Extra Space Storage Inc (EXR) — Q3 2015 Earnings Call Transcript

Thank you, Melory. Welcome to Extra Space Storage’s third 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, October 29, 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.

Hello, everyone. For 2015, the top two priorities at Extra Space are operational excellence and seamless integration of new stores onto our operating platform. Year-to-date, our focus on these priorities is paying off. Operationally, we had a record-breaking quarter. We excelled in producing same-store revenue growth of 9.9%, NOI growth of 12.6% and a peak occupancy of 94.9%. This enabled us to achieve FFO as adjusted growth of 12.5% on top of last year’s growth of 26.3%. This marks 20 consecutive quarters of double-digit increases. To perform at this level while simultaneously preparing to close a large and complex transaction showcases the depth of our operations team and our ability to execute. In the first three quarters, we added 82 wholly-owned stores to our platform. On October 1st, we closed our acquisition of SmartStop and integrated an additional 165 properties. This brings our store count to 1,335, all branded Extra Space. Preparations to have these stores began months earlier. Thanks to the work of our team and the cooperation of SmartStop, we were able to review financial systems, train employees, plan technology conversions, and evaluate CapEx needs well ahead of closing. There is still work to be done but we hit the ground running. This is the right acquisition at the right time for our shareholders. And I’d now like to turn the time over to Scott.

Thanks, Spencer. Last night we reported FFO of $0.81 per share for the quarter. Excluding costs associated with acquisitions and non-cash interest, FFO as adjusted was $0.81 per share, exceeding the high end of our guidance by $0.02. The beat was primarily the result of better than expected property performance. This was partially offset by higher than forecasted income tax as well as an increase in interest expense as we accumulated the funds for the SmartStop acquisition. Our same-store revenue growth was driven by higher rates to new and existing customers, increased occupancy and lower markdowns. Our top performing markets year-to-date include Atlanta, Denver, Houston, Los Angeles, Sacramento, San Francisco, and Tampa/St. Pete, all with double-digit revenue growth. Our platform continues to maximize results in this favorable operating environment. During the quarter, we acquired one store in Maryland for $6.1 million and we acquired a certificate of occupancy store with a JV partner for $5.4 million. Subsequent to the end of the quarter, we acquired 124 stores for just over $1.3 billion. All but two of these stores were part of the SmartStop portfolio. We currently have 9 operating stores under contract for $82 million. Six of these acquisitions totaling $53 million are scheduled to close before the end of the year. In addition, we have another 17 certificate of occupancy stores under contract. The total purchase price of these stores is $177 million, of which $26 million is expected to close in 2015. We were active in the capital markets in the quarter. We filed a $400 million ATM under which we sold 31 million. We also issued $575 million in exchangeable senior notes and used a portion of the note proceeds to repurchase $164 million of an existing tranche of exchangeable notes. The October 1st SmartStop acquisition, as well as our strong year-to-date results, require revisions to our guidance. Our full year FFO guidance is $2.69 to $2.72 per share. Our guidance includes dilution from certificate of occupancy deals, acquisitions that operate below our portfolio average, and $45 million in transactional and debt elimination costs related to the SmartStop acquisition that will be recognized in the fourth quarter. Our FFOs adjusted increased to $3.10 to $3.13 per share, which removes the non-cash interest and non-recurring transactional cost. I will now turn the time back over to Spencer.

Thanks, Scott. Fundamentals for the sector continue to be strong. New supply, which is still muted, will not be a factor in the next couple of years. We expect occupancy to remain at all-time highs, which should allow us to further increase rates for new and existing customers. Only time will tell if pricing power will remain as strong as it is today, but the fundamentals support the positive outlook. The acquisition environment will continue to be extremely competitive and Extra Space will remain a disciplined buyer. We’re focused on accretive acquisitions and maximizing shareholder value. I’m pleased with the outstanding performance of our team. We have executed at a high level across the entire organization. Now let’s turn the time back to Jeff to start the Q&A session.

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 will turn it over to Melory to start a Q&A session.

My first question is on the integration of SmartStop. I know it’s only been a month, but any lessons learned you could share with us on the underwriting of the deal, positive or negative, and maybe specifically on some of the new markets you’ve entered?

Yes, in terms of underwriting and performance, I would tell you it’s probably too early to really comment on that. What I would say is the properties are performing right where we were expecting them to perform when we put this under contract several months ago. So, the occupancy and the revenue performance when we took them over was right where we expected.

