Extra Space Storage Inc (EXR) — Q2 2017 Earnings Call Transcript

Good day, ladies and gentlemen and welcome to the Extra Space Storage Q2 2017 Earnings Conference. At this time, all participants are in a listen-only mode. Later we will have a question-and-answer session and instructions will be given at that time. As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s conference, Mr. Jeff Norman, Vice President of Investor Relations. Sir, you may begin. Thank you, Nova. Welcome to Extra Space Storage’s second quarter 2017 earnings 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, Wednesday, August 2, 2017. 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 Joe Margolis, Chief Executive Officer.

Thank you, Jeff. Good morning, everyone. We had another solid quarter and we are pleased with our results for the first half of the year. In the quarter, we saw a healthy demand and steady rental volume which outpaced that of the second quarter of 2016. We maintained our same-store occupancy gap and ended the quarter at 94.4%, 70 basis points ahead of where we were in 2016. We were also able to grow street rates, which together with our occupancy gains increased same-store revenue by 5.2%. We demonstrated great expense control with a 1.1% decrease in same-store expenses. As a result, same-store NOI grew 7.7%. We also saw growth outside of our same-store pool, which contributed to an increase of 16% in FFO per share as adjusted. All of our markets show positive revenue growth with the exception of Houston, which was effectively flat. The markets in the western states continue to perform particularly well, many with revenue growth in high single-digits. Our top MSAs have been affected differently by the current development cycle and we believe that we continue to benefit from our highly diversified portfolio. In the quarter, we added 27 new properties to our third-party management platform, bringing the total additions to 54 for the year. These managed stores provide us additional fee income, density in key markets, efficiencies that come from scale, customer data and potential future acquisition opportunities. We recently held our 2017 Partner’s Conference in Park City, Utah where over 150 partners joined us for two days of meetings. This is the best turnout in our history and our managed pipeline for the next six months is the largest it has ever been. However, we were recently informed that one of our partners Strategic Storage Trust, formerly known as SmartStop, has decided to internalize management and its 94 stores will be leaving Extra Space’s system effective October 1. Although the loss of these stores is unfortunate, we have over 100 properties scheduled to be added in the back half of 2017, the majority of which are in higher rent per square foot markets than the managed SmartStop properties. For example, we added an 11-store portfolio in New York City just last week. We remain enthusiastic about our third-party management platform and expect it to continue to be a valuable part of our growth strategy.

Thank you, Joe. Last night we reported FFO as adjusted of $1.09 per share exceeding the high end of our guidance by $0.03, the beat was the result of property performance, tenant insurance and management fees. Repairs and maintenance, payroll and insurance have been lower than expected and contributed to the expense reduction. We also incurred a one-time $6 million loss related to the write-down on three parcels of land, two of which are under contract for sale. Occupancy for the same-store pool ended the quarter at 94.4%, a 70-basis point year-over-year increase. While occupancy is just one driver of revenue, we are encouraged by the strong rental activity and peak occupancy levels we’re seeing this summer. We were able to increase rates for new customers in the low single-digits during the quarter and discounts, while up year-over-year, remain at levels below historical norms. We continue our existing customer rent increase program without changes. During the quarter, we did not access our ATM. Acquisitions and loan maturities were funded by draws on our credit facility. We also completed a 10-year $300 million private placement at 3.95%. The notes have a delayed drop feature and they will be issued on August 24. The private placement proceeds will be used to finance acquisitions, loan maturities and to pay down revolving balances. These notes help us achieve our goals of increasing our average debt term, our fixed-rate debt ratio and the size of our unsecured pool. Based on the performance year-to-date, we raised the bottom end of our same-store revenue guidance by 25 basis points to a range of 4.25% to 5%. We lowered our annual expense guidance to 1.75% to 2.5%; as a result, our annual NOI guidance increased to 4.75% to 6%. We reaffirm our original acquisition guidance of total investment of $400 million comprised of $325 million in wholly owned stores and $75 million in joint venture acquisitions and developments with approximately $75 million in capital that would be contributed by Extra Space. Approximately $200 million is currently closed under agreement. We are in discussions on several other acquisition opportunities, and our guidance assumes the remaining $200 million will close late in the fourth quarter. We remain focused on only acquiring properties that create long-term value for our shareholders. As a result of the Q2 beat, we are increasing our full year FFO’s adjusted guidance to $4.25 to $4.32 per share. This includes the Q4 impact of losing the managed SmartStop stores. Our guidance also includes $0.07 of dilution from our CofO stores and an additional $0.08 from value-added acquisitions for a total of $0.15. I’ll now turn the time back over to Joe.

