Essex Property Trust Inc (ESS) — Q1 2018 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 comment on three topics: our first-quarter results and outlook for 2018, regulatory matters, and investment markets. Our first-quarter results were stronger than expected, with significant improvement from a challenging second half of 2017. As noted at the Citigroup conference in March, these results were better than our 2018 plan because of higher occupancy and other income, which John will discuss in a moment. Market rents for our portfolio grew 3.8% from year-end to the end of the first quarter versus 3.1% in the same period last year and are mostly consistent with our market rent growth expectations for the year. Job growth was relatively stronger in the first quarter, with Essex markets achieving 2.2% job growth on a trailing 3-month basis versus the U.S. average of 1.5%, with most of the outperformance emanating from the tech markets. This growth is notable considering the tight labor market conditions, which are demonstrated by ultra-low unemployment rates, averaging 3.4% in the Essex markets and 4.1% for the U.S. We are encouraged by the strong start to the year, and we’ll reevaluate our MSA forecast on Page S-16 of the supplemental next quarter. The positive job growth has been achieved in part from migration from other areas, indicating the ability of local employers to source and retain skilled workers. The Bay Area continues to be a net attractor of talent, especially from high-cost East Coast metros. This trend is highlighted in the monthly workforce report published by LinkedIn, which details migration patterns of workers within LinkedIn’s network of more than 130 million users in the U.S. On Page 16 S-16.1 of the supplemental, we have reproduced a visual from the report that illustrates migration in and out of the Bay Area over the past 12 months. This supports our view that the number of educated workers moving into the Bay Area continues to outweigh the number departing. The Bay Area and Seattle remain among the most innovative and dynamic economies in the world, which compete successfully for high-skilled workers. Wage growth continues to improve as the skilled labor shortage intensifies. Estimated personal income growth for 2018 for our West Coast metros ranges from 4.6% to 6.5% compared to 4.1% for the nation. Affordability pressures are relieved when wage growth exceeds rent growth, as it has recently. This has led to a reduction in rent-to-income ratios year-over-year in all of the Essex metros. As cited in the Wall Street Journal, a recent study by Up for Growth National Coalition analyzed America’s housing shortage and proposed potential solutions. The study acknowledged the widespread nature of housing shortages for the U.S. in the 15-year period ending in 2015 affecting 23 states. In total, the study indicates the nation has produced roughly 7 million fewer housing units than needed to keep up with economic growth over that period. California, in particular, has the largest shortfall, consisting of nearly half of the total underproduced housing or roughly 3.4 million housing units. The chronic shortage of housing in California and related problems of traffic congestion and long commutes remain key issues on the West Coast. Turning to supply. Our multi-family supply projections for the Essex markets remain unchanged on S-16 of the supplemental, and the impact of deliveries across submarkets vary widely. As a result, we continue to expect periodic disruption to pricing power and stabilized communities when multiple lease-ups in a submarket offer concessions exceeding 6 weeks of rent. At this point, we expect supply to be mostly flat in 2019 versus 2018, with an increasing share concentrated in downtown submarkets. Factoring in shortages of labor, strict land-use regulations, construction costs rising faster than rents, and a more conservative construction lending environment, residential construction appears to be slowing even though permits have continued at a strong pace. We are seeing many examples of residential developments being put on hold as the economics don’t pencil. This supports our belief that the construction pipeline has peaked in our markets and supply will slowly taper off over the next several years. On to my second topic, regulatory matters. I wanted to provide an update on California’s proposed referendum that seeks to repeal the Costa-Hawkins Rental Housing Act that will likely appear on the November 2018 ballot. As you may recall, Costa-Hawkins, in part, restricts local jurisdictions from enacting rent control on any apartments completed after February 1995 and mandates that vacated apartments be priced at market rates. When the law was created in 1995, a primary consideration was that cities with extreme forms of rent control, including San Francisco, Berkeley, and Santa Monica, produced minimal rental housing after enacting rent control ordinances in the 1970s. In passing Costa-Hawkins, California’s legislature thought to increase the production of rental housing to counter shortages and affordability issues, especially in cities that failed to contribute to the housing needs of the state. The California legislature recently considered Assembly Bill 1506, which, like the proposed ballot measure, would have repealed Costa-Hawkins. AB 1506 did not get passed the committee level in 2017 and again earlier this year. We believe that the legislature clearly understands that abolishing Costa-Hawkins could result in even greater shortages of housing in California, which could be a major headwind to business expansion and thus economic growth. The significant issues and unintended consequences of rent control have been researched and documented in great detail by the academic community and California’s government. This includes a 2017 study of San Francisco rent control by the faculty of Stanford University and a 2016 report by the Legislative Analyst’s Office. These studies conclude that rent control is a contributing factor to housing affordability issues, mostly due to shortages of housing. Rather than elaborate here, we refer you to links to both studies on the Internet at savecostahawkins.org. We will continue to provide periodic updates on regulatory issues in the future. And my third topic, investment markets. The demand for apartment property remains healthy. And as a result, we have seen no change to cap rates in our markets despite higher interest rates. For example, we are currently in contract on a disposition that is likely to close in the second quarter at a low 4% cap rate. This transaction and other recent sales support our belief that cap rates have not changed. Quality properties and locations continue to transact around the 4% to 4.25% cap rate used in the Essex methodology. B quality assets and locations are generally 25 to 50 basis points higher, though often contemplate upside from redevelopment and/or value-add activities. As noted last quarter, we continue to see a slowdown in the preferred equity pipeline. This is consistent with my earlier comments that cost increases represent a headwind to new development. We continue to believe that we will be close to our target for preferred equity commitments this year. As of quarter-end, our total commitments for preferred equity and subordinated debt investments aggregated $395 million. That concludes my comments. Thank you for joining the call today, and I will turn the call over to John.

