Essex Property Trust Inc (ESS) — Q4 2015 Earnings Call Transcript

Thank you for joining us today and welcome to our fourth quarter earnings conference call. John Burkart and Angela Kleiman will follow me with comments and John Eudy is here for Q&A. I will cover the following topics on the call. First, comments on Q4 and market conditions and second, commentary on investment activities. On to the first topic. Yesterday, we were pleased to report continued strong operating results for the fourth quarter and full year ended December 2015. In the fourth quarter, core FFO per share increased 17% compared to Q4 2014. For the full year, core FFO was $0.42 per share above the midpoint of the initial 2015 guidance range. For the five year period from the 2010 recessionary trough, we have grown core FFO per share by 96%, increased our dividend nearly 7% per year and led the multi-family REIT industry with an annual total return of 19%. Angela Kleiman will comment on guidance in a moment which anticipates continued strength into 2016. As widely reported, an unanticipated slowdown in rent growth occurred in Q4 in northern California. Third-party research firms have reacted by lowering rent growth and occupancy expectations for 2016. We believe that the Q4 slowdown does not materially change the 2016 outlook for northern California for the following reasons. First, we believe that 2015 rent growth in Northern California was greater than anyone expected. I'd say, 2015 was an extraordinary year. This context is important when comparing results because any disruption can appear disappointing. In this case, we expect to go from extraordinary in 2015 to strong in 2016 which is a scenario that we outlined in our 2016 market forecast in connection with our Q3 2015 conference call and we're now reaffirming that forecast. Specifically, we believe market rents will increase by 7.5% in Northern California in 2016, down from the 2015 average of 10.9%. Our second comment relates to the typical seasonality in Q4 which in my 30 years at Essex always occurs, although in varying intensity. Demand driven by job growth moderated in Q4 which is typical as many companies wait until after the holidays to add workers. New apartment deliveries will also vary throughout the year. And so, above average deliveries in Q4, along with lower demand can cause temporary softness until demand recovers, typically by early February. We estimate that Q4 deliveries of apartments in Northern California represented about 44% of the roughly 10,000 apartments delivered in all of 2015, versus 35% and 25% in Q4 2014 and 2013, respectively. John Burkart will summarize January results in a moment, giving us confidence that the Q4 slowdown is not indicative of a trend. Our final point relates to our estimation of excess demand relative to supply in 2016. In our market forecasts, again unchanged from last quarter, we project the three Bay Area counties to generate 2.9% job growth in 2016, significantly lower, but still strong relative to the extraordinary job growth of 4.1% for the comparable metros in 2015. That 2.9% Bay Area job growth equates to around 95,000 jobs. Those 95,000 jobs will produce demand for around 47,000 housing units, assuming the typical two-for-one relationship between jobs and housing demand. In 2016, we expect the Bay Area to produce around 18,000 homes, both apartments and for sale which represent only 38% of the demand attributable to job growth. With market occupancy around 96%, expensive single family homes and demand well in excess of supply, we believe that great pricing power will continue in 2016. Rental affordability is often mentioned as a possible cause for lower rent growth. However, these are high income and high cost areas and fortunately incomes in the Bay Area are growing substantially. San Jose, for example, has a median household income of around $102,000 and personal incomes grew by 7.3% in 2014 and are estimated to increase 6.5% and 7.1% in 2015 and 2016, respectively. In Santa Clara County which includes San Jose, monthly rents in the Essex portfolio average around $2,500, as compared to median rents in San Jose of around $2,200. The median income will allow someone without a roommate to rent either the average Essex apartment or the medium-priced apartment in the metro area. Nothing in this discussion should imply that we lack concern about the U.S. economy, recent market volatility or the resiliency of tech jobs, all of which are risk to our market outlook. If economic conditions worsen, we may not be able to achieve the macro assumptions driving our forecast, including 2.8% U.S. GDP growth and 2% U.S. job growth. We see nothing in our markets that would indicate that tech jobs are imploding. To the contrary, the tech markets continue to do well, as indicated by San Jose's 4.4% December year-over-year job growth. Further, our analysis of the largest tech companies indicates that they are growing in market capitalization and generating huge amounts of cash. Who would have thought 10 years ago that Alphabet and Google would be the world's largest listed companies? A comparison of the top 10 U.S.-based tech companies against the top 10 non-tech companies shows just how much the world has changed. The top 10 tech companies are worth around $2.8 trillion, 21% more than the non-techs and have $556 billion in cash, more than twice as much as the non-techs. Approximately $1.8 trillion of the equity capitalization of the tech leaders was created in the past 10 years, over 3 times the non-techs. Finally, while only three of the non-tech leaders are based in the Essex markets, all of the tech leaders are headquartered on the West Coast. We clearly don't see the end of large investments in technology in the foreseeable future and believe that our portfolio is well-positioned for this continued growth. To the second topic, investment activity. So far acquisition markets have experienced little impact from global economic conditions, cap rates have not moved much. At this point, A quality property and locations trade at around a 4.25% cap rate using the Essex methodology, but more aggressive buyers are often sub 4%. B quality property and locations typically have cap rates 25 to 50 basis points higher than A quality property. We're seeing three significant headwinds affecting development in the West Coast markets which we believe will moderate apartment supply going forward. First, construction lenders are sizing construction loans based on loan to cost ratios of between 60% and 65%, down about 5% from a few months ago. Second, cities continue to increase demands from developers in the form of low income housing units, higher fees and costly improvements. Finally, construction costs have increased around 10% in each of the past two years despite declining commodity prices, as skilled labor forces are inadequate to meet related construction activity. Obviously, this lower housing supply is beneficial to the Essex portfolio overall. As previously announced, we sold the 296 unit Sharon Green Apartments in Northern California for $245 million or $828,000 per unit, at a cap rate in the high 3% range. We used 1031 exchanges to reinvest the proceeds of Sharon Green into three properties that are detailed in the press release. We estimate that core FFO will increase by approximately $1 million in 2016, as a result of these transactions. Our business plan for investments is outlined in the press release. We hope that economic uncertainty will bring more transactions to the market and that financing rates remain attractive. Depending upon the stock price, acquisitions may be funded as part of our co-investment program or on our balance sheet. We currently have two properties in contract to be sold. Similarly, the use of proceeds from dispositions will also be strongly influenced by the stock price. That concludes my comments. Thank you for joining our call today. Now I'll turn the call over to John Burkart.