Thanks, Scott. Coming into 2017 we received many questions related to demand, new supply, external growth and our ability to increase revenue and FFO. We are more than halfway through 2017 and to a very large extent our predictions related to these topics have been accurate. First, demand has been steady; stable demand has led to positive growth in rates, rentals and occupancy, resulting in solid revenue growth. The rate of our revenue growth has moderated since the beginning of the year and as our guidance implies, will moderate further in the second half of the year. However, our systems have proved adept at adjusting rates, occupancy discounts and marketing spend to maximize revenue in the current environment. Despite headwinds in difficult comps, we still expect stores to produce some of the best revenue growth among REITs and we expect to lead the pack in this sector. Second, new supply, while present, has been manageable so far; several markets have felt the impact of new development while others have remained relatively immune. Most markets continue to see revenue growth and our performance continues to be solid due to our diversified portfolio. Construction pipelines have been pushed back as projects are taking longer to get done and the fallout of projects in planning remains significant. Third, we will have both challenges and opportunities related to external growth. Pricing for marketed acquisitions remains at elevated levels; sales volume is down significantly and we have not seen sufficient long-term value to increase our bids to meet seller expectations. Most acquisitions have come from existing relationships rather than on the open market. However, our prediction that we could see an increase in demand for third-party management has come to fruition and we expect our pipeline to remain robust. Finally, we continue to produce outsized FFO growth. Our sector-leading same-store performance together with accretive acquisitions, tenant insurance, third-party management and an efficient balance sheet have resulted in another strong quarter of FFO as adjusted growth of 16%. We are focused on being responsible stewards of our shareholders' capital and providing the best long-term return on that capital in this sector. Let’s now turn the time over to Jeff to start the question-and-answer session.

Thank you, Joe. In order to ensure we have adequate time to address everyone’s questions, I would ask that everyone keep your initial questions brief. If time allows we will address following questions, once everyone has had an opportunity to ask their initial questions. And with that, we’ll turn it over to Nova to start our Q&A session.

Hi good morning. I was just hoping if you guys could speak to what your thoughts are on the slowdown that’s baked into the second half guidance for same-store revenues and how we should think about that into 2018? And if you could also as part of that give us any sense of how July is trending particularly with one of your larger peers commenting about cutting rates significantly?

Okay, I hope I can remember all those questions. So, I'm not really prepared to talk about 2018. The slowdown for the second half of the year is partially due to a lessening time which is the impact of the prior year’s acquisitions, as we discussed. So, we get a greater benefit from our acquisitions—the 2015 acquisitions—earlier in the year than later in the year and secondly, it is just a slowdown in revenue growth in the market. July is generally a continuation of what we’ve seen in the year. There is nothing significant to report in change in July. And what was the last—am I missing one question there?

No, I think you got it. Have you changed your guidance for SmartStop while we’re on that topic in terms of the contribution in the same-store revenues for the year?

No, our guidance always implied or predicted that we would have the greatest impact in the first quarter and if that impact would diminish as the year went on to when by the end of the year we expected that portfolio to be performing at or around portfolio averages.

Okay. And then just one follow-up on the same-store expense obviously a big top versus the first half implied. If you could just give us some sense of what’s driving that and the visibility into those expense increases implied by guidance?