Thank you, Mike. We’re off to a good start in 2018 with year-over-year NOI growth of 3.6% and revenue growth of 3.3% for the first quarter. Our strong revenue growth was favorably impacted by an additional 60 basis points of occupancy over the prior year’s period and higher-than-expected utility reimbursements due to timing and increases in the underlying utility expenses. Strategic adjustments made by the operations team led to increased occupancy through the promotion of short-term lease extensions, which led to fewer move-outs and an increase in month-to-month leases. Turnover in our portfolio dropped to 40% on an annualized basis in the first quarter of 2018 compared to 46% in the prior year. Part of the reduced turnover relates to the Executive Order signed by Governor Brown as a result of the devastating California wildfires, which effectively limited rent increases on all California housing to 10% above the price in place when the order was signed in October of 2017. It has been extended for selected counties directly impacted by the wildfires through the end of the year. We are working to ensure that we comply with the law where applicable, and we expect that it will impact operations in selected markets. Our operations strategy will continue to change with market conditions. As we enter peak leasing season, we expect occupancy to decrease while turnover increases, as is typical for this time of year. Preliminary April 2018 results already show that our strategy is playing out as our year-over-year financial occupancy is only 30 basis points over the prior year’s period versus a 60 basis point increase we achieved in Q1. In April, scheduled rent grew at approximately 2.3% and gross revenues grew at approximately 2.7%. April results indicate a sequential decline in revenues, a significant but expected slowdown from the first quarter. Overall, the Essex markets are performing as expected with Seattle a little weaker and SoCal a little stronger versus our expectations. Moving forward, we expect to see a more typical seasonal pattern in rent growth, which is assumed as part of our 2018 forecast. Now I’ll provide an update on our markets. In Seattle, job growth continued to be the strongest in the Essex portfolio, posting year-over-year growth of 3.2% for the first quarter of 2018. This is the highest growth the region has seen since the third quarter of 2016. However, the impact on supply is evident in the rental market. Rents in March 2018 are slightly below where they were in the prior year’s period, and there was a gain to lease of 1.1% as compared to a 3.1% loss to lease at the same time last year. In Downtown Seattle, WeWork signed leases totaling 250,000 square feet. On the east side, Microsoft continued to expand their footprint in Downtown Redmond. Seattle MD has roughly 4.8 million square feet or 5% of the space currently under construction, nearly half of which is already preleased. Seattle median home prices continued to gain momentum, increasing almost 17% year-over-year for the month of March, making it the second fastest-growing region in the Essex portfolio, only surpassed by Bay Area markets. Our year-over-year same-store revenues for the first quarter of 2018 were 4.8% in the CBD, 4.2% in the east side submarkets while the north and south submarkets grew by 5.1% and 5.4%, respectively. Moving on to Northern California. In the first quarter of 2018, job growth in the San Francisco Bay Area averaged 2.4% year-over-year with roughly 75,000 jobs added. San Jose led the way with 2.9% job growth while Oakland and San Francisco were up 2% and 1.7%, respectively. Market rents in the Bay Area were up 2.5% in March over the prior year’s period leading to a loss to lease of 2.2%. In San Francisco, WeWork continued their growth trend, signing the largest year-to-date lease in the city for 250,000 square feet in the downtown area. Moving down to the South Bay. Facebook preleased 1 million square feet of planned office space in Sunnyvale. Google continued to acquire land near the Diridon Station, purchasing a site approved to build 1 million square feet of office space. In total, the company has invested roughly $300 million in that central San Jose submarket. Additionally, Google continues to expand in the Silicon Valley submarkets, having purchased 3 industrial buildings in North San Jose and 2 additional properties in San Jose and Mountain View. Silicon Valley and San Francisco markets have approximately 9 million square feet of office space or 6% of the total office stock under construction, roughly two-thirds of which is preleased. Median home prices in the Bay Area continued to soar, led by San Francisco and San Jose gaining approximately 20% and 33%, respectively, in March 2018 over the prior year’s period. The San Francisco and San Jose median home prices are now over 30% higher than their prior peaks in 2007. During the quarter, we started a lease-up of Station Park Green Phase 1, located in San Mateo with six-week concessions on selected units. As of April 26, we are 40% leased. Our year-over-year same-store revenue growth for the first quarter of 2018 was led by our Fremont and Oakland submarkets with 4.8% and 4.0%, respectively. Heading down to Southern California. Job growth in Los Angeles County in the first quarter of 2018 averaged 1.5% year-over-year, which was in line with the U.S. Market rents increased 2.3% in March over the prior year’s period and loss to lease was 1.6%. Leasing activity by tech and entertainment companies remained strong in West LA with several leases from high-profile tenants, including another lease by Amazon Studios, expanding their Culver City presence for content production. As discussed last quarter, the downtown CBD submarket continues to be challenged with elevated levels of supply, causing our same-store LA CBD revenues to decline 1.1% in the first quarter of 2018. However, other Essex submarkets less impacted by the downtown supply performed much better in the first quarter of 2018 compared to the prior year’s quarter, with revenue growth ranging from 2.7% in Long Beach to 5.1% in Woodland Hills. In Orange County, job growth improved in the first quarter to 1.9% year-over-year, a 20 basis point increase from Q4. The impact on supply on market rent is evident, with market rents only increasing 70 basis points in March over the prior year’s period and loss to lease was 40 basis points. Finally, the San Diego MSA continued to perform well, recording year-over-year job growth of 1.9% in the first quarter of 2018. Market rents increased 2.1% in March over the prior year’s period and loss to lease was 1.4%. Revenue growth in the first quarter of 2018 was between 3.6% in Chula Vista to 5% in the Oceanside submarkets on a year-over-year basis. Currently, our portfolio is at 96.8% occupancy and our availability 30 days out is at 4.5%. Our renewals are being sent out at about 4% for the second quarter overall. Thank you, and I will now turn the call over to our CFO, Angela Kleiman.