With regards to the markets, one of the really nice things about this transaction is in many markets, we picked up an even greater footprint, which is going to give us greater presence digitally on the internet and allow us to further drive occupancy and rates at those stores. So, it’s coming together very well. We are pleased.

So too soon to tell if the underwriting was too conservative; it seems like the integration has gone very well, as you said, and then acquired properties performing better than expected within the first, let’s say, month and other deal.

Everything is right on course; it’s too early to tell what the trend is but we are very satisfied with how we started.

And then I had just have one other question on the 17 certificate of occupancy under contract. I guess can you provide a little bit more details on that; where those came from, existing markets, some of these markets?

So, I would tell you that they are similar markets to where we have been in the past. I mean they’re all markets where we currently have properties; they range from Boston to Phoenix; so they’re across the U.S. These are local developers, most of whom we have relationships with. The majority of them, we feel like are going to be very good acquisitions and as we’ve underwritten them, we would say certainly prudent lease-up assumptions, meaning we’ve kind of gone to our historical average. We recognize that the market won’t always be what is today. Some of these Certificate of Occupancy deals are out into 2017, even out into 2018. And so we have been prudent in our underwriting assumptions, and we expect them to perform well.

I have a broader question. You mentioned that supply should remain stable for the next couple of years. I believe we were sourcing about 16 units, now it's around 17. Initially, your same-store NOI was in the 8% range, and now it's clearly between 10% and 11%. Looking ahead, which metric do you think will continue to show strong growth, and what concerns you the most?

Vikram, it’s Scott. So, obviously we are not ready to give 2016 guidance, maybe just kind of commenting on where we are today and where we can kind of see things going. I would tell you we’ve had a very good year. I think that we have had outstanding performance. If I look into the next year, I think it’s going to be very good. I think that our occupancy can’t continue to have a 200 basis-point delta year-over-year; our discounts, we can’t continue to push them lower year after year but I do think we will have some pricing power going into next year and it will be a very good year still.

And just one clarification, so, on that pricing power, you had very solid growth. Can you just sort of give us a bit more color on what was the price increase in terms of street rates, how much did they grow, and then the price increase to existing customers?

Yes. We are continuing to see a high single-digit increase in our existing customer base. Regarding pricing, it varies depending on the season. We experienced an 8% growth during the summer months. Our growth can be attributed to slightly over 200 basis points in occupancy, around 50 basis points from discounts, and the remainder from pricing, primarily due to new customers.

Just first question following up on rents and then price increases, if I think about your portfolio overall generating rental income growth of 10% in the quarter, some markets obviously well above that. Just given the churn you see in your portfolio and the time it takes to re-tenant space when customers move out, that suggests to me that you are increasing rents well above 10% across the portfolio. You just mentioned that you are increasing rents to existing customers in the high single digits and even in the peak season street rents were only up 8%. So, I’m just sort of curious, what am I missing that the blended overall portfolio rental income growth in the quarter was 10%?

One of the things that happened is we actually have some negative churn that takes place. So depending on the time of year, our negative churn is typically mid-single-digits but it could go higher than that, depending on what we’re doing with rates. So if someone moves in, in the summer where there are peak rates and then we drop the prices in the fall, if someone moves out, you have a negative churn. So that’s one of the things that I would tell you, just in doing the simple math you’re missing. The other one is raising our existing customers high single digits but we did that last year. So year-over-year, it’s really not generating a lot of lift to our income.

It seems that both factors may hinder rental income growth, correct? If a tenant moves in during the summer at a higher rate but then vacates for a lower rate in the fall or winter, that affects overall income. Additionally, you're indicating that customer turnover reduces the rental increase. I'm curious how the overall rental income growth for the quarter reached 10% if you're not raising rents by that much. Street rates increased by 8% during peak times, and existing customer rent increases are under 10%.

So 200 basis points to 250 basis points on occupancy, you get a 0.5% of discount, so that’s 3%. You then get the rest from rate. So, if you’re pushing your existing customer’s high single digits and you did that last year, maybe slightly more this year, you get a little bit from that. And then we pushed street rates this year 7% to 8%.

And then my second question just regarding the Certificate of Occupancy deals, curious how big that pipeline will get. During the last cycle, you had about $300 million development pipeline, obviously the size of the Company was much smaller and it’s much larger today, but just curious where you see that pipeline growing? Do you think you’ll get back to $300 million or even higher?