So, we don’t see a big expense increase in the third or fourth quarter. It’s more a comparison to last year. So last year during the third quarter, our expenses grew at about 1.5%; we are expecting those to grow at more normalized rates with property taxes growing 5% to 6% and payroll growing more than inflation. In addition, in the fourth quarter last year we saw expected decreases by about 2%. So, year-over-year that’s why it’s looking like expenses in the third and fourth quarter are elevated.

So, I was wondering in terms of markets, are there any markets that are ahead of your initial 2017 guidance and any markets that are behind?

I would tell you that I think California continues to probably exceed expectations. In terms of markets being behind, I don’t think we are surprised by any of the markets. I would tell you it’s somewhat the benefit of the diversified portfolio as one market goes up, other typically goes down.

Maybe a market that’s underperforming first guidance for us would be New York City.

Okay. And I guess as a follow up in terms of renewals, are you seeing any pushback from your existing tenants from any of your markets?

No. There’s really been no changes in customer behavior with respect to the response to our rate increases.

Hey. Good morning, guys. Can you talk about your customer acquisition cost? It seems like your market expenses are really low considering you built occupancy, and then to bolt on to that, will you see any reallocation of the platform cost from the SmartStop JV, for the JV management go to the consolidated, when will they leave the system later in the year?

So, our marketing spend is just one tool we used to maximize revenue, the others being rate discounts and occupancy. When we believe it’s been beneficial to maximize revenue to increase marketing spend, we will do so. I would not be surprised to see us use this lever sometime in the second half of the year if we feel we need to. But we’ve been able to achieve the results we’ve achieved while staying on budget in marketing so far.

In terms of the SmartStop cost and losing those stores, we have 100 stores coming on in the next six months, so we expect those stores to absorb some of that or be able to allocate the stores across the new stores. In addition, we have some termination fees associated with these properties that should help soften the blow in the fourth quarter.

Hi. Good afternoon. Can you give us some update on the 30-property portfolio that you guys have on the market?

Sure, we’re making good progress on the recapitalization of the 36 properties that we had on the market. We’ve selected a joint venture partner and we’re on to the next stage of documenting the deal and we’ll be happy to provide all the details once it closes. We expect it to close prior to the end of the year.

And can you just talk about the use of the proceeds and whether you think the pricing on assets you’ve purchased would essentially be equal to or better than what you’re selling?

Yeah. We expect to use the proceeds to fund acquisitions, and our goal is to purchase higher quality, better located, higher long-term returning properties.

Thank you. So just wanted to follow up on a question related to one of your peers indicating they would seriously cut rates in the rest of the summer months. So, I’m trying to get a sense of how—can you give some maybe anecdotal color or just from a strategic perspective, how would you directly respond to rates being simply cut by peers that are located close to your properties and maybe just as some of the new supply is coming on, tactically what are you doing to kind of pull customers to your facilities?

So, our revenue management systems are designed to react to what’s going on in the market and with individual properties; and it’s possible that a competitor could cut rates significantly and have very minimal impact on us because of other factors. But if it does have an impact, our systems will respond and maximize the revenue at that store.

Okay. And then just going back on the expenses, what specifically changed around some repairs and maintenance and labor costs that sort of saw the numbers negative for the first two quarters? I am just trying to understand what changed.

So, they are some controllable and some uncontrollable. We had a very mild winter and that helped us on our repairs and maintenance, and we also tightened our belts a little bit. We went and renegotiated all our landscape contracts, about a 9% reduction in landscape costs without any change in service. We took a good hard look, knowing this would be a tough year, and we were able to find some savings.

On the payroll side, we have normalized hours for our stores as we have created efficiencies for our site managers whether it’s through the systems and the ability to attract customers in different areas; we have normalized those hours across all properties.

Okay. So, we should expect that the benefit on those two line items should continue in the back half.

To a lesser degree, we started much of the payroll change in the end of summer, early fall of last year.

Hey. Good morning, guys. So just first on the Strategic Storage Trust internalizing, was their decision purely based on they had reached critical mass where it made sense to internalize? And then are there any other sort of large portfolios of assets under third party management where we could see that happen to someone else?

