Essex Property Trust Inc (ESS) — Q1 2016 Earnings Call Transcript

Thank you for joining us today and welcome to our first 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. Second, investment activities. And finally, an update on rent control proposals. Yesterday, we were pleased to report continued strong operating results for the first quarter of 2016. For the past several years, one of our primary operating goals has been to grow core FFO per share. I congratulate the Essex team for accomplishing that goal with over a 100% increase in core FFO per share since Q1 2011. Generally speaking, the West Coast economy continues to perform well and we are on track to achieve our 2016 market rent forecast shown on page S16 of the supplement. Recent job reports have generally equaled or exceeded our expectations. In Southern California, we have modestly increased our market rent growth expectations from 5.2% to 5.5%, again mostly related to better-than-expected jobs representing more evidence that our thesis for slow and steady growth continues. For Northern California, we are lowering our economic rent growth forecast from 7.5% to 6.5%. As noted on our last call, supply deliveries during the typically weak fourth quarter caused lower rent growth in Northern California. Most notably focused on three submarkets, Dalston market in San Francisco, the Peninsula South of San Francisco and North San Jose, which combined account for approximately 7% of our same-store NOI. As reflected in our Q1 results, we experienced a choppy but nicely down from Q4. March and April have brought renewed pricing pressure focused on these three submarkets in the form of greater concessions, often equal to six to eight weeks of rent as newly delivered apartments push rapid absorption in a competitive market. The greater concessions provide enough incentive to draw people out of nearby properties pressuring prices for stabilized communities. Apartment supply deliveries and hiring are inherently lumpy and much like Q4 2015 and the past couple of months, conditions can change quickly. John Burkart will elaborate further in his comments. Turning to Seattle. We have significantly increased the economic rent forecast for Seattle from 4.9% to 6.1% as its great job growth and strong economy has provided the demand to absorb Seattle's significant new apartment pipeline at higher than expected rents. On to the second topic, investments. During the quarter, we originated a preferred equity investment on an apartment development consisting of 494 apartment homes located in Glendale, California. The investment provides a 12% preferred return on outstanding principal with a total commitment of $47 million. We are working on other preferred equity transactions as developers are finding themselves in need of additional equity given construction cost increases, more conservative construction lending standards, and more challenging and expensive entitlement processes. Market clearing cap rates for development deals typically generate around a 4.5% to 4.75% untrended cap rate, which is below our yield threshold. We continue to look for development opportunities that meet our underwriting criteria and we are not likely to lower our target in the near term. There has been widespread discussion of increasing cap rates in the West Coast markets. Two of our recent acquisitions, Mio and Enso, both in San Jose, were cited by brokers as examples of cap rates that are higher than comparable properties trading a few months earlier. We take this as a compliment that we acquired properties at a better than market cap rate. However, in our valuation, many deals that we have recently underwritten, the value of Mio and Enso did not change materially in the past several quarters. In our experience cap rates change slowly primarily because buyers and sellers don't change their pricing expectations quickly or easily; rather, buyers and sellers need to be convinced that market conditions have permanently changed. Financial distress often shortens this process for changing cap rates, but currently there is almost no distress in well-located apartments. To the contrary, the amount of positive leverage available to buyers at existing cap rates represents a compelling opportunity in this yield-starved environment. During the quarter and as outlined in the press release, we acquired two properties to facilitate 1031 exchanges and sold two properties as part of a portfolio culling process. Similar to last quarter, A-quality property and locations traded around a 4.25% cap rate using the Essex methodology, but from time to time more aggressive buyers will pay sub-par cap rates. B-quality properties and locations typically have cap rates 25 to 50 basis points higher than A-quality properties. Now on to my third topic, which is rent control. There have been several new developments with respect to rent control in various California cities, mostly in Northern California. Most notably, the City Council in San Jose has amended the existing rent stabilization ordinance to lower the maximum rent increase on renewals to 5% from 8% previously. The amended San Jose ordinance also contains a provision to bank or accumulate up to 8% of potential rent increases to be used during periods when market rent increases are below the 5% maximum. Finally, the San Jose ordinance is applicable only to properties built before 1979. Oakland, which also has an existing rent stabilization ordinance, recently passed an emergency 90-day moratorium on rent increases applicable only to properties built before 1983. In addition to the specific actions in San Jose and Oakland, we believe that tenants rights groups will attempt to win approval of referendums that will impose rent control in several cities. It is important to note that all local ordinances including the activity just described must comply with state law, which mandates, among other things, that vacant apartments are prohibited from rent control and rent control can only be applied to properties built before 1996. We believe that these various ordinances will have limited impact on Essex, primarily because the vast majority of our properties are newer than the rent control cutoff date from the various stabilization ordinances. In addition, because rent control limits renewal rent increases, residents stay longer, which reduces turnover at rent-controlled properties. Reduced turnover means that fewer apartments are available to rent for people moving into the area, which likely pushes rents upward on the available apartment inventory. Thus renewals will often occur at below market rates, but this impact is partially mitigated by higher rents on new leases reflecting the unintended secondary effect of rent control. I am incredibly grateful for John Eudy and many Essex team members for attending and advocating on behalf of the company and the industry at several city council meetings. The meetings contain a lot of emotions and often end well past midnight. That concludes my comments. Thank you for joining the call today. I will now turn the call over to John Burkart.

