Essex Property Trust Inc (ESS) — Q2 2018 Earnings Call Transcript

Good morning, and thank you for joining us today for our second quarter earnings conference call. John Burkart and Angela Kleiman will follow me with comments, and John Eudy is here for Q&A. Today, I will discuss three topics: second quarter results and revisions to our 2018 market outlook, investment market conditions and an update on regulatory matters. On to the first topic. We’re pleased with our strong second quarter results, which reflect a mostly normal leasing season when compared to the early peak in market rents that we experienced in 2017. The deceleration in revenue growth in Q2 versus Q1 2018 is attributable to the occupancy gain difference in the two quarters of a 30 basis point increase in Q2 as compared to a 60 basis point benefit in Q1 2018. While the market rent growth comps become easier in the second half of this year, it is our expectation that revenue growth will slow modestly as we push rents at slightly lower levels of occupancy, which will mostly benefit 2019. Overall, fundamentals for apartments remain favorable and demand for rental housing continues to be strong. We are seeing strength in our Northern and Southern California portfolios, particularly in San Jose and San Diego, and supply-related weakness in Seattle. As expected, favorable macroeconomic trends support a positive outlook for the U.S. and West Coast economies, indicated by a re-acceleration in job growth across much of the country. During the quarter, hiring continued at a healthy pace in the Essex West Coast metros with 2.1% job growth for the trailing three months ending in June. This outperformed our initial forecast for the year of 1.6%. The tech markets of Seattle and San Jose continue to lead the way with more than 3% job growth during the period, driven by increases in the information sector. Given this strength, we are increasing our full year job growth forecast for San Jose and Seattle by 130 basis points and 70 basis points, respectively. This resulted in an increase in our full year job growth forecast for the Essex markets by 40 basis points to 2%. Throughout the U.S., a stronger economy and tight labor market conditions are drawing more people back into the workforce. In the past year, the labor force is up 1.9 million people or 1.2%, which is double the average growth rate seen over the current cycle. The higher labor participation rate can lead to incremental demand from people still living at home with parents or those currently doubling up. Strong jobs data has resulted in a weighted average unemployment rate in the Essex markets of 3.5%, well below the U.S. average. Shortages of skilled workers are pushing wages, which are growing faster than rents. Personal incomes are expected to grow 5.6% for the Essex portfolio in 2018 compared to market rent growth of 3%. As a result, we are seeing an improvement in rental affordability in all of our markets compared to one year ago. On S-16.1 of the supplemental, we published a chart on the cost to own a home versus rent in our West Coast market. Due to severe for-sale housing shortages and recent tax reform, the premium to own a home versus renting an apartment has risen to 77% as compared to the historical average of 49%. Large increases in median home prices, which are up 13% year-over-year, along with tax law changes are driving the substantial increase. As a result, we expect this to favorably impact demand for rental housing and apartment fundamentals. Turning to supply. During the quarter, we completed a full scrub of our supply analysis, including on-the-ground surveys of under-construction projects, to assess recent progress and expected delivery timing. Overall, supply remains relatively unchanged in our markets from our prior projections with the exception of Los Angeles, where delays pushed back deliveries to later in 2018 and into 2019, and Seattle where supply is up slightly. Our analysis indicates that Orange County, San Diego, San Francisco and Seattle will be past their peak supply by the end of 2018. Overall, across our markets, we expect 2019 apartment deliveries to be relatively flat compared to 2018. Multifamily deliveries continue to be heavily concentrated in the downtown and CBD markets. As noted previously, when several nearby properties are delivered at the same time, lease-up concessions will often increase, temporarily disrupting pricing at stabilized communities. Specifically, in Seattle and downtown Los Angeles, the concentration and timing of deliveries have resulted in four to six weeks of leasing concessions at new communities, impacting price and resulting in periodic concessions at nearby stabilized communities. These concessions begin to abate once the pace of apartment deliveries subsides. Going forward, we believe construction starts will slowly decline in our markets given rising construction costs, shortages of skilled labor and a more conservative lending environment. As it relates to revisions to our 2018 market rent growth forecast, there is no change to the Essex portfolio rent growth of 3%. However, there are changes with end markets, namely: we now expect San Jose rent growth to be 4%, which is 100 basis points stronger than our initial expectations due to better job growth; conversely, Seattle is expected to be weaker than expected in the second half of 2018 given higher apartment deliveries in Q3 and Q4, and the greater seasonal drop-off in demand that usually occurs in Seattle in the back half of the year. My second topic, updates on investment markets. During the quarter, we closed on one disposition in San Diego at a low 4% cap rate and have one acquisition in a co-investment entity in contract for approximately $100 million. We reviewed recent institutional apartment transactions in the Essex markets and concluded that there has not been any significant change to cap rates. Therefore, we continue to see A-quality property in locations trading around a 4% to 4.25% cap rate, with B-quality property and locations generally trading 25 to 50 basis points higher. As noted in the past two quarters, and even with healthy levels of multifamily permits, we continue to see a slowdown in the volume of preferred equity opportunities that meet our underwriting criteria. Development yields are compressing given that construction costs increase generally exceed property NOI growth rates, representing a significant headwind to new development. So far this year, we have closed one preferred equity investment for $26.5 million, bringing our total outstanding commitments to $398 million as of the second quarter. Angela will discuss revisions to our full year investment guidance momentarily. Third topic, regulatory matters. During the last few months, there has been a great deal of investor concern and reaction to Proposition 10 in California seeking to repeal the Costa-Hawkins Rental Housing Act. As a reminder, Costa-Hawkins is a state law that seeks to promote housing production to meet demand by establishing guidelines for rent control policies that can be enacted by cities. In summary, Costa-Hawkins became state law in 1995 to counter the unintended negative effects of severe rent control laws adopted by certain cities, which resulted in a dramatic suppression of housing development and property improvement. Prior to Costa-Hawkins, there were 12 local rent control ordinances enacted. A few cities, including Berkeley, San Francisco and Santa Monica, passed ordinances containing severe provisions, such as rent control of vacant apartments, which had draconian impacts, including no meaningful production of rental housing for the following 20-year period. As a result, these cities remain chronically undersupplied with respect to housing. The state legislature passed Costa-Hawkins in 1995 to increase housing production and quality, requiring vacancy decontrol in all California jurisdictions and exempting any new construction built after February 1, 1995, from rent control. Following the enactment of Costa-Hawkins, new housing development experienced a significant rebound. Essex has been part of a broad coalition to oppose the repeal of Costa-Hawkins, joined by other apartment companies, trade organizations, unions, veterans, the NAACP and a variety of pro-business groups. We believe that rent control is bad policy. Given California’s severe housing shortage, vibrant economy and an estimated 180,000 new jobs in coastal California in 2018, it remains unclear where many of the people filling the new jobs will live. We continue to vigorously oppose any expansion of rent control at both the state and local levels. Strategically, the outlook for changing rent control is now a critical consideration in all portfolio allocation decisions. Property in cities that tighten rent control will be less attractive, leading to greater housing shortages over time, while nearby cities without rent control become more attractive for investment. We operate in about 70 cities in California, and information about what cities might do if Costa-Hawkins is repealed is often incomplete or not available. Keep in mind, in the past two years, 10 cities pursued rent control for pre-1995 properties, with 80% of the proposals rejected. We will continue to periodically update you as needed. That concludes my comments, and I’ll now turn the call over to John.