Yes, we were told by Strategic that this was a decision to internal management based on their internal business goals—it has nothing to do with performance or dissatisfaction with us in any way. We had two other owners that we managed large portfolios with. We have the same risk with those portfolios because SmartStop had an operating platform before we purchased their portfolio. They kept many of those resources in place. The other large portfolios we manage, well they don’t have any operational management experience or history. So, I'll be very surprised that we’re in a position to do this.

Okay. And then just one thing on pricing, has there been any divergence during the course of the year in terms of internet rate and walk-in rate?

Year-over-year you may see some variability, but in the current year it has not changed significantly. But we are moving those all the time, when I say by year-over-year, maybe last year the difference was 5%, this year it is 15%. So, year-over-year it looks different. But remember the difficulty when it comes to our revenues at the stores and our pricing on the stores in the current year is we’re coming off two of the best years we’ve ever seen in the market.

Thanks. So, supply has been one of the bigger topics for this sector lately. One of your peers talked about supply likely peaking this year as far as impacted in another year. Wondering which side of the coin you choose?

Respectfully I think it’s not a very hopeful question, right. The gross numbers of 600 to 800 this year and next year, it really doesn’t matter. It hopefully gets delivered in December this year or January next year. So, the gross amount of supply across the country is sort of interesting but this is very much a micro market business. And what we’re very focused on trying to understand is what’s happening in the markets where our stores are and how do we react to maximize revenue. That being said, I think the peak impact that’s what you're looking for, I think the impact will be greater next year than this year because you have the cumulative effect of things that we delivered in 2017 as well as in 2018.

Okay. And then on the second half of the year. Could you just tell us what your expectation is for occupancy, just the year-over-year delta in the third and fourth quarter?

So, it’s lessening. So the SmartStop stores, they come up to the average, it will lessen. So by the end of the year it is negligible. We expect these SmartStop stores and the other 2015 acquisitions to be performing at our current portfolio level by the end of the year, and so there is a moderate benefit throughout the year, but by the end of the year, flat.

Hi. Good morning. First, not sure if I missed this, but can you comment on occupancy at the end of July and where that stood year-over-year?

We would tell you that occupancy continues to hold, and July is not performing significantly different than the rest of the quarter, the rest of the year.

Okay. And then in terms of asking rents, you maintained higher asking rents throughout the portfolio year-over-year, which you mentioned, and others are seeing asking rents decrease year-over-year at this point in the cycle. I’m just curious if there’s anything that you can speak to that might explain that difference?

Well, it could be different companies are using a different mix of rent than the other factors to get to revenue. It could be individual market exposure and it could be properties within that market that are more or less affected by new construction or better or worse located.

Okay. Do you expect to be able to maintain higher year-over-year asking rents in the back half of the year just given the slowdown that you mentioned?

We would like to be able to do that, if that is the way to maximize revenue, and if we need to lower rates to increase occupancy or not spend as much on discounts and other things. Whatever the right formula is for a particular market or property to maximize revenue, that’s what we will pursue.

Okay. And just one quick last one also a follow-up. Just about public storage’s expected rent cuts in some markets, which they mentioned as of last Thursday I believe. I’m not clear, I’m not sure I heard whether or not you are seeing that decrease in rents in any markets and what the magnitude of those cuts may be if you could comment on that?

It is a property-by-property analysis, and we’ll see public storage or someone else do something that will cause us to react because if the effect on our property, or we will see public storage or someone else do something that has absolutely no effect on our store and we are still able to operate it the way we want to. It really depends on the individual situation of the property.

Hi, thanks. Joe, I think in your opening remarks you mentioned landing a third-party management contract with a New York City operator. Can you give more details on that and who it is and where they are located?

It’s Tuck-It-Away stores and they are in New York and they are in the Boroughs of New York.

And they will be re-branded as Extra Space just like the rest of the properties?

