Extra Space Storage Inc (EXR) — Q2 2020 Earnings Call Transcript

Thank you, Oren. Welcome to Extra Space Storage’s second quarter 2020 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, August 5, 2020. 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 thank you, everyone, for joining us on today's call. The second quarter presented unique challenges to our country, our industry, and Extra Space. I am incredibly thankful to our employees who helped continue to operate our stores, service our customers, grow our company, strengthen our balance sheet and do all the day-to-day blocking and tackling, that allows us to optimize our performance. All this good work was done in unusual and sometimes difficult working situations and often with added personal and family stress and uncertainty. It is said that crises do not create character, but reveal character. And I could not be prouder of the character that the Extra Space team has shown during these past several months. This quarter also presented a stark reminder of racial injustice in our country. Approximately 40% of our teammates are black or other people of color, and I am proud of them for recruiting, developing, and retaining diverse talents that have been a focus of our company for many years. This is not a new initiative. However, the tragic events of the last two months reinforced to me that Extra Space is a values-driven company with a great inclusive culture, and we can do better. In response, we have enhanced our existing diversity and inclusion initiatives and have taken several concrete steps to improve as a company. These steps are consistent with our company values and I am committed to ensuring that our response will not be limited to making statements or temporary measures, but will involve ongoing and substantive actions. Turning to our performance in the second quarter, most importantly, we were able to grow FFO in the quarter on a year-over-year basis. We have started to see several positive trends on which Scott will provide further details. Our platform is able to find and capture high-value customers. Rentals have normalized and vacates remain muted. As a result, our occupancy is at an all-time high and prices have begun to move in the right direction. Where we can, we have resumed more normal pricing, operational practices, and auctions. However, these positive trends should not obscure the macro and industry-specific risks we still face. There are still uncertainties regarding the course and length of the virus, its economic impact, and its effect on consumers and their willingness to pay for storage. While our occupancy is at an all-time high, until recently we have not been allowed to initiate the auction process in several markets, which represents approximately 47% of our same-store NOI. At the end of June, approximately 150 basis points of our occupancy is from non-paying tenants due to delays in auction. By the end of July, this inflated occupancy increased to approximately 200 basis points. We are now moving forward with auctions in most states, but due to notice periods, actual auctions in several states won't begin until September, which will be outside of the peak leasing season for re-tenanting these units. Occupancy has also benefited from lower-than-normal vacates. I do not personally believe that the moderation in vacates represents a permanent behavioral shift of our customers. Instead, at some point, more historically normal activity will resume and we will see vacates increase, putting further pressure on occupancy, when we may not have our full set of tools available to optimize returns due to government state emergency orders or regulations. Also, the non-COVID headwinds that we had coming into 2020 are still present. While we believe the pandemic has delayed new deliveries and may reduce new projects in planning, properties are still being delivered, and there is still excess inventory leasing up in many markets, which is depressing rate growth. So, while we are encouraged by recent results, there are enough remaining uncertainties and risks that we are not in a position to reinstate guidance. The possible outcomes remain too broad for guidance to be meaningful, depending on how the risks I've outlined play out. We will continue to be transparent on all metrics and answer any questions that you may have, and we will continue to work hard every day and remain laser-focused on maximizing shareholder long-term value. And now, I'd like to wish Scott a happy birthday and turn the time over to him to walk through some of the metrics that I mentioned.