Thank you, Mike. We had a good quarter delivering total same-store revenue growth of 7.3% and NOI growth of 8.8%. Our renovation team got off to a great start in 2016. We increased the number of units renovated in the same-store portfolio by 229% from 247 units in the first quarter of 2015 to 813 in the first quarter of 2016. The increased unit turns negatively impacted our vacancy rate by about five basis points for the quarter in the same-store portfolio compared to the prior year. Now I will share some highlights for each region. Strong demand in the Seattle market fueled by employment growth of 3.3% in March, which was above our expectations, enabled the market to absorb the new supply and continue to grow revenue. Our Seattle portfolio grew revenues 7% in the first quarter of 2016 compared to the first quarter of 2015. We made a strategic decision due to the market strength in the first quarter to emphasize achieved rental rate over occupancy, and we will continue to do so as we enter the spring leasing season. That decision is paying off well with better-than-expected performance and it will position us well going forward. The submarkets performed similarly to last year with CBD growing rental revenue by about 4% in the first quarter of 2016 compared to the comparable quarter, and the East, North Seaside, North and South submarkets are all growing between 7.5% and 9% for the first quarter of 2016 compared to the comparable quarter. In the Bay Area, as I mentioned previously, our expectations for the first quarter was that the market would be choppy followed by the normal seasonal pattern. However, the market is currently softer than expected. Our same-store achieved rent in March 2016 was about 6% over achieved rent in March 2015, and the achieved rent in April of 2015 was roughly 4% over the comparable month, due to the difficult comps. The BLS survey continues to show strong employment growth in the Bay Area. An industry survey reported a March 2016 employment growth rate of 4%, 2.4%, and 3.8% for San Francisco, Oakland and San Jose MDs, respectively, which are above our expectations. The household survey reported unemployment declined at an average of 50 basis points in each MD year-over-year, which is consistent with strong job growth. Both reports indicate a strong employment market, which should be able to absorb the total supply of multifamily and single-family units and continue to grow rent. It appears that in addition to the lumpiness of the multifamily supply deliveries during the low demand period, other factors are currently impacting the demand in the Bay Area market, such as doubling up, increased renting to single-family homes, which enables more roommates to share the rent, the one-time impact of the crackdown on the student Visa program which has reduced demand from outside the country, and an increase in flexible work arrangements enabling employees to telecommute from outside the normal commute zone. We have noted a slight change in the geographic location of the open positions listed by the major tech companies with a slight increase in total open positions between Washington and California. However, California open positions have declined slightly while the Washington open positions have increased slightly. This shift may be a product of a tight labor market and housing market that we have in the Bay Area. Southern California region continues to perform driven by strong job growth exceeding our expectations. As expected, the momentum we saw in 2015 continued into 2016, enabling us to achieve revenue growth of 6.1% in the first quarter of 2016 compared to the comparable quarter. In the LA MSA, LA CBD, which is impacted by popular supply, grew rental revenue by 4.9% in the first quarter of 2016 compared to the first quarter of 2015. The Woodland Hills submarket, which had the greatest positive impact from the Porter Ranch relocation, performed at the top of the MSA with an increase in rental revenue of 8.6% for the first quarter of 2016 compared to the comparable quarter. We estimate that the increased demand for short-term rentals related to the Porter Ranch leases increased the year-over-year growth rate for the LA MSA portfolio by about 30 basis points during the first quarter of 2016. Currently, our portfolio occupancy is at 95.8% and our availability 30 days out is at 5.4%. Considering the underperformance in the Northern California portfolio, we are cautiously optimistic about the spring leasing season. Thank you. And I will now turn the call over to Angela Kleiman.