Thank you, John. I will begin by reviewing our first-quarter results and the updated full-year guidance, then touch on recent investment and capital market activities, and finish with a balance sheet update. For the quarter, core FFO surpassed the midpoint of our guidance by $0.05 per share, as detailed on Page 4 of our press release. Of this outperformance, $0.02 is associated with the timing of operating and G&A expenses and is not expected to happen again. The remaining $0.03 comes from revenue growth achieved during the quarter, primarily due to our occupancy strategy, as John mentioned earlier. Given this context for our first-quarter performance, we now anticipate that same-property revenue growth in the first half of 2018 will exceed that of the second half. Additionally, in the first quarter, we declared a quarterly common dividend of $1.86 per share, reflecting a 6.3% increase year-over-year. This marks our 24th consecutive year of dividend growth and positions us on track to become a dividend aristocrat in 2019. Moving on to the 2018 guidance, we are raising the midpoint of our same-property revenue growth guidance for the year by 15 basis points, which in turn raises the NOI growth by 20 basis points to 2.7% at the midpoint. This adjustment is mainly driven by our first-quarter performance, allowing us to increase core FFO guidance by $0.02 per share to $12.46 at the midpoint. For the second quarter, we forecast core FFO per share of $3.05 at the midpoint, which is $0.04 lower than the first quarter. This decrease is primarily attributed to two factors: higher interest expenses in the second quarter from the $300 million bond issuance completed in March, which had minimal impact on first quarter results, and anticipated lower NOI growth as we shift our strategy to prioritize rent growth over occupancy, coupled with increased operating expenses as we enter the peak leasing season. Both factors are timing-related and align with our plans for the year. Regarding investments and capital market activities, during the quarter, we enhanced shareholder returns through our joint venture platform by realizing $20.5 million in promote income from the amendment of the BEXAEW entity. Last year, we outlined our strategy to capitalize on the embedded value within our private equity platform, and I’m pleased to share that we have now monetized nearly $60 million of promote income. This approach is consistent with our history of structuring unique transactions to maximize value while maintaining a disciplined and thoughtful capital allocation strategy. Lastly, concerning the balance sheet, we issued $300 million in 30-year unsecured bonds with a coupon rate of 4.5%. The proceeds from this bond offering were used to pay off secured debt maturing in 2018, thereby addressing our most significant refinancing needs for the year. As Mike pointed out earlier, we are in contract to sell one property, and the proceeds from this sale will significantly fund our development projects in 2018. Consequently, our need for additional capital this year is minimal, subject to new investment opportunities. With $1.2 billion available on our line of credit, 26% leverage, and limited near-term debt maturities, our balance sheet remains robust and well-positioned. That concludes my comments, and I will now pass the call back to the operator for questions and answers.

