Extra Space Storage Inc (EXR) — Q2 2015 Earnings Call Transcript

Thank you, Shannon. Welcome to Extra Space Storage’s second quarter 2015 conference call. In addition to our press release, we have furnished unaudited supplemental financial information on our website. Please remember that management’s prepared remarks and answers to your questions may contain forward-looking statements as defined in the Private Securities Litigation Reform Act. Actual results could differ materially from those stated or implied by our forward-looking statements due to risks and uncertainties associated with the company’s business. These forward-looking statements are qualified by the cautionary statements contained in the company’s latest filings with the SEC, which we encourage our listeners to review. Forward-looking statements represent management’s estimates as of today, Thursday, July 30, 2015. The company assumes no obligation to revise or update any forward-looking statements because of changing market conditions or other circumstances after the date of this conference call. I would now like to turn the call over to Spencer Kirk, Chief Executive Officer.

Thanks, Jeff. Hello, everyone. For quite some time, I have wondered when our business would go from being great to just really good. Through the first two quarters, it continues to be great. We reached a record high occupancy of 94.5%, while producing same-store revenue growth of 9.4%. Year-over-year, NOI grew 12.1%, FFO as adjusted grew 17.2%, and we increased our dividend by over 25%. This kind of growth is directly attributable to accretive acquisitions, muted new supply, and our ability to source higher value customers online. We have been acquisitive year-to-date; we have closed over $350 million in acquisitions. In addition, last month we announced the definitive merger agreement to acquire SmartStop, the seventh largest storage company in the U.S., for approximately $1.3 billion. This single transaction will add 122 owned stores, 42 managed stores, and will increase our footprint by 15%. Including this transaction, we will likely acquire $1.8 billion in 2015. Customer acquisition on the internet is about size and scale. With these acquisitions and the growth of our third-party management business, we will finish the year with over 1,300 stores on the Extra Space platform. The expansion of our physical and digital footprint allows us to reach more customers than ever before and increases operational efficiencies. As I have said, it is a great time to be in storage. I’ll now turn the time over to Scott.

Thanks, Spencer. Last night, we reported FFO of $0.72 per share for the quarter. Excluding costs associated with acquisitions and non-cash interest, FFO as adjusted was $0.75 per share, exceeding the high end of our guidance by $0.01. The beat was primarily the result of better-than-expected property performance. Our same-store revenue growth was driven by increased occupancy, higher rates to new and existing customers, and lower discounts. Some of our standout markets in terms of revenue growth include Atlanta at 11%, Los Angeles and San Francisco at 12%, Orlando at 15%, Sacramento at 16%, and Denver at 17%. Our platform continues to maximize results in this favorable operating environment. As Spencer mentioned, we've been busy deploying capital; we closed on 31 stores for $262 million in the quarter, two of which were properties that we purchased upon completion of construction. We also purchased the remaining 1% of the joint venture partner's interest in a 19-store portfolio for $1.3 million. Subsequent to the end of the quarter, we acquired a certificate of occupancy store with a joint venture partner for $5.4 million. We currently have three operating stores under contract for $27 million; these acquisitions should close before the end of the year. In addition, we have another 16 certificate of occupancy stores under contract. The total purchase price of these stores is $172 million, of which $36 million is expected to close in 2015. Additional details related to our certificate of occupancy deals can be found in our supplemental package that’s posted on our website. Last month, we announced the SmartStop acquisition and we completed an equity offering. The offering was well-received, and we issued 6.3 million shares at $68.15 per share. This resulted in gross proceeds of $431 million. We're well into the process of securing additional debt to fund the balance of the SmartStop acquisition. The financing will include CMBS debt, secured bank loans, and draws on our revolving lines of credit. These draws will be turned out in the three to six months following close. The SmartStop acquisition, as well as our strong year-to-date results, require us to revise our guidance. These adjustments assume an October 1 closing of SmartStop. Our revised full-year FFO guidance is $2.89 to $2.96 per share. Our FFO as adjusted is $2.99 to $3.06 per share; our guidance includes dilution from our certificate of occupancy deals and acquisitions that operate below our portfolio average as well as the additional shares issued in our June offering. I will now turn the time back to Spencer.

Thank you, Scott. Through acquisitions, joint ventures, and third-party management, we continue to expand our portfolio and consolidate stores under the increasingly potent Extra Space brand. By the end of 2015, we will have closed approximately $4 billion in acquisitions over the last five years, and there's still room to grow. Fundamentals of the storage industry continue to be favorable, and we are leveraging our scalable platform to maximize revenue, NOI, and FFO. I am pleased with the outstanding performance of our team; we have driven 19 consecutive quarters of double-digit FFO growth. I’ll now turn the time back to Jeff to start our Q&A.