Thanks John. I will start with our first quarter results and then provide an update on recent capital markets activity. I am pleased to report that our core FFO for the first quarter exceeded the midpoint of our guidance by $0.08 per share. Although $0.04 was related to the timing of expenses, the remaining $0.04 was primarily driven by stronger than anticipated operations, which led to another quarter of solid operating results. Also, in the first quarter, we declared a quarterly common dividend of $1.60 per share, which is an 11% year-over-year increase and represents our 20th year of consecutive dividend growth. Moving on to recent capital markets activities. In April, we issued $450 million of 10-year senior unsecured notes at the rate of 3.375% per annum. The net proceeds from the offering were used to pay off the balance on our line of credit, redeem the Series H Preferred Stock and fund other corporate activities. While there is a temporary mismatch on the timing of the use for some portion of the proceeds, we believe it was an opportune time to enter the debt market. The only remaining maturity this year is a $200 million term loan which comes due in November. With zero outstanding on our $1 billion line of credit and limited near-term debt maturities, our balance sheet is well-positioned to be opportunistic as we evaluate future investments and refinancing alternatives. For the full year, we are reaffirming our guidance for same property revenue, expenses and NOI growth and the midpoint of our core FFO per share of $10.92. Lastly, I would like to highlight a new page S12.1 in our supplemental which provides additional disclosures on our revenue-generating and non-revenue generating CapEx spending. We hope these enhanced disclosures will be beneficial to the investment community. I will now turn the call back to the operator for questions.

Hi guys. It's Austin Wurschmidt for Jordan. On the preferred equity deals, I was just wondering if you could give us a sense of the number of deals you are looking at and the potential magnitude of transactions?

Sure. This is Mike Schall. We are looking at several deals. So somewhere between around five deals going forward. Previously, we have established an overall cap on what we would consider at 5% enterprise value. I think at the end of last quarter we were somewhere around $140 million funded on the preferred equity investments. And so we have quite a ways to go. I don't think we will get anywhere close to the cap.

Okay. That's helpful. Thanks for the detail. And then just on affordable housing, do you think at any point that it spurs, I guess, loosening and permitting or zoning for multifamily housing in the Bay Area?

Again, it's Mike Schall. And John Eudy is here and he may have a comment on this as well. It seems like all the forces are working against that. Number one, the entitlement process is just very challenging. If anything, there are some cities like San Francisco that would like to bump up the number of units that are dedicated to below market rate units. And construction costs are going up at double-digit rates. So it would be difficult to see, especially with rents moderating, a lot of momentum toward more apartment development going forward at this point in time.

Thanks for taking the questions.