Thank you, Mike. 2015 was a great year in the West Coast markets. Our results exceeded our initial revenue guidance in all three regions for the combined Essex BRE portfolio and expenses were favorable to guidance leading to an exceptional 10.7% NOI growth, the highest in 15 years. Our outperformance was attributable to job growth exceeding expectations and lower than expected housing supply. As of December 2015, our markets added 361,000 jobs, compared to December 2014, 40 basis points higher than our original projection of 2.5%. A total of 63,000 new units of supply, both multi-family and single family was delivered into the market in 2015. That's about 6,900 units below our original forecast, largely for the reasons that Mike mentioned including, labor shortages, municipal delays, rising costs and more stringent lender underwriting. The supply/demand imbalance is the key factor behind our market strength. We estimate, assuming two jobs create one unit of demand for housing, that the 331,000 jobs created is equivalent to about 165,000 units of housing demand, compared to only 63,000 units of new supply delivered, meaning demand exceeded supply by over 2.5 times. The fourth quarter which is the low point in seasonal demand and rental rates in our markets was relatively strong across all three regions, with a 7.5% increase in gross revenue, compared to the fourth quarter of 2014. Achieved rents on new leases were up 8.6% in the fourth quarter compared to the fourth quarter of 2014. We have made great progress in our management of the BRE portfolio. However, we still have more work to do with respect to refining unit amenity pricing, lease expiration management and renovations. Therefore, for the purpose of comparable sequential results, the Essex legacy portfolio provides the best insight. Adjusted for occupancy changes, the Essex portfolio achieved 1.6% sequential revenue growth in the fourth quarter of 2015, the same as 2014. We continued to find opportunities with our renovation program. We increased the number of units renovated in the same-store portfolio143%, from 254 units in the fourth quarter of 2014, to 618 units in the fourth quarter of 2015. The scope of the unit turns are site-specific based on opportunities in the marketplace. Now I will share some highlights for each region. The Seattle market continues to absorb new supply and push rents outside of CBD higher. Revenues for our Seattle CBD portfolio increased 5.3%, while revenue for the majority of our portfolio which is located on the east side near Bellevue and Redmond, grew 8.3% for the fourth quarter compared to the prior year's quarter. According to Axio, the Seattle market had the strongest year since the Great Recession, ended the year with approximately 8% year-over-year rental growth as of December 2015. In the Bay Area, the successful technology companies continue to lease or pursue space to grow their companies. The technology-driven San Francisco peninsula and Silicon Valley markets absorbed over 1 million square feet of space in each in the fourth quarter of 2015 or 50% of the total absorption for 2015. Alphabet leased space in Alameda, North San Jose, Shoreline. YouTube, a division of Alphabet leased space in San Bruno. And Microsoft recently submitted plans for a new campus in Mountain View, with construction expected to begin next year. Southern California region continues to be strong, just driven by solid job growth in each market. The 8.4% NOI growth rate achieved in 2015 was the highest in 15 years. We expect the momentum we saw in 2015 to continue into 2016, given the limited new supply in the Southern California region, although we do expect some challenges in the downtown LA, as that local market absorbs the planned deliveries. Rental increases in the San Diego market have increased each year since 2010 and ended the year up 7% over the prior year according to Axio. I'm pleased with our 2015 results and although I recognize the real economic risk and concerns in the marketplace, the current conditions that we're experiencing in our markets, gives me confidence that we will achieve our plan outlined in guidance. Our portfolio occupancy as of February 2 is at 96.1%, consistent with our budget and our net availability out 30 days stands at 5.3%. We're positioned well to take advantage of the spring rental season. Looking forward into 2016, we again expect demand to substantially exceed supply in our markets by over 2 times, leading to continued rental market strength. In January of 2016, our average achieved rent for new leases for our three regions was 2.4% above our achieved rent in December of 2015, consistent with our budget. I think our momentum positions us well for 2016.