Thank you, Mike. Q2 was another solid quarter for Essex with year-over-year same-store revenue growth of 2.8% and NOI growth of 3%. Southern California led the portfolio in the second quarter with year-over-year revenue growth of 3.3% in part due to its 60 basis point gain in occupancy over the prior year’s period. This leasing season is playing out as anticipated. Our rents are following the historically normal rental rate curve, which peaks in July as opposed to last year when rental rates peaked early. The impact of the 2018 seasonal pattern is evident in our loss to lease numbers, which grew to 3.6% in July of 2018 compared to last year when loss to lease in July was 2%. In order to maximize revenue over the next 12 months, our operating strategy is favoring market rents instead of favoring occupancy. Therefore, we expect that our occupancy during the third quarter of 2018 will be about 30 basis points below the prior year’s period or approximately 96.4%, which will create a significant headwind for revenue this period. In July 2018, our same-store financial occupancy was 96.1%. Q3 2018 will be our low point for year-over-year revenue growth due to the occupancy headwind and timing of other income. Now we’ll provide an update on our markets. The Seattle market continues to be supported by strong job growth, posting year-over-year job gains of 3.1% in the second quarter of 2018, the second highest in the Essex portfolio. WeWork and Zillow continue to expand their downtown Seattle footprint by leasing the combined additional 200,000 square feet of office space. The Seattle MD has roughly 5.2 million square feet of office space currently under construction, 45% of which is already preleased. Revenue in our East side and Seattle CBD submarkets grew 2.8% and 2.1%, respectively, for the second quarter of 2018 over the prior year’s period. After years of outperformance, market rents are relatively flat compared to last year. Moving on to Northern California. Job growth in the San Francisco Bay Area in Q2 averaged 2.5% year-over-year with over 76,000 jobs added. San Jose led the way with 3.3% job growth, while Oakland and San Francisco were up 1.8% and 1.7%, respectively. Facebook’s expansion was robust this quarter, signing the largest San Francisco office lease in history for 756,000 square feet, taking over the entire Park Tower building as well as adding an additional 750,000 square feet across the bay in Fremont. Demand for prime office space continues to intensify as major tech companies compete for office space. An under-construction project in Mountain View changed hands from LinkedIn to WeWork and finally to Facebook, which ended up leasing both buildings totaling 450,000 square feet. Other office leasing activity remains healthy in the market. In San Francisco, a self-driving car maker and two biotech companies expanded their footprint by a combined 675,000 square feet. And in the South Bay, Amazon grew the Bay Area footprint by adding a 385,000 square foot lease in Sunnyvale. San Francisco quarterly office absorption was the highest amongst the Essex markets at 1.9% of total stock. Between San Francisco and Silicon Valley, there was about 7.5 million square feet of office space under construction, of which 68% is preleased. In July, we completed the lease-up of Station Park Green Phase 1 and estimate that pre-leasing for phases 2 and 3 will start sometime in mid-2019. Our year-over-year same-store revenue growth for the second quarter of 2018 continues to be led by Oakland and Fremont submarkets with 3% and 2.6% revenue growth. San Mateo and San Jose grew at 2.4% and 1.8%, respectively, for the same period, while San Francisco was last for the period. Heading down to Southern California. Job growth in Los Angeles in Q2 2018 averaged 1.4% year-over-year, 50 basis points above the pace of growth a year ago. Notable leases for the quarter include Spotify’s 110,000 square foot expansion into the Arts District in downtown L.A. and WeWork’s 75,000 square foot lease, its 17th in the L.A. area. Revenue growth for the second quarter of 2018 was led by Woodland Hills with 5.1% and West L.A. with 3.9%, trailed by the Tri-Cities with 2% and Long Beach with 2%. Orange County jobs in the second quarter grew 1.3% year-over-year. While this pace was weaker than our other markets, it’s worth noting that reported growth was similarly soft at this time last year and then it was revised materially higher in the BLS’s annual benchmark revisions. Office activity continues to be healthy with 1 million square feet under construction, 40% of which is pre-leased. That is up from 20% pre-leased in Q1 of this year. Essex’s South and North submarkets grew year-over-year at 3.5% and 1.8%, respectively, for the period. Finally, in San Diego, year-over-year job growth remained at 1.9% in the second quarter of 2018. Revenue growth in the second quarter of 2018 was between 4% in the North side submarkets to 6.3% in Chula Vista over the prior year’s period. Currently, our portfolio is at 96.5% occupancy, and our availability 30 days out is at 5%. Our renewals are being sent out, consistent with the loss to lease. Thank you, and I will now turn the call over to our CFO, Angela Kleiman.

