economy will be resilient and the markets will rebound. In Washington DC, 70% of our NOI comes from within 5 miles of the new location of HQ2. In New York, we have more than 20 properties that are set to undergo new developments. In the Long Island City location of HQ2, several of our properties are in new developments, similar to the new Google expansion location in the West Village. We expect that 2019 will be another good year for us, with strong demand across our markets creating high occupancy conditions. However, continuing elevated supply levels for some of our markets keep us cautious. Our internal dashboards are blinking green, but we are also aware that economic and other headlines are giving more cautionary yellow signals. With that in mind, I’m going to turn the call over to Michael Manelis, our Chief Operating Officer, to give you insights on how we’re looking at revenue growth across our markets in 2019, followed by Bob Garechana, our Chief Financial Officer, who will review normalized FFO and expense results and guidance, and also discuss our balance sheet. Then I’ll wrap it up on the prepared remarks side by discussing our investment activities, and afterwards, we will open the call to your questions. Go ahead, Michael.

Thank you, Mark. Today, I’m going to begin with a quick recap of our 2018 performance. I’ll share our assumptions that create the midpoint of our 2019 guidance range and provide updated commentary and outlook for each market. First, strong demand fueled by good job growth and record low levels of unemployment in our markets aided the absorption of elevated supply. Additionally, equity employees delivered remarkable experiences to our residents, resulting in the highest customer satisfaction scores and the lowest resident turnover in the company's history. We reported 51.1% turnover in 2018, which is around 200 basis points less than in 2017. Excluding turnover for residents who moved to a new unit within the same community, our net turnover dropped to 45%. Our same-store revenue growth was driven by a 96.2% occupancy rate, negative 30 basis points new lease change, and renewal increases of 4.9%, all stronger than 2017 results. As we sit here today, we have strong momentum coming out of the fourth quarter. We have more pricing power today versus the same time last year, which keeps our dashboards blinking green and allows us to remain cautiously optimistic about the outlook for 2019. Our overall guidance assumes approximately the same occupancy and renewal performance as in 2018, with modest improvements in new lease change based on expected pricing power in the first half of the year and an embedded rent roll that is better than one year ago. Our guidance assumes steady but lower job growth expectations predicted by many economists, which will lead to efficient absorption of the new supply in our markets. In 2019, supply will decrease in Boston, New York, and Orange County, while other markets are expected to remain flat or increase. Our 2019 same-store revenue guidance range of 2.2% to 3.2% gives a midpoint at 2.7%, which is 40 basis points better than our 2018 results. The upper end of our range assumes slight improvement in occupancy with strong pricing power on new leases staying in place through the peak leasing season. The low end of our revenue guidance assumes no intra-period growth in rents and a modest reduction in both occupancy and renewal performance. All our markets, except for Seattle and Orange County, are projected to deliver better revenue growth in 2019 compared to 2018. For Boston, we finished the year strong with continued growth in biotech and other high-wage jobs, accelerating job growth in the second half of the year, aided by light deliveries in the fourth quarter. We expect a favorable leasing season in Boston, with revenue midpoint expectations of 2.8%. New York, although delivering 80 basis points of revenue growth in 2018 with 96.5% occupancy, negative 150 basis points new lease change, and a 3.4% renewal increase, still has strong momentum heading into 2019. We anticipate the competitive footprint to see approximately 50% lower new supply than in 2018. The guidance for 2019 in New York stands at 1.8%. Moving onto DC, we finished 2018 with revenue growth of 1% and expect an improvement in 2019 to a forecasted 1.4%. Seattle delivered 2.8% revenue growth in 2018, although supply in 2019 will increase slightly. The guidance for Seattle in 2019 is at 2% revenue growth. San Francisco had solid job growth but is also seeing new deliveries. The revenue growth for 2019 is set at 3.4%. Los Angeles saw 3.6% revenue growth in 2018, with expectations of 3.8% for 2019. In Orange County, we finished 2018 with 3.5% revenue growth but expect a decline to 3.1% for 2019 due to job growth slowing. San Diego maintained a stable outlook with a projection of 3.9% revenue growth. Overall, we have a strong outlook supported by high demand and robust performance across our markets.

