Extra Space Storage Inc (EXR) — Q4 2018 Earnings Call Transcript

Thank you. Welcome to Extra Space Storage's fourth quarter and year-end 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 combined 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, February 21, 2019. 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, and hello everyone. Thank you for joining us for our fourth quarter and year-end call. It was great to have so many of you here last month for our Investor Day, and we appreciate your interest in and support of Extra Space Storage. 2018 was another solid year; same-store revenue was in line with expectations. Our diversified portfolio and best-in-class platform are maintaining very high occupancies while producing positive rate growth despite a challenging environment with new supply in many markets. Expenses were also generally in line with expectations, with the exception of a couple of uncontrollable expenses that hit in the first half of the year. Our team stepped up and did a great job with controllable expenses, especially in the last two quarters, and found ways to offset some of the expense growth through savings and efficiencies. Our same-store NOI grew 4% for the year despite a challenging operating environment. Same-store NOI was enhanced by our strong external growth from third-party management and off-market acquisitions, resulting in core FFO growth of 6.6%, which was above the high end of our annual guidance. Looking forward to 2019, many of the themes are similar to 2018. We continue to see new supply delivered in many markets. The rate of deliveries has started to slow, and while we still believe new openings in 2019 will be lower than in 2018, we expect the impact of new supply to be greater due to the cumulative effect of several years of elevated development. These concerns are the same concerns we discussed on our call a year ago. However, there are also some encouraging themes from last year that will continue into 2019. First, the economy continues to be healthy. Second, we are in a need-based industry with steady demand and solid fundamentals. Third, concerns about declining use of storage due to millennials, disruptive new businesses, or otherwise are proving to be unfounded. And fourth, large operators continue to have a significant technology advantage over most of the industry. As a result, occupancy remains very strong, and we have positive rate growth in most markets. We have a geographically diverse portfolio and a platform built to drive traffic to our stores, our website, and our call centers. In short, Extra Space is well prepared to navigate today's competitive landscape. The challenges presented by new supply also continue to bring us opportunities. In 2018, we added 153 stores to our third-party platform and continue to have a robust pipeline for 2019. We invested $580 million in acquisitions, $145 million of which was invested in certificate of occupancy or development fields. We were successful at finding accretive acquisition opportunities for our partners and other relationships before they were exposed to the broader market. 84% of all 2018 acquisition volume was completed through off-market transactions. This off-market acquisition trend has continued into 2019 as we recently completed the buyout of one of our joint venture partners in 12 properties in Los Angeles and the Bay area; these are well-located, purpose-built properties that we developed ourselves in the early 2000s in top-tier infill markets with true barriers to entry. Extra Space realized a $72.8 million promote in the joint venture through the transaction, which was applied to the purchase price. While 2019 will not be without its challenges, we are making the necessary investments to strengthen our platform and support our growth while maintaining operational excellence in the current environment. I would now like to turn the time over to Scott.

Thanks, Joe, and hello everyone. Our core FFO for the quarter was $1.22 per share, and our core FFO for the year was $4.67 per share, ahead of our guidance. The peak was primarily due to property performance and G&A savings. Core FFO includes a $0.02 adjustment for the write-off of deferred financing costs related to the prepayment of notes payable to trust. We continue to evolve our balance sheet, which has never been stronger. During the quarter, we amended our credit facility, accessed our ATM, and increased our unencumbered pool, which now stands at $5.6 billion. These efforts are part of our goal to further diversify our capital structure, ladder our maturities, and minimize our average interest rate while extending the average term. This will ensure that we continue to have capacity to fund future growth through multiple sources of capital. Last night we provided guidance and annual assumptions for 2019; our new same-store pool increased by 38 stores to a total of 821. Same-store revenue is expected to increase 2% to 3% in 2019. As Joe mentioned, we believe the impact from new supply will be greater in 2019 than it was in 2018. The level of this impact will depend on the timing of deliveries and the speed of absorption in impacted markets, specifically the major Florida and Texas markets. Our guidance also assumes some revenue growth moderation in markets not heavily impacted by new supply. This is due to multiple years of outsized growth resulting in tough comps. Same-store expense growth is expected to increase 3.75% to 4.75%. The increase in expenses is primarily driven by outsized growth in property taxes and marketing spend. Our revenue and expense guidance results in NOI growth of 1.25% to 2.75%. Our full-year core FFO is estimated to be $4.73 to $4.83 per share. In 2019, we anticipate total dilution of $0.23 from value-add and C of O acquisitions, up $0.03 from 2018. We recognize that short-term headwinds cause to our core FFO growth rate but believe the investment in these lease-up stores continues to improve the quality of the portfolio and generates long-term value for our shareholders. With that, let's turn it over to Jeff to start our Q&A.

Thanks, Scott. 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'll address follow-on questions once everyone has had the opportunity to ask their initial questions. With that, let's turn over to Michelle to start our Q&A.

Good morning, guys. This is Shirley Wu with Jeff Specter. So thanks for the actual call on our supply. I think in previous earnings calls you've mentioned that the percentage of a portfolio being affected by the new supply would be around 60% to 90%. Has that changed, and what do you think 2020 is going to look like?