Thank you, John. I’ll start with a review of our second quarter results, provide additional color on our full year guidance revisions and conclude with a balance sheet update. In the second quarter, core FFO grew 5.7%, exceeding the midpoint of guidance by $0.09 per share. As noted in our press release, $0.03 of the favorable variance relates to timing of operating expenses, which are now expected to occur in the second half of the year. The remaining $0.06 of outperformance is comprised of the following: $0.02 from property revenues, $0.02 from property tax adjustments in the non-same-store pool and $0.02 from a combination of various miscellaneous items. As a result of our second quarter performance, we are increasing the midpoint of our full year guidance for same-property revenue and NOI growth by 15 basis points to 2.8% and 2.9%, respectively. Year-to-date, we have raised the midpoint of our same-property revenue and NOI growth guidance by 30 and 35 basis points, respectively. But the strong second quarter results have also enabled us to raise our full year core FFO per-share guidance by $0.07 at the midpoint to $12.53. This represents a 5.2% year-over-year growth, which is 70 basis points higher than our original guidance of 4.5% core FFO growth per share. Turning to our full year investment guidance. Our initial guidance assumed between $400 million to $525 million of acquisitions, which would be funded with joint ventures or disposition proceeds. Therefore, our initial disposition guidance of $550 million to $750 million was dependent upon achieving our investment targets. Year-to-date, we have not acquired any properties as the assets in our markets remain highly desirable in the current competitive landscape, resulting in a continued tight cap rate environment, as Mike discussed earlier. Given this dynamic, we have chosen to stay consistent to our disciplined underwriting and capital allocation strategy. Accordingly, we are modifying our 2018 investment guidance to assume $100 million to $300 million of acquisitions and $200 million to $300 million of dispositions for the full year. The revised guidance range includes transactions in the current pipeline. Note that our dispositions guidance excludes funding for our $250 million stock buyback program. Therefore, the amount of dispositions could increase from our guidance range, subject to the stock buyback volume, which we would execute on a leverage-neutral basis. Lastly, a brief update on capital markets and the balance sheet. As we look to the second half of the year, our capital needs remain de minimis. The sale of Domain in the second quarter provided for all of our development funding needs. And we only have $120 million of secured debt maturing in the second half of the year, which was already contemplated in our $300 million unsecured bond issuance in the first quarter. With net debt-to-EBITDA of 5.5x and over $1.6 billion of liquidity, our balance sheet remains strong. That concludes my comments, and I will now turn the call back to the operator for questions and answers.

Thanks. I just want to start on guidance. You mentioned that Q3 would be the low point for same-store revenue growth. So what are you assuming for Q3 and Q4?

For the guidance range, we assume Q3 same-store revenue in the low 2s and Q4 in high 2s.

Thanks. And then just on Prop 10. Hypothetically, if it does pass, some municipalities move to rent control, what do you think the timing would be in terms of how long it would take to actually implement?