Thank you, Spencer. In order to ensure we have adequate time to address everyone's questions, I would ask that everyone keep your initial questions brief and, if possible, limit it to two. If time allows, we will address follow-on questions once everyone has had an opportunity to ask their initial questions. With that, we’ll start our Q&A session.

Thank you. So as you almost approach Public Storage’s scale and you have been growing pretty quickly. Do you think you've already felt comfortable that you maximized the benefits from economies of scale or being bigger and being more present on the web, or do you think there's more to be added? I think, get closer to like 2,000 properties.

Ki Bin, it’s Spencer. We think that there is upside. We’re pleased with our performance; we’re pleased with our potency. But the game is far from over, and we need to continue to expand our footprint. The Internet is about size and scale, and we’re going to continue.

Okay, and just curious, is there anything else that you guys have changed in the pricing strategy or the way you advertise on the web this past couple of quarters that you found to be, I think, a little more useful than it has been in the past?

Not a lot of changes in the last two quarters, Ki Bin. We continue to refine our models, we continue to refine our approach, and we continue to go after the higher value customers.

Okay, that's it from me. Thank you.

Thanks, Ki Bin.

Good afternoon. Just a little bit more about Spencer, your initial comments that you’ve been waiting for that turn I guess from great to good. It sounds like we’re still in the great phase. At the same time, we’re seeing some mixed economic data. What should we be focused on going forward in the next six months, as we head into the Fed hike? Is it just a slowly improving economy? The housing market? Consumer sentiment seems to be mixed here. So what do you think we should focus on?

There is no one single thing I would ask you to focus on, Jeff. The overall health of the U.S. economy is the single biggest determinant for how we’re going to do. As you look at storage operators, they have done well in spite of what I would call a less than robust economy. So for the next 12 to 18 months, I think the two things that we need to underscore again, again and again. Number one, there is very little new supply today and for the foreseeable future — that bodes well. Number two, the Internet — old rule is changed, the Internet is not the great equalizer; it’s the great divider, and we continue to use it to our advantage.

Okay, thank you. And then my second question is can you comment on the cap rates for the 29 assets that you're acquiring?

Yes, the assets that we acquired in the second quarter, I would tell you, are on the lower end. I mean, typically, we are looking at year-one cap rates of 6% to 6.5%. The forward-looking first-year cap rates for the management fee, and we have acquired a portfolio in Dallas — it was actually below that. But we feel like there is a fair amount of upside, and it should grow from there. There is some lease about set in there; in fact, one of them is just opening today.

Great. Thank you.

Thanks, Jeff.

Thanks, Jeff.

Hi, guys. Can you just comment on some of the larger expense growth in certain markets like 8.5% in New York and obviously Atlanta had a 15% expense growth?

Yes, the major areas of our expense growth we see above average are due to one or two things: you have seen some higher than expected snow removal this year, and then the second one is just property taxes. It depends on when these assets get reassessed; the other one in Atlanta is a little skewed by a land lease. It was basically an increase in the timing of when the land lease expense was reassessed.

Okay, and then just one thing on the financing front: we are seeing a large SmartStop acquisition coming up. Any sort of change in your thought process in terms of potentially at some point adding unsecured bond offerings into the mix?

So right now, I would tell you our balance sheet is largely investment grade. I think if you look at our ratios and things, we are very close. There are a few things keeping us from being rated, and right now those issues focus more on covenants as well as across the provisions in unsecured debt. So to date, we're going to operate similar to a rated entity, but right now we do not have any imminent plans to become a rated entity.

Okay, thanks, guys.

Thanks, George.

Hey, good afternoon, guys. Question on your underwriting of the CFO deals; can you talk about maybe how that’s changed or different expectations over the past year given the improvement in fundamentals?

RJ, this is Scott. We actually haven’t changed our underwriting. I think that we have still been pretty consistent in how we underwrite these deals. I think that, if anything, we’ve been surprised on the upside, meaning these assets are leasing up quicker than expected, but at the same time, that could change. Some of these CFO deals we’re looking at today; one or two of them are opening in early 2018 now, so your problem with becoming more aggressive in the short term is these assets may be more of a long-term play. So we pro forma them more with three to four-year lease ups; 36-month lease ups being pretty standard.

Okay, and my second question is on the increased guidance: same-store NOI for the year up to about 200 basis points at the midpoint. Can you talk about the different drivers of that increase? What was going on in the second quarter that surprised you guys to the upside?