I want to go back to one of the comments that you mentioned at the very beginning about population migrations. It’s one of the first times that I’ve heard you or your peers talk about this, and I’m sorry if I missed you talking about it previously. But I was hoping you could elaborate on that a little bit more. We’ve heard some comments that San Francisco just doesn’t have enough people moving there, and so I’m curious how sustainable do you think those population migration trends are. And obviously, it’s probably a little bit of a zero-sum game. So are they moving from one market to another market? How are you thinking about this?

Rich, thanks for the question. I think it was invigorating. And I’m playing off some of the other comments that were made on some other calls. But no, what we’re trying to demonstrate is whether the West Coast metros are competitive with the East Coast metros, and that may be countering some of the facts that you see out there with respect to U-Haul rates in and out of California and similar types of things. What we think is happening is that we are attracting more than our fair share of the more skilled, highly skilled and highly compensated worker and perhaps losing some of the lower skilled and lower compensated workers, and we think that’s a normal process, normal evolution. And we’re obviously very concerned about whether our metros are competitive with other metros around the U.S. because employers have choices about where they’re going to locate. And so the competitiveness of the California markets is really important. We look for evidence that supports that basic thesis, and the LinkedIn information seemed to make a lot of sense. And if you go into the report we’ve published on S-16.1, the San Francisco metro movement in and out, but they go beyond that, and they look at some other metros as well. So you can go on to that report. But it really comes back to are these metros, the West Coast metros, competitive, and are people willing to come here. Obviously, housing costs matter, but also compensation and opportunity matter as well. Making sure that we’re competitive with respect to that is something that we think is really important.

And just one quick follow-up question. I think it’s an important distinction, but are you guys seeing these population migrations because of jobs? Or is there job growth because of population migrations?

Well, I think it’s a bunch of different things. I think the competitiveness of the industry is where the best opportunities are being created, and that’s why we think that the West Coast metros and specifically the tech markets, when you look at the job growth that was created, the outperformance of jobs relative to what our expectations were this year, it’s clear that the tech metros are attracting a lot of talent and bringing people here, confirmed by the commercial construction in the San Francisco, San Jose, and Seattle metro areas, the office construction being a pretty good proxy for what’s going to happen a year or two down the road. So again, we’re looking for things that confirm whether the West Coast metros are attractive. And obviously, migration patterns, job growth, all these things put together to determine whether these metros are being successful and competing for talent.