Thank you, Joe, and hello everyone. All of our properties are open and have been fully operating since May. We modified our stores by adding plexiglass partitions, stanchions to direct the flow of traffic, and sanitation stations to provide a safer experience for our customers and our employees. These updates have been effective as demand started to pick up through the quarter. Our rentals rebounded, improving from a negative 35% year-over-year delta in April to a positive 4% rental growth rate in June. Vacates for the quarter were approximately 17% lower year-over-year, resulting in strong occupancy growth, which went from a negative 60 basis point year-over-year gap at the end of April to a positive 100 basis point gap at the end of the quarter. At the end of July, this has expanded to 150 basis points. However, this increased occupancy came at a price. Our average achieved rate for the quarter was down approximately 17%. As Joe mentioned, our quarter-end occupancy was inflated by 150 basis points from non-paying customers. In May, we restarted our collection efforts, which have been successful. Accounts receivable less than 60 days have dropped back to historical levels; however, due to the delayed auctions in key states such as California, New Jersey, and New York, we are still working accounts receivable greater than 60 days through the system. Today, accounts receivable greater than 60 days as a percentage of rental income are running approximately 325 basis points higher than historical levels, and we have recognized a loss on aged accounts receivable based on estimated collections. All of these factors, together with temporarily pausing existing customer rate increases in March, April, and May, will continue to drag on revenue growth in the back half of the year. While street rates and rental activity have improved significantly, it will take time for the impact of May and June's lower achieved rates to flow through to revenue. We do not anticipate positive same-store revenue growth in the second half of the year. While we are being proactive in controlling expenses to offset lower revenue, we will continue to have expense pressure from payroll, property taxes, and marketing expenses. Property-level performance will continue to be challenged in the back half of the year, but we are finding success in other parts of the business and have strengthened our balance sheet. We continue to find ways to grow externally and to accretively deploy capital in the self-storage space. We have closed $52 million in bridge loans year-to-date with another $170 million under agreement to close in 2020 and 2021. In July, we purchased a $103 million senior mezzanine note at a discount with an anticipated yield to maturity of 6.1%. Our third-party management platform provides capital-light growth, driving management fees and tenant insurance, contributing to non-same-store income. We are also vigilantly pursuing acquisition opportunities and will act swiftly when we identify transactions that we believe add value to our shareholders. We continue to strengthen our balance sheet with the addition of a new $300 million revolving credit facility and the closing of a $425 million private placement transaction during the quarter. Funds from the private placement transaction will be taken through delayed draw to pay off our convertible notes and will increase our weighted-average debt maturity. As Joe mentioned, we haven't been immune to the impact of COVID-19, and the pandemic has had and will continue to have an adverse impact on our business. That said, it is good to be in storage, and our company is well-positioned to navigate the current landscape. Our team has a track record of consistent high-level execution, and we will continue to find ways to provide value to our shareholders regardless of the economic climate. With that, let's turn it over to Oran to start our Q&A.

Hi. Good morning, Joe and Scott. Scott, can you talk about the Company's bad debt policy and how you think about expensing? And what the amount was in the quarter that you expense? And how you think about the accounts receivable greater than 60 days going forward? Thanks.

Thanks, Rick. Our bad debt has historically run at 1.6% to 1.8% of our revenue. During the quarter, our bad debt expense was about 50% higher than that. That primarily has to do with the older accounts receivable and the things that have gone to auction. Our policy is to reserve for the majority of all accounts receivable that are 90 days or more past due. So, much of what's in the 60 days and certainly almost all of what's in the 90 days or more past due have already flowed through bad debt.

And then maybe just shifting Joe to supply growth and talk about supply. What are you seeing in terms of perhaps delays in supply growth and deliveries and which particular markets do you see that supply growth particularly challenging currently?

We are experiencing delays in the delivery of new products. While we had a successful quarter in terms of new properties added to our management platform, the results were slightly below our expectations due to some project delays that will push the timeline into later in the year. We are indeed facing delays with new product deliveries. The markets we are focused on have not changed; they remain Texas, Florida, the Boroughs of New York City, and similar areas. The impact of COVID has not altered the supply challenges we face in these markets.

I wanted to ask you this a little bit more about the existing customer rate increases. I think in June you provided an update where you were able to increase rates in 27 out of 40 states in which you were operating. What is that now? And I guess what percentage of customers have been, or are expected to receive rate increases? Maybe you could just talk a little bit about the acceptance rate and what you've seen so far as you push out rate increases for those who can get them?

So, there are six states now where we're prohibited from issuing existing customer rate increase notices, and a few of those states, we have some meaningful exposure to, and then there's another 14 states where our ability is limited to a certain percentage and in some cases that percentage is so high, it's a meaningless limit. So far as we have re-instituted existing customer rate increase notices, we have not seen any change in behavior. We've not seen increased move outs in response to those notices. Although I would also caution you it's something we're closely monitoring and we're probably still early in that game. We're interested to see what happens when the additional unemployment insurance runs out and factors like that. So, something we're watching closely, Smedes.

Okay. And then could you just talk a little bit more about the mezzanine loan that you mentioned that you purchased? Is that backed by a portfolio of assets and kind of, how are you thinking about that kind of loan to own, or just to get the yield or maybe a little more color there?

Sure. So it's absolutely a portfolio of 64 self-storage assets. You know, they're in markets that overlay our footprint and as with any loan we make, if we end up having to own the assets, we're fully capable of operating them and adding value, and that's not a negative experience for us. So, we are always looking for opportunities to smartly invest our shareholders' money in a creatively position with a good risk posture. Our position in the first year is about $53 a square foot. So we feel pretty good about that. We think we're getting a fair return and we're very comfortable with the risk posture of the investment.

Thank you. Good afternoon. Appreciate Joe, your balanced comments in your introductory remarks and just trying to think about many of the lessons you learned during some of the worst months we've seen, let's say, March, April into May, and recognizing of course the risks in the coming months. Would you do anything different in the coming months, let's say, if the reopening or closings continue versus what you initially did?

So, I can't tell you we were perfect. We certainly did things and learned lessons that we will apply in the future. One thing that I will tell you that a company like Extra Space that has a large portfolio has an advantage is we don't have to guess too much. So as we were going, we were faced with many of these new situations. We very quickly tried different things on a test basis in several hundred stores and learned what worked and what didn't. So we didn't have to make final decisions for the whole portfolio. And that was very beneficial because we were faced with new customer situations and customer behaviors. We were able to quickly get to what performs best. And we'll certainly take those lessons with us in the future and also take our testing culture and approach to new situations with us as well.

And, again, just thinking about the comments, in particular the risk with your auctions, a lot of them, let's say, happening in September outside peak leasing. I mean, we've heard other sectors, people comment that this year that maybe there's no peak leasing, it's just steady leasing, maybe there's even pent-up demand. Again, I'm trying to get a feel for your comments. And I totally respect and get the comments that we need to be cautious here. There's still a lot of risk. I think expectations coming into the year, by the way, were pretty low. But I mean, do you think that there actually was peak leasing or could the fall surprise?

I agree with you. I think we don't know. I think we're in a new situation. And we don't know if there will be steady leasing, if there is pent-up demand, or if we'll see the more traditional leasing patterns. And it's one of the reasons we're uncomfortable providing guidance on what's going to happen for the rest of the year because there are these unknowns.

Just first question. Following up on the bad debt expense, Scott, you've indicated that historically, the reserves are 1.2% to 1.8% of revenue, so 50% greater this quarter and incremental 80 to 90 basis points of bad debt. Is that going to trend higher in future quarters or will that normalize beginning in the third quarter as you work through some of the options and delinquencies?

So, we think July will be a little bit higher, but we would expect it to normalize going forward. And what we're basing that on is, if you look at our zero to 60 ARs, they're back to historical norms, they're not continuing to grow. So assuming that trend continues, those 0 to 60 become your 60-plus, if they were not paying them. And so, the fact that they've gone back to historical norms, hopefully, everything else will back to historical norms from here. So by the end of July, you've recognized the majority of your bad debt related to this.

And then the delayed auction activities, that's causing this inflated sort of physical occupancy. Have you started getting back in at all, or with notice periods, as you mentioned, is that process really just beginning now? And as we think about the auction activity increasing in the months ahead, is that going to result in an influx of rentable units and effective sort of increase in supply coming back to the market over the next few months? Or is that not the right way to think about it?

So, we have, one of the negatives of the delayed auction is the opportunity cost to not ever get the unit back. So we will absolutely try where we can to work with our tenants and come to some arrangement where they turn the unit back to us, so we can have it. But the majority of the units have to go through the auction process. We won't get them back until late in the third quarter. At that point, we'll have to return to them. And kind of similar to Jeff's question earlier, we'll see what the environment is done to do so.