As you think about a Certificate of Occupancy pipeline, the governor for us is dilution, and we’ve set a target of about 3% of FFO as what we’re willing to tolerate. And depending on whether we do those Certificate of Occupancy deals just by ourselves or with the JV partner can affect that calculation. So obviously, we would like to do nice new properties in as many core markets as we can. It’s a competitive market and we have a dilution threshold that we want to be very disciplined, so that we don’t go backwards.

Can you provide some fundamental data points for the operating properties, or the one you acquired in Q3, you also have some under contract that you’re expecting to acquire in Q4, just seeing that these are stabilized and any details you can provide?

Most of the properties we’re looking at are stabilized cap rates in the mid-6s; your year one cap rate is usually going to be slightly below that. Some of these properties have a little bit of upside but not that significant.

But occupancy or rental rates, anything, any context you can provide with those.

It’s both. And it will depend a little bit on the properties. So for instance that one we bought in the quarter had more rate growth potential as well as a little bit of occupancy, going forward. Some of the other properties we’re looking at buying have a combination of rate and occupancy and then others just have rate growth opportunities.

That's helpful, Scott. Please continue.

I said it really depends on the property and the market.

And just switching gears to the third-party management. We used to talk about it a lot more often, it seems like it’s been overshadowed by your good fundamentals; definitely you’re entering into Certificate of Occupancy deals. Just wanted to get a sense of how much the third-party management pipeline provides you guys with acquisition opportunities; how much of that is still in place?

It still is the prime reason we’re in the business, Todd, to create off-market acquisition pipeline. We haven’t made a lot of noise about it, but we added 43 managed assets on the SmartStop acquisition, and by the end of the year, we’ll have grown that pool by more than 100 assets. So for us, the strategic opportunity that it presents and we continue to buy from that portfolio that we manage. We also get economies of scale and the tenant insurance, and the power of spending more on the internet in those respective markets. So, it continues to be a very important part of our business.

I just had one question on the outperformance relative to the peers on a same-store NOI basis. I mean it’s been pretty substantial this year. I’m just wondering what you guys think the driver of that is. I know a part of it can be just how you guys determine the same-store pool relative to the peers, but what also you attribute your outperformance to?

It’s tough to comment on their results. I would tell you we’ve put information in our supplementals, breaking out our current pool versus our last year’s pool. But I would tell you, both pools have performed. I think that we’d like to think that we have the best mousetrap out there that we are most aggressive on the internet; we have the best revenue management systems. But it’s tough to comment on how we compare to them.

George, it’s Spencer, if I could just make a comment since this continues to come up. We have not changed our same-store definition in over a decade. We’ve been consistent. And I can tell you in Q3, the same-store properties that have been added, which were not primarily lease-up, but rather just properties that we acquired, provided an uplift of 80 basis points on revenue and 110 basis points on the NOI. So, if you subtract that out we’re still very pleased with what our properties are producing, our platform enables us to do, and probably most importantly what our team is executing on. I think it’s a combination of people, platform, and properties that have allowed us to produce the results that we’ve produced.

Are you experiencing any resistance to pricing in certain markets that might be causing a slight decline in occupancy, or is that not an issue you’re encountering?

So, even our worst markets, we’re still seeing 5% growth. So, I think that it’s healthy across the U.S. Markets are somewhat cyclical, some are better than others. I would tell you, our worst markets are probably Chicago and maybe Washington D.C. but they’ve been very strong in past years and they’re still experiencing 5% growth.

Looking ahead, without seeking guidance, the same-store revenue composition this quarter is around 10%. You mentioned that 250 came from occupancy and reduced promotions. If we take that as a baseline and it doesn't recur, what factors do you consider in assessing whether we can reach 7.5? What economic, population, or pricing changes could positively or negatively influence that growth rate?

First of all, we will push rate on both existing and new customers as hard as we can. We don’t want to get ahead of ourselves. There might be another 100 basis points on occupancy. The overall health of the economy obviously will be a big determinant. But as we look at 2016, as Scott said, our expectation is our results are going to go from phenomenal to maybe just really good. And we’ll have to see how the year transpires. But I don’t see any disruptive element on the horizon with regards to new supply for the next couple of years, which I already commented on. And I only see us getting more powerful and potent in the digital world, particularly with our mobile strategy. And we’re going to continue to invest wisely and we’re going to do everything we can to drive optimal performance from these assets.

