Extra Space Storage Inc (EXR) — Q2 2018 Earnings Call Transcript

Thank you, Valerie. Welcome to Extra Space Storage’s second quarter 2018 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 statement 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 1, 2018. The company assumes no obligation to revise or update any forward-looking statements because of the 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.

Thanks, Jeff. Hello, everyone. Thank you for joining us for our second quarter call and for your interest in Extra Space Storage. We have crossed this year’s midpoint and to date, the year is right in line with our expectations and with our guidance with the exception of some uncontrollable expense items. Revenue is on budget and occupancy continues to remain strong, ending the quarter at 94.2%. We have maintained pricing power during the busy summer leasing season with achieved rates up mid-single digits. This led to same-store revenue growth of 4.1%. New supply continues to be at the forefront of most operators' and investors' minds, and we are certainly focused on it as well. Our view continues to be the same. We are seeing an impact from new supply in certain submarkets and its impact varies by location. We are benefiting from our highly diversified portfolio across primary and secondary markets, which reduces the impact of individual market volatility. In addition, our best-in-class platform continues to drive high-quality traffic to our stores, and our proprietary revenue management systems are optimizing price and promotion to convert that traffic to rentals. As I mentioned on our last call, our scale and technology advantages become more apparent in periods of elevated supply. We continue to focus on and invest in our platform to maintain this advantage. These advantages reflect a significant growth in our third-party management platform. We added 42 stores in the second quarter and we are approaching 100 stores year-to-date. Between our third-party and JV programs, we now manage 700 stores, which continues to be the largest in the business. We’re happy to report that Inside Self-Storage magazine just named us as the best third-party management company for the seventh year in a row. The acquisitions market continues to be competitive with numerous types of capital seeking exposure to the sector. We have yet to see any expansion in cap rates despite elevated interest rates and supply. We continue to be selective and disciplined in our acquisition efforts. This year, we are primarily sourcing accretive acquisition opportunities through existing relationships, rather than in the open bid auction market. In the quarter, we invested $274 million through a combination of wholly-owned and joint venture acquisition, which includes the buyout of a JV partner's interest in a 14 property portfolio for $204 million, which we highlighted in our first quarter call. Year-to-date, our acquisitions closed or under contract to close in 2018 totaled just end of our annual guidance of $600 million. Before I turn the time over to Scott, I want to reiterate. Revenue performance year-to-date is solid and exactly as we expected. As we discussed on our last call and as our guidance implies, we knew revenue would be accelerated and elevated discounts would create a headwind in the second and third quarters. We are pleased with our strong growth in occupancy, which has allowed us to increase our FFO guidance. I will now turn the time over to Scott.

Thank you, Joe, and hello, everyone. Last night, we reported core FFO for the quarter of $1.15 per share, exceeding the high-end of our guidance by $0.01. The beat was primarily due to stronger than expected tenant reinsurance income. Rental rates to new customers continue to be strong. Throughout the quarter, our achieved rental rate was up approximately 5% to 6% year-over-year. As expected, and as discussed on our last call, discounts as a percentage of revenue were also up, partially offsetting revenue growth. We anticipate elevated discounting levels to continue in the third quarter. Discounts should taper off later in the year reducing the impact on fourth quarter revenue growth. Our guidance included outsized expense growth in the first half of 2018 due to negative expense comps in the first and second quarters of 2017. Same-store expenses were up 4.9% in the second quarter, which was in line with our forecast with the exception of property taxes. We had three properties receive unbudgeted tax increases for 2016, 2017, and 2018 that totaled $872,000. Without the impact of these three stores, expense growth for the quarter would have been 3.5%. We continue to execute our balance sheet strategy to increase our percentage of unsecured debt and the size of our unencumbered pool and prudently ladder our maturities. During the quarter, we announced a 10-year $300 million private placement, which was funded on July 17. We also negotiated better terms for a number of existing secured loans, which lowered rates, extended maturity date, and reduced maturity concentrations in 2020. Subsequent to the quarter-end, we sold $34 million on our ATM at an average price of $99.75 per share. The decision to access the ATM was based on lower than expected OP unit issuance, as well as last quarter’s increase in acquisitions guidance. We’ve updated our guidance in annual assumptions for 2018. We raised the bottom end of our same-store revenue guidance by 25 basis points to be 3.75% to 4.25%. We’ve increased the top end and the bottom end of our same-store expense growth by 50 basis points to 4% to 4.75% due to uncontrollable expenses in the first few quarters. The changes to revenue expense guidance results in unchanged same-store NOI guidance of 3.25% to 4.5%. We’ve increased our core FFO guidance to be $4.60 to $4.67 per share. In 2018, we anticipate $0.06 of dilution from value-add acquisitions and an additional $0.15 of dilution from C of O stores for a total dilution of $0.21. Our investment in C of O stores and value-add acquisitions continue to improve the quality of our portfolio and generate long-term growth for our shareholders. With that, let’s turn it over to Jeff to start our Q&A.

