Extra Space Storage Inc (EXR) — Q3 2018 Earnings Call Transcript

Thank you, Lisa. Welcome to Extra Space Storage’s third 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 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, October 31, 2018. 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. Thank you for joining us for our third quarter call and for your interest in Extra Space Storage. 2018 is playing out as we expected as we move into the last couple of months of the year. Revenue, NOI and FFO growth are all starting to remain within guidance and expectations. Occupancy continues to be strong, ending the quarter at 93.9%, 20 basis points above 2017’s mark. This is especially encouraging because last year’s quarter end occupancy benefited from the hurricanes. We continue to have solid rate growth, which was partially offset by increased but expected discounts, resulting in same-store revenue growth of 3.2%. The year-over-year impact from discounts should taper off in the fourth quarter and we project higher same-store revenue growth. External growth was also strong in the quarter. We continue to be selective and disciplined in our acquisition efforts, but we have been able to find acquisitions with acceptable risk-adjusted returns, primarily through existing relationships. By year-end, we expect to have acquired over $1 billion in properties with Extra Space investing approximately $600 million. Between acquisitions and third-party management contracts, we have added 140 stores through the quarter. We have more than 500 third-party properties and a total of 734 stores, including joint ventures. Our report related to new supply remains generally unchanged. We are seeing an impact from new supply in certain sub-markets and its impact varies by location. New starts appear to be down in many MSAs already saturated with new development and activity is migrating to markets where there may be a better yield. We continue to see delays in deliveries and see many proposed projects being abandoned. Our highly diversified portfolio, while certainly not immune to the effects of new supply, reduces volatility. And our sophisticated platform is better prepared to respond to competition than ever before. At this time last year, we were reporting the impact hurricanes had on our customers, our employees, and our properties. Unfortunately, the Southeast experienced severe weather again, but I am happy to report that our portfolio was relatively unscathed. We did not have any material disruption with customers or employees, and damage to our properties was minimal. I would now like to turn the time over to Scott.

Thanks, Joe, and happy Halloween, everyone. Last night, we reported core FFO for the quarter of $1.20 per share. Rental rates to new customers continue to be solid. Throughout the quarter, our achieved rental rate was up approximately 3% to 4% 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. As Joe mentioned, we anticipate the impact from discounts to decrease in the fourth quarter, resulting in an increase in same-store revenue growth. We saw expense growth normalize in the third quarter, and we were successful in minimizing increases in our controllable expenses. Property taxes, while elevated, were in line with our expectations. The increase in insurance premiums was not a surprise due to the elevated level of property claims caused by last year's hurricane. We also chose to invest more in marketing in the quarter, allowing us to grow rates and keep our stores full heading into the fall and winter. We continue to execute our leverage neutral balance sheet strategy. During the quarter, we increased the percentage of unsecured debt and the size of our unencumbered pool and further laddered our maturities. We're also in the process of increasing and extending our credit facility. In the quarter, we sold $34 million on our ATM at an average price of $99.75 per share. We also disposed of one property in California for $40.7 million. The property was sold at a below-market cap rate for an alternative use and we anticipate the reinvested proceeds will produce a significantly higher yield. This store, as well as three other stores with large expansions or redevelopment projects, were removed from our same-store pool, consistent with our same-store definition, changing our total same-store number to 783 properties. We’ve updated our guidance and annual assumptions for 2018. Our same-store revenue guidance remains unchanged. We’ve increased the bottom end of our same-store expense growth by 25 basis points. We’ve tightened same-store NOI guidance by 25 basis points at both the top and bottom end of the range, with the midpoint unchanged. We increased our core FFO guidance by $0.50 at the midpoint. FFO guidance includes $0.06 of dilution from value-add acquisitions and an additional $0.14 of dilution from C of O stores for total dilution of $0.20. The lease-up of these properties continues to exceed underwriting expectations as a portfolio and will generate long-term growth for our shareholders. With that, let’s turn the call back over to Jeff to start our Q&A.

Thank you, Scott. In order to ensure that 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 follow-on questions once everyone has had an opportunity to ask their initial question. With that, Lisa, we will start our Q&A.

Joe, on the supply front in your opening remarks, you mentioned delays and deliveries and some projects being abandoned, but you also noted no change to your expectations. So I'm just trying to reconcile those because it sounds like some of the items you’re pointing to would lead to arguably feeling better about the supply outlook for next year if there are deals starting to fall out?