They were re-branded last Wednesday; all the signs went up Wednesday and Thursday and they will be operated under the Extra Space platform just like all the other stores in our system.

Okay, thanks. And just looking at acquisition volumes, your guidance is saying $300 million, I wanted to see what’s in that number, if you just look at your straight acquisitions, if I have my numbers right here, about $115 million of stuff that’s either closed or going to close which suggests a pretty good ramp for the rest of the year, are those deals included in that, what else is in there?

Yes, so it’s $325 million for wholly owned acquisitions, and we see those deals are included in there if they are wholly-owned. We have a number of things in process that we hope come to fruition. And if we are able to do that and meet our guidance, that will be a good thing. But if we can’t—we are not going to buy things just to meet guidance. And if we don’t meet our guidance, it’s not going to have any effect on our performance or our ability to hit guidance this year. So, we left that number out partially based on what we are working and hope we make it. But again, we are going to find things which is in the best interest of our shareholders, not to meet some guidance number we put out there. One other point of clarification, Todd, the $325 million wholly owned we have also has $75 million of JV investment to total the $400 million; and of that JV investment most of that is identified. So, the $75 million plus the $115 million you referred to is kind of what’s either identified or closed to-date.

Thanks, and good morning out there. I am not sure if I missed this but did you comment on the street rate growth you experienced in the quarter and maybe in July?

So, street rates year-to-date have been up 3% to 5%—just over 5%. The actual achieved rates are going to be lower than that. Our achieved rate year-to-date has been 0% to 3% and I am getting a range because it really depends on what specials we are running, what tests we are doing, but achieved rates have been our street rates, but our street rates continue to be in that 3% to 5% year-over-year.

And how that’s trended in July, same or towards the lower?

No significant changes in July to-date in terms of operations.

Okay. And for argument's sake, if the achieved rate remains at 0% for the foreseeable future and there is no change to the customer rate increase program in terms of increased frequency or acceptance rate, how long does it take for things or revenues to follow suit and get close to that 0% number? I’m just trying to get a sense of the wind down of the contribution program if how long it helps?

Yeah. Just to make sure I understand the question, are you asking how long our current achieved rates to take the flow through to become our rent growth in the future?

Yeah, and assuming there is no change in changing the ECRI program.

Yeah. So, first of all I mean things have changed, it’s hard to really make that assumption we have a lot of variables, things are changing all the time. I would tell you things will flow through in four to eight quarters. You know at some point your rates today become your rates in the future, but one point I would clarify is achieved rates have been better than zero.

Yeah, I know that, that was a theoretical question. And do you know what percent of properties are impacted by new supply in the way you guys look at it?

In terms of new supply, I would tell you that if you look at our revenues, about two-thirds of our revenues come from markets that have somewhat elevated supply, but then I would tell you, you need to be very careful in assuming that two-thirds of our properties have new supply and new competitors. For instance, in Dallas, Dallas is the market that has elevated supply, but our properties in South Dallas are almost unaffected. So, it’s very, very difficult to give you that number and have it be meaningful just because of the impact of supply and the assumptions people then take from there.

Hi. Thanks for the time. Just hoping you guys could comment a little bit more on where you see cap rates, you know deals are down but what the spread is and just commentary on cap rates where you see them for prime and the secondary markets?

Yeah, sure as you point out sales volumes are down significantly and we see a number of deals just get taken off the market because the spread is too wide. So, we have fewer data points. I would also point out that most of what we see on the market is of lesser quality even in terms of quality of markets than we would like; so, it’s difficult to compare those cap rates to previous cap rates which might have been better quality product. That being said, we don’t see a significant expansion of cap rates. There is still a lot of equity chasing this product type; fundamentals are still very good. Things are highly occupied and rent growth is going in the right direction. So, I think all that capital is supporting prices; there might be some modest increase in cap rates, but it’s really hard to pin down.

Okay. And then you noted that supply was going to be or has been pushed back in delays and starts and fallouts as well as the potential future developments. Any numbers around that or any markets in particular that stand out in terms of first half versus second half spread down versus your initial expectations that what would be delivered?