Thank you, Scott. In order to ensure we have adequate time to address everyone’s questions, I would ask everyone to keep your initial questions brief. As time allows, we will address follow-on questions once everyone has had the opportunity to ask their initial question. And with that, Valerie, let’s go ahead and start our Q&A.

Hi, good morning. Just hoping we could talk a little bit about supply and your latest expectation for 2019 deliveries versus 2018 and thinking about things on a three-year rolling basis, maybe how 2019, at least, your thoughts now compare to 2016?

Sure. Our supply outlook hasn’t really changed that much from last quarter. We would expect 2019 to be similar to slightly moderating down from 2018, subject, of course, to things getting delayed and being pushed into 2019, which seems to happen a lot in this business, things just don’t deliver on time. So overall, when you look at national numbers, I would expect a similar to slightly down number. But what’s more important is where the product is being delivered. And we do see a shift in the markets to where folks are concentrating, less people looking, less if any people looking at markets like Dallas and more people looking to secondary markets, which haven’t yet been impacted as much by new supply.

Great. And then just on the same-store revenue, how should we expect the trajectory of second-half growth to be? And would you characterize a fourth-quarter run rate as a good sort of starting block in terms of thinking about 2019 growth?

Yes. So, Juan, it’s Scott. So if you look at our guidance and you look at kind of how we’re looking at the year, I think our top line revenue growth, kind of ignoring discounts for a second here, our top line revenue growth implies deceleration throughout the year. So we’ve implied that in our guidance, we’ve talked about that. The impact of discounts are going to be larger in the second and third quarter with that impact moderating into the fourth quarter. So you could potentially see the fourth quarter be slightly higher year-over-year than the third quarter. So that’s kind of the current year. I’m not sure we’re ready to give 2019 guidance, but that’s our outlook for the current year.

Could you quantify the drag in the second quarter from the discounting?

Yes. The discount drag in the second quarter was about 40 basis points.

Thank you.

Thanks. Hey, guys. Joe, I just wanted to go back to your comments on supply just now about 2019 at this point, kind of expectations feel like it could be in line to even slightly down. I’m just wondering what you’re seeing out there in the market today that gives you that confidence that it doesn’t actually ramp up just given that returns are still quite good and obviously, fundamentals are holding in there?

So it’s hard to have perfect transparency to 2019 or high level of confidence as you characterize it. But what we do see is our costs are certainly going up, interest is going up, labor is going up, materials, steel is going up. So you have an increased cost basis and we know projects that are being canceled and not pursued because of cost. And you do have moderating although solid fundamentals. So I think, between the discipline of some of the developers who’ve been in this business for a while and understand the business and lending some discipline from lenders, and I’m not going to say that there’s discipline all the way across the board. I think you will have some market forces that moderate development. Certainly, you’ll see that in markets where saturated, right? It’s hard to find – it is that keep using Dallas as the punching bag. But it’s hard to find a site in North Dallas that makes sense now.

No, that makes sense. But – and it sounds like lending is at least one of those factors that you’re seeing maybe get a little tougher at this point?

Situationally, I think there are a lot of local folks who have their local banks who can get loans, but it is a factor that’s getting tougher.

Okay. And then just second one for me. I mean, you talked about the advantages the larger players have on revenue management technology front, especially at points in the cycle like we’re in where supply is rising. So, Joe, as you look at your systems today, the results you’re generating, are you happy with where the system is at today or will you continue to put more capital into it? And where do you really see the biggest opportunities for improvement, or what are you most excited about on that front going forward?

So we’re happy with our systems and always striving to improve. So we’re always seeking to improve, particularly in the world with technology. Anytime you stand still, you’re just hoarding ducks. So we spend a lot of time and effort trying to improve our models, improve our systems, do many, many different tests to find out how we can maximize revenue, deliver a better product to our customer, and I just think it’s something that we do well and I hope we continue to do well.