Our perspective remains consistent; we are currently experiencing a supply cycle and a development cycle, both of which are affecting our store operations. While new supply is being introduced, some is also being withdrawn. Last quarter, I mentioned that for 2019, assuming that what was scheduled for 2018 might be delayed, we anticipated that 2019 would be flat to moderately down in terms of new deliveries. However, based on the current data and observations, I now believe that 2019 will experience a decline. We are witnessing a slowdown in the development cycle, but the change is not significant. We will still feel the effects of new supply in 2019, as the cumulative impact of deliveries continues, although I do see the pace of delivery tapering off.

And can you tie that into maybe just some of your bigger measures in terms of where you maybe see supply pressures getting worse even just from deliveries of ones where you maybe see it abating more than others and feel better?

So the Florida markets, I think are going to get worse before they get better. We’ve seen the acceleration in Dallas, Portland; I think it's going to get worse; Washington DC, it may get worse; Chicago is a market that’s on the other end of the spectrum where we’re seeing some improvement.

Last one for me. Scott, you mentioned the achieved rates holding in that mid-single-digit range. I think you said 3% to 4% this quarter. Discounting has been a drag, which you noted. So if you factor all that in, where are your net effective rates and how has that been trending?

Our achieved rates for the quarter were between 3% and 4%. The impact of discounts during the quarter reduced our revenue by approximately 80 basis points. Without these discounts, our revenue would have been 80 basis points higher if discounts had remained constant compared to last year.

Scott, Joe, your comments about the discounts being lower year-over-year in the fourth quarter and revenue growth being higher. It seems like the comps overall beginning in late 3Q from the hurricanes last year and over the next couple quarters would be a little bit more difficult. I understand the discounting dynamic, but I was just hoping you could provide some additional context around that comment and maybe provide some insight around some of those factors heading into 2019?

The discounting strategy is part of our overall approach to maximizing revenue. This year, we have decided to use discounts as a key lever. The main difference between this year and last year is that we did not discount as much in the third quarter last year, particularly during the summer months when our discounts were low. This year, we opted for higher discounts while maintaining our rates, making this year more comparable to last year rather than indicating a change in our overall strategy. We anticipate that this year’s discounts will be similar to last year's. Therefore, approximately 80 basis points of the impact we experienced last quarter would have influenced our revenue. We expect most of this impact to decrease in the fourth quarter. Although overall revenue growth is becoming more challenging both year-over-year and sequentially, the effect of discounts will be less significant in the fourth quarter.

And then how should we think about that? So you’re anticipating your model shows revenue growth being higher in the fourth quarter versus the third quarter here. Any insight into how we should think about 2019 just in terms of maybe setting expectations?

So, obviously, we’re not ready to give 2019 guidance, we’ll give that on the first quarter. I think with the supply cycle, we expect things to continue to moderate. But I don’t think that we expect things to go negative by any means. So we’ll provide our guidance in the first quarter of this next year.

And just last question for me, the decrease in net tenant insurance income, I don’t know if I missed this in your prepared remarks, but was that attributable to the hurricane expenses or is that something else? And how much expense that's not non-recurring, what was in that number?

It actually was not attributable to the hurricanes. We had some claims from the hurricanes but not significantly higher. It was primarily due to some water claims from the tough weather during the winter months of this past year.

And how much was that in the quarter?

In the quarter, we were $1 million to $2 million high, and some of those claims were processed late. So while they happened in the winter months, they didn't get processed or adjusted until the third quarter.

Scott or Joe, can you share your current perspective on property taxes for 2019? Based on your numbers, it seems you had higher taxes, particularly in the first half of this year and mainly in the second quarter. If that trend doesn’t continue, comparisons could be easier, leading to better net operating income growth, especially in the first half of 2019. It seems that some companies we cover have experienced these one-time higher tax items, which they claim are one-off occurrences, yet they keep happening. I’d like to hear your thoughts as we consider growth for 2019.

So certain states are pretty fixed in property tax growth. I mean California is relatively fixed. Other states like Texas or Florida reassess quite frequently and are quite aggressive. As those values approach what things are trading for, they typically slow in their reassessments. So I think property taxes are potentially your biggest risk on expenses and potentially the biggest benefit in expenses as year-over-year comps become easier or as some of these states slow down in their reassessment.

