Extra Space Storage Inc (EXR) — Q4 2020 Earnings Call Transcript

Thank you, Cindy. Welcome to Extra Space Storage's fourth 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, February 23rd, 2021. The Company assumes no obligation to revise or update any forward-looking statement 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. And Joe, you may be on mute. Operator, do we have Joe's line connected.

Thanks, Jeff. Can you hear me now? Sorry everyone. Thanks, Jeff, and thank you, everyone, for joining today's call. I hope everyone and their families remain healthy and that your 2021 is off to a good start. In my 35 years in real estate, I can't remember another year with as many positive and negative twists and turns in such a short period of time as we saw in 2020. The range of emotions I felt from March, when I was worried about the daily safety of our employees and customers; to April, when I wondered when rental demand in our sector would return; to September, when we saw some of the strongest occupancy and rental rate fundamentals in our company's history are hard to describe. I am proud of our team's resilience in how well they responded to 2020's unprecedented challenges. Our team's efforts together with our balanced portfolio, sophisticated platform and innovative external growth efforts yielded a great result in the fourth quarter. We ended the year with same-store occupancy of 94.8%, an all-time year-end high for Extra Space. Our elevated occupancy has given us significant pricing power, which we have experienced since August and a return to positive same-store revenue growth in the fourth quarter of 2.3%, a 380 basis point acceleration from the third quarter. We also had excellent expense control with a 0.6% decrease in same-store expenses, resulting in 3.4% NOI growth in the quarter. Our return to positive NOI gains coupled with strong external investment activity yielded core FFO growth of 16.5% in the quarter. Despite the challenges of the year, the fourth quarter was full of accomplishments, including the completion of two preferred equity investments totaling $350 million, $147 million in acquisitions, $168 million in bridge loan closings, the addition of 44 stores to our management platform, and receipt of NAREIT's Leader in the Light award, recognizing Extra Space for its sustainability efforts. This is the first time a storage company has received this award. While we are excited about the accomplishments of 2020, we are even more optimistic about how our efforts have positioned us for 2021. Rentals continue to be steady and vacates continue to be muted. We are heading into 2021 with the highest occupancy we have ever experienced at this time of year and expect rental rates to remain strong. We have already added 51 third-party management stores in 2021 and our acquisition, management and bridge loan pipelines are robust. But we are also mindful of the risks we face. We recognize that current or potential government regulations could impede same-store revenue and expense performance. We believe that vacates may eventually return to more normal levels and we recognize that the challenges related to new supply have not subsided completely and will continue to suppress rate growth in many markets. As in the past, our team is prepared to use all our available tools to optimize performance in the face of any risks which materialize. In short, despite significant turbulence, we had a very successful 2020 and look forward to an even better 2021. We continue to execute on our strategy to maximize shareholders' long-term value and to deliver the results our shareholders have come to expect from Extra Space Storage. I would now like to turn the time over to Scott.