Yeah, I could tell you a couple of data points; I don’t know if it will give you your full answer, but we currently have a little over 350 development properties in our management plus pipeline, and that number has grown a little bit but has always been a pretty significant number. And the fallout rate we see on those properties is about half. So that may be an over-inflated number because the public storages of the world don’t ask us about their developments but that’s a good data point. I would also tell you that markets are in different stages of the development cycle. So, we look at Chicago and we are tracking 78 projects in Chicago, the majority of them have already been delivered and the pipeline is getting smaller. And you compare that to Miami, where many more in the development process have been delivered. And so, we kind of look at markets that way and feel that in some markets like Miami, more of the impact is coming, where a market like Chicago hopefully were past the great point of impact. We are actually seeing that in our numbers as well.

Was that 50% fallout similar to last year?

Yes.

Okay. And then just one last question for me. You guys talked about demand being steady to up. Any numbers around that in terms of where the call volumes or any way to get a sense of the robustness of that?

Without giving numbers, I would tell you we are citing that from our rental volume, our web searches and our call center volume.

Hi, guys. I’ve two quick ones. First, what percentage of your first half FFO came from the SmartStop contracts? And then also in the guidance when you considered changing the same-store pool, you referenced 50 basis points from SmartStop, is that in the updated guidance also?

So, make sure I understand your question. You are asking what percentage of our—or how many cents of FFO in the first half came from the SmartStop management contract?

Yes, then that income, I assume it’s really small.

It’s small and we have never broken it out after that level in terms of the exact profitability for management business and we prefer not to. I am sorry the second question is?

And I guess I also say, at the risk of repeating ourselves, we have sufficient stores that we will be putting online in the second half to replace all of the SmartStop stores. So, we are not going to take a step backwards; obviously we would rather not lose the SmartStop store and our growth would be greater, but we are not going to take a step backwards.

Okay, and then for the guidance, the 50 basis points from SmartStop acquisition, is that still in the updated range?

Yes, so SmartStop, it’s not just SmartStop but the 2015 acquisitions continue to benefit. At the start of the year, it was 110 basis points in revenue. This quarter it was 90 and we assume that will continue to go down and below for an average of 50 to 75 basis points for the year.

Hi, thank you. I just wanted to ask you on the development side. Are you seeing any change in the availability of capital or hearing anything in terms of banks' willingness to lend in the space now?

I think availability of debt capital is a constraint on development now, and obviously strong well-capitalized developers can get loans and we see local banks still in some of the cap curve but absolutely we see I think that capital is a constraint.

Okay. And then I just—thank you. I wanted to ask you on your management platform just as a reminder, when someone does join, is there a minimum period that they have to— that they sign a contract for or can they just kind of give a month's notice or how does that exit process work?

So, people can leave our management platform anytime because they want to internalize management like the first situation or they want to sell it, but there is a termination fee that amortizes over time and compensates us for someone meeting before the term of the contract is over.

Okay. Thank you. And the termination fees would be included in your guidance through the back half of the year or for the fourth quarter right now?

Yes. The termination fees we expect to receive from SmartStop are included in our guidance.

Just a couple of quick ones here. Is there anything inherently you’re doing differently versus peers that’s allowing you to keep a little bit more of an elevated revenue run rate? And because you’re decelerating at a slower pace, so just curious if you can provide any commentary around that?

Yeah. I hope so and we certainly wouldn’t discuss it on a conference call.

Yeah, don’t want you to disclose but I just want to get your thoughts on it. But a second question, it seems like one of the hitting continuities of storage is the bays loss and inventory term. So, when you actually find out a customer has left and the days it takes to release it, has there been any noticeable change in that? Does it stick over the past couple of years?

No, I mean it’s markedly different during times of the year maybe going from 30 days average in the winter months to closer to 15 in the summer, but it’s been very consistent.

I want to thank everyone for their participation and interest in Extra Space and I hope everyone has a good day. Thank you very much.