Thanks, Michael. This morning, I’ll take a few minutes to discuss our guidance assumptions for 2019 same-store expenses and normalized FFO. I’ll round out my remarks with a brief discussion of our balance sheet and capital market. Before I begin, a couple of quick comments on the fourth quarter 2018. In the quarter, our same-store revenue grew 2.6%, expenses grew 4.2%, and NOI grew 1.9%, which generally aligns with our full-year operating expectations from the third quarter call. For normalized FFO, we delivered $0.84, which is a penny shy of the midpoint of our expectation, primarily driven by the negative impact of higher-than-anticipated casualty losses due to rainstorm damage at several properties in our Washington, D.C. portfolio. Regarding 2018 same-store expenses, the relatively high year-over-year expense numbers we experienced in repairs and maintenance and insurance were partly due to very low or negative growth for the comparable period in 2017. For example, repairs and maintenance grew 1.6% for all of 2017 and only 0.7% for the fourth quarter of 2017. Moving over to payroll, our expectations for full-year 2019 is for growth between 4% and 5%. The last major category is utilities, which we expect will grow between 1% and 3%. Overall, we anticipate same-store expense growth for 2019 between 3.5% and 4.5%. Our guidance range for normalized FFO in 2019 is $3.34 per share to $3.44 per share. Major drivers for this change include a $0.10 contribution from same-store NOI, a $0.04 contribution from leased-up properties anticipated to generate $40 million in NOI in 2019, and a $0.01 contribution from the timing of acquisition and disposition activity. Our financial position remains the strongest in the company's history. During 2018, we issued $900 million in unsecured bonds and retired over $1 billion in higher coupon secured debt. For 2019, we anticipate issuing between $700 million and $900 million in debt capital to refinance debt maturing in 2019 or 2020. We are very manageable regarding development spending, and we anticipate it will be funded entirely from free cash flow.

Thanks, Bob. On the investment front, we had a relatively quiet fourth quarter with no transactions as you saw in last night's release. We had a busy January, acquiring three properties, which included a newly constructed property in Denver, a 174-unit property in the South Lake Union neighborhood of Seattle, and a 131-unit property in Jersey City. We are also in the process of disposing of several assets. As for our guidance for 2019, we gave guidance for $700 million of acquisitions and $700 million of dispositions. We will continue our selected portfolio pruning to find attractive opportunities for new investments in our markets. Values and cap rates are holding steady in our markets as there continues to be demand for high-quality apartment assets. Overall, we're optimistic about our investment activity and portfolio performance moving forward. Now let's go to the Q&A session. Operator, if you could begin?

Hi, good morning. This is Trenter Hill here with Nick. Thanks for all the market level color in your prepared remarks; that's great. Kind of a big picture question related to supply and the theme that we continue to hear is more of it being pushed further out. So, now 2019 based on industry level data, it seems to be the new peak for supply deliveries at the national level. And we appreciate your internal analysis of supply. But we've been talking about this for a while as it gets pushed and pushed further and further. So, when do you think we truly see the peak supply as it pertains to your markets?

Hey Trent, it's Mark Parrell. Thanks for that question. We always seem to have this conversation every year. Our internal estimates for 2019 are around 77,000 units, but we fully expect 10% to 15% of that to move because it always does. Right now, our 2020 numbers are lower. We see continued pressure on construction costs. Labor costs, material costs, land prices are not declining. So, I can't give you an exact guess, but something will likely shift. We do think 2020 will be lower than 2019.

Okay, thank you very much. And just a quick follow-up relating to your guidance. It looks like you have a 25 basis point dilutive cap rate spread between acquisitions and dispositions, and you've already announced a healthy amount of acquisitions in the mid-4% range. So what are your plans to acquire assets that would flip this dynamic from being accretive to dilutive?

Sure, Trent. Our guidance is just an estimate. We have an accretive trade going on, but there are other assets we've identified for sale that would be higher cap rate assets. So, there's almost equal probability that we could be 50 basis points accretive or dilutive. It’s a small margin between the two.

All right, thank you very much. Thanks for taking the questions.

Thank you.

Thanks. In the last few years you've been conservative with initial same-store revenue guidance that ultimately ended up at the high end of your expectations. So, is there a basic change with the tighter guidance? Which markets have the largest potential variations driving the high-end or low-end of the range?

Our process remains the same. We talk with our field personnel and consolidate our insights. Four core markets are driving a significant share of our revenue: D.C., New York, San Francisco, and L.A. We're up to a great start with good momentum but must watch D.C. and L.A. for signs of softening as we gauge absorption of new supply.

Thanks. With supply coming to Oakland in the East Bay do you think that it will pull demand from San Francisco or do you expect it to be muted?

Great question. Oakland does have areas to go to today, so it's a more established comparison. We need to monitor how pricing interacts between Oakland and San Francisco.

We're looking at about 3,500 units being delivered to an area that needs more housing overall. In the long run, this market will absorb these new products due to significant demand for housing.

Thanks.

Mark, now that you're CEO, is there any potential change in strategy regarding more or less development?