Thank you, Joe, and hello, everyone. As Joe mentioned, we had a great fourth quarter with reaccelerating same-store revenue growth driven by all-time high occupancy and strong rental rate growth for new customers. Late fees and other income were lower year-over-year, which partially offset rental income, but we saw improvement in both areas compared to the third quarter. We reduced expenses across all controllable categories in the quarter and, despite a 6.4% increase in property tax, we achieved an overall reduction in same-store expenses. This led to same-store NOI growth of 3.4%. Core FFO for the quarter was $1.48, representing a year-over-year increase of 16.5% and exceeding consensus estimates. Our same-store performance was the main factor driving this outperformance, along with contributions from growth in tenant reinsurance income, management fees, and interest and investment income. We are actively managing our balance sheet to reduce secured debt and expand our unencumbered pool. As a result of these efforts, Moody’s issued Extra Space a BAA2 credit rating on January 28th, which is our second investment grade credit rating and enhances our access to the public bond market. We are pleased to have added another financing option to support future growth, reduce overall costs of debt, and better manage our maturities. At year-end, we had higher than normal balances on our revolver and variable rate debt due to significant capital activities in the fourth quarter, such as settling our convertible notes, completing preferred equity investments, and closing a substantial volume of bridge loans and acquisitions. A large portion of these transactions was temporarily financed from our revolving lines. We were comfortable with this approach since we were also actively issuing on our ATM, had pending bridge loan sales, and were recapitalizing stores into a joint venture, which will bring our revolver balances back to historical levels. Last night, we provided guidance and annual assumptions for 2021 with wider ranges than in previous years to factor in the uncertainties related to COVID-19 and its effect on customer behavior and government regulations. Our new same-store pool includes a total of 860 stores, which is essentially flat compared to last year. The number of new stores added to the pool was largely balanced by sites removed due to disposition or redevelopment. We believe these changes will benefit our 2021 same-store revenue growth by about 20 basis points. Same-store revenue is projected to increase by 4.25% to 5.5%, driven by higher occupancy in the first half of the year and elevated rates for both new and existing customers. Same-store expense growth is anticipated to be between 3.5% to 4.5%, primarily due to increased property tax expenses. Our revenue and expense guidance leads to a same-store NOI growth range of 4.25% to 6.25%. The acquisition market remains expensive and we will continue to be disciplined yet opportunistic. We expect to engage in significant acquisition volume and plan to finalize several transactions with joint venture partners. Our guidance includes a $350 million investment in Extra Space, with about $180 million already closed or under contract. We also expect to finalize around $400 million in bridge loans and aim to retain 20% to 25% of those balances, which is about $100 million in 2021. We have ample capital to invest should we identify additional opportunities that offer long-term value for shareholders, and we will be creative in how we deploy our capital in the sector. Our full-year core FFO estimate is between $5.85 and $6.05 per share. We expect $0.16 of dilution from value-add acquisitions or Certificate of Occupancy stores, which is down $0.04 from 2020. We have also provided additional guidance regarding our anticipated interest income for 2021, along with notes clarifying the recognition of our preferred investments in SmartStop and NexPoint, which are detailed in the outlook tables of our earnings release. As Joe mentioned, 2020 has been a memorable year for Extra Space. We are eager to move forward and are already on track for a very strong 2021. Now, let's turn it over to Cindy to start our Q&A.

Hi, everyone. Thank you for taking the questions today and congrats on a great quarter. And it looks like 2021 is going to be great for you guys as well. So, I just wanted to start off and ask a little bit more on what you guys are expecting for revenues this year? So, how are you thinking about occupancy for the first half versus the second half and a little bit more on the rental rate assumptions?

Yes, Alua, this is Scott. I can give you a little bit more detail in terms of what our guidance assumes. We are assuming that our occupancy stays strong. So, in January and into February, our gap has actually expanded to be just over 300 basis points. So what's happened is January and February typically have lower occupancy, declining occupancy. We haven't seen that. So we moved from a 240 basis point delta in occupancy to over 300 basis points where we are today. So we are assuming that occupancy holds at this high level through the end of the summer, at which point we expect occupancy to fall more to historical levels. So last year in the fourth quarter, third and fourth quarter we saw occupancy 200 basis points to 300 basis points higher than normal. This year, we expect that to be a 100 basis points to 200 basis points headwind for us. So we expect it to be lower and to fall back more to historical levels. We expect the first quarter to be strong in terms of revenue growth continuing to accelerate from the fourth quarter. The second quarter should be the peak and that is mainly due to some easy comps from last year and then continued good into the third quarter with the end of the third quarter and fourth quarter being challenging.

So, this is Joe. Thank you for your kind words about our performance. It's not just Scott and me; it's over 4,000 employees who bring their best work every day and have really done an outstanding job. Regarding third-party management, our activity in January and February, with 51 stores added, is somewhat elevated because we took on 37 stores related to the JCAP transaction. Therefore, I expect our activity in 2021 to be similar to our activity in 2020 in terms of gains.

Hi, thank you. Can you guys just provide a little bit of color on how existing customer rate increases have been trending just relative to your historical norms? And do you suspect that you're going to be able to continue pushing these pretty aggressively in '21?