Thanks, John. Today I will briefly review 2015 results, then focus on 2016 guidance and provide a balance sheet update. For 2015, I'm pleased to report that our same-property revenue growth for the full year was 8% which exceeded the midpoint of our guidance. Same property revenue growth and NOI growth for the combined portfolio which consists of the last three quarters of the year was 7.6% and 10.1%, respectively. Both of these also exceeded the midpoint of our most recent guidance. On to 2016. We anticipate another strong year, with 11% projected core FFO per share growth, primarily driven by same-property growth assumptions. Top line growth of 7% at the midpoint reflects our expectation of continued favorable supply/demand relationship. For reference, this midpoint is 25 basis points higher than our initial guidance for 2015 which was 6.75%. We're projecting higher operating expense growth of 3.75% at the midpoint. Controllable expenses are expected to increase modestly at around 1% for the year; therefore, the two key drivers to expense increases are as follows. First, higher utility costs. Note that 2015 utility costs increase was only 0.3%, so very muted, primarily due to water conservation; and second, an increase in our allocation to property management expense. This is consistent with what we've previously communicated. We will review this allocation on a regular basis, in conjunction with our transformation plans. The new management fee allocation equates to 2.4% of revenues which is less than 3% commonly used within the industry. The resulting bottom line is that we're expecting another strong year, with 8.5% NOI growth at the midpoint. As for G&A, the increase by 5% of the midpoint is primarily due to our new corporate headquarters lease. The offset to this expense as discussed on the previous call, is the yield from reinvesting the proceeds from the sale of our former Palo Alto headquarters, thereby the resulting net impact of FFO is about a $0.01 per share. For the first quarter of this year, we're projecting core FFO per share at the midpoint to be $0.03 below fourth quarter of last year. The reduction is attributed to one-time items such as favorable variance in the fourth quarter in property tax for the legacy BRE portfolio, generating $0.04 of core FFO per share. In addition, we have recently sold several properties, including Sharon Green, and have not fully redeployed those proceeds. The result is a $0.01 per share drag on the first quarter, compared to the fourth quarter of last year. Other assumptions for our guidance can be found on page 5 of the press release and S-14 of the supplemental. Moving on to the balance sheet, we repaid $150 million of private placement bonds in January and have assumed an unsecured bond offering in our guidance for 2016. The only noteworthy maturity remaining in 2016 is the $200 million term loan in the fourth quarter. We have several options available to refinance this debt which allows us to be opportunistic. We generally favor refinancing our maturities with unsecured debt that is 5 to 10 year in term, depending on the interest rate curve and the related spreads. Lastly, we're ahead of our schedule in reducing our net debt to EBITDA to 5.8 times, due to substantial growth in EBITDA. Based on recent $215 stock price, our leverage or debt to market cap is at 27%. In comparison, heading into the great 2008 recession, our leverage was 35% at the end of 2007. Therefore with our $1 billion line of credit extended to 2021, unfunded commitments of $230 million which is below 3% of total market cap and with a light maturity schedule over the next several years, we're well-positioned to be opportunistic and to weather any potential capital markets dislocation. That concludes my remarks and I will now turn the call over to the operator for questions.