I wanted to ask about the fourth quarter from last year. Do you sense any lingering effects of higher occupancies due to the hurricanes that we should consider for this year? Also, regarding acquisitions, are you noticing any changes in pricing in the private market given the rise in interest rates? If not yet, how long do you think it will take for this to have an impact?

Smedes, I'll address the Florida Houston question and then Joe will take the acquisitions one. Florida really provided no benefit for us last year in terms of upside from the hurricanes. What we saw is a lot of people moved in, most of those people moved in for the first month free and then moved out 30 days later. Houston was a little bit different. In Houston, we saw a fair benefit. Our occupancy jumped quite quickly. But Houston is less than 2% of our portfolio. So I wouldn’t say it’s going to impact it significantly. And if you look at our occupancy overall as a portfolio at the end of the third quarter, we are 20 basis points ahead of where we were last year. Even though a market like Houston is 400 basis points behind in our occupancy, Florida is actually slightly behind as of the end of September. Florida will come back in October in terms of occupancy. But we expect Houston to be a tough comp for the year, but a small percentage of our income.

Smedes, on the acquisition question. We really have not seen any material change in pricing. We have not seen cap rates increasing. Although, you would expect them to as interest rates go up. I guess as interest rates started to go up, lenders tightened spreads a little bit that made up the difference. But that can't go on forever. So, if there are several rate increases next year, at some point, you would expect cap rates to react but we haven’t seen it yet.

So I mean do you guys remain primarily focused, I guess, on your third-party managed as a potential pipeline of acquisitions, or I guess, where do you stand on external growth at this point?

So a little over 80% of the $1 billion of acquisitions gross that we’ll do this year came from relationships, either joint venture partners or third-party management relationships. We’ve had less than a fifth that were brokered deals where we’re competing in the market. And I think that's going to continue. We find very few situations where we can be the high bidder in a brokered situation and we're very lucky and fortunate to have these great relationships and some are proprietary pipeline that allows us to continue our external growth.

Joe, just wanted to clarify what you said earlier when you mentioned seeing new supply activity, migrating to markets with better yields. Are those secondary tertiary markets you are talking about, or suburbs and primary markets?

I would say secondary tertiary markets. A lot of suburbs are primary markets. I think of the secondary markets too. So, I would include all of those. But moving out of the main downtown or primary suburbs or excerpts of the main markets and moving to these other secondary-type markets.

Going back to Smedes's question about external growth, you mentioned that 80% of the assets or acquisitions from the third-party platform are already managed, which was around 30% a few years ago. The underwriting for those assets is very strong, implying lower risk. The capabilities of your platform are quite notable. Why not consider acquiring more non-managed stores that present additional operational potential, assuming they are available for purchase? I am examining the integration of these third-party managed properties into your existing portfolio going forward and the anticipated growth, which may be limited in the future due to minimal upside. Would you say this is a reasonable perspective?

For the most part, yes. So, not all of that 80% were managed. Some of it is truly from relationships we have with people and we don’t actually manage the properties at the time. Secondly, we’ve been buying this year more than ever before many of these stores in joint ventures, which even though they are maximized from a management standpoint because we do manage them, we do get outsized returns because we’re not investing 100% of the capital but we get a management fee, we get the insurance proceeds and we have the opportunity to earn or promote. In a perfect world, I would love to buy more from the mom and pops and from under-managed properties and get them more juice out of the deals, but I want to pay for it. So, we’ll do that when the pricing is right. And when the pricing isn’t right, we need to remain disciplined and patient.

And then just one more and I’ll jump off. But could you just maybe give us details on the yields on the operating store acquisition this quarter scheduled to close by year-end? I know you said transactions market hasn’t seen any change but curious what you paid for those couple stores? Thanks.

The stores were at various stages of stabilization. The Fort Lauderdale store was fully stabilized, while the other stores required between 10 and 22 months to achieve stabilization. Therefore, the initial yield was not always equal to the stabilized yield. However, when averaged together, the first year yield was in the low 5s, and the stabilized yield was in the mid-6s.

Joe, could you comment a little bit on the cause of some of the supply decreases or the drops in attendant starts?