We are still facing restrictions on rate increases for existing customers in many markets, which limits our options. Without those constraints, our ECRI increases consistently hover around high-single-digits, approximately 10%, similar to what we have seen before. Interestingly, as we adjust our rates in line with ECRI, we have not experienced an uptick in move-out rates. We hope that the regulations will eventually be lifted, allowing us to return to normal operations. We are currently aware of these limitations and have factored them into our guidance, and we are optimistic about returning to normal sooner rather than later.

Okay, thank you. And then just to make sure, on growth front, are you guys currently seeing more opportunity with stabilized assets or with assets in some sort of lease-up right now?

Thank you very much. What we focused on acquiring are primarily lease-up assets. It's challenging for us to assess pricing on stabilized assets. We anticipate being more active in that area in 2021 alongside joint venture partners to ensure that the pricing aligns with our expectations. Everything we acquired in 2020 was lease-up. On average, we achieved mid-3s in the first year and stabilized to mid-6s on average in 17 months. I believe this strategy represents the most effective use of our acquisition funds at the moment.

Good morning, Joe and Scott. I have a question for Joe regarding supply growth. How do you see supply across your markets? You mentioned it being somewhat flat. Are there specific markets where you're experiencing significant supply growth? Additionally, what are your thoughts on supply for 2021 and into 2022? Thank you.

Sure. Thank you for the question. Supply remains a challenge, and that's the brief answer. We experienced a significant reduction in 2020 due to COVID. I will focus on our same-store pool, rather than national figures, since that's what is relevant to us. We had estimated in 2020 that around 30% of our same-store pool would be affected by new supply, but the actual impact was only about 21%. This means nearly a third of anticipated new supply was delayed or canceled due to COVID. For 2022, we expect that 22% of our same-store pool will be influenced by new stores, and as is common each year, some of these may face delays or cancellations. There is a slight decrease in new supply, which is positive news. However, I want to caution that we have still seen substantial supply come into many markets over the past few years, which impacts our ability to increase rates. Additionally, given the strong performance of storage compared to other asset classes, it may attract more capital and developers into the market. Although new supply isn't a concern in every market, in those where it is, it's an issue we need to manage.

Thank you. And then, Joe, just maybe one other follow-up on the bridge loan program. You mentioned, I think $400 million targeted for 2021. Is that sort of in the pipeline or is that an aspirational goal? Maybe help us frame that and then how you think about the path forward from some of these bridge loan and other investments that you're making to help with the FFO growth?

So, we have about $196 million in the pipeline. So we believe $400 million is an achievable goal and the bridge loan program is very accretive for us because the whole note reach maybe in the 5% to 6% but by the time we sell the A and keep the B, the rate we're getting is 9%, 10%, 11% plus we're getting management of the stores and the economics there. We also hope to buy a bunch of these and I think we bought one and have two that we're targeting to buy. And it's an immature program. But as we get deeper into it, I hope it turns into an acquisition pipeline as well.

Hi, thanks. I wanted to ask you if you are noticing any impacts from migration throughout your portfolio during this pandemic and if it influences where you are considering future investments, especially regarding acquisitions.

Thank you, Smedes. We haven't noticed any performance differences between the markets where people are reportedly leaving, like San Francisco and New York, and the markets they're supposedly moving to. It’s unclear if this is because people are storing their belongings in Manhattan before relocating to areas like Borough, New Jersey, but currently, we don't see a performance difference linked to this trend. The performance differences we observe are primarily due to new supply, which is where we experience the most weakness. Additionally, there have been several articles recently questioning the extent of urban flight reported during COVID. One article noted that most people leaving San Francisco are settling in nearby counties rather than moving to states like Utah, Florida, or Texas. Lastly, in my opinion, I don't think COVID signifies the end of New York City. Young people still prefer living in urban areas because cities offer many advantages. I don't believe this marks the demise of major cities. To address your question, we're primarily focusing on micro markets for our investment strategy and we have not yet changed our approach based on urban flight.

Okay, thank you for that. I just wanted to ask you too, your net-adds in the fourth quarter for third-party management were quite a bit lower than the gross additions. And I just was wondering what sort of caused that churn and is that something that you would expect to see going forward, perhaps, seeing it like from the first quarter.