Hey, Nick, it’s Mike Schall. It’s a good question. There are many conversations that are going on at the local level with respect to rent control. And they are debating at the local level what exactly is going to happen if Prop. 10 passes. But at this point in time, either because they haven’t decided or because the deliberations are not open to the public, it’s pretty tough to tell exactly what they’re going to do or when they’re going to do it. There have been various cities that have tried to pursue new rent control proposals, including three that were defeated: Long Beach, Pasadena and Inglewood. There are some that are on the local ballot. Santa Cruz and Santa Ana are examples of that. And of course, there was the failed attempt to repeal the Washington state law that would have banned rent control currently. So there’s a lot of activity in this area, and none of it is complete. For example, it’s difficult to distinguish what types of rent control these different cities are going to have. Some forms, as noted in my comments, are extreme, those that involve controlling vacant units, for example. But many of them are not nearly that extreme. And therefore, there’s a lot to be learned, and we still need a lot more information before we can make a good decision about what the impacts are going to be.

Yes. This is John Eudy. I’d like to add one comment. With all the cities that we deal with on the entitlement side, I can tell you the vast majority do recognize the fact that if rent control were to be initiated in a city, it would have a very large impact on their ability to produce housing. Most cities are behind on the housing element, and we believe that’s another governing factor. On part of your question, you asked how long it would take. We don’t think most cities are waiting at the altar to initiate rent control, assuming Prop. 10 were to pass. We think they’re going to be thoughtful and methodical how they approach it. And it’s too speculative to say, like Mike said, exactly where it lands, but we believe that it will be done in a balanced way. In a few cities that do, it will probably be much less draconian than the 1970 version of rent control, is our general belief.

Thank you.

Hi. Thanks for taking the questions. I was just curious if the job growth outlook in your revised revenue guidance assume that the pace of job growth moderates in the back half of the year. It sounded like some of the Q2 data points on job growth were above some of the full year assumptions you provided.

Sure. Job growth – this is John. Job growth, obviously, moves around quite a bit, and we follow it on a monthly basis. But in the end, we’re expecting the economy is doing well. We see the economy doing very well right now. We raised our numbers a little bit to reflect that reality. We’re not expecting a big slowdown, but the numbers are somewhat volatile. So we just see a solid second half as it relates to job growth and just with some limited movement up and down.

Thanks. And then I thought your comments around households doubling up and an improving affordability was interesting, and I was just curious if you’ve seen this phenomenon in the past and if you have any sense of what the benefit this could provide from a demand perspective or an impact on market rents.

Yes, this is Mike. Yes, we, for a long time, have believed that as long as we’re in the band of 90% to 110% of long-term average rent-to-median income ratio, that tends to be a good spot in terms of rental pricing. If it’s below 90%, it probably indicates that there’s something wrong with the market. And if it’s above 110%, then you get into these affordability issues. And that ratio improved in each market, as noted in my script. And interestingly, in Northern California, we are under the 110% threshold in all three major metros. So that’s good news. And we’re pretty close to 110% in most of Southern California. So we’ve actually really come a long way with respect to affordability in the last several quarters.

And where has that ratio been historically?

Again, it’s – we’re comparing this to the band of 90% to 110% of the long-term, 25-year, from 1990 to 2017 average. So it depends by market. Typically, Southern California is in the 22% range typically, and Northern California is in the 22% range except San Francisco is more like 27%. And Seattle is about 19%. That’s the long-term historical average.

Great. Thank you.

Thank you. Hi, everyone. I would like to revisit your opening remarks, Mike, and seek clarification regarding your comments on occupancy for 2019. It seems you're suggesting that there will be a slight decline in the second half. Are you indicating that you're focused on pushing rent? Do you believe that based on demand, occupancy is expected to improve again in 2019?

Yes, let me actually kick that to John because I think you’re referring to his outlook for the rest of this year. So John, you want to handle that?

Yes, absolutely. So what I’m seeing is in Q1, we had a benefit of 60 basis points occupancy year-over-year. Q2, that shifted to 30 basis points. And in Q3, it’ll actually be a headwind of 30 basis points, and that clearly impacts the year-over-year numbers that Angela was referencing. The reason being is we’ve shifted to the strategy that the market has improved and the seasonality of the curve is consistent with the past, with last year or with historical standards. Last year, it fell off early. So we shifted strategies to favor achieving market rent as opposed to maximizing occupancy. So it’s that adjustment, which is also in line with increased turnover, increased units turning. Each unit that turns, there’s a certain occupancy related to it. So as we turn more units in the summer and as we focus on achieving market rent instead of occupancy, there’s a natural adjustment. It’s not because the market’s weak, it’s because actually the market’s stronger, and we’ve adjusted our management strategy to maximize revenue over the next 12 months. So Q3 is the one that’s most impacted negatively, as I mentioned. And then Q4 will bring our occupancy back up as we enter the weaker part of the rental season. Does that answer your question?

Yes. Thanks. And I thought Mike in his opening talked about the expected benefit in 2019. But that’s helpful.

Sure, yes. I’ll...

Let me... Yes, exactly. So if we’re going to create an occupancy headwind in Q3, then by pushing rents – obviously, the rent growth – we only have four months left of 2018, and so the benefit from the higher rent growth is going to mainly start us out on a positive foot into 2019. Keep in mind that loss to lease at the end of July was 3.5% this year versus 2% last year. So that increment, you could expect to help us in 2019.