The two things that have really been better than we expected: one is our occupancy; we expected to peak at about 94%, 94.5%. The second part of occupancy is we think it will continue to be strong for the year. We expect our occupancy delta to average 1.5% to 2%, and then the second one is discounts; discounts have been significantly below where we originally estimated.

Great. Thanks, guys.

Thanks, RJ.

Thank you. Just on that occupancy comment: if you would have kind of—if you look at all your assets and break them up into maybe three buckets, what proportion would you say—obviously, based on every submarket has different peak occupancies—but what proportion would you say it’s kind of at peak occupancy versus maybe just way below where you think you can really get a lot more gains in the next 12 months?

So I would tell you, in terms of the number of properties that we think there's a lot of upside, it’s minimal right now. Most of our properties are above 90%. I mean, we do have a few that maybe have some functional issues; most of our properties are actually more in the 95% range. We do have a few that are completely 100% full, and we have a few that are in the upper 70s just because maybe they're too big, or new competitors come in right nearby.

So it seems like the kind of one in the data since very, very small right now; most of them are kind of near or at that biggest level?

Yes, that’s correct.

And then just on the rate growth that you saw: it was use of the discounts to price; but if we look forward, how sustainable is this, you know, kind of mid-single digit growth in terms of the overall rent per square foot growth?

As far as how long it goes, I think it's difficult to say. I think supply is going to play into that. The other thing is the usage of storage and how your rates compare to apartment rates and things like that, and the rate per square foot. We have some markets where they approach that, but the one thing you do have going for you in storage is it’s infrequent transaction. So someone knows what they're supposed to pay in rent because typically, they have friends that rent for or they know a lot of other renters, and so they know what your average rental rate is. But at the same time, people don't rent self-storage very often. So they typically just end up paying what the market is.

Okay, thank you.

Thanks, Vikram.

Yes, hi, thanks. Just want to dig in a little further on the scalability of the property type. Spencer, you mentioned the importance of growing your digital footprint. I am not suggesting growth for growth's sake, but how important is the growth of your digital footprint when it comes to driving core growth? Is that something that you can quantify or discuss as it pertains to the decision to buy property? How is that factored into the equation when you look at new investments?

Todd, it's your lucky day! We are fortunate to have James here, our Executive VP over marketing and the Internet, to help answer that question.

Hi, Todd. I guess just walked by the room at the wrong time here, but it influences our decision. Is that a 30% or 40% decision? No, I think it’s around the edges right now. But thanks to the data that we have, we know where we’re going to be able to have a little better impact on the marketing side with certain acquisitions. We will acquire properties in areas that we currently don't have scale; it’s going to be a little more difficult to get those listings up in a quick fashion. But we do know the benefit will be there. If we acquire property, like say, Los Angeles, Chicago, or Dallas, the impact is almost immediate, especially if it’s a smaller operator — we've seen huge upside in terms of their Internet traffic. So it does influence our decision, but mostly goes back to the underwriting and the revenue assumptions. We always have battles in our RAC about it being too aggressive or too conservative. I think we've been properly valuing properties, but we do see the Internet being more and more of a factor in terms of customer acquisition going forward, and we will look for those opportunities where the small providers can't compete with us and so we will look for those opportunities in the future.

Okay, and then with regard to SmartStop and that transaction, how did you value the third-party management agreement that is part of that transaction overall? What’s that opportunity like for you?

We feel like it’s a big opportunity, Todd. They have two more funds that are going to be raising money and buying properties. So we will acquire those management contracts. In terms of how we value it, we viewed it more as a benefit, and so therefore we were maybe willing to pay a more aggressive cap rate on the existing assets. We didn't necessarily say it’s worth X because those management contracts are month-to-month, and we don’t expect them to go anywhere. But at the same time, we don't put a huge amount of value on that.

Okay, thank you.

Thanks, Todd.

Hi, thanks. C of O activity continues to astound. We see activity you guys are doing, especially across the industries as well? Is there a general increase in lenders in the space? I wanted to speak to how you guys assess who is supplying liquidity to developers. How are you thinking about increasing your supply of these assets, and are you guys potentially taking more incremental risk? Just seeing how you are thinking about the front end on the lending side.

Yes, on the lending side, I think the lenders are still conservative. A well-capitalized developer is going to be able to get a loan. I think the majority of these developers we work with are well-capitalized. We want to make sure that our developers have the ability to absorb losses if that's required and that they can perform to our standards. So I think that lenders are willing to lend, but I don't think they're willing to lend at a rate that is going to cause significant new supply at this time.