Well, thanks. I just want to go back to the comment John made about, I was a bit confused about, April. I think, you said something about 4% year-over-year rents. Was that for the entire San Francisco Bay area?

This is John speaking. That was for Northern California. So effectively, what happened is rents between March and April were basically flat on a year-over-year comparison because last year normally seasonally rents move up in April. That means that our comparison went from 6% to 4%. And so that flatness is what I was commenting on which is unique in the context of the season. So it's a short window, but that's what we are at right now.

And that's your blended new and renewal rent growth?

No. That's new only. Our renewals are in the 6.5% zone in Northern California at this time.

Okay. Just wanted to clear on that. And then can you just remind us seen in the entire shore of Northern California region, where are your rents in place today are versus market?

Do you mean loss off-lease?

Yes, right.

I have that number. This is Mike Schall. Northern California loss to lease, so the difference between scheduled and market rent is 4.8%. A year ago, it was 8.1%.

Okay. Great. Thanks, Mike.

Thank you.

Thanks. One question on guidance. I think for the last two years after the first quarter, you would beat in the first quarter and you raise for the full year 2016. I recognize that part of the beat in this first quarter was timing, what are your thoughts on revisiting overall 2016 guidance at this point?

Hi. It's Mike Schall. I think John Burkart's comments cover that to some extent. It was that slowdown, from month-to-month actually through the first quarter and into April that was concerning and there were a couple of other pieces too. One is that our evaluation of apartment supply indicates further lumpiness in Q2 and Q3. So roughly in the San Francisco MSA, 3,600 units get delivered in Q2 and 2,700 in Q3. So roughly 70% of the expected annual deliveries will happen in Q2 or Q3. So we are concerned about that and the significance since we renew or turn around 50% of the leases in these next several months, that has a pretty significant impact on the overall result. So I guess perhaps we are being overly cautious but those were the factors that led us to do that. And actually, let me add one more factor and that is overall supply and demand, as you look at the numbers, appears to be disconnecting in some way. As an example or to go through the numbers, the Bay Area is expected to produce about 93,000 jobs in 2016. That would ordinarily add a 2:1 looking at all housing, not just apartments, would give you 46,000 units of demand against about 20,000 apartments and homes being delivered into the marketplace. So about a 2.1 relationship. So there should be sufficient demand to absorb the supply if it comes onboard yet what we are seeing in the marketplace is that there are more concessions and the supply is not being absorbed as easily as we otherwise would expect. So that supply demand disconnect is of concern to us. It could be indicative of perhaps employment is slowing, but it hasn't really hit the numbers yet. And the last many years that I have been here, it seems that sometimes we see changes in the marketplace before they actually get reported in the numbers. So those would be the little bit of background on why we decided not to change guidance.

Thanks. I appreciate the color. And then the spread in terms of same-store revenue growth between Northern California and Southern California continues to contract for the reasons you have discussed. Do you expect at any point this year for Southern California to actually outperform Northern California?

Yes. This is John. It's hard to tell, right. We right now are expecting that NorCal will follow seasonal patterns. As Mike laid out, there is a lot of strength if you look at the jobs versus the supply. But honestly it's not necessarily working out that way. So yes, there is a year that it happens. This year, Southern Cal is stronger than expected and is doing very well. It might happen somewhere down the line this year or into 2017.

Thanks.

Thank you.

Hi. Good afternoon guys. Can you talk a little bit about LA County results? Was it strong across the board? Or were there pockets of relative strength, relative weakness in the quarter? Obviously, 7% plus relative weakness is probably a strong statement, but where within the portfolio was the best performance in LA County? And was it noticeable between some of the submarkets?