Okay. Thanks. Then just one follow-up on the rent control conversation. I mean, is it too early to talk about – if a town does implement rent control, what would Essex do with their – in that town or a municipality?

Yes, this is Mike. Yes, we’ve given a lot of thought to this, and we’ve done a lot of research on what the discussions are in these various cities. And it’s pretty difficult to glean any conclusions, obvious conclusions from those discussions because so many things are in flux right now. Because all rent control is not the same. There are, as we’ve said, relatively few cities that have extreme forms of rent control, and then there are other cities that have moderate forms of rent control. As we think of the world given – and John said this a few minutes ago, but I’ll just reiterate part of it from my perspective – there seems to be a real split in how to deal with California’s incredible housing shortage. A lot of the politicians and legislature have chosen to do things that are going to promote more housing development, consistent with California’s Global Warming Solutions Act, which effectively seeks to put housing and office next to one another and get people out of their cars. There were 15 bills signed by Governor Brown last year, for example, that had the objective of increasing housing development, raising money for affordable housing, penalizing cities that didn’t produce their housing element, et cetera. So you have that on the one hand, and then you have this whole other political movement to try to use rent control as a solution to a problem. Well, rent control obviously doesn’t produce more units. In fact, it produces less units because cities with extreme forms of rent control are going to produce less housing like they did last time around. So we know that. They also – there’s also a fiscal impact in that the estimated cost to the state and local governments is in the hundreds of millions of dollar range, which is, I would think, problematic as far as that goes. And then finally, the third problem with rent control is there’s conversions, for example, condos from rental housing into other forms of housing. So it actually depletes the housing stock. So what we’re talking about here is, there are people in the short term that will benefit from rent control, i.e., those that get a rent control unit. And then further down the road, there’s going to be greater shortages, and the people that will be most vulnerable in that scenario will again be the people of limited means because there’s going to be fewer houses – fewer housing units available in that scenario, and they’re likely to be more expensive and more difficult to obtain.

Okay. Thank you. That helps.

Hey, good morning out there. Mike, just appreciate your comments on the nuance of the conversations over rent control with the different cities. But I guess from on the point of vacancy decontrol because that seems to be one of the most key elements of Costa-Hawkins and whether or not cities did draconian or not, is there any sense, as you guys speak to the different municipalities, that they understand the impact that removing vacancy decontrol would have? Or is it all part of a nebulous thing and they’re not even bringing that element up?

This is John Eudy, Alex. There’s no question that cities understand that. And if we were to lose vacancy decontrol by virtue of a city passing that, it also brings in the element of a fair rider return. And it’s pretty clear that if you don’t have the ability to turn units at market, you wouldn’t be able to achieve that. So there’s a legal argument there that also keeps the cities in line to understand that metric. So we believe the vast majority of cities get it. There will be a few exceptions that we’ll have to work with if it comes to that.

Okay. And then the second question is, you guys – Mike, you spoke earlier about the impact of pricing versus last year’s early peak and then with the wildfires, and you spoke 30 basis points – or Angela, you spoke about 30 basis points lower occupancy hitting the third quarter. But still, you guys definitely crushed on the quarter. Classic Essex. So how much do we take your comments with a bit of grain of salt when you’re saying that, hey, third quarter is going to be the low point of the year versus things are going better? And I guess the point is, has the economy improved a lot more than you guys thought when you had your outlook and discussions at NAREIT earlier this year? Or is it the standard Essex conservatism?

Hey, Alex thank you for the compliment, I guess, and this is John. And where we’re at as it relates to the numbers, I in my script, I mentioned that July, we were at 96.1% occupancy very specifically to show that occupancy really has drifted down pretty significantly. And I, of course, ended the script with the fact that we’re at 96.5% current fiscal. So we’ve pushed it back up some. But that 30 basis point change from last year for the third quarter, which the third quarter last year we were at 96.7%, and so we’re expecting to average in on the third quarter this year at 96.4%, still a good number, it’s real. There’s a real headwind, and it really is a difference from Q2 when we had a 30 basis point benefit. That’s a 60 basis point swing. So the real numbers, with respect to the strategy change, then that actually tied back to yes, the market is performing as expected and it’s performing well. And the curve has – market peaked, as expected, in July as opposed to early, and so we were adjusting to that. So no, we’re not seeing me baking it in a big way, but thank you for the compliments.

Okay. But were you saying, John, that the market hasn’t improved more than you thought? The market has been consistent with the way you guys originally thought earlier this year?

Yes, it’s Mike. Think of this as a big lagging machine. And what happens today, it doesn’t show up in the numbers until some future day because again, we have to turn leases in the new reality. So what we’ve done last year is we were given a choice between how much rent can we get in the third quarter. I’m talking about 2017. How much rent can we get? Or are we better off trying to push occupancy? We made an occupancy-based decision to push occupancy given that scenario. Now we’re looking at this year, 2018, and we come to a different conclusion. And the way it shows up in the numbers, it looks like it’s getting weaker, but it’s not getting weaker, it’s getting better. It’s just going to take several months or a couple quarters for you to really see the benefit of that. 2018, because again, the shape of the market rent curve, for the first half of the year, we have really tough comps because we gave up so much rent growth in the second half of 2017. That won’t happen this year. Again, I go back to this loss to lease being the critical piece of it. At the end of – July 2017, it was 2% and going down. And in 2018, it’s 3.5%, much more normal and much stronger. So again, it’s going to take a few months and some quarters for this to become apparent, but we’re looking down the road in terms of our pricing decisions and trying to maximize revenue down the road somewhere.