Thanks for the time.

Thank you, Jeremy.

Hi, thanks. Good afternoon. First question just back to the discount drag that you talked about the 40 basis points on the same-store revenue in the second quarter. Will that drag in the third quarter be the same or more than it was in the second quarter?

Comparable to slightly higher. You have summer months; we typically don’t discount as much. In this quarter, you really have July and August, where last quarter you had May and June, but typically more rentals in July and August.

Okay. And then, Scott, your comments, so it sounds like same-store revenue growth might trough in the third quarter and then begin to improve sequentially into the fourth quarter just based on your comments. Is that the right read?

That’s the way we’re looking at it, correct.

Okay. And then just last question on for the third-party management business, how many net additions are you anticipating at year-end? And is this sort of pace of additions to the platform anticipated to continue in 2019?

So we’re at 75 net additions to our third-party management platform through the second quarter, and we expect that pace to continue for the rest of this year. I would not be surprised to see it slow down in 2019 as about two-thirds of our additions are development. And as development starts to moderate, I would expect we would feel that in our third-party management platform.

Okay. Thank you.

Yes. Good afternoon, guys. Just one thing looking at the trends in third-party management, just kind of following on that question line. What have you seen recently in terms of canceled contracts whether it’s customers who are exiting to go to another manager or customers internalizing their own management?

We only had one experience with a customer internalizing its own management; that was last year when we lost a large portfolio, and we talked about that. Part of the business is that people will sell their properties or have some type of transition, and you will occasionally lose property. So we’ve lost six in the first quarter and we lost two in the second quarter, and that’s just part of the business. I don’t think we’ve seen any trends increase or a different behavior in terms of owners.

And those six in the first quarter, two in the second quarter, were all those due to property sales and the new owners looking to switch management, or any of these just people switching for any other reason?

So we lost one contract for someone switching to another manager. We were not willing to make the fee concessions necessary to retain that contract. And that happens. To date, that has happened very, very occasionally; but when it happens, that’s part of business.

Okay. Thanks. And then also, just looking at acquisitions going forward kind of what trends are you seeing in competition for assets in terms of any new sort of players in the market that have new recent inflows of capital they’re looking to put to work?

We continue to see a lot of interest in self-storage investment. I mean, the basic fundamentals of the property type are still very strong with 94% occupancy, positive revenue growth. And to the extent people are concerned about a downturn in the economy, this is an asset class that performs well in a downturn economy. So there’s a lot of reasons that people are interested in this asset class. For that reason, there’s a lot of different types of money from big private equity funds to more local regional people who put together pools of money looking to invest in asset classes. And it’s our opinion that’s why we haven’t seen the expansion in cap rates; there’s such a demand for the asset class.

Okay. Thanks for the color.

Thank you, George.

Hi, can you hear me?

Yes.

Thanks. Sorry, we’re still learning power phones here apparently. I just wanted to ask you about the tax increase on three stores that cost you $1 million. With 800 owned stores and another 200 in JVs and 250 managed, how do you think about maybe the risk going forward for kind of unbudgeted tax increases? And what’s the risk across your other assets, I guess?

Yes, Smedes, this is Scott. This was actually kind of a unique situation where a school board challenged the valuation that was put on by the local municipality and obviously had a negative impact on us. That affected 2016, 2017, and 2018. In terms of prior years, the risk on this happening in this situation to other properties is not an issue, it’s the statutes of running that. We constantly are looking at reassessment. This was one that went against us; it happens occasionally. But I wouldn’t tell you the risk is any greater today than it has been in the past. More often than not, we win appeals and we have these types of surprises.

Okay, that’s helpful. Thank you.

Thanks, Smedes.

Thank you. Joe, do you have any sense just based on what you perceive as a more moderate supply growth challenge in 2019? How much of a decrease do you think that’s attributable to rising construction costs?

I don’t – to the extent we have moderation in 2019. I don’t think I have any way to kind of allocate the causes between rising construction costs or tighter lending or just the top line going down. So development yields are getting suppressed. I’m not sure I can divide up those different causes.

Maybe I can ask that question a little differently. How much overall cost increases are your development partners seeing today versus say a year ago to construct a self-storage facility, excluding land?