Maybe just following up on that. Looking at out-migration from San Francisco, do the trends make you consider expansion in Portland, Denver, Austin? And then what would you need to see to decide to expand?

Clearly, Denver is, I think, attractive. There have been a number of other multi-family companies that have made movements into that market. We have been invested in Portland, and we are looking at that once again. It’s a relatively small market. And the cost of for-sale housing is less expensive, and therefore, the transition from a renter to a homeowner can be a little bit of a headwind, and I’d say both Denver and in the Portland market. I mean, our basic mandate is to go to areas that don’t produce enough housing and where the housing choices, for-sale housing versus rental, that the for-sale side makes it a challenge to transition from a renter to a homeowner. So that has served us well over a long period of time. Those are the markets we primarily look for. And so there are a couple of markets that are interesting. But I think that they would be a step down relative to what we have in the markets where we’re currently invested.

And then if Costa-Hawkins were to be repealed and I recognize that rent control is not immediately enacted, how do you think about your current portfolio positioning in terms of cities more prone to enacting rent control? And then is there anything you can do to proactively mitigate any impact?

John Eudy is here. I’ll make a couple of comments, and if John wants to add to it, that would be great. It’s obviously virtually impossible to determine the financial impact of Costa-Hawkins. Costa-Hawkins would allow local jurisdictions to adopt rent control measures, but we don’t know which cities might do that or the severity of their rent control ordinances. Without that information, it would be very challenging to determine the impact. There is an old saying that as California goes, so goes the nation. We may be leading in some of these rent control issues, but we're not the final word on it. There was also a proposal in Washington to repeal the statewide ban on rent control, and we’ve seen similar movements in several other states. This appears to be part of a broader trend. Therefore, it’s not something that will immediately prompt us to change our portfolio allocations.

My first question is on supply. I feel like your comments on ‘19, I think you said basically equal to ‘18, is that new? I thought previously you were saying down, maybe even last quarter you said down 25%. Has that changed?

We experienced a 25% decrease last quarter. While the figure was smaller, we anticipated a decline next year compared to 2018. By the end of the year, we shifted nearly 4,000 units from 2017 to 2018. However, we have not yet moved units from 2019 to 2020, assuming that the delays continue, which seems probable. As we mentioned in the last call and more recently, it is challenging to determine the exact timing of deliveries and how they will unfold. Consequently, there may be a slight decrease in 2019, but we are uncertain. The numbers are difficult to clarify, and our best estimate suggests that in the upcoming years, including our examination of permits, there will be a minor reduction and slowdown, though it will be relatively small. We do not expect any significant declines, even though there are notable increases and decreases when looking at each metro area. For instance, the Bay Area is expected to decline in 2018 but see slight growth in 2019. Such variations will occur, but we believe the overall trend is still downward. Many permits are likely to be delayed due to the relationship between rental growth around 3% and construction costs increasing in the high single to low double digits. This situation is clearly unfavorable for residential construction. Therefore, we expect a downward trend, but it is not likely to be substantial.

Yes, this is John speaking. As I mentioned earlier, we provided some information in April, and things are unfolding as we anticipated. We are monitoring the market closely. Overall, for the portfolio, the market was up just under 2% year-over-year, comparing April '18 to April '17. We are doing our best under the circumstances as we track the market. Our plans are coming together, and we have managed to reduce our vacancy as we work to optimize our position. The markets are strong. This year, we expect to see a typical seasonal pattern, whereas last year the markets peaked a bit too early. This year, we anticipate a normal seasonal trend. We are benefiting from entering the peak leasing season with higher occupancy, which is part of our strategy to position our portfolio effectively for maximizing our returns this year.

With respect to kind of the expectation for the standard seasonal pattern in the back half of the year and you referenced significant improvement early in the year versus the second half of last year, how should we think about the deceleration throughout the year? And when would you anticipate stabilization in sort of the second derivative of revenue growth in the second half this year?

Sure. Let me try to address that. This is John again. So the big move that you’re going to see is really related to our occupancy. We largely did very well in Q1 because we had higher occupancy, as I mentioned, 60 basis points over the prior year’s quarter. We expect that to go down. Our plan is that our occupancy will be materially consistent with last year at about 96.6%, and so that will be the big change. Our expectations for rents really haven’t changed in our S-16, which is 2% to 3%. And right now, we’re at about 2%. The difference between last year and this year is we do expect the curve or the peak leasing to continue through the midsummer or late summer period as it historically had. And so we’ll start to benefit, we expect, by locking in higher rents, but that really will benefit ‘19, not ‘18. Did that answer your question?

Yes. No, I think that covers the gist. And then as far as LA, you mentioned it being a little bit stronger with weakness mostly in the CBD, which probably doesn’t come as a huge surprise. When would you expect some of that supply to leak into West LA? Or would you?

Yes, it's been interesting to observe the different submarkets. Clearly, downtown LA has significant demand due to a large number of jobs compared to supply. Ultimately, everything will balance out. The quality of life in downtown LA is continually improving, which is appealing to people. However, there is currently a lot of new supply in that area. Although it's a small fraction of the overall supply in LA, there’s still a substantial amount in downtown. Various markets are being affected, and we've seen different impacts across submarkets. Sometimes the demand shifts to areas like Pasadena or Glendale, and at other times, it moves towards Torrance or Woodland Hills. The fluctuations are difficult to explain. This quarter, the Tri-Valley and Woodland Hills areas are performing better, while Long Beach has seen some growth. Overall, we've observed these market dynamics rotating over the past 1.5 years. Regardless, the overall demand continues to far exceed supply, indicating that people are making lifestyle changes to move to downtown, which remains an increasingly attractive location.

First question, just want to go back to the comments on the same-store revenue growth. Last quarter, you had said that the first half of the year would be weaker than the second half of the year, and then that flipped today. But it sounds like the approach you took on occupancy is exactly what you expected going into the quarter. So can you maybe just bridge what drove the difference in the cadence for the year?

Sure. So our expectations for market rents, we’re just trailing a little bit in where we expect the market rents to be. Our expectations on scheduled rent, the rent roll, are really spot on. The real big change was in occupancy, and that all really came together at the end of the year as a combination of factors from concession strategy that we launched as well as working to ensure that we do whatever we can from a community perspective as it relates to the fires, related to the Executive Order that was signed and, of course, comply with the laws. So all that together meant that we ended up lowering our prices on a month-to-month and increasing our month-to-month about 1.3% across the portfolio as well as we restricted renewal. And again, I mentioned on my comments that our turnover went from 46% down to 40%. So all of that kind of came together from the end of the year and then into the first quarter and gave us a benefit of the occupancy. But the market overall is really operating consistent with our expectations, and our scheduled rent is. At this point in time, we’re watching as we expect our occupancy to decline. And so it’s really not a change in our expectations for the year. It’s just we ended up with some extra occupancy Q1 and adjusted our guidance accordingly.

And then bigger-picture question just on the supply dynamic. You noted the new supply not penciling or new opportunities not penciling, but at the same time, I think you purposely talked to some of those academic studies or I think just what we all realize is the shortage of housing in general. So those two things don’t necessarily seem to go well together. If we have a shortage of housing and I’m on the side of high cost in one form or another, it doesn’t seem like I’m going to lower my cost anytime soon. So what would be the breakage, what causes costs to go down in that environment? Or if I’m a developer, said another way, why wouldn’t I look past those short-term issues if I feel there’s a shortage in front of me?

We happen to have a developer in the room in Mr. Eudy, so he can answer that. But I would say, John, how many times in the 30 years you and I have worked together have we seen cost overall go down for new development? I mean, I don’t think ever, right?

Well, in the recession, it went down dramatically but it grew in recession, we went through a lot of measures to get stability in the market.

Okay. So that’s perhaps the only significant one and that was driven mainly by the construction. The general contractors have very little to do, and they want to get something started, so they’re willing to do it at very low profit margins. I guess, I contrast that with what we see now, which is commercial construction booming, various types of residential booming, and dramatic undersupply housing. And that’s driving construction costs again at around this 10% increase, which, again, there’s an imbalance here. And it doesn’t appear that the mend of that issue is anytime close to being at hand. So we would agree with you.

If you could look at that, those prior cycles, have elevated costs ever been the catalyst to slow supply?

Certainly. Many times, this has caused supply issues. Usually, development is riskier than simply purchasing buildings and securing loans on them, which is why we require a premium; things don’t always go as planned in a development deal. The issue arises when rents don’t increase as quickly as hoped or forecasted, while costs are rising, resulting in squeezed margins. Some landowners choose to proceed with deals at what would be considered a subnormal risk premium, adding more equity to move transactions forward rather than putting them on hold in hopes of future improvement. This typically happens on a limited basis; eventually, people exhaust additional equity to make their deals work. We are currently in a situation where the market is navigating these challenges, as construction costs escalate faster than rents and net operating incomes. This is the primary reason we are exploring preferred equity deals and other development opportunities, as making transactions work is proving to be quite difficult.

A couple of other comments. At this stage of the cycle, too, exactions and city requirements and takes on additional fees tend to go up. So you have that coupled with hard costs and items that Mike mentioned that make it more and more challenging to economic and make a deal make sense.

This is Alex Kubicek on for Drew this morning. My question is a little bit of a follow-up to what we were just talking about with the general transaction market as a whole. It sounds like it’s tough to make things taper and attractive for you. But where do you guys see the incremental opportunities that you can take advantage of to hit your 2018 targets for the rest of the year?

Well, this is Mike, and that’s a great question. It’s a little bit unclear. In the first quarter, obviously, the stock traded off pretty considerably and we thought that the better transaction or the better capital allocation was to buy some shares back. Now that the stock has recovered somewhat, somewhere around NAV, let’s say, ordinarily, we would look more to our co-investment platform in that scenario to make deals work. There were 20 deals in the first quarter that were in our marketplace that would generally have satisfied our overall transaction parameters. So there are deals out there. Again, when we have stock trading at a discount to NAV, we’re going to pursue that as opposed to buying deals at market. And so I guess, where we are now is probably relying on the JV platform to make deals. And if there’s significant changes in either direction, in the stock price, then our expectations can change pretty dramatically and pretty quickly.

Kind of just as a follow-up, do you foresee this Costa-Hawkins uncertainty overhang causing any general shift in the next, call it, nine, 12 months in underwriting expectations on both the acquisition and the disposition side?

It’s difficult to predict exactly what will happen because interest rates are also a factor. Currently, we've shifted from a situation with strong positive leverage on acquisition transactions to just a slight amount of positive leverage. I don’t see this as negative, but it isn't positive either. The 20 transactions, mostly in California, that closed in the first quarter don’t indicate that Costa-Hawkins is affecting the transaction market. As we approach November, there may be some impact, but it's still important to note that Costa-Hawkins does not automatically lead to rent control. Even if rent control happens, the extent of it and which cities will be affected remain significant questions. It’s still a bit too early to make definite conclusions. Looking at the broader view, California faces a substantial housing shortage. The legislature considered AB 1506, which clearly shows they are aware of the housing shortages and opted not to advance the repeal of Costa-Hawkins. It appears there are factors suggesting it’s premature to assert that there will be widespread effects. However, I cannot speak definitively at this time, and we will continue to keep a close eye on the situation.

Mike, I wanted to follow up on the rent control discussion. Is your understanding that single-family rentals are included in the rent control proposal, or will they be treated separately? Additionally, from your conversations with people in California, do you think enough individuals realize that rent control could negatively impact development and increase unaffordability? Or do you sense, based on the polling, that the support is growing for overturning Costa-Hawkins?

Yes. John Eudy is here and he spends a tremendous amount of time and has really led the industry in this discussion. So John, do you want to take that one?

Sure, Mike. First on your first question on single-family, the repeal measure that is going to the ballot, it appears, does include removing the exemption of single-family. So yes, if passed, single-family would be exposed to having rent control applied to it, which is one of the big proponents for us because it means the majority of the rental units, as you well know, in California are mom-and-pop-owned and smaller local-owned entities and they have a lot to lose. And that brings the attention to the ballot measure in a wide way to be in our favor to oppose it. Generally speaking, we’ve been working on this pre-campaign for about 9 months before it officially got put into play in January. And they just recently collected enough signatures to technically qualify this to the Attorney General’s office to get to the final legs by the end of June. But we believe from a policy perspective, clearly, the legislature gets it. That’s why it never made it out of committee at AB 1506. And we also know that every academic study that’s ever really been done on rent control understands the unintended consequences that it actually hurts those that it supposedly is intended to help. So we’re pretty encouraged with our initial polling and how we’re going to be managing the campaign. We’re actually going to push this back, and at the same time, come up with, at the tail end, ways to bridge the gap on affordability issues at the lower and middle end of the range because that’s really where the problem is. Rent control per se, the reason Costa-Hawkins was enacted in 1995 was because it stopped housing and the last thing you want to do in housing production. So we’re fairly confident that we’re going to get there and message it through. And if it does go to the ballot, which it appears it will, that we will prevail.

Okay. Regarding the second question, you mentioned that some emergency rent measures are still in effect in certain submarkets until the end of the year. However, you also indicated that your strategy for the second quarter will prioritize increasing rent over maintaining occupancy. Could you provide insight into what percentage of your portfolio is still affected by the 10% rent limit and how you plan to manage the potential decline in occupancy as you raise rents in the second quarter?

Sure. Let me provide a broader answer to that, Alex. The primary county affected where we operate is Ventura, which accounts for less than 5% of the company. However, we intend to collaborate with the community in any area we believe there might be an impact. Essex has always prioritized working with communities. So far, we haven't encountered situations where individuals affected by the fire are relocating near our properties. Regarding the change, I wouldn't describe it as a policy shift; it's more about our seasonal operations. Seasonally, the rents in our portfolio tend to rise from a low in January or December by about 5% to 6% and then come back down. We tailor our operational strategy based on the season. During what could be considered the slower season, our focus is on maintaining occupancy, while in the higher season, we aim to align our rents with the market. Overall, as I mentioned, our rents are moving about 2% year-over-year, and we anticipate a similar increase of about 2% or 3% this year. This represents a minor adjustment, but it will affect our occupancy in the second quarter. Does that answer your question?

I’ll try to be brief. I wanted to revisit the occupancy strategy from the quarter in relation to job growth and supply. I’m confused about why you increased occupancy so much and limited renewal pricing before peak leasing if job growth is improving and supply is expected to decrease year-over-year. Can you help clarify that situation?

Sure. We look at it and say if you’re sitting on a vacant unit, you’re not collecting any income. And so if we can create a scenario where our residents are benefited and we’re benefited because we keep that unit occupied during a slow season, we think that’s a good thing. And I think we were able to accomplish that objective very well. We had, again, our turnover go from 46% down to 40%, which really means the majority of the boost in the occupancy was fewer move-outs, which is a great thing. In doing that, it enables us to be positioned well to meet the market as the peak season leasing comes upon us. So we’re not looking with buildings that have occupancy issues and struggling with our market rents. We’re able to try to meet the market wherever the market is. And again, our expectations are that the market will move up in the 2% to 3% year-over-year range, but we’ll be able to meet the higher end of the, meet the market where it’s at. So the strategy makes sense from our perspective. Otherwise, we would have just ended up in the same spot but with lower occupancy for Q1 and, in essence, less income. Yes, that's correct. The decline we experienced in occupancy was not due to Seattle. I noted that scheduled rent was at 2.3% and our occupancy showed a year-over-year increase of 30 basis points in April. I shared this to highlight our transition from a 60 basis point increase in Q1 to a 30 basis point increase in Q2, with the expectation that our occupancy will align with last year's. The year's developments are unfolding as anticipated, and we are well positioned. It’s important to clarify that the market is performing as expected; the main difference lies in occupancy and the positioning of our portfolio, which is strategically aligned to capitalize on the peak leasing season.

Thank you, operator, and thank everyone for your participation on the call. We look forward to seeing many of you at the upcoming NAREIT conference in June. Have a good day. Thank you.