Yes. Overall the submarkets were fairly consistent. However, if we are really breaking it down, clearly the Woodland Hills area got some benefits from Porter Ranch. And so that moved it up. It doesn't really move the needle so much as it relates to Essex. But that enabled that submarket to move up a little bit. You might see it some of the AXIO numbers. And then of course the downtown area is a little bit on the low side, again, we have supply going in, in that market, but still doing strong. Overall SoCal, as a big picture, is doing well as is LA County. Really, it is interesting. There weren't a lot of changes. And if you look at the Bay Area, it's a little different. In the Bay Area, you clearly have San Francisco is underperforming and then you have other market, other submarkets in the Bay Area doing stronger. SoCal was much more consistent.

Okay. And then in terms of the shadow development pipeline, how many units are you sort of working through entitlement process that could start the next year, year-and-a-half or so out there versus basically exhausting your land supply at this point?

Yes. This is Mike. And again, John Eudy may want to add to this. Our view is that we are more aggressive on development at the bottom of the cycle and we scale office, we go to the top of the cycle. And so we do not have a significant land inventory or land bank at this point in time. In terms of deal-making, I know John is looking at deals that are fully entitled, ready to go; we are not taking any cost risk because again construction costs are moving so rapidly that we are concerned about committing and being exposed with respect to when we commit to a deal and when it starts. So we have turned to become more conservative and again that really provides the opportunity within or for the preferred equity transactions where we can come in between somewhere sum around the 60% loan to cost to about 85% loan to cost and earn a 12% return there. We fundamentally like that business and we think it's a great time to do that relative to the opportunity in the marketplace.

Are you looking at that business as a path to ownership? Or just basically a 12% investment at this point?

Well, we would love to negotiate an option to buy at the end of that, but we have not really been able to do that. We could do it if we were willing to give up a significant amount of current return. We haven't made that choice at this point in time. So at this point in time, we are happy to earn that fixed return and get repaid, and if there are some bumps down the road somewhere, perhaps we are in a position to buy out our partner.

Okay. Thanks guys.

Thank you.

My questions have been asked. Thank you.

Thanks.

Thank you. Good afternoon guys. Can you talk a little bit about the refinancing environment with respect to availability of financing for construction lending and just land development? And if anything, if we should be modeling more conservatively if the cost is increasing given some less desire from the banks? Or are you guys not seeing that?

No. That's exactly what we are seeing. A number of our preferred equity transactions over the last several months have really come together because a construction lender is cutting back their construction loan commitment and becoming more conservative. In one case, the construction lender was at the 65% to 68% loan to cost, they cut it back to about 60%, and actually in that deal, we went from essentially, there wasn't a place for us in the transaction, they could finance it themselves to creating this tranche that we ultimately invest in between the 60th and 85th percentile loan to cost. So we have seen a pretty significant change, not just in one or two lenders but really across the board as construction lenders have become more conservative.

Got it. Well, that's helpful. And then just secondly, I think you or Mike Schall was citing some numbers on expected deliveries and I really compliment you guys on being conservative with respect to the outlook. I think that's prudent. When you talk about those deliveries in Q2 and Q3, Mike, were you talking about deliveries in the Bay Area for all of multifamily or was it just the rental portion?

Yes. Ivy, there are a couple of nuances there. We do not include student housing, and we essentially ignore under 100 units and that's part of it. And I was referring to San Francisco directly when I gave out those numbers. So San Francisco, we have again 3,600 units in Q2 and 2,700 units in Q3. San Jose also has pretty significant deliveries in Q2 and Q3 as does Los Angeles. So again, relative to the total, we see Q2 and Q3 as creating potentially more lumpiness similar to what we saw in the fourth quarter and again in March, April.

And just then keeping with the prudent more conservative guide, when you think about deliveries that are coming from condos and recognizing that many of those condos are being bought by investors that might want to cash flow and rent out those units, is there potential risks that could put more pressure relative to market because we are hearing about Equity Residential mentioned, they had someone come in below market against their rent by like $800 more than the cash flow. So how do you guys think about that as a rift to your guidance?

Yes. In terms of how we approach it, we try to lump all housing together because we know that people move out of apartments and buy condos or homes and some will actually go the other direction as well. So our basic analysis is to look at all the jobs, try to determine what the total households are and really not distinguish between what's a rental home and what is a for-sale home. Having said that, the other thing that we pay attention to is affordability of rentals versus homeownership and in every one of our markets and Ivy, you know this better than anyone, the cost of these homes is pretty significant. I think the median-priced home in San Francisco is over $1 million, and so that transition from a renter to homeowner is really important to us and it's obviously very difficult in this marketplace. But in order to avoid this issue of, okay, how many of these demand units are going to go to for-sale versus for rent, we just look at the whole thing.

No. And I appreciate that. I am sorry. I may have miss-communicated the question, right. What we are hearing is that the condos that are being delivered, those that have already been purchased as for-sale units, they may be investors, whether they are from outside the U.S. foreign buyers that want to now rent it out. Is that a risk that you have incorporated into your outlook that they may be competitive now in the rental and I guess you are saying you just look at it overall and shelter, and every delivery you view as a competitive risk?

Exactly. It's a household. And so we don't care. Well, I mean we care, but it should not affect us.

Hi guys. Just wanted to circle back on the preferred equity. Obviously, there's a lot of demand for this capital, but could you speak to a little bit about the supply of preferred capital? And maybe the other players involved that are offering it? And then maybe how you are mitigating it in terms of risk?

Yes. It's Mike Schall. I think there are several people that are active in that area, different types of specialty finance organizations. So we have plenty of competition there, and much like acquisitions, we don't win nearly all of the business and part of the reason for that and it goes through your risk mitigation point, is we only want to originate preferred equity on apartments that we would like to own. So it has to meet our locational and other criteria and again, if everything goes great, then it's a good piece of capital for the developer. If things don't go great, we want to position to step in at what would be an attractive price to us. So that's how we think we have the best of both worlds. We have high-yielding vehicles and we also have something that is synergistic with our portfolio if things don't go well.

That makes a lot of sense. Okay. Second question, when you are looking within a market and you are looking at cap rates that they are trading at, do you see a difference, obviously adjusting for properties that are just above or just below the year where you can do rent control in California?

I haven't looked at it really that closely, but let's see, I just look at Oakland and San Jose and then again the statewide law, Costa-Hawkins, has a pre-1996 date and so we have obviously more properties that are within the Costa-Hawkins realm that is pre-1996. But with respect to the cities that already have rent control ordinances like the ones in Oakland and San Jose, that were pre-existing, the nice thing about them is they can't bump their prior date or effective date or cutoff date, they can't move it to 1995, at least at this point in time, because that was prohibited by Costa-Hawkins as well. So again I think our overall exposure to rent control is actually not that substantial, as I look at the portfolio.

Hi. Good afternoon guys. Can you talk a little bit about LA County results? Was it strong across the board? Or were there pockets of relative strength, relative weakness in the quarter? Obviously 7% plus relative weakness in probably a strong statement, but where within the portfolio was the best performance in LA County? And was it noticeable between some of the submarkets?

Yes. Overall the submarkets were fairly consistent. However, if we are really breaking it down, clearly the Woodland Hills area got some benefits from the Porter Ranch relocation. And so that moved it up. It doesn't really move the needle so much as it relates to Essex. But that enabled that submarket to move up a little bit. You might see it some of the AXIO numbers. And then of course the downtown area is a little bit on the low side, again, we have supply going in, in that market, but still doing strong. Overall SoCal, as a big picture, is doing well as is LA County. Really, it is interesting. There weren't a lot of changes. And if you look at the Bay Area, it's a little different. In the Bay Area, you clearly have San Francisco is underperforming and then you have other market, other submarkets in the Bay Area doing stronger. SoCal was much more consistent. Thank you. Thank you very much. Hey, we really appreciate your participation on the call and obviously we are pleased with the results and we look forward to seeing many of you at NAREIT next month to continue the discussion. Have a great day. Thank you.