Okay. Thank you.

Hi. Thank you. Actually, following that last question. So when you look at the decision of a year ago and push occupancy versus today to be more focused on the rent side, when you think about the change in the market, how much of that better outlook that you have today is due to stronger demand versus less supply? Or what’s the right way to think about the balance of those two things shifting over the last year?

I’ll – this is John. I’ll start and Mike want to – Mike might want to follow on. But really – certainly, we have strong demand out in the marketplace, and it’s showing in the curve. As well as, supply was a little bit light in the first half of the year, which we benefited from. So it’s really a combination, and that’s probably what brought the curve back to what you might say is the normalized seasonal pattern. And the result of that is better year-over-year comps as it relates to market rents and then, therefore, the shift in operations strategy.

Okay, just to clarify. When you say less supply in the front half of this year, was that a push out of supply into the second half of 2019?

So you know what? It seems like that’s just the ongoing theme for the last two years is supply keeps getting pushed out. And certainly, in some markets like in L.A, we saw supply getting pushed out, and it continues to be pushed out. So yes, it’s not that supply somehow kind of evaporated, it’s just more of a continued delay.

Dennis, I would add maybe one thing to that. And that is, it’s very difficult to determine when the supply is going to actually be completed because of these labor shortages and other things that tend to delay. So the way we have it now, for example, is we had much more supply in L.A. in the first half. But now, according to our projections, it looks like it’s mostly second half focused. However, we don’t know how much of that is actually going to get pushed into 2019. It’s just impossible for us to get down to that level of detail and to understand the labor markets in enough detail that we can make that comment. And Seattle is the other piece of it, which is, again, heavy second half supply in 2018. Some of that very easily could get pushed into 2019. So – but again, when we look at price and look at pricing and expectations, we use the best information we have, recognizing that some of these things are very difficult, if not impossible, to predict.

Yes. In understanding that volatility, I guess what I was trying to get at to make sure I understand your comments correctly is if you’ll be more offensive today on a go-forward basis than you were at this time a year ago, that more offensive strategy sounds like it’s being driven from the demand side, and it sounds like the supply side has a relatively similar outlook. Is that fair?

That’s a – yes, okay, I get more of what you’re saying. Yes, we think supply and demand, critical housing shortage, we think there’s no way that demand catches up – or supply catches up with demand under any scenario. The issue is that when you get into some of these markets, the apartment deliveries are much more concentrated in the Downtown L.A. or Downtown Seattle, for example, and the more you get that concentration, the greater chance you have that several buildings are going to compete with one another and are going to start getting to six to eight weeks of concession, which effectively stops rental growth in your stabilized communities. So that phenomenon is what I’m talking about. And this is periodic disruption. This has nothing to do with overall supply and demand. It just has to do with how aggressive owners become on lease-ups of multiple properties competing with one another in order to each absorb somewhere around 30 units a month. How far do they have to push rents or concessions in order to make that happen. I think that’s the key issue, and it’s very difficult for us to estimate what that would be. As noted in the comments on the call, Seattle tends to also be more seasonal with respect to job growth and demand. And so that’s why we have pushed back on Seattle or pushed those estimates down in terms of market rent growth for the year.

I’d like to add just one point. And that’s the fact of so we keep tracking for our geography. We just – all the data is in a lot of these MSAs, looking for where the delivery of the new product will come from. And we can see that the amount is still there and we’re doing through our deliveries more heavy in the second half. So it’s not going away, but there’s – but it would be scattered versus concentrated. That’s the key issue.

One other question of Costa-Hawkins. If you’ve done any work – when we look at your mix of assets pre and post-1995, any sense on where the market would be as to whether that change would be a relative benefit to you or headwind to you versus the broader market?

It’s Mike. I’m not sure I understand exactly where you’re coming from. Let me just try and make a couple of broad comments. And Dennis, you can chime in here and if I’m off base. We have – we’re operating in seven cities, as I noted on the call, in California. Four of them, we have more than 2,000 units in. And so the rest of them were, again, properties scattered throughout many cities in California, and there’s no greater concentration. So what we have done, and this is not a perfect science, what we’ve done is try to evaluate our portfolio in those four areas that we have the greatest concentration. Two of them have a less onerous but longstanding rent control ordinance. That’s L.A. and San Jose. And two of them do not have rent control at all. And so we’re, again, trying to monitor, make good portfolio allocation decisions, recognizing that we’re very diversified. And as John Eudy said, this conundrum of more of a rent control movement throughout California, while you have an enormous housing shortage and a bunch of law, again including the Global Warming Solutions Act, the 15 bills signed by Governor Brown last year, the conundrum embedded or the contradiction in that discussion leads us to believe that there has to be a compromise somewhere in the middle, which will be to the benefit of less severe forms of rent control. But we don’t know, and it’s impossible to know at this point in time.