I've been with the company for many years and fully invested in the strategy. The strategic process evolves over time but is not currently subject to dramatic changes.

Is there any historical impact when there's new supply in Oakland on your San Francisco portfolio?

Yes, in the past they’ve never had a concentration of new supply like this. Oakland's situation may differ given the volume delivered in a short period.

The Bay Area has very strong demand for housing overall, so while there may be temporary impacts, we think demand remains strong.

Thanks.

Thank you.

Thank you. Regarding D.C. and waiving late fees during the government shutdown, what's your revenue recognition process for late-paying tenants?

Revenue recognition is not waived on late fees. We recognize late fees when due and write off what remains uncollected over time.

To provide some context, we’re talking about two dozen people involved. We're not concerned about impacting the majority of our occupancy.

Will federal workers catch up on rents once the government shutdown ends?

There isn't evidence suggesting they won't catch up, and most residents seem to be in a position to get back on track after the shutdown ends.

We have family members of workers who are confirming that they expect compensation to catch up.

What are your comments on the investment market and how you are perceiving unlevered IRRs today?

We feel unlevered IRRs are generally in the sixes, however, the things we've been purchasing have been in the sevens and the pricing is focusing on high-quality products.

How do you consider the future of your development pipeline?

Development will remain a long-term value creation method for us. We are currently busy looking at adjacent land sites and verify overall expectations on development for the next couple of years.

For 2019, the timing for capital debt matters will, in fact, be mid-year with operational expenses accounting for our upcoming financing down the road.

And where do you think pricing is from a new ten-year deal?

Sitting here today, I’d say under 4% overall considering current treasury yield factors.

Thanks, Steve.

As we move toward peak season, what are your expectations for leasing spread improvement?

Overall, most markets are on track to improve. New York stands out with significant improvements in new lease change assumptions.

Regarding repair and maintenance costs, can you clarify why building improvement costs are decreasing?

Building improvements are one-time, large-scale expenses, and the mix of projects changes year-to-year and timing plays a part.

Are there any talks about larger affordable housing projects with tech companies?

It’s too early to say; we are interested in working with potential partners. We have managed affordable properties before and are ready to do so if the returns make sense.

What’s your expectation for fee growth in 2019, and are there any new fees being implemented?

Right now, our projection looks about 3% for the year. We did hard looks at parking revenue, which has grown significantly, and we're still looking for optimization opportunities.

What are the expected stabilized development yields for properties in the current pipeline?

We're looking at yields specifically for each development property as we analyze our active pipeline.

What is the gap between the REIT and normalized FFO guidance for this year?

The biggest issue is the write-off of an unamortized discount on a tax-exempt bond we expect to incur during a planned disposition.

Yes, it’s essentially a non-cash charge from the acquisition of this asset that we will write off.

Given the administration's stance on GSEs, how do you see debt financing affecting your plans?

At the moment, we see no disruption. They had high production volumes and plans are operating as usual.

Our exposure to GSE risk is low due to our portfolio's pricing structure and we can still access capital through other means.

Thanks, guys. Stay warm.

Thank you.

Thank you. Regarding operating expenses and wages, do you see continued expense growth driven by payroll?

Over the last five years, our expense growth rate averaged 2.5%, and while we expect it to be higher in 2019, it may stabilize again depending on broader trends.

Looking at rent control discussions in Boston and Cambridge, how concerned are you about potential impacts?

This is a complex area. We believe that enlisting the private sector through incentives is better than imposing rent controls. We remain engaged with local associations to advocate for sensible regulations.

Okay, thanks Mark.

Thank you.

In terms of market guidance, where do you see potential for upside and downside?

Several markets carrying elevated supply present both upside and downside risk. However, we are seeing green signals in almost all our markets right now.

Can you elaborate on New York City’s performance and what is driving this?

The performance is driven by various neighborhood strengths and overall demand. Our embedded growth adds to stability in pricing regardless of fluctuations in the broader market.

I wanted to ask about supply levels and how private equity impacts construction.

I think private equity is more invested in existing projects rather than development right now. However, there’s evidence of land coming available at lower prices recently.

Thank you.

Thank you.

What do you believe the overall yield on cost that merchant builders are willing to accept is compared with yours?

The weak industry in general approaches development differently than we do, usually needing higher spreads to justify construction than we do based on our own investment principles.

Great, thank you.

Thank you.

Is the guidance for 2019 expecting any benefits from the HQ2 or Google expansions?

No benefits are factored into our guidance at this time. It’s still too early to see any economic impact.

Thank you all for your time today. We appreciate your attention during this lengthy call and look forward to engaging with many of you on the conference circuit in the coming months. Thank you very much.