And then can you just comment on what the recovery rates or I guess the collection rates have been like on the ARs here? Are you seeing bigger write-offs than you have historically? Is there any information you can share on that?

Todd, our recoveries have actually been slightly better than the historical norm. We'll see if that continues, but that's been our experience so far on the auctions that have happened.

What do you attribute that to?

Some of these people might just be choosing not to pay and so they may just be paying late versus having a true problem. I don't know for sure. That's some of our speculation.

One thing we see across other asset classes is when the government tells you, you don't have to pay, or the government tells you there's no penalties if you don't have to pay. Some people just choose not to do so.

Scott, as we think about the headwinds we're facing now and you've talked about the occupancy being inflated 200 basis points, 225 basis points of AR, which could potentially be bad debt. Is this a setup for a quarter or third quarter where things are going to get worse before they get better? Or do you think the second quarter is sort of a trough in revenue growth? And then there's sort of enough tailwinds where we start to see improvement going into the back half of this year? Where things are still negative but less bad?

First of all, I think just to clarify one thing that AR, the majority of that has a large majority already been written off. So you basically reserved for it in the second quarter. Once they hit that 60 to 90 days, especially the 90-day accounts receivable have been reserved for. So we don't expect that to be a negative in the third quarter to the degree it was in the second quarter. We do expect those units coming back online to be a potential headwind for us.

And what about just following up with tailwinds? Do you think there's enough sort of tailwinds here to see some improvement in revenue growth? Where things are going to be less negative, or is that too early to say right now?

I mean, we always hope for and we have confidence in our team in our systems that we're going to get every dollar we can optimize performance, but I would tell you there's enough uncertainties in the macro economy and other factors that we can't say for certain now.

Okay. I have another question, and I know this was touched on earlier regarding ECRI, but I'd like a bit more detail. California has a well-known maximum increase of about 10%, and I believe other states and municipalities have imposed restrictions as well. How should we view the resistance you're facing from states and municipalities? This isn't really a question about this year's growth, but as we look ahead to next year's growth, what should we consider from the ECRI perspective?

We would hope that these restrictions would be lifted and we can go back to our normal operating practice with prospective ECRI auctions. But we don't control that. So, our job is to control what we can control and maximize performance and follow the guidelines in other places.

The other thing I would maybe add there is, they're not necessarily additive in a normal year, but in a year like this, where they are going to be below average, if you have certain states that either don't allow them or allow them to a limited amount, it does make it difficult to continue to grow your revenues, especially for customers who came in at a level significantly below street rate. It's difficult for us to move them more quickly to the average rate there.

Thanks. Joe, last quarter, you said that you were likely to seek a good number of distressed, maybe see about deals or stores in some stage of lease-up coming to market, given the stress in the market. Given what appears to be at least some improvement in demand in recent weeks, do you still anticipate the same volume of distressed assets coming to market maybe this year or next?

Yes. I think there's going to be a number of stores that were not stabilized that the owner or the lender or the equity investor is going to force some type of capital event. So I would say yes.

Okay. And then, I think you've mentioned in the past that operating changed so dramatically in March and April that many of the rules or relationships that govern sort of revenue management systems were either sort of less effective or not applicable in a very human environment and the approach to revenue management had to sort of temporarily be reworked. I'm just curious any color would be great. To what extent has your approach to revenue management sort of returned to normal, or are we still operating in sort of a different and trying new things?

I guess part of my answer is, I would say, at Extra Space, we're always trying new things. We're always testing, innovating, trying to make the tools a little sharper and seeing what works. As I said earlier, I think we've learned a lot through this experience, some of which may be the permanent lessons and some may just be temporary. We are seeing more return to normal in terms of customer behavior. For example, our walking traffic has improved significantly. And that's an important metric that we look at and govern some of our behaviors.

A couple of questions and I've had phone issues, so I apologize if this was addressed earlier. First, can you disclose if you have already, what the rate is on the most investment that you made? And then second, if you're working C of O deals in the market today, have you seen any meaningful changes to pricing?

So, we have not approved a new C of O deal certainly in 2020, maybe even for 12 months. I'd have to think about that, but we have certainly not approved a new C of O deal in 2020. The pricing doesn't seem to make sense for us now. The rate, the base rate on our note is 5.5% and the yield to maturity is 6.1% on the C of O deal.

I think Scott, you mentioned in the external pressure on payrolls, which I thought was interesting, just given the unemployment rates. But I was wondering if you can comment on that as well as the potential ability to more permanently alleviate this cost with either touchless leasing or available employee hours?

Yes. So, the payroll cost comes, the pressure on payroll comes more from a tough count from last year. Our payroll was actually very low last year in wonderful quarters; I believe we were negative. So, it’s the tough comps, that’s the main comment there. In terms of what we're looking at, we think our managers are important; we think they're an important part of the sales process. We're always looking for opportunities to go touchless and deliver our customers the product in the manner that they would like to consume it. So, the example I would give you is pre-COVID. I think most people enjoyed working with a manager, and they were very successful in leasing units. Since this has happened, we've gone to a touchless process where your managers are involved via telephone. We have expanded that even further where they can do a complete rental online at 3 am with no manager involvement, and that's at, I believe, about 1200 of our stores as of today. So we continue to evolve that.

Okay. And you also mentioned that you are actively or more actively pursuing acquisition. I was wondering if you could elaborate on how pricing has moved and if you're seeing more interesting opportunities in newly developed products, stabilized assets, or more potential mezz investments.

So I'll clarify in my remarks. I didn't mean to give the impression we are more actively pursuing acquisitions. We're always pursuing acquisitions. We're always looking for ways to smartly grow this company. And we're lucky to be in a great capital position where we have plenty of capital of all different sorts to pursue any acquisition that we think makes sense. The acquisition market has been somewhat muted in terms of things coming to the market and particularly things that seem to make sense for us. But we're always trying to find smart ways to present a good risk profile for us to grow the company. So whether that's acquisitions, acquisition adventures, reinvesting in our existing properties through expansions, bridge loans, or the mezz loan that we just bought, we're just going to try to be smart allocators of capital. So I don't think pricing has moved for stabilized properties, and there's not a ton of cost out there, but if you have a stabilized self-storage asset, it's going to attract in a good market. It's going to attract a very low cap rate because people understand the stability of cash flow that comes from self-storage assets. Rates are low, and the alternatives are not as good. So I think cap rates are still low. What is much more difficult to say is on a lease of asset. One’s view of the cap rate depends on one's view of the timing and rate on which you can lease up that store, and people can have very, very different views of what that is. And I would say pricing is uncertain.

Two quick ones from me. One was just going back to sort of the bad debt. I know the apartment peers geographically vary. Just curious, when I think about states like New York, New Jersey, California, was there any sort of notable differences there versus sort of the average of the portfolio or any other color you can provide?

Some observations we can make. We are seeing higher AR at stores that are in markets with lower household income and also at stores, if there are more cash paying customers as opposed to credit cards. But the biggest impact is if you kind of get the trifecta of lower household income, lots of cash paying customers, and you're in a state where we can auction, that's where we have the highest concentrations.

Got it, understand. The other question was, we're hearing a lot more about theme de-urbanization, people moving from urban to suburban, and curious when you think about your portfolio. Are you seeing that translating into potentially more traffic or more demand on the margin for your suburban versus the urban part of the portfolio or it's just too tough to tell?

I would say we're seeing good demand across our portfolio. If there is that trend, it is probably too early to tell. But one of the advantages of having a broadly diversified portfolio across a lot of primary and secondary are urban and suburban, however you want to characterize them, growth markets, you know, we should be in a good balanced position to benefit from that if it occurs.

And you've mentioned July occupancy. Did you provide July achieved rates as well? We did not achieve our targeted rates in April, May, and June, with declines of 10%, 20%, and 16% respectively. However, in July, our achieved rates were essentially flat. This appears positive, but it's important to consider that July 1 was a favorable comparison point since we had decreased rates last year to boost our occupancy. Additionally, we've noticed a shift in our channels in July, with more tenants coming in person and renting through our highest price channel. Overall, we are optimistic about July, especially given the improvement from the negative results in May to flat rates in July, which provides important context.

It's Michael Bilerman here. Joe, you made the SmartStop preferred investment last October of $150 million which had a $15 million add-on future. Did you invest that in the quarter? Or do you have plans to buy in October, which I think was the one-year timeline?

That's a decision SmartStop will make. We can't force them to take that money; they have the option to take that money.

And your discussions with them will make that likely or unlikely, would you, which way are they going to draw that capital, and do you have any sort of details on how the portfolio is trending?

So SmartStop would be the appropriate folks to ask if they want to take the capital, and I don't want to speak for them. We do monitor their portfolio, and I think they're a very good manager, and they're performing similar to other good managers in the country.

And how do you, when you look at the competitive landscape? What are you seeing from the larger institutionally owned platforms versus the smaller operators and what sort of opportunities but also challenges does that present in still a pretty dispersed set of owners in terms of the competitive landscape?

It's a difficult question to answer, Michael, because there's not a lot of clarity as to how some of the real small folks are behaving. We really don't know what their occupancy rate senses are until they want to sell it, and you can take a look at their financials. In general, when we see smaller operators either, because they want us to take over management of their stores or because they're putting their store up for sale, we can manage them better. It's just as simple as that. We can run the stores better, we can throw them up more, and we can get higher rates. And I don't think that has changed at all because of COVID. If anything, I think maybe because more customers are now accessing stores through the web, our advantages may have improved.

You mentioned that the yield on the mezzanine was in the five range with a six-one yield to maturity. Where do you position yourself within the capital stack? Additionally, could you discuss the value per square foot and elaborate on the capital structure? I understand interest rates are low, but the yield for mezzanine seems low. Please share some insights on the dynamics involved.

Yes, I can't share details about the capital status. However, it's a great question regarding what percentage we are at. My focus is on the valuation of the portfolio. Considering that self-storage is valued at $53 per square foot, it indicates that we are in a very secure position within the capital structure.

So maybe just talking about that capital structure, without giving us the equity value, maybe just talk through how much debt is there? Is there other sort of loans that are outstanding, just to understand the pieces that are in front of you or behind you?

So, there is about $100 million first, there's our piece, and then there's a junior mezzanine of about $82 million, and then there's the equity. So, our loan to value is much lower than a traditional mezzanine where you would expect to see a higher interest rate.

Right, 82 of junior. So this thing's got to fall pretty dramatically for you to be in an ownership position versus just getting repaid.

Correct.

But you got to blow through that $82 million of junior mezz.

That's correct.

And then, is there anything on the valet storage side that you've witnessed sort of during this pandemic? Is that increased at all? Are you finding that an increased competitive source at all, as people want to maybe just store their goods and let someone else grab it from them?

I would not say we’ve seen increased competition from valet during the pandemic. We've not observed that.

I certainly would want them to come into my home, but I just didn't know whether there was just given the movement of people, whether that was being used by others.

Yes.

Thank you very much.

Thanks, Michael.

Hey, good morning out there. On the external growth front, have you guys looked at any large portfolios lately, or just one-off? I know you mentioned you always look at extra growth opportunities. We did see a big portfolio transact recently. Curious if you looked at that one or if it's more of a focus on the one-off opportunities.

We're an active acquirer every year of storage, and because of that, we're brought and we see every opportunity in the market. We underwrite them all. We look hard at them, and we think that we can acquire in a creative fashion, we'll try to execute, and if not, we'll let it go. So, I feel confident saying that we see and analyze everything that's out there.

Okay. And then can you quantify NOI exposure to those six states that are prohibiting the rate increases? Is that similar or maybe identical to the I think 47% of NOI under option restrictions?

It's much less than the 47%. I'm looking at the states now. I don't have a number for you. We can get back.

Yes, thank you everyone for your interest. As I said earlier, we have some headwinds. We're battling through them. We will control what we can control and focus our efforts on enhancing shareholder value, regardless of what gets thrown at us. I hope everyone in their families are well. We will get through this, and we want a better time soon. Thank you very much.