I wanted to explore the same-store revenue growth guidance further. It seems you're projecting a roughly 100 basis points decline in the revenue growth rate, but given that rent growth in 2015 was about 70 basis points higher than in 2014, could we assume there may be around 50 basis points attributed to higher loss to lease? Additionally, while I understand the slowdown in San Francisco, does that really account for the revenue growth rate guidance you have for 2016?

This is Mike, and if I miss a part of your question, please correct me. Our general thesis has been that Northern California has been the strongest market for a long time, with Seattle following closely behind. Over time, we expected Southern California to gradually improve, while the double-digit NOI growth rates in Northern California would start to decline. We still anticipate that trend to continue, although the resilience in the tech markets has been somewhat surprising, which is a positive development. For this year, if you look at our market forecast, we have Northern California at about 7.5%, and our guidance is slightly higher than that. We expect to see some loss to lease usage, which accounts for the difference between the two numbers. Does that make sense in relation to Northern California?

Right. It just seems like that would imply a pretty strong slowdown, given the loss lease is higher this time this year, than versus same time last year.

Well, it was at the end of the year, loss to lease was 2.8% and so it decelerated a lot in Q4. Of course, Q4 was a dip and it is higher at the end of January than it was at the end of December. Again, you have the impact of what we think happened. Again as I mentioned in my comments, we had lumpy supply hitting the market in Q4 in Northern California. And when that happens, some people that are trying to lease up their apartment buildings become more aggressive, with respect to concessions and/or rent levels and when that happens everyone else adjusts along with it. And again, this is within a period that you always have a lower demand for a variety of reasons. And so, you have lower demand. You have too much hitting the marketplace and owners reacting very aggressively. I think that, that as John Burkart has pointed out has largely run the course, because demand has returned to normal levels. Some of those lease-ups have adjusted in price. And as a result, the world looks like it's more or less on track for what we thought was going to happen. So again, from my perspective, the fourth quarter is the least relevant quarter. And I know, seems like the analysts focus on it many times over the last 10 years and I think that they give it too much weight, in terms of the overall relevance of the quarter. It's the least relevant. Things can happen, just given the slowdown in demand and I think that's what happened this year and it's happened many times before.

It seems you are likely to be a significant net acquirer next year as well. Although you currently enjoy a near historic low cost of capital and prices, private valuations in apartments may not have reached their peak yet, and they still appear relatively high. Is this primarily due to your implied cap rate in comparison to your price relative to NAV? Additionally, could you explain the reasoning behind being a strong net buyer this year, especially when many peers are leaning towards heavy net selling?

I think we're going to be more proactive in selling, while maintaining a consistent approach to buying. The key question is how we will fund our activities. We have a co-investment program, and if we don't find the stock price attractive—meaning if we believe the return implied by the stock price is higher than the assets we're purchasing—we won't issue stock to make those acquisitions. Instead, we'll utilize a co-investment approach. From my experience, we tend to perform best during market disruptions when asset prices may become misaligned. If such situations arise, we want to be prepared. The way we fund these activities can vary daily, influenced by stock prices. Based on today's price, I wouldn't feel confident using our stock. However, if we look back three months, our stock price and the overall market have been quite unstable. We can't predict the future, but we acknowledge that we're in a very volatile period. I ask for people's trust in our ability to make prudent decisions in managing our investments. It's possible that our acquisition activity may be limited if we can't find suitable transactions that align with our cost of capital.

Just wanted to dig a little bit deeper into the same-store revenue growth guidance. It looks like you're modeling about 100 basis points decrease in the revenue growth rate...

This is Mike and if I miss a piece of your question, please go ahead and correct me...

Thank you, Mike. 2015 was a great year in the West Coast markets...

Thanks, John. Today I will briefly review 2015 results, then focus on 2016 guidance and provide a balance sheet update...

Just wanted to dig a little bit deeper into the same-store revenue growth guidance. It looks like you're modeling about 100 basis points decrease in the revenue growth rate...

This is Mike and if I miss a piece of your question, please go ahead and correct me...