Yes, great question. So, we had 38 stores leave our platform in the fourth quarter and 87 leave our platform in 2020, almost all of them were because of sales. Very, very few were a change in managers. We bought 15 of those 87 stores, not a huge percentage and the issue is pricing. We try to remain disciplined and not overpay, in our view, for things. There is also some subset of these stores that are not of a quality we want to own. We have to manage but not own. So given where prices is, I would expect that we continue to have sales. I hope we can do a better job through structures that we buy more of them, but our number one goal is not to do something that's dilutive to our shareholders' value. So if pricing gets beyond what we think is reasonable, we're going to do our best to transition the store to the new buyer.

Hi, good afternoon. First question, Scott, apologies if I missed this, but what were move-in rates or move in rate growth, I guess, in the quarter and in January and what are you seeing early in February?

Yes. In the fourth quarter and for the second half of the year, our achieved rates were approximately 10% higher than the previous year. In the first quarter of this year, specifically in January and February, we are observing rates at similar levels, also about 10% above where they were last year.

Okay. And then, just following up on rental rate trends and just given how the industry has tightened up here over the last couple of quarters. And you've seen a lot of rent growth during the off peak season which Joe, I think, you noted began in August. As we think about the peak leasing season ramping up now, is it possible that we see rate increases similar to what Extra Space and the industry has experienced historically during the peak periods from where rates are today and is that factored into guidance?

So, we are assuming that the first quarter we continue these rates that we've been experiencing. Second quarter, our achieved rates, we would expect to be very strong, because if you remember, in the second quarter when things really dropped, we dropped rates 20% to 30%. And so when you're looking at a rate that was 20% to 30% lower and then it's already 10% above, you're going to see some significant rate growth for customers that move in at April, May even into early June and those are all factored into our guidance.

Okay. Where do the current rates stand compared to the March, April, May timeframe?

Our achieved rate is currently lower than our in-place rents. It's important to note that this comparison is not between move-out and move-in rates. Typically, this period sees the most negative comparisons, with achieved rates in January and February being at their highest compared to existing customer rates over the year. The fact that our rates increased by 10% year-over-year in February is a positive sign. Currently, our in-place rents are in the high single digits above the achieved rates.

Okay, that's helpful. And then just one question, the taxes in the TRS that are forecast to be up to about $19 million to $20 million. I know in the past you've executed on sort of a variety of different strategies to minimize that tax expenses. Are there any opportunities that you see today as you look ahead?

We are still leveraging solar opportunities that align with our ESG and sustainability goals, in addition to some tax advantages. That is the main focus for us right now.

Do you see any potential downside to the tax expense in the TRS going forward?

I think it will depend on the direction of tax rates and the future of solar credits. We've seen those diminishing recently. With the new administration, it's possible they will implement additional credits, and we will keep an eye on those.

Thanks. It was a great quarter and the guidance looks strong. I'm curious about the rent increase limits that cities like California have implemented. What is implied in your guidance regarding the loosening of these policies? Are you operating under the assumption that you can raise rates more in the latter half of the year in California, or is that just a potential opportunity for upside to your guidance?

So, we don't assume that we get relief from those in the first half of 2021. The back half of 2021, I believe, we still are moderating some of those rates. So, there is some upside to that. But there's also a downside if something turns in the wrong direction and additional restrictions are put into place.

Got it. Going back to the supply topic, you mentioned the percentage impact on your same-store pool. I'm interested in the decimal impact, so not just the percentages of 30% or 21%, but the actual decimal impact. In the end, does a decimal impact indicate something even better?

I'm not sure I understood the question. We've tried to be clear that supply is the biggest factor affecting our performance in markets like the Boroughs in Northern New Jersey, Texas, and Florida. We can fill our stores and maintain very high occupancy rates, but our ability to raise rents is hindered by the new supply. Ki Bin, I don't know if that addressed your question, so please let me know if it didn't and I'll try again.

Well, you said I think about 21% we're seeing are so called impacted by supply, but that could mean 10% more supply coming to those markets or it could be 2% more spike in those markets. So that's how I was trying to gauge if it's leaning one way or another.