Okay. That’s helpful. Thank you, guys.

Hey, guys thanks for your time. Why don’t we just come back to the supply question a little bit? Is there anything – I know supply can be somewhat volatile and somewhat hard to completely forecast. But is there anything that would give you upside to expect that maybe supply would be lower than what you’re projecting? I know you mentioned development yields, and that makes a lot of sense to me. But where could upside be where this sort of supply crest happen sooner than we’re expecting?

Yes, this is Mike, and maybe some others want to chime in here. There’s a lot of things happening that affect development. It’s one of the most sensitive parts of our business. I’ve made the comments with respect to our preferred equity program where we’re seeing less opportunities. We started the year with a very robust pipeline, and little by little, it’s been pared down. And our belief is we were somewhere around $100 million this year, but we thought we were going to be well in excess of that. And when you look at the factors that are constraining that production, it goes back to those things that I said. But you have some new things. We have tariffs, which include Canadian lumber, for example, and steel. And you have direct – the rent control discussions are not pro-development or pro-business for that matter. And so you have a number of issues that you didn’t have before. And even though the state is trying to produce more housing, the environment seems to be pushing against that, leading to that contradiction that I was talking about earlier.

Got it. And so is there any – are there any specific markets where you think supply might surprise to the downside versus the upside? Or is that getting a little bit too detailed?

Well, we think Northern California mostly has peaked. And I mentioned the markets that we’re very confident that had peaked. The areas that we remain concerned about are L.A. and, I guess, Seattle would be the two because we don’t think that they have peaked at this point in time or there are very significant permitting. I would guess that when you get down to the starts, that’s where you’re going to start seeing problems on those deals because – and John Eudy – John has two jobs. He’s the co-chair of our coalition, which is a full-time job – actually more than a full-time job; and he’s also Head of Development. And he looks at a lot of deals. John, why don’t you chime in and talk about what you’re seeing out there?

Well, I can say that in our dealings with cities on a couple of entitlements that are in the process, most cities’ impact on their stack is far less than it was a year or two ago. There are far fewer deals being processed now than there were in the peak, if you will, of the development pipeline buildup between 2014 and 2015. So I think that the outlook two years from now is going to be very much aligned lower than it is in the worst-case exception that it’s growing because it’s not. And then the headwinds between construction costs and the concern right now in the short run with the Costa-Hawkins repeal is muting it even further. So supply is going down.

Got it. And then just maybe one more question on Costa-Hawkins and Prop. 10. Your comments are very well taken on the market not having enough supply of affordable housing. But given all the noise associated with it, if Prop. 10 was to occur, would it lead you to think about maybe entering into some markets that you’re not currently participating in? Or are you just very confident with your markets over the medium to long term?

Yes, this is Mike. It’s interesting, again, back to the scenario. So if there are a few cities – let’s go back to the pre-Costa-Hawkins world, which we did just fine, by the way. In that world, as John and I have talked about, there were a few cities that had very extreme forms of rent control and basically we built no housing in those cities. So obviously, the demand is the demand for housing. And therefore, it has to go somewhere else. So if you have cities with extreme forms of rent control, you would be more likely to invest in the cities that are nearby those cities, the places where those – the people that are working in San Francisco, for example, or Berkeley, for example, might live. And we got – have a pretty good idea of how that will work. Because presumably, if you’re going to lock down housing in some cities, the cities that are the likely beneficiaries will be the cities nearby. And rents will – because again, you’re talking about a net reduction of rental housing in that scenario, rents will probably go higher, not less high. So they will benefit from the greater demand or the lack of supply, let’s say, that is caused by the rent control cities.

Understood. Thank you, everyone. I appreciate the color.

Sorry about that. Glad to hear we’re back. I wanted to just ask one more about Prop. 10. I know you said that cap rates haven’t moved in your markets, but are you seeing more product starting to come to market from landlords ahead of potential repeal?

Karin, it’s Mike and thank you for sticking with us. Anecdotally, we’ve heard that there are some more listings out there. But as I said in my comments, we really scrubbed all the deals that have been completed year-to-date just to make sure that we weren’t missing something. So we went through them one by one, the deals that were in our markets that we care about. And so there was no indication that cap rates have changed in those transactions. But again, so there are some anecdotes that maybe there’ll be a little bit more transaction activity as we get to the back half of the year, although that’s not unusual because all the sellers now that rents peak in June and July, and therefore, they typically wait until June or July to get the best underwriting of their deals. So I wouldn’t say that’s at all unusual.

Great. Thanks. And my second question is I was interested in your comments about single-family affordability in your markets and the lack thereof, given the current tax regime. We started to see some weakness in the housing markets here in the Northeast, and we obviously don’t have the same job growth that you guys have out there. Do you think that single-family headwinds could be a real demand driver for you guys in 2019 as people start to recognize the tax impact of the tax law change?

Karin, it’s Mike again. We’ve seen – when you look at production of housing in California, we’ve seen very, very low levels of production for single-family homes largely because of California’s Global Warming Solutions Act, which seeks to put housing – high-density housing near the jobs, lower carbon pollution, fix the traffic problems that we have, increase in spending for public transit, et cetera. So that agenda is sort of operating in the background, and that is not a pro-single-family home type of agenda. So we see more densification of housing in the urban markets. And so I don’t think that’s going to happen. I think that if anything, there’ll be more condos being developed, and I think that’s a big possibility. And more on that discussion as well as it relates to a number of our properties. So I think it’s more likely to be in the high-density area than it is in the single-family home.

Oh, great. Thank you. John Guinee here. Quick question for you. If you’re looking at land at today’s prices, and the current hard costs and, as you know, land prices are sticky and really haven’t come down, on an untrended basis, what does your underwriting show is the return on cost for development if you have to pay today’s prices?

This is John Eudy, John. It depends on the specifics, obviously, but far less than it would motivate you to do a deal. If you take it on today’s numbers, probably average somewhere in the high 3%, low 4%, 4.25% at the high.

Do you see institutional money essentially willing to continue at that kind of – those kind of returns? Or are they finally backing off?

From my perspective, it appears like they’re backing off. And we see it through the preferred equity program as well as the pipeline going down. Mike, what do you think?

Yes, I totally agree with John. And I would say maybe one caveat because there are deals that have a significant amount of money that are already invested in them, and those are the ones that tend to move forward. When you get beyond those transactions because, let’s say, a 4% yield is better than having $10 million invested in a deal that’s not going forward. So you end up with that conundrum. But aside from that, I totally agree with John.

Great. Thank you very much.

Thanks. Mike, I’d like to get your thoughts just on the broader political risk in California. I mean, Costa-Hawkins is one aspect, and you have some other legislation about initiatives moving against commercial landlords like Prop. 13, Prop. C. So the odds of legislators or voters reaching for the economics of landlords seem to be increasing. It’s becoming increasingly less leaning to date. I guess my question is, how do you approach political risk in comparing any type of risk-adjusted return framework to California markets versus non-California markets? And have you started factoring that into investment decisions outside of this Costa-Hawkins, very city level-specific considerations?

Yes, John, this is Mike. It’s – that’s a – it’s a good question. And we – you pretty much everything through the lens of supply and demand for housing. And so if the regulatory environment gets so extreme that you start seeing job growth slow, which drives the demand side, then that would cause us to make a different decision potentially. But we are always going to be the same. We’re going to look through the lens of supply and demand for housing, and we’re going to seek areas that have the best dynamic – the best supply-demand dynamic. And right now we believe that’s in California, in the various markets that we’re in. If that dynamic changes because of the political risk, then we would come to a different conclusion. So it’s – and I think it’s far from certain what California is going to do because we have seen, certainly on the office side and in various ways, the local governments very willing to accommodate the growth of California, wanting to accommodate the Apples and Googles, et cetera, of the world. And you’re right, more recently, you’ve seen these head tax proposals and a variety of things that seem very focused on those entities. Notably, in Washington, Amazon, the head tax was repealed after being passed. But I think to give you some idea, there is some give-and-take here, and where the politicians come out on this is going to be really critical. I think, again, there’s a dichotomy here. You have Gavin Newsom that is supportive of our position with respect to Prop. 10. He’s not favor of the repeal, but the Democratic Party is in favor of repeal. You have a variety of issues going back and forth. I think we just need to let it play out. I mean, our hope is that reason prevails at the end of the day. And the – there’s a study by UC Berkeley’s Terner Center that starts a conversation about what should happen that I think is notable, and it’s available online. And so I think it’s too early to tell. And we will see – we will know in the next year or two which way this is going to go.

Okay, that’s super helpful. Today – back to the rent control risk. Today’s prepare – portfolio allocation decisions, are you redlining any cities right now from an investment standpoint?

I wouldn’t say redline because, again, an investment decision – rent control is only one factor within the investment decision. And in fact, you would say that if, for example, Santa Cruz decides to establish a pretty extreme form of rent control, would there be a cap rate that would also bend? It’s not the current cap rate environment, obviously, but, again, there’s a number of considerations that really prevent you from absolutely redlining things. Again, assuming that the cap rates and yields do not change very significantly to compensate you for that risk and for the lower return.

Okay, great. Thank you.

Hi. This is Peter Abramowitz. I just wanted to touch on the tax expense growth in the same-store pool in the first half, just given that it has particularly kind of climbed down in the second quarter but also below the peers’ in the first half. So I was just wondering what sort of trends you’re seeing that’s keeping that pretty low. And how sustainable is that going forward? Or what are you seeing for the back half?

On the tax front, first half was lower, but it’s primarily because we had essentially property tax adjustments. And so we had expected – in the non-same-store pool. So as far as the same-store pool, it’s coming in pretty much as expected. Seattle is always a little bit of a wildcard and coming a little bit higher. And so we do expect third-party property taxes to be even higher than in the first half. Does that answer your question?

Yes, sure. Thank you.

Thank you. Hey, we’re so sorry for our technical problems during the call. Apologize for that. And I want to thank you for your participation today. Hope to see many of you at the BofA Merrill Lynch conference next month. Good day.