So our view of 2019 has not changed. The only thing that's changed on the ground is a certain number of developments that we expect to be delivered in 2018 were, in fact, delayed and now will be delivered in 2019. But we expect the same thing to happen in 2019 in some of the properties that are scheduled to be delivered late in 2019 will, in fact, be delayed and not delivered until 2020. So our view continues to be that deliveries will be higher in 2018 than in 2019, although peak impact is in 2019 because of the cumulative effect. As to 2020 and our views, frankly, it's all subject to the trend continuing of decreasing new developments. If, in fact, people start putting more shovels in the ground, then we could be wrong, and we just have to wait and see what happens.

All right. Could you talk about street rates in 4Q and maybe how that's going to look in 1Q of 2019 as well?

Yes, Shirley, our street rates in the fourth quarter were in the low single digits, achieving about 2% in January.

Did you mention the drag from discounting at all? I know last quarter's about an 80 basis points drag or supposed to update a little bit here in the fourth quarter. What was it?

So in the fourth quarter, there was really no drag or no benefit from discounts; it was flat. Our guidance for 2019 is the same – no benefit or drag.

So if we combine that with the 2% effective rate you just mentioned here, it obviously takes a while to roll through same-store, but as we think where you're at today and where your guidance is – the 2.5% midpoint for revenue, assuming you are actually going negative on that effective runs, and it sounds like January is holding. But are you seeing any sort of signs already maybe in February of some slowing that's making you more cautious?

February is not significantly different than January, and I think guidance all depends on where you are in that range.

Okay. And then just one last one, Joe. At the investor day, you touched on the new bridge financing program you started. Can you just give an update on where that stands today? What sort of activity you're seeing out there, and how much capital allocation are you putting in the budget here for 2019?

Sure, Jeremy, I'd be happy to. For those of you who weren't at investor day, we started a new bridge lending program, the goals of which are to expand our management platform to form additional relationships across the industry because we found through management partnerships and other activities we do that those relationships frequently turn out to produce acquisitions or other benefits and to fill what we perceive as a capital void in the market and make some money by lending to non-stabilized stores. We will not be lending to development stores; we don't want to have to take over a half-finished development, but we believe there is an opportunity to lend on stores that are not yet stabilized. We're just starting this program; we've made a couple of loans, we have a few in the hopper, we're getting very good reception in the marketplace. But we are just beginning. We're going to walk before we run. We're going to see how the market reacts to this, and I would not expect it to be a significant capital allocation in 2019.

Just following up on same-store expenses. I think you mentioned outside property taxes and marketing spend. Just curious if you can find more details? How does that – how does the growth rate compare for those versus 2018 and if there's any markets or any kind of one-time thing that's really driving this outside nature of these expenses?

Yes, our property tax budgets for 2019 assume about a 4.5% increase year-over-year. We continue to see pressure across multiple markets, so it's actually down slightly from 2018 but continues to be higher than inflation. 2019 marketing spend is about 11% is what we budgeted, which is up from our annual run rate of 2018. That comes from a couple of things. One is just overall inflation from more people bidding on using the search engines, and that's driving the cost of the bids up, as well as, you know, we're going into a supply cycle and wanting to make sure that we stay top of mind in people's buying decisions.

Right. And then just a quick one on development. Maybe could you just comment versus 3, 6, 9 months ago? Have you seen any incremental signs from developers, whether it's deal compression or whether it's projects taking longer to lease up? Any incremental color on slowing that supply pipeline?

I think we are seeing the factors you described: yield compression, increased costs, and just an awareness that many markets are over-built or fully built, and some more caution. So we are seeing a hold back in new supply in some areas, new developments in some areas, but there still are people who have either more optimistic views or lower yield requirements that are still trying to go forward.

Great. And the last one for me is; just I noticed in the release that Miami was added to markets lagging in Philly was cited as the market that is performing. Can you just maybe a little bit more color on what's going on there? Is there anything to note?

I think that's directly related to new supply. Miami has had a very large influx of new development that is affecting performance, and we haven't seen the same thing in Philadelphia.

Hi, thank you. I wanted to ask you, did sequential decline in curated occupancy from 3Q to 4Q feel steeper than what we've seen in several years now? Did that surprise you at all? Can you maybe provide a little more color on the, I guess, the case over the course of the quarter?

First of all, I would tell you I think sometimes people focus too much on rentals and vacates; I think if you look at our year-end occupancy, it was quite strong, maybe slightly stronger at the end of the third quarter. But again, the goal here obviously is to maximize revenue. You'll see it plus or minus 10, 15, 20, 30 basis points depending on the month, depending on the quarter. But I don't think the fourth quarter played out significantly different than what we were expecting, and we felt like we had a strong ending to the quarter of the year.

Okay, you were looking for that level of kind of sequential decline and that wasn't a surprise at all.

Not necessarily decline, but on an annual basis, we were expecting no benefit from occupancy, and that's largely where we ended up.

I just want to go back to the same-store calculations. The news confirms or you said that it's a 15 basis points; can you just confirm the number of stores that can be added in the same-store pool?

We're adding, so our current pool is 783, and the new pool goes to 821, so a total add of 38.

And the average occupancy for the roughly, I guess, 440 or so stores, is that significantly lower or the same as what you currently have?

It's pretty much the same, very close to being right on top of each other.

And then, I know you mentioned a question regarding your capital allocation guidance here and the investments you have under contract in what you're hoping to close. But it seems like you're 70% of the way there essentially in terms of what you have under the contract or closed and what you're guided to; that seems somewhat conservative. Maybe you could provide a little more color on how you're thinking. I guess you have roughly $160 million of deal that you have in gone under contract or closed now, but it’s based on your guidance. Any reason why that shouldn't be higher just kind of given all the trends that you're referring to?

The only thing I could say is it's very difficult for us to predict when we're going to have opportunities to transact on an off-market basis. And as I said earlier, that's really where we are able to be successful. So, we could talk to the brokers, and we can understand the pipeline and what we think is coming forward, but we know we're not going to be very successful there. So is it possible that we exceed our guidance and buy more? Absolutely, but accretive opportunities are available and good deals; we have a balance sheet and capital flexibility to execute on those transactions. So I hope we do exceed our guidance in 2019 like we did in 2018, but we're not banking on that.

When rent growth slows, is it driven more by changing distribution channels or lower street rates?

The street rates are really what's going to drive your rent growth. I mean your current street rates, your current achieved rates at some point flows through and becomes your rental rate growth, and so street rates are going to probably be more influential than anything.

And then, going back to that 3-year rolling supply, when do you see that peaking and do you expect a gradual decline or a sharp decline, or how should we look at that going forward?

So we believe that 2018 was the peak delivery year, and we expect a gradual decline, and that's fully caveated by we don't know what people are going to do in terms of picking up development. We're looking at current trends and assuming that they continue. But if, for whatever reason, a bunch of people go capital into development and start putting shovels in the ground where they shouldn't, then we could be wrong.

And then, maybe going back to Keithman's question about the developers not hitting the returns; are there certain markets where you see maybe in the next year or two you can have an opportunistic fund and take advantage of some of this?

I think that is likely. I think there are going to be opportunities to purchase projects that are not hitting pro forma or not doing as well as a lender would like or an equity partner would like. And our acquisition guys are fully focused on that.

Just to go back to the $0.23 dilution expected from C of O and value add; have you guys separated those two on how much do you ascribe to those two buckets, each if you have?

It's about $0.16 from C of Os and about $0.07 from lease-up properties.

It could represent a significant opportunity for earnings growth. Out of the 17 anticipated openings, 12 are scheduled to occur in the first half of the year. However, I also want to consider any potential offsets to that. Have you utilized the ATM in January or February due to your substantial acquisitions? I'm interested in understanding the source of your capital.

Well, we used the ATM in the fourth quarter, and in the current quarter, we've not. Yes, correct, third and fourth quarters of last year we used the ATM.

And then just finally, excluding the 12 assets you've described in California that you've already gotten, where are the other locations? I know you've had a couple of C of O deals that are wholly owned, that you've acquired already in the first quarter; where are those in markets?

Louisville, Kentucky, and many in Pennsylvania. We just posted one in Brooklyn too last week.

Yes, we had several little closes. We have two in Brooklyn, one in Queens, and then also in Massachusetts.

A couple of questions. The first one is the 2% increase in street rates that you guys have discussed; is that net of concessions, or is that without concessions?

It is not net of concessions; that is just we have achieved rates as the average, some of this pain, no matter which channel they come from. This can say discounts year-over-year, there is no change.

Okay, so that's the first thing. Then I'm going back to a question I was asked earlier about not getting a lot of push back from in-place tenants on rent increases. But I was just curious, the guidance contemplates a slower rate of rent increases going forward because of supply or no?

No. We really don't believe supply impacts our ability to increase rents to tenants when appropriate.

Okay, that's helpful. And then could you help us understand what the mark-to-market is in the portfolio? Like today, if a tenant moves out, average rents are X versus if a tenant moves into probably moving on average at this particular rent?

Yes, if you look at our employees' rents and compare those to our cheap rents, what people rented at when they come in the door on average for the year, it is mid-single digits, so call it 5%, that is considerably higher in the offseason, so right now it's call it double digits, and then it goes to zero in the summer months. So depending on the time of the year, we typically know our rates are typically higher in the summer when more people are moving in and lower in the offseason with fewer people moving. So that rolled down is higher in the colder months, and I would tell you to be careful to assume that's the roll down on everybody because you have many people that moved in and moved right back out, so they are at very close to what the street rate is.

Thank you, everyone, for joining us today. We expect another great year in 2019 despite the challenges we're all aware of and we've all discussed. We operate in a resilient sector; our demand is needs-based. We're able to achieve high occupancies and positive rate growth, and we have significant external growth opportunities. We continue to invest heavily in technology. Our digital marketing and revenue management systems continue to evolve and improve. But none of this would be possible without our people. We have an incredibly deep team of dedicated, motivated, engaged employees who live our values every day and are driving our performance, and I want to recognize their contributions to our efforts and our success. Thank you all for your interest, and now we'll talk to you soon.