Yes, this is a micro-market business and that's a valid observation; it varies significantly. We've seen cases where new properties are developed very close to existing ones, and due to factors like traffic patterns or geographical barriers, we've experienced no impact on our property at all. Additionally, it's more advantageous for a new store to enter a market with 10 square feet per person compared to one with only two square feet per person. In a market that has 10 square feet per person, a smaller share of overall demand is needed to successfully fill the store. In contrast, if the market has just two square feet per person and supply increases by 50%, that presents a bigger challenge, at least in the short term. So, while we mention percentages like 21% or 30%, it really comes down to an analysis that's specific to each market and store. That's how we formulate our guidance. We develop individual budgets based on what we expect might occur in each store's market. We make the best possible performance projections and compile that information into our guidance.

Hi, thanks. Just listening to your posture calling for some moderation in occupancy. Certainly, these are historic highs and it's probably prudent to do so. But what drives that move lower? Are you assuming some housing transaction slowing? Is it frozen consumer behavior that begins to thaw and people naturally start to move out after a 13 or 14 months. Maybe where do you kind of point to?

So Todd, I would tell you to go ahead, Joe.

Sorry Scott. So, our elevated occupancy, one of the very important factors is moderation in vacates. And at some point, COVID is going to be in the rearview mirror and we believe customer behavior will return to normal. Now, I don't think that means there is going to be an end of COVID day and someone is going to flip the switch and everyone runs to move out of their storages, right. We know that our customers have a great deal of inertia and it's not high in their list and it may take them some time. We know that the largest increase in reason for storage we've seen over COVID is de-cluttering of the house. And I don't think just because COVID is over, people are going to want to reclutter their house, right, that this may be a more permanent change. But with all that being said, we do believe vacates will eventually get back to more normal levels, and that will cause a reduction in occupancy.

Thank you, Joe. I have one more question regarding the bridge loans. I noticed you have sold some of your bridge loans and it appears you have sold a bit more this year. This puts you in a good position when looking to acquire a property, but with those sales, does that restrict your ability to pursue those deals? Also, how fluid is that market if you are looking to reduce your loan exposure or mitigate risks? A bit of context on that would be appreciated.

Once we've sold an A-piece and $76 million in additional A-pieces in 2021, it complicates the purchase since we can waive our portion of the prepayment penalty. However, the A-piece seller won’t do that because they don’t gain anything from our purchase. That presents a challenge. As we approach maturity and those issues expire, it becomes less of a challenge. When we initiated this program, we had a co-lending partner with whom we co-originated the loans, closing them while only assisting with the B-piece. Over time, we realized that it worked better to close both pieces, package the A-pieces into larger amounts, and then sell them. This means we hold the A-pieces on our balance sheet for some time, which was evident in the fourth quarter when having those sold slightly increased our debt. However, it provides us with better execution, especially since we now have two buyers for the A-note, creating competition and redundancy, which has proven beneficial for us.

Yes, hi. Scott, want to go back to, when you were talking about occupancy being strong up to 300 basis points through the summer and then you made a comment about a headwind down to a 100 basis points. Were you implying that by year-end, the occupancy comp was going to be a negative 100 basis points or your 300 basis points positive was going to shrink to 100 basis points positive?

So in the back half of 2020, it was a 200 basis point to 300 basis point benefit, and we are assuming that in the back half of 2021, it is a 100 basis point to 200 basis point headwind. So it's a negative comp year-over-year in the back half of 2021.

Got it. Okay, that's helpful. And then, when you were talking about the portion or the markets where you still run into rental increase restrictions, how significant is that as a percentage of the whole portfolio.

Sort of thinking how to measure that. Some of the rental rate restrictions are at a level that it's not that meaningful, right. In Alabama, you can't increase your rates more than 25% or Kansas to 25%. Now those are biggest states. But that gives you the idea. And other like California where it's 10% and it's a meaningful state for us, that is much more of a restriction. So we think the opportunity cost if you will, in 2021 because we were not able to raise the rates, is meaningful. It's likely over $10 million, but it's all included in our guidance.

Congratulations on the quarter. I have two quick questions. First, regarding the same-store expense guidance, could you elaborate on how we should consider property taxes and payroