Extra Space Storage Inc (EXR) — Q2 2019 Earnings Call Transcript

Thank you, Jason. Welcome to Extra Space Storage's second quarter 2019 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, July 31, 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'd now like to turn the call over to Joe Margolis, Chief Executive Officer.

Thank you, Jeff. Hello, everyone. Thank you for joining us for our second quarter call and for your interest in Extra Space Storage. We had a solid quarter with positive rate growth and healthy occupancy in a competitive summer leasing season. Same-store revenue and NOI both increased by 3.9%, exceeding our estimates. This property outperformance contributed to better-than-expected FFO growth of 6.1%, which was $0.02 above the top-end of our guidance. We are pleased with our results in the first half of the year and the success our team and best-in-class platform have had mitigating the impact felt from new supply. In order to achieve this performance, we significantly increased our advertising spend on a year-over-year basis. We do not expect the increased advertising spend to abate anytime soon. As anticipated, we have seen the timing of expected deliveries slip on many developments. As these delayed projects deliver and begin their lease up, we expect additional moderation in the back half of the year. However, while the market will continue to be very competitive, large operators with diversified portfolios and sophisticated systems like Extra Space Storage are best positioned to navigate the supply cycle. We continue to actively explore external growth opportunities that present attractive risk/reward metrics. Widely marketed acquisitions are still very expensive. However, we continue to find success acquiring off-market acquisitions through long-standing relationships. During the quarter, we purchased a non-marketed 11 property portfolio in a joint venture structure for $228 million. We also acquired one Certificate of Occupancy project and completed one development for a total investment by the company of $57 million. We have also executed innovative capital-light opportunities to enhance shareholder returns. In the quarter, we closed our first net lease transaction with W.P. Carey, which will include 36 total assets including five New York City assets that are new to our platform. We are gaining traction in our bridge-lending program and our third-party management platform continues to see significant growth. In the quarter, we added 48 managed stores bringing our six-month total to 94 stores. Between our third-party program and our JV platform, we now manage 838 stores with a strong pipeline for the back half of the year.

Thank you, Joe and hello, everyone. Our core FFO for the quarter was $1.22 per share, exceeding the high end of our guidance by $0.02. The beat was primarily due to stronger-than-expected property performance and tenant insurance income. Revenue growth was driven by increased street rates with lower discounts also providing a tailwind. Year-over-year occupancy declined marginally in June, but we have already seen that bounce back in July and today our occupancy gap is approximately 30 basis points below this time last year. This is in line with our annual expectations. Like last quarter, same-store expenses were a mixed bag with increases in property taxes and marketing spend which were partially offset by savings in payroll and utilities expenses. We view our elevated paid search and digital spend as one lever to drive revenue growth. However, pay per click advertising is expensive, especially in markets impacted by new supply. Now turning to the balance sheet. We continue to have access to multiple sources of capital and during the quarter, we accessed our ATM and issued approximately $100 million in equity. Subsequent to quarter-end, we completed a transaction that converted $500 million of secured debt to unsecured debt and extended the term. For many years, we have been laddering our maturities and increasing the size of our unencumbered pool to strengthen our balance sheet. The quality of our balance sheet was recently recognized by S&P Global when they assigned a BBB flat rating. This is another step in our overall balance sheet evolution. Due to our outperformance in the first half of the year, we have raised our annual same-store guidance to 2.5% to 3.25%. As Joe mentioned, we still expect moderation in the back half of the year as we feel the additional impact from new supply. We also increased the bottom end of our expense guidance due to elevated marketing spend, resulting in an annual range of 4% to 4.75%. These changes result in raised annual same-store NOI guidance of 1.75% to 3%. We raised our full-year core FFO guidance to $4.79 to $4.87 per share, which includes the $0.02 beat from the second quarter. Our core FFO guidance includes $0.07 of dilution from value-add acquisitions and an additional $0.16 of dilution from C of O stores for a total dilution of $0.23, which is unchanged from our initial guidance. We believe these acquisitions will provide significant long-term value for our shareholders and improve the overall quality of our portfolio. With that, let's turn it over to Jason to start our Q&A.

Operator, do you have our first question with you?

Hey, good afternoon guys. So my first question has to do with your revised revenue guidance options. So you raised revenue 40 basis points at the midpoint and that implies a 20 to 30 basis points acceleration of revenues in the second half. So, I'm just curious as to your thoughts on the cadence of revenue growth into the second half. And what would it take to get to the high versus the low point of your guidance range?

Shirley it's Scott. So, without getting into too much detail on the exact cadence here, we obviously decelerated from quarter one to quarter two about 30 basis points. We are assuming that that cadence or some sort of that cadence continues into the back half of the year where we continue to decelerate and depending on where you're in the high and the low, it's pretty simple math in order to get there. But without giving guidance as to where we are in that range, I think we do assume deceleration.

Okay. Thanks a lot. And so, on the street rates side, you mentioned that you saw slight increases. What were your achieved street rates in 2Q and also maybe quarter-to-date into July?

Yes. Our achieved street rates during the second quarter were between 1% to 2% and in July, they are slightly below that. But in exchange for that slightly lower street rate in July, we actually did see our occupancy bounce back a little bit, so as our model adjusts we did see some benefit in occupancy.

Thanks for the good color. Thank you.

Thanks, Shirley.

Hey, I guess I just wanted to follow up on that last question. As you think about where net effect of rents are and you talked about the occupancy gap coming, but the deceleration you're expecting, do you think that's going to come more from the rent side? Or do you have a plan? You mentioned the tailwind in discounting has been. Do you expect to ramp up discounting more here on a year-over-year basis into the back half?

Jeremy, we don't expect discounts to benefit to the same degree in the back half of the year that it did during the quarter. During the quarter, it benefited us by about 50 to 60 basis points. And if you look at our street rates or our achieved street rates over the past year, they continue to soften and those continue to flow through into our current rental revenues.

All right. So it sounds like a little bit of both. So that's fair?

Correct.

Sure, Jeremy. We have about eight assets for $41 million under contract for the remainder of the year, and then a modest pipeline also compared to historically for 2020. And that's a function of how we perceive pricing in the market today. We see a lot of equity seeking exposure to self-storage. I think people are concerned about a potential downturn in the economy. Self-storage performed well in downturns and attracted that asset class because it is easy to leverage. So there's lots of equity keeping prices high and we're trying to remain disciplined. If a particular deal doesn't work for us, we don't think it provides long-term shareholder value with good risk/reward metrics, we will sit on the sidelines with respect to marketed deals. That being said, historically, and certainly in this last quarter we've had success working our relationships and growing without accessing the marketed deals. I hope that that continues in the future. Sorry for the long answer.

No, I appreciate that. I mean, just given those dynamics that you talked about does it change any thoughts on selling some assets into that strong bid? I mean, you had the one in New York, but maybe some stuff beyond that to capitalize on that bid that you're talking about?

Yeah. Certainly, we look at our portfolio at least every year and we try to find assets that we think have lower future growth prospects than we can reinvest in. When that situation occurs, we will dispose of assets. Hi. First question so you touched on street rates. I was just wondering if you can comment on move-in rates in the quarter. And how was this sequential increase that you achieved in move-in rates this quarter compared to prior years just moving as you move throughout the peak season?

So Q1 to Q2 rates were up slightly in terms of achieved move-in rate. In terms of where they are to in-place rates, we are below our in-place rates, as we move into the summer months. That's not odd. What I mean by that is, if you look at an average existing customer rate compared to the achieved rate when they move in typically there is a roll down, but that is the average existing versus the new achieved. You typically have more churn in short-term customers that are below average. So it doesn't necessarily mean that there is always negative churn as people move in and move out.

Got it. Was the move in the increase in achieved rates from Q1 to Q2 this year, how did that compare to what you've seen in prior years?

It was up, but it was probably a little softer. As we've seen rates soften with the new supply, I don't think that's any surprise to anyone.

Okay. And then Joe since announcing the net lease deal or transaction with W.P. Carey, I'm just curious if you had additional conversations with other owners to structure similar transactions? And how big is the company's appetite for these types of transactions?

It's a good question. So we issued a press release and as usual when that happens the phone starts to ring. So we are in conversations and have had conversations with other folks where this type of structure may make sense. Our appetite is as big as the deal dynamics that make sense. We're not going to target doing any more of these if we can't get the right type of returns for the risk we're taking, but as long as we can underwrite the deals successfully, and they are in markets within our operational footprint, we'd be happy to do more.

Okay. All right, great. Thank you.

Thanks, Todd.

Just a couple of quick ones for me. The first is just obviously there was a big increase in marketing spend and that will benefit move-in volumes. Just could you give us some color if that's still sort of a good use of cash? You're getting good returns on that spending? And if that's something we should expect maybe going into the back half of the year and potentially into next, as well as does that change the type of customers that move into the property? So said another way, is it more a millennial? Is it more tech-savvy? Is there any discernible trends from the move-ins? So, I'll take those in reverse order. I don't think it changes the type of customers. I think almost everyone in society today searches for goods and services on the computer somehow. So we don't think it materially changes the type of customers. Yes, we do see continued elevated marketing spend throughout the rest of the year. And we're spending this money because it produces a great return for us. Our systems bid on millions of keywords a day and they go through complicated algorithms to determine how much to bid on any particular keyword and track the results to that. We bid on keywords that produce acceptable returns to us and don't bid on keywords that don't.

Just a couple of quick ones for me. The first is just on obviously there was a big increase in marketing spend and that will benefit move-in volumes. Just could you maybe give us some color if that's still sort of a good use of – you're getting good returns on that spending? And if that's something we should expect maybe going into the back half of the year and potentially into next? As well as does that change the type of customers that moves into the property? So said another way, is it more a millennial? Is it more tech-savvy? Is there any discernible trends from the move-ins? Thanks.

Yeah. I'm a little uncomfortable with the word customer fatigue because there is still strong demand for our product and we don't see any moderation in demand anywhere. I think with respect to rents, I agree with you. You're right if you increase rents in a market like Sacramento by mid-teens three years in a row, at some point the product just gets a little too expensive and you can't increase it by that amount. Again, you need a little break. But we're still getting a bump portfolio at average rate increases in those markets. So to the extent fatigue means you raise prices so hard, it backs off for a little bit. I think that's a fair observation.

Hi. Thank you. I just wanted to ask you when you're looking at acquisition opportunities and you said some of them come through off-market relationships and off-market deals, but is there any sort of market difference between what you're seeing for stabilized properties versus facilities that are still in lease-up on pricing? Or are there any more attractive opportunities I guess for lease-up? We just have heard that the valuations there become much more interesting for some of those that are underperforming relative to initial expectation.

So, I'll tell you if you look at the four stores that we have approved for acquisition this year, all of those are unstabilized. They're somewhere between 54% and 79% occupied, initial yields between 3.5% and 5%. So, they are value-add type acquisitions that will stabilize in the low 6s somewhere. It's not that we haven't seen a huge rush or volume of those stores at prices that we believe makes sense to us.

You think that's something that could come maybe to fruition over the next several quarters?

I don't think that the amount of capital that is seeking exposure to self-storage is going to change materially in the next few quarters. Therefore, I'd be surprised if all of a sudden there is a flood of these opportunities that make sense to us. I think we're going to have to, for the foreseeable future, work hard, be innovative, and do some different things for our external growth as opposed to go out there and be the high bidder when there is lots of other capital bidding on these assets.

Thank you. I just wanted to circle back on the topic of the loan book. You said you're closing in on $100 million by the end of the year. Is there a target size that you're looking for that total book of business? Or how big will that business be? Or how big do you think it can be? And what kind of rates are you charging on that business?

So we don't have any limitation. Our balance sheet is in shape that we have plenty of access to different types of capital. As long as we can make loans that earn a good risk-adjusted return, we'll continue to make loans. We don't have an artificial cap on the size of that business. I don't really know the answer to the second question. We're still walking, and we'll see – I think time will tell how big it's going to get. We have this debt partner also that allows us to provide good flexibility and also a way to increase our returns. And then your last question was on pricing?

Great. Thank you everyone for your time and interest in Extra Space. If I could just highlight a couple of things, we continue to experience solid property level NOI growth despite new supply. We do expect some moderation, but we're very happy with the way the teams and the systems are able to maximize performance in this environment and we've gotten better. As we get deeper into the development cycles, the systems and the machines learn how to do better, and I think that's showing in our numbers. Secondly, external growth is tough now, but we will continue to be disciplined and innovative to find ways we can to grow as long as it makes sense for our shareholders in the long-term. Thank you very much. I hope everyone has a good day.