So I would tell you that we are hearing about 10% to 15% increases in steel before the tariffs were announced. So we know we have some increases there, labor, and interest rates. So I think if you put that all together, you probably have 10% to 15% increases in overall cost, excluding land.

Okay, that’s helpful. Thank you. And just a follow-up question. Do you perceive in your budgeting weeks going forward the next foreseeable future wage rates appreciate at the same pace it has this year?

So our current year increase, I would tell you, is attributable not so much to wage rate pressure; it’s attributable more to the fact that our benefits saw outside growth this year. Our health insurance and benefits increased faster than they have in the past. And then the second thing I would attribute it to is a very tough comp. Last year through two quarters, we were negative 2% on payroll. So if you kind of look at it on a two-year rolling number, it’s pretty much inflationary. Our healthcare has not gone up for several years. So we experienced an outsized increase this year. We hope to be able to control more than inflationary number.

Thank you for the explanation.

Thanks.

Thanks.

Hey. Yes, I just had a quick question on San Francisco. Just looking at some of the deceleration this quarter. Just curious if you can maybe provide any color there, and how you guys are thinking about the market and maybe the West Coast in general? Thanks.

So our numbers in San Francisco are really driven by San Jose. So San Jose is weaker than San Francisco and Oakland, which are doing better.

Got it. And then if I can just ask another quick one about acquisitions. Clearly, this year a lot of success being able to source a lot of off-market deals. So maybe if you can just kind of comment on what that pipeline looks like? So is there a kind of a one, two-year runway where you can continue to kind of source these attractive deals? Thanks.

Our pipeline of off-market opportunities is really hard to predict; right, because you never know when these opportunities are going to come up. We know that some of our joint ventures that we have are in either finite life funds or funds that we’ll be seeking exit at some point and we hope to have an opportunity to acquire those assets, but there’s no guarantee. But what I can tell you is, if history is any guide, if you look back, we’ve been pretty successful year after year after year in generating a significant portion of our acquisition pipeline from our relationships, either on the management side or on the joint venture side or just our relationships with people we’ve done business with for many, many years. And I don’t see any reason why that shouldn’t continue in the future.

Helpful. Thanks so much.

Thanks, Ron.

Thanks. I guess, good morning out there still. Just wanted to maybe talk a little bit about customer rate increases. And just how you’re sort of looking at the new customers, folks staying kind of on the short end of the curve and then the longer-stay customers. And are you seeing any trends in length of stay or ability to absorb rent increases in the two different buckets of customers?

Yes. Our length of stay, Steve, continues to increase mildly or moderately here. So customers are behaving very similarly to the way they have in the past. Our existing customer rate increases are still high single digits. We continue to do those on a monthly basis. We have a roll down in rates of between 5% to 10% depending on the time of the year, similar to what it’s been in the past. And customers are reacting very, very similarly to the way they have in the past to rate increases and rates in general.

Okay. And then, I guess, maybe just circling back on the expense question. I know it’s kind of been asked a bunch of different ways. But as you look into next year and you look at kind of just overall operating expense growth, is there anything that would get you nervous outside of that one-time hit you had here in the second quarter? I mean, do you look at expenses being at a similar rate next year, or do you think things could accelerate because of wages, potential upward pressure on real estate taxes?

Yes, the two or three areas that I would point you to. One is, I think, you’ll continue to have some pressure on property taxes just with valuations where they are, municipalities reassessing things. So property taxes are always a risk. Our insurance – our property insurance is going up also. You’ll see an increase in the back half of this year. We renewed it at the 1st of June, and that’s due to the fact that we’ve actually been kept very low for several years and with the hurricane year that we had last year it went up. But overall, I think we hope to keep things inflationary with property taxes probably being the biggest risk and then the current year bump in that insurance.

Okay, thanks. That’s it for me.

Thanks, Steve.

Thank you.

Hi, thanks. Just looking at the investments you made alongside your JV partner, I wanted to compare those to what you would consider for your wholly-owned investments. Can you go through the five operating stores and maybe how they compare to the seven silo properties that you made alongside the JV partner?

It was actually combined. So it was stores that were in lease up, as well as some stores made a Certificate of Occupancy. So the stores that were in lease up have been open between one and two years. So it’s all one joint venture investment.

What kind of growth – can you go into some of the economics around that maybe growth rates just to see if a property opening now or whether it’s in lease-up? The economics around those growth rates yields expected in the first two years, call it, and then silo properties?

In terms of our underwriting assumptions?

Yes, see where we are in the cycle?

So we’ll – yes. So we’ll typically underwrite – all of these stores had a significant portion of lease-up. The C of O stores obviously had 100%, the others were lightly occupied, so still had significantly lease-up. We’ll look at the markets. We’ll determine the rates we believe we can achieve based on what we’re achieving in our stores around what’s coming in the way of development and what the local economic situation is. We’ll underwrite those rates. We typically grow at 3%, and we will attach certain discounting to those rates to achieve lease-up to economic stabilization. When we underwrite C of O stores, we want to get to an 8, maybe 7.5 to an 8 on stabilization. The yield to us in a joint venture is much higher; it’s in the double digits because of the effect of the joint venture.

And that would be leverage and third-party management fees?

No. Those are all unleveraged numbers, but including management fees.

Okay. And all these properties, are they included in your 42 third-party management additions?

No. When we talk about third-party management stores, we talk just about stores we manage whereas the owner owns 100%. We also manage our joint venture stores, but we don’t refer to those as managed stores.

Got it. Thank you.

Thank you.

Thanks, Todd.

Hey, it’s Michael Bilerman here with Smedes. Joe, just wanted to get your views around equity issuance, especially with the furthering of the external growth through the acquisitions that you just talked about. You tapped the ATM as the stock got to almost $100, raising just over $30 million. The stock's back down to the low-90s, still trading at a low 5% implied cap rate. I guess, how do you give us some sort of goalposts of how you think about using the ATM and doing equity, especially as the external growth pipeline, which you desire continues to be there to expand?

Yes. So we – our goal and our strategy is to maintain leverage neutrality as we grow. So we need – as we find acquisitions, we need to find ways to capitalize those. And as you point out, as our pipeline grows, our need for capital grows. We will certainly – and as we did tap our ATM or seek equity when we have a need for it, and we also use other sources of capital, for example, sales proceeds. We’ll have some sales; it is used when we use those capital. So equity certainly is an option for us, and when we have a use for it, we’ll consider it.

Right. But I guess, how do you think about the pricing of that capital? It seems that during the second quarter, even though you had, call it, $300 million to $400 million forward commitment between the acquisition and the developments. You didn’t do it. It wasn’t only until the stock really ratcheted up close to $100. I’m just trying to get your views around how you view the common equity at various prices relative to selling assets?

Yes. So from our perspective, as we gave guidance this year, we looked at OP unit issuance. It was coming in a little bit light. Clearly, we want to issue equity when we feel like we’re appropriately priced. This year, we will sell an asset here in the third quarter that is one that’s going to go for a very below market cap rate. It’s a higher and better used situation. So our issue, we’re up against today is, we’re trying to balance cash on hand with the equity needs. And so at this point, we felt like this was the best way to do it and remain leverage neutral.

And how big is that asset sale just dollar-wise?

It’s about $40 million.

And is there any other sales occurring in the back half of the year that we should be aware of?

That’s the only one under contract.

And you said that will be below market cap rate. So are we talking somewhere in the 3% to 4%, 4% to 5%, 5% to 6%?

So it’s being sold to a non-self-storage user and it will be substantially low cap rate.

And when you – Scott, when you say appropriately valued, I guess, should we view $100 as appropriately valued, or is the current price at $92 million appropriately valued to where you would execute?

I think it’s time on the table in the range where it is today if we have a place to put it.

Yes, sorry, guys. Just one quick follow-up. Can you just maybe talk about the business demand that you’re seeing? And has there been any real change in that line? And do you expect that to change in 2019?

We have not seen any change in demand from business customers. We think it’s been very steady for many, many, many years. So we don’t expect to change in 2019. We also – and maybe this is different between us and our peers. We like the retail customers better than the business customers. The business customers can drive high bargains. They’re difficult to raise rents on. And if we can fill our stores to 94% and maintain our current percentage of business customers, we’re very happy with.

Okay. Thanks, Joe. I appreciate it.

Sure.

Thank you. Thanks to everyone for joining us today. We are pleased with our ability to drive rental rates and occupancy in the face of heightened new competition. 2018 is following our expectations. In our diversified portfolio, our investment class platform is performing well. We continue to execute our strategy to combine steady property-level NOI performance with consistent external growth to produce strong FFO growth per share. Thank you, and I hope everyone enjoys the remainder of this summer.