Okay, thanks. That’s helpful, Scott. And just going back to the third-party management again: the shift is more towards the C of O deals and not stabilized facilities that you guys manage. But just wanted to get your current thoughts on how you are looking at that potential pipeline to acquire your third-party assets.

So, Todd, it’s Spencer. Nothing has shifted; we’re very interested in stabilized assets because you take that stabilized asset and put it into our operating platform. And that's where you squeeze a lot of incremental performance out of what we would generally consider an under-managed asset. So it hasn’t been a shift of the C of O; we like stabilized assets when we think that the market is wide open for additional operational consolidation. My personal math is if there are 54,000 self-storage facilities in the U.S., you could probably knock 30,000 of those out as being too small, too old, or in the wrong markets for us. You take out another 4,000 to 5,000 for the larger national operators, and you’re still looking at around 19,000 to 20,000 properties that are wide open for operational or financial consolidation, and we think there's plenty of room to grow on both fronts.

Great, thanks, Spencer.

Thanks, Todd.

Hey, guys, good morning out there. First question is on rent growth and trends: given that we’ve seen a pickup in housing velocity vis-a-vis existing home sales, just strength out of that market, and that is your number one demand generator at the residential market. We've seen wage pressure kind of pick up recently. Do you think that even if new supply comes on in 24 months more than it is now, we could see a ramp-up still in rental rate growth given that strong correlation with the housing market and your performance?

Neil, it's Scott. So first of all; I think we do see some correlation with the housing market, but it’s not a perfect correlation. I think the thing that has the highest correlation is change. So whether that’s a housing change or it changes in someone’s personal life, you know, that's what causes people to rent self-storage. They all have a need coming in the door. We think that those needs are going to continue, and as long as new supply is low, we think that we’ll have pricing power.

Okay. And then Spencer, I guess this one is for you. Talking to some brokers, it seems like in those certain markets, like Denver for example, there are probably 50 or so permits for storage, and probably new things only, you know, 8 to 10 will be actually delivered near-term. Can you explain or help explain why there's a large disconnect between permits and then actually getting approved? I mean I know some fallout just by the nature of the permitting process, but can you give some color on the difficulty or complexity to get a permit from start to ground break time?

Yes. So there are a lot of factors in there; one of the biggest ones is self-storage is not a welcome asset class in most neighborhoods. We don’t provide a lot of jobs; we don't collect a lot of tax revenue, and most municipalities don't roll out the red carpet. You throw in the cost of land because everybody is trying to develop, not just folks that can do storage. If you look at the lending environment, probably one of the biggest ones, Neil, that I have observed is the risk versus reward curve shifted, and it's not in favor of the developer. So the local developer has an ability to go out and get the property entitled, if they're lucky, and get it constructed on budget, if they're lucky; and then they’re left with the questions, 'Now what do I do?' Because I can’t take out a yellow page anymore and I’m in no man's land. They need to align themselves with a management company that can drive traffic to this property, and they’re going to pay management fees and probably going to give up some or all of the tenant insurance. They’re going to get downstream to a bunch of other costs, and at the end of the day, they’re going to make a lot less money than they would have made otherwise. So the return on these investments for these guys trying to go out and get a permit, I think there’s some hesitation. I think land costs are higher than a lot of people have thought they would be; permitting is more difficult. I can tell you I have two cases in California on properties that we have worked on: it took more than 10 years to get a permit in some prime locations. So this is not easily done in some locations. Yes, you're seeing some development come out of the ground inside Denver. Sure, across the country, we still maintain an assertion that the rate of growth of new supply is still less than the rate of growth of the populations in the U.S. It is a great time to be in storage.

Thank you.

Thank you, Neil.

Good morning, guys. Sorry about getting cut off earlier, but most of my questions have been answered at this point, but I had one follow-up. So how aggressively do you plan to raise rates in the SmartStop portfolio you want to close in 4Q? I noticed that the rates are like 20% below your standard per square foot. They don’t get there right at the back, but I am just curious about the trajectory and how quickly you’ll try to narrow that gap?

Yes, we’ll focus mainly on occupancy in the first year. We will try to get their occupancy up to exactly where we are. The only thing I could caution you on, as you can just look straight at 20% because they may or may not compete directly with our properties. So we’ll aggressively move the occupancy, and then from there we will aggressively move the rates to be in line with our existing stores in the same markets.

Okay. That’s it for me, guys. Thanks.

Great, thank you. End of Q&A.

Thank you, everyone, for your interest in Extra Space today. We look forward to next quarter's call. Thank you.