Extra Space Storage Inc (EXR) — Q1 2019 Earnings Call Transcript

Hello, everyone. Thank you for joining us for our first quarter call and for your interest in Extra Space Storage. We had a good first quarter with positive rate growth and high occupancies, resulting in same-store revenue growth of 4.2% and same-store NOI growth of 4.8%. This contributed to better-than-expected FFO growth, which was $0.02 above the top end of our guidance. Performance continues to be steady despite new supply and we are well-positioned heading into the summer leasing season. While we are very pleased with the better-than-expected first quarter results, our views for the balance of 2019 remain generally unchanged. We still believe 2018 was likely the high watermark for total deliveries, and we expect 2019 deliveries to be only modestly lower. Further, we expect the total impact on performance from new supply to be greater in 2019 than it was in 2018 due to the cumulative impact of several years of elevated development. We are seeing this impact in the lease-up of our C of O stores. Lease-up has slowed from a pace that was well above pro formas in 2015 to '17 to trends that today are more in line with historic norms and with our underwriting. That being said, our people and our systems are working hard to maximize performance in a challenging operating environment. Our digital marketing platform continues to drive qualified traffic to our stores. We have maintained occupancies above the market averages and MSAs with new supply, but it comes at a cost. Cost-per-click is elevated due to a competitive bidding environment and we are choosing to pull the advertising lever harder in order to ensure web visibility. In the current environment, large operators, like Extra Space, are best positioned for success on the web. In the quarter, we invested $270 million in acquisitions. We continue to have success acquiring properties through off-market transactions. For example, and as we mentioned last quarter, we bought a joint venture partner's interest in 12 properties in Los Angeles and the Bay Area for $192 million. We continue to explore other opportunities to enhance shareholder returns through mutually beneficial partnerships. We also continue to see significant growth in our third-party management platform. In the quarter, we added 46 stores, while only 2 stores left the platform, both due to property sales. Additions to our third-party platform continue to be a mix of newly constructed and existing properties, bringing high-quality stores into our system as well as additional income. Between our third-party program and our JV stores, we have 805 managed stores with a strong remaining pipeline for the year.

Thanks, Joe, and hello, everyone. Our core FFO for the quarter was $1.16 per share, exceeding the high end of our guidance by $0.02. The beat was primarily due to stronger-than-expected same-store property performance and lower-than-anticipated G&A and income tax expenses. We continue to see solid performance in the majority of our markets. Revenue growth was primarily driven by achieved street rate growth. Discounts were also down as a percentage of revenue in Q1, providing a modest tailwind that we don't necessarily expect in future quarters. Our same-store revenue growth includes a change in pool benefit of 30 basis points in the quarter and we anticipate that it will provide a benefit of 15 to 20 basis points for the full year. This quarter, we've added an additional disclosure to our financial supplemental showing a third year of same-store pool performance. This disclosure should help further reconcile differences in same-store pool definitions in the industry. Same-store expenses were a mixed bag, with increases in property tax and marketing spend, which were partially offset by savings in payroll and utilities expense. We expect continued pressure on property tax and marketing expense, but we are comfortable with our ability to operate within our guidance. We have not made changes to our annual same-store revenue expense or NOI guidance, which imply moderating revenue growth. As we said in our last call, the moderation will result from the increased impact of new supply, along with the difficult comps in markets that have performed well above the portfolio average for multiple years. We've increased our full-year core FFO guidance to $4.76 to $4.85 per share, which includes the $0.02 beat from the first quarter. We also made minor changes to our G&A, interest expense, income tax, and share count guidance. Our FFO guidance includes $0.07 of dilution from value-add acquisitions and an additional $0.16 of dilution from our C of O stores, for total dilution of $0.23, which has not changed from our initial guidance. We believe these acquisitions provide significant long-term value for our shareholders and improve the overall quality of our portfolio. With that, let's turn it over to Towanda to start our Q&A.

I was wondering if you could discuss the crossover between discounting and marketing. I recognize this might be a little dated, but if I look at your discounting trends from your last slide deck and assume those more or less carry through the first quarter, it looks like there's perhaps, call it a 40 basis point give or take benefit to revenue growth from the lower discounting as a percentage of revenues relative to last year on a dollar basis. It's about equivalent to the increase we're seeing in the marketing spend, which is up 24%. So I'm just wondering if there is any toggling between those two items?

Yes, Jeremy. During the quarter, we didn't have a significant change in our discounting strategy. It was actually impacted a little bit by the lower number of rentals. So if we had fewer rentals, your discounts are down a little bit. And then we gave a slightly fewer number of discounts to rentals coming in the door, so it wasn't a significant change. In terms of marketing, we did choose to pull the marketing lever in order to maintain our market share and to continue to move the needle in terms of rentals.

But they're not one-to-one correlated. If discounts go up, marketing goes down and vice versa. They're just two of several factors that all interplay together to achieve our goal of maximizing revenue.

All right. And then, Scott, obviously, the balance sheet is in good shape. Your stock is out there hitting all-time highs, it's well above at least where consensus is standing. How do you think about raising equity here, whether to get more active with new investments or even just warehouse in capital for the stuff you have in the pipeline?

Yes, it will obviously depend on how we find a use for that money. We have always stated that we want to maintain leverage neutrality in our balance sheet, and if we identify a need for the capital, equity becomes a potential option. While our approach to underwriting a deal remains consistent, the way we finance a deal may vary based on our stock's trading position compared to interest rates, but it is certainly an option for us.

And maybe just to figure that, Joe, can you just talk about how active the market is for acquisitions right now and anything notable on the pricing front that you're seeing?

Sure. We've invested $270 million to date. So we feel that's a good number, we're happy with that, we're happy with the deals that we had. There's not as much activity in the market in the first quarter as there was, say, in the second half of last year. It's been somewhat quiet. We hope that's seasonal. The market will pick up. There are more opportunities either in a broad brokered market or, more importantly, through our relationships, which is where we usually have the most success. I've seen absolutely no changes in pricing. There is still lots of equity of all different flavors seeking exposure to storage and that is keeping cap rates where they are.

Sorry about that before, my handset wasn't working. So my first question is on street rate trends in Q1 of '19. You mentioned that it was up. Could you give a little bit of color on how much that was?

Yes. Our achieved street rates in the first quarter were between 2% and 3% on average for the first into new incoming tenants.

And how that changed in April?

It’s closer to 2%, but it's still solid.

Okay. And on the flip side for discounts. You mentioned that you don't expect the discounts coming down as a percentage of revenue to continue. So how do you see concessions kind of trending throughout 2019?

Our guidance and our budgets for the year don't assume any benefit, so it's flat year-over-year compared to where they were last year.

I was just wondering if you could provide a little bit of color on the performance in a couple of your larger markets like L.A. and New York, which look to put up pretty good results. And I think if I'm remembering right, it sounds like maybe in markets like L.A. there were more mature — you were sort of maybe bumping up against sort of an absolute dollar increase in pricing that you thought you could achieve. So could you just maybe talk about how things are trending there? And maybe you were surprised too in the first quarter?

Yes, L.A. continues to perform very well. We are concerned, as you pointed out in these markets, where we've had year-after-year of above inflationary rent increases, that's not sustainable. But we had a great quarter in L.A. And if you look at the L.A. MSA, there's only certain sub-pockets where supply is an issue, but for the most part, supply is not an issue and we're continuing to be able to move rates in a pretty healthy manner.

Okay. And then same, I guess, sort of same observation in New York?

So the New York MSA, I will tell you, we were surprised that it performed better, particularly in Northern New Jersey and Long Island than we anticipated. And in the face of some new supply, particularly in Northern New Jersey. So our systems and our ability to attract customers, part of that as a result of increased marketing spend has allowed us to increase revenue at a greater rate than we thought we'd be able to in that market.

Okay. And then I just — last question, I just was going to ask you. Are you seeing any change in behavior of new competitors, whether it's maybe an overabundance of supply at least in the near term sort of differences between independent operators versus the larger players? Any sort of the way that they're driving pricing or occupancy?

I'm not sure if it's a change. It is competitive out there. I would tell you, I think the large operators are more rational in their pricing movements, and sometimes the small operators can do things that we would consider ill-advised, but I don't think there's been any significant change.

First question. Joe, you know over the last few months, it seems like there was an expectation that there would be some opportunity around some distressed development yields, maybe some lease up projects. And you commented that the pace of lease up on some C of Os in your portfolio is slowing. It's now back to historical norms, which is consistent with what you're underwriting. So it doesn't sound so bad. Are you still expecting to see some distress in some opportunity? Or is that not the case maybe conditions are improving a little more broadly across the industry relative to your prior expectations?

Yes. I hope you didn't take from our comments that conditions are improving across the industry. Obviously, this is a market-by-market business and there are some markets that may be later in the development cycle that are improving, but there are also many markets that the development cycle is hitting full force and will de-accelerate in the future. I'm still hoping for the distress with the disappointing deals. We didn't see them in the first quarter, but I'm still hopeful and anticipate in a challenging environment that those acquisition opportunities will appear.

Okay. And then, Scott, I know your guidance implies growth slowing throughout the balance of the year and you commented on that a little bit. I may have missed some of the ins and outs here. But right now, growth is heading in the other direction. So maybe you could just provide a little bit of additional color around what's — what you're expecting to change that trajectory and maybe pressure growth a little bit in the portfolio throughout the balance of the year?

Yes. Our first quarter, obviously, was a strong quarter. We had it budgeted, but our first quarter actually exceeded our budget slightly. Throughout the year, we're assuming that it continues to — the rate of growth continues to decline throughout the year. That's our assumption in our budget. It's impacted heavily by certain markets that have a lot of new supply. Florida is a tough market. As we look forward, we think many of these stores continue to slow in terms of their rate of growth, whether it's a same-store pool or a lease-up store. So overall, our guidance and our budgets continue to slow. We'd like to get into the second quarter and see where that goes before we change guidance or do anything that sort.

Okay. And just lastly, I was wondering if you could tell us where occupancy was April 30, what that looked like year-over-year?

At the end of April, our occupancy was up from March by about 40 basis points, but it was slightly — if you take year-over-year comparison, we were down 20 basis points at the end of March, and it was down 40 basis points at the end of April. So slightly different, but again, within our guidance and no big surprises, April was still a solid month.

Guess bit of a follow-up on the last question here. We noticed in the last couple of years that you had a steep Q2 same-store slowdown versus the first quarter. I was curious what the mechanics were for this to happen? And do you think this pattern will repeat for the rest of the year?

So Q2 is typically better than Q1. Obviously, it's — kind of you moving into the leasing season, but it's going to be somewhat a comp year-over-year and how we did the prior year. So that could potentially be what you're seeing a little bit there.

I think last year was primarily discounting.

Correct. And then the other thing is Q1 typically has more benefit from our change in same-store pool. So Q1 this year, we had 30 basis points in the first quarter and we're estimating for the year that to be 15 to 20, which would assume, by Q4, it’s very little benefit.

That's helpful. You didn't mention in your guidance that you don't expect any benefit from discounts. Do you think you'll need to reintroduce discounts at some point or do you think the environment for pricing has improved as of late?

No. We continue to use discounts. Most new rentals get a discount. Well over 50% of our new rentals coming in the door are going to get some type of discount.

Got it. Your peer, PSA, has announced a property of tomorrow initiative, which requires a significant investment and will take several years to complete. Just curious, how do you think your portfolio compares with newer generation products currently in the market?

I think we've done a good job of continuing to invest and upgrade our properties to keep them relevant and attractive to customers. We spend money every year doing that, and we'll continue to do that.

Just looking at the California properties that you bought from your JV partner, can you characterize the properties, maybe just look into the submarkets and maybe share any CapEx that's required? I guess, just to look inside that portfolio.

So these were all properties that we built. They're in infill areas, 10 in Los Angeles, 2 in the San Francisco area. We've owned them in partnership for many years with our partner. They've been well-maintained. Capital has been spent every year. They've been part of our seven-year rebranding program that we started 3 or 4 years ago. We're about halfway through the portfolio, a little more than that so far. So these are not stores that need a lot of capital. They're great, solid, steady core acquisitions.

And you've been managing them on a third-party basis, is that right?

No. We were about a 95%-5% joint venture partner, but we did manage them. Not on a third-party basis, on a joint venture basis.

Okay. And then, how about pricing on this? How do you look at pricing? You take out your JV partner, they're obviously stabilized getting market rates. What kind of pricing do you ascribe to this?

So on the gross value that was negotiated for the portfolio, the purchase price forward 12-month yield after tax reassessment was sub-5%, which is market for these types of assets in California. But we had an embedded promote in the venture of $72.8 million that we couldn't realize without a capital transaction. So putting that promote towards the purchase price, the first-year yield after tax reassessment was 6.3.

Just a couple of quick ones from me. Just wondering if you could provide a little bit more color on the marketing spend? Meaning, are there any specific markets or regions that really drove the increase in spend? And also, I think you touched on that bid pricing is going up every year. Is there a way to quantify that? Is that high single-digit? Is it double-digit? How should we think about that?

Our spend for the year, our original budgets were a 15% increase, which is what we were thinking we were going to need to spend to kind of keep up with the inflationary pay-per-click spend. We have spent a greater number higher than that in the first quarter and we're assuming we'll have to spend at an accelerated level throughout the year. It's across the country, the additional spend, but it is probably a little more focused on new supply markets or markets where we're struggling.

Great. That's helpful. And then, sort of touching back on some of the bigger markets. Just looking at Dallas, we're still seeing a lot of projects in the pipeline. Just curious if you could remind us how you guys are thinking about that and maybe how your assets are positioned versus the new supply coming in?

Yes. Dallas is a market that is challenged. If you look at our supplements and see our revenue growth there, which was less than 1% is below portfolio average. Our stores in the North Dallas area are the most challenged and those are our stores that we're focused most on. In South Dallas and other areas, we're doing slightly better.

Great. And then the last question I have was just, if you could remind us what the spread between the asking rate and the existing tenant rate was maybe during the quarter and how that's trending in April?

The quarter was actually our worst time of the year. On average, we're mid-single digits in terms of where our ask rates are and our in-place rates. The worst time of the year is the winter months. So kind of January, February. The best time of the time is the summer months when they're essentially flat. But on average, it's mid-single digits. So this is the worst time of the year, so higher than that.

You guys typically, you always kind of do very interesting things, trying to figure out the best way to maximize profits between pricing and volume. Just kind of curious if you could talk a little bit about maybe some of the checks you may have done this quarter or maybe even the last few quarters and that must be telling you about just the elasticity of demand from customers?

So I'm happy to say that we continue to do tests every quarter, every month. We're very data-driven shop. We don't make any decisions without having the data analyzed and testing based on that. But I'm not comfortable telling you what are the things we're actually testing.

Could you tell us anything about what you may be telling you about customer demand or elasticity of demand?

So we don't see any significant difference in customer behavior. Demand is steady to increasing. The fear that folks have that millennials weren't going to rent has proven incorrect. Millennials make up a higher percentage of our renters than they do of the population. We see the stickiness, if you will, with the customers once they get in, in the face of rate increases to be the same. So we don't see significant changes in customer behavior.

Got you. Okay, that's helpful. And then anything incrementally you could talk about also in regards to just business demand for storage?

So business demand has been pretty steady for many, many years here. We don't see any significant increase or decrease in business demand.

Joe, thanks for your view on supply. You talked about '18, which was the high watermark on deliveries, but then you continue to see impact from sort of developments, kind of the cumulative impact. So you kind of taken those two generally, I mean, it doesn't have to be for your company, but generally as part of the industry, where do you think the trough in revenue growth will be? I mean, people say it's '20, but do you think it gets further pushed out into even '21 at this point with all the delivery and the impact of what's come on in the last couple of years?

So, we don't have perfect transparency into the future. We don't know if development is going to continue its moderating trend that we see. That's what we would expect, given the economics of development. But we don't know if people with lower yield requirements or higher risk tolerances are going to keep sticking shovels in the ground. So when the inflection point will occur depends on things that we currently don't know.

Okay. And just switching gears a little bit on the disposition side. Considering where cap rates are. And it sounds like cap rates are fairly low. For well-stabilized assets, do you consider — could you consider even maybe selling into this market where pricing is favorable?

We just closed the disposition of a store in Upstate New York this quarter, I guess, after the quarter it actually closed. Every year, we look at our portfolio and look for assets that would make sense to dispose of either outright or into a joint venture to reduce our exposure to those assets or markets, and we'll continue to do so and execute when it makes sense.

First, appreciate the additional disclosure under older venture to same-store pools. But just one simple question. Can you elaborate on the brief or the small adjustment to G&A expense guidance?

Yes. Part of it has to do with just the timeliness of some hires that we had, and still we are estimating the majority of that should flow through and then some consulting expenses that did not come to fruition.

Looking at the broader stabilized storage data just to get a larger sample size of your performance in L.A. and San Francisco specifically, it looks like rental growth was flat sequentially, but the number of facilities in those pools were down from the fourth quarter. Just curious what's going on there? Did you maybe lose some of those third-party managed stores? Because I think the same-store pool was up a little bit.

I'd have to go back and look at that because I'm not sure we were down in L.A. or San Francisco. We could look at that and get back to you.

Okay. Fair enough. And then, I guess, going on the other coast and New York. And that stabilized pool saw a pretty nice sequential increase in revenue growth. I guess, what was the benefit from the new adds to that same-store pool? Was it similar to the 30 basis point boost to the overall portfolio on same-store revenue growth?

It's really market-by-market and it will depend on how many properties we have in it. A market that only had 10 properties, obviously, when you add 1, it's going to get impacted more versus Los Angeles where you have a larger number of properties and you add 1, it will impact it very little. So it's tough to really give you a market-by-market basis here.

Just a bigger picture. What do you think were a couple of things that positively surprised you during this quarter?

I would tell you, discounts being down, I think, were a positive surprise for us. I think the fact that some of these markets that have been hit by supply so hard have held on as well as they have. For instance, Dallas. And then the last one is, I think our payroll was a little lower than we expected, and so we've done some things there to try to get some efficiencies, but we don't expect that to continue through the year, somewhat of a one more of a one-time benefit in Q1 than rather an ongoing thing for the year.

I think certain markets performed better than we anticipated. Atlanta certainly performed better than we thought. Some of the broader markets that we thought were going to be impacted, either due to delays in delivery or otherwise, are performing a little better.

Okay. And going back to your comments about seeing elevated marketing spend throughout the year. And payroll, like you said, maybe it was a one-time benefit in the first quarter and that normalizes higher. How do you feel about your same-store expense guidance, especially at the higher end?

So we're still comfortable with our guidance. I think that it will depend a little bit on your marketing spend on where you are in that range.

All right. And then just last question. You probably thought I knew that MakeSpace is partnering up with Iron Mountain. Does that change your views at all about the long-term efficacy of value storage companies? I know it's quite early but.

It doesn't. I mean, when we look at current pricing for — to wallet customers versus storage, it's kind of played out as we expected. It's hard to — it seems like they have not been able to pay for the logistical piece of that and still make storage an economical choice. Not to say some people aren't going to use it, but it's not competitive with what we have. That being said, we think there is a segment of customers, elderly or whatever, who don't want to move their own boxes. We would expect as our business evolves to be able to offer some service to customers who want it.

Thank you, everyone, for joining us today. As we discussed, we continue to experience solid property-level NOI growth despite new supply. We expect that we're going to have a very solid summer season and another strong year for Extra Space. We're off to a good start on the acquisition front, on the external growth front, both through acquisitions and third-party management. What's most encouraging is that I feel our teams and our systems are tested mostly during competitive times; they are performing very well and delivering their results for our shareholders. I look forward to seeing many of you at NAREIT. Thank you, and have a good day.