So one thing is that there is better information out there in the market today than there was a couple of years ago, there are some third-party providers that are doing a pretty good job of putting together information. So when a developer or an equity source or a bank is looking at a proposal to build the next store in North Dallas, it’s fairly easy to see there’s a lot there already. And that may not be the smartest thing to build the next store in North Dallas. Secondly, costs are up; interest rates are up, we talked about that; land pricing is up; labor is certainly up; material is up. So you have increased costs. And then the other side, you have moderating operating projections. If someone honestly underwrites a deal, they’re not going to underwrite 8% rent growth. And so a few that you have increased costs and moderating projections that squeeze your development yield. And then you have lenders that are somewhat more cautious where you have a little bit more difficulty getting loans. So I think all those factors make it harder these days to stick the next shovel in the ground.

Is it fair to say that a lot of developers were underwriting a lease-up time of say two years, three years, or is it most, which is maybe common a couple of years? But that's turned out to be what has historically been a three to five-year range?

I don’t know if it was lease-up time or rate. But in general, developers are optimists and they will create a pro forma that has an aggressive lease-up rate and aggressive lease-up time period, and an aggressive unit mix too, which is what we frequently see where the unit mix is meant to maximize revenue but may not actually work in the market. And the equity providers and the lenders and the operators, the manager's job is to try to make sure that developer has a realistic pro forma and if that can get financed then the deal typically goes forward. And if not, sometimes it gets put on the shelf.

Just another developing financing-related question, I think when your public peers take on the strategy of underwriting a construction mezzanine loan business. Whereas, I think what you and some of your peers do more of the certificate of occupancy-type acquisitions, those are available. Would you consider being in the lending business as well if it led to more investment opportunities?

So we do not want to be in the lending business for development. And the primary reason for that is because if you make a loan, you have to be willing to own that project. And we don't want to own a brokered development deal where we have to continue development take the project to completion. There's obviously already problems, that's not a risk we're willing to take. We are willing to make loans on completed buildings that we want managed and to be willing to own.

My first question has to do with the comment made earlier about discounts declining in 4Q. I'm just again wondering how confident you are in that just given some of the supply issues that are still out there, why you wouldn't keep discounts and try to maximize revenue?

So, I don't think we're necessarily cutting back on discounts. It's more a comp issue. So, we will discount in October, November, December, but the difference is as we also discounted last year in October, November, December. So just seasonally, you typically have more discounts in the fall and winter than you do in the summer whereas this year, we increased our discounts in the summer month. So our strategy year-over-year is much more similar this year.

And then the second question. Just given your meaningful exposure to L.A. and San Francisco and some of the talks happening around Prop 13 potentially hitting the ballot in 2020. Just wondering what you're hearing about that, what you're thinking about that? And if you've done any homework about what impact that could have on EXR?

So obviously we recognize that as a risk. Some of our properties are legacy properties that we've owned for quite a while that have just had the 3% raises every year. We have done some math. It's pretty simple math where you’re basically comparing what you're paying in taxes today compared to if they were assessed at full value. We understand what that is. Clearly, it's an impact. It will depend a little bit on; one, if it gets passed; and then two, how they phase that in. So, very difficult to really comment on the impact at this point, but it's a risk we’re monitoring. I think the Self Storage Association is aware of that. I think that there you'll probably see some lobbying efforts around that.

Is there anything you’ve done in regards just the worst case analysis like if at all shows up straightaway?

We have, but it’s probably not something we would want to disclose on the call today.

I just want to go back to the $0.20 dilution this year from acquisitions and C of O deals. Will those still be dilutive next year? I know you might have some more roll in, but just for this comp set here. Will you get to, I guess, a no dilution point next year? And has there been any change in stabilization of C of O deals as far as timing goes?

So we’ll continue to add C of O deals, you can see that in our supplement. So, as the value-add and C/O deals that are causing that $0.20 lease-up, we'll have others added into the pool.

And it depends a little bit on what stage they’re at in terms of their lease-up. So a property they opened in the fourth quarter of this year, clearly, will be dilutive next year. An acquisition that we bought that was 70% full and we bought it in January of this year, it likely is not dilutive next year. So overall, I would tell you, part of that $0.20 continues into next year but it's a different pool, a different group.

And then what is still the typical underwriting? And what I'd recall before was up to three years, but they were stabilizing maybe one to one-and-a-half-years. Has that changed at all?