Have you seen any notable change in customer move out activity based on the rental rates that you’re pushing through from previous cycle?

No, sir.

I wanted to ask you about your earlier comments regarding new supply not being a significant issue in the next couple of years. Based on feedback from some brokers we've talked to, it seems like obtaining financing for new supply in smaller markets is proving to be more challenging than in larger markets. Do you notice this trend? Additionally, could you share your insights on the overall lending environment as stakeholders try to enter this industry? It appears there should be a considerable amount of capital available, yet it seems to be underutilized. I would appreciate any thoughts you have on this situation at the ground level.

From what we’re seeing, it’s hard to comment a lot on financing just because we’re not out there looking for it. I think well-capitalized developers are going to be able to get loans; obviously better markets, it’s going to be better but it also probably affects your returns. Your returns in New York City are going to be less than your returns in Dallas you would expect. The other thing that’s happening is land prices, I think are pricing some people out of certain markets. We have not seen anything substantial out of Southern California, out of San Francisco, out of Seattle, some of these markets where it’s difficult; everybody is competing for the same piece of land. So from our perspective, we are seeing some new construction. It’s more in the markets like Denver, Dallas, Atlanta, South Florida, even some in New York City, but from our perspective, we don’t see it across the whole U.S.; we see certain pockets. We do expect it to come with the returns of the properties, but I’m not sure it’s going to be a tighter wave of new construction.

Okay. And then can you just talk about the average length of stay; is that continuing to lengthen out?

It’s about the same; there might be a very, very slight uptick on the length of stay, but it’s in very stable state.

Yes, thank you, good afternoon. Just a quick one on the lease-up period. You have a few stores that are in their operations now. I was hoping if you can comment on the impact of technology that you’re seeing on the time it’s taking to lease up those stores?

So, we are seeing quicker lease-ups at our Certificate of Occupancy stores. It’s probably a combination of technology as well as no new supply. In our supplemental package, page 23, we show the details and kind of where the occupancy is for those stores. We are doing tests on our store to see if you can move the needle in terms of marketing spend, in terms of rates, but overall typically, we’re going to go into the market with lower prices and try to be as aggressive as we can to fill them up as quickly as possible.

Okay. And following up on the construction financing, is that the only reason you are seeing an increased interest from merchant builders and other developers to bring Certificate of Occupancy deals to you guys, the lack of constructing financing or something else going as well?

So with them bringing Certificate of Occupancy deals to us, clearly they are getting some type of financing in the interim. I’m guessing most of them have some type of construction loan and then potentially this helps as far as the takeout. The other thing that’s changed in today’s cycle for a lot of these developers is it used to be that they would build the property, they’d open it up, they’d take out a yellow page, they’d operate it themselves. I think with the sophistication now of the larger players, that’s becoming more and more difficult. It’s difficult to compete on the internet for a small operator. Many of them are coming to the big players to have them manage those properties or at least sell them at Certificate of Occupancy.

Thank you. The 19 Harrison Street properties saw outsized acceleration of revenue and NOI growth this quarter, could you provide some color on what drove this and whether anything has changed operationally now that these are wholly-owned?

Nothing has changed operationally; I would tell you it’s just timing on those properties. There is nothing significant that’s changed if I recall right. I think those properties revenue-wise are operating very similar to many of our existing properties.

Looking at the 61 stores that are added to same-store, you may well increase NOI there by a pretty impressive amount this year, something well ahead of 20% the first nine months. Could you just talk about the contribution from those assets versus the 50 basis points guidance at the beginning of the year, and then maybe looking ahead could we expect a similar boost from those properties that get added next year?

So, if you look at page 18 of our supplemental that actually compares last year’s 442 pool to this year’s 503. And in the third quarter, they had an 80 basis point change in pool and then 100 basis points year-to-date. I would tell you that that is a little bit of anomaly. I think that we would expect a small bump from next year’s changing pool but nothing like we’ve seen this year.

And then lastly, kind of a broader question, I am anxious to hear your thoughts about on-demand storage services in some urban markets like New York, Boston, and D.C., do you see these as competitors to your business or do you see them as complementary where they may actually run units facilities you currently own the store there been?

There are many questions in that, Jonathan. We are definitely exploring on-demand service. Currently, I'm aware of several dozen competitors trying to establish this product concept. Given our 1,300 stores across the U.S., we are well-positioned to play a role in this. We are keeping our options open and monitoring the situation closely. We have engaged in many discussions, and this idea is in development. Whether it ultimately becomes a significant solution for storage needs remains to be seen. However, I can assure you that we are not overlooking it; we are particularly interested in urban markets where small units are essential. We believe it could find a niche there, but it involves significant logistical challenges. Real estate contributes to the solution, but it is not the complete answer. We need to approach this thoughtfully and continue exploring its implications for our core market. Currently, its impact is minimal and not affecting our business, as reflected in our results.

Have any of them approached you maybe try and team up and come up with a solution or…?

We’re just keeping all options open, Jonathan.

Most of my questions have been answered, but I was wondering if you could share with us perhaps what’s on your plate in terms of R&D; what’s kind of net out there? And while we’re on the topic, can you talk about your new mobile app and some of the features there?

So, in terms of R&D, Paul, I’m not at liberty to talk about what we’re cooking in the kitchen; we’ll bring that when we’re prepared. Mobile, it’s really interesting. I think on April 21st of this year where Google changed the algorithm; it’s called Mobilegeddon. I think our team perhaps as much as a year in advance started working on mobile strategy. And the mobile strategy definitely favors those that actually own the real estate, especially when you look at the maps. The Mobilegeddon piece was the algorithmic change at Google that favored sites that were mobile friendly. And what I can tell is mobile has become the leading search device that eclipsed desktop and laptop and it’s a core strategic advantage of this Company. I don’t believe that the smaller operators have the resources to throw at the mobile platform what we and the other national storage operators have been able to do. And I think this is once again the internet creating a landscape of the haves and have-nots. And that chasm is widening and the rate at which that chasm is widening is accelerating. And I think we’re in the great position with the other storage REITs; a great time to be a large national operator.

And while we’re on the topic, what is the cutoff or did you consider those four or maybe five public operators as large enough or are some of those $1 billion portfolios large enough to enjoy some of these benefits?

It depends on the company and their commitment to technology. They’re regional players that are very sophisticated and doing a great job, but once again, it ultimately comes down to how many dollars you have to spend on your mobile strategy. And size and scale are a decided advantage in the allocation.

With regard to the exclusive you have in managing new acquisitions for strategic, is that an option like a ROFO where you say yes, we’ll manage the property or is it something that as they acquire, you’re required to manage those properties regardless of where it is and how close it might be to your existing properties or whether or not it’s in markets where you’re concentrated?

We’re going to take them all, Todd. And quite frankly the more properties we have in the market, the more power we have in that market. And I would much rather have an asset in close proximity to one of our assets that we control pricing and promotion than having it be in the hands of someone that may not be rational in their behavior.

And then just one quick follow-up on the mobile technology. How much of your rental demand is sourced from mobile today and where was that last year?

More than 50% last year was probably 30%. So, the rate of growth is tremendous. And the impact on our business is significant. And we’re really pleased that we’re ahead of the path.

Sticking with topics such as the structural barriers and Mobilegeddon, are you seeing developers just growing the talent out and what is the development pool like versus the last cycle?

First of all, last cycle on average through to mid-2000s, Wes, it was more than 2,600 properties per year being put into the marketplace. Today, depending on whose number you want to use, we’re 20% to 30% of that number. And for us, I think that there is a growing awareness, the smaller operators and would-be developers that they have the advantage in the local markets when it comes to connections and maybe getting a deal done, but they cannot compete because we are not in the world of yellow pages anymore. We’re in the land of digital real estate. And they are recognizing that they don’t have a sophistication or the dollars to even attempt to compete against the REITs. So yes, I think many, many folks out there are throwing in the towel and that that is going to continue to accelerate.

And then you mentioned Denver, Dallas have been markets for supply on the horizon but all of these markets are economically full. Would you expect the initial round of supply to be absorbed by the pent-up demand or are there any markets that concern you with the first round of supply?

I think there was quite a dearth of supply, Wes, 2008, 2009, 2010, 2011 and I think that the supply that’s been put into those markets is largely fixing the pent-up problem. So we feel comfortable with the supply issue for the next couple of years, as I’ve said a couple of times today.

And then lastly, you guys have a lot of good consumer data; the economy appears to be softening a little bit at the margin. Are you seeing anything in your dataset that is at least the yellow flag for you the moment?

Not sir.

We appreciate your interest in Extra Space today and we look forward to next quarter’s call. Thank you.