So we are underwriting C/O deals between 36 and 42 months to achieve economic stabilization, depending on the size of the property in the market that it's in. And we’re currently doing maybe slightly better than 36 months, maybe 30 to 36 months to get the economic stabilization and we’re getting to occupancy stabilization earlier than that.

I wanted to ask Joe about your thoughts on the Certificate of Occupancy and lease-up duration. How are you factoring in potentially higher risks in your underwriting assumptions? Since this is being acquired through a wholly owned joint venture, are your yield expectations increasing? Is leverage being factored into these portfolio deals? I’m trying to understand if you expect a higher yield upfront, considering the potential strain on NOI in the future. What are your thoughts on the associated risks?

Everything needs to make sense on an unleveraged basis. We underwrite without leverage, and if a deal doesn't make sense, we don't pursue it by adding debt. We’ve consistently underwritten at 90% occupancy, with a lease-up period of 36 to 42 months and a 3% growth in rental rates. Some of these assumptions may actually be conservative considering our current occupancy and revenue growth. However, we believe this is the correct approach to underwriting these deals. Our target stabilized yield on certificates of occupancy deals has been around 8%. If we receive a proposal in a prime location during a temporary market dip, we might accept a slightly lower yield, while potentially aiming higher in other markets. This target yield adequately compensates us for the dilution during the lease-up period, and we involve joint venture partners to manage our dilution and risk. This strategy allows us to pursue more deals, spread our equity, and enhance our returns.

And then lastly, the Menlo Park property sold, you got a huge gain but it’s also in a high barrier very affluent market. Is that just an offer you couldn’t refuse?

We sold the property to a large corporation looking for an alternative use and achieved a sale around a three cap rate. Although it's likely unfeasible to build storage in Menlo Park, we can reinvest those proceeds to double our yield, which we've accomplished through a reverse 1031 exchange. Essentially, every property is available for sale if the right offer comes along.

So I just wanted to touch back on supply? Do you have a sense of what percentage of your portfolio is going to be exposed to that three-year rolling supply in '19 versus what that number is in '18, and if that delta is going to be a greater percentage and to what extent?

So let’s start by looking at 2018. About a third of our portfolio of 841 stores will be facing new supply in 2018. However, almost half of those stores have not yet been delivered, as some are still under construction and will be pushed into 2019. Others are on the proposed list, meaning they may or may not be delivered. In 2019, the number is less than half of what we’ve identified for 2018, which indicates a drop off into 2019. Did I answer your question?

Yes. When you say less than half, so 15% if ’18, is that fair?

14%.

Do you have an idea of what that looks like over a three-year period of deliveries? Is it increasing or decreasing?

So it actually goes up. The three-year rolling goes up by 9%, because you're dropping off 2016, which was a relatively small number and adding the 2019, which is while a smaller number than 2018, a bigger number than 2016.

And that's up 9% to what or from what base? Just to be get sense of the total portfolio exposed on three-year basis?

So, a three-year ending in 2018, is probably close to 50%. And then you're closer to 60% in the three-year ending in 2019. Is that the right question?

Yes sir. Thank you very much, that was perfect. And then just on from a same-store perspective. How should we think about the benefit of the new stores being added next year to pool and relative to the benefit you've had this year, which has come down as the year has gone?

We haven't completed the 2019 budgets yet. However, I believe that most of the benefit will come from Certificate of Occupancy stores entering that pool rather than from acquisitions. I would estimate that the impact will be relatively minor. The same-store pool is large enough, and since we are not adding many properties, the effect is not likely to be significant.

And one last question for me. So you said that the concessions were about an 80 basis points drag to the third quarter same-store revenues, and you've described the fourth quarter given an easier comp has not been an issue. Does that mean that that 80-point delta goes away to zero in terms of a drag on a year-over-year basis?

Not sure it goes to zero, but a significant portion of it goes away.

Thank you. Thank you for joining us today. We are pleased with our platform and our team's ability to continue to drive rental rates and occupancy. We have always invested in our platform, our portfolio, and our people, and it is paying dividends in the current competitive environment. 2018 is following our expectations and our diversified portfolio is performing well. We're excited about our outsized external growth as we enhance our size, scale, and brand. We thank you for your interest in and support of Extra Space Storage. We look forward to seeing you and speaking with everyone at NAREIT. Have a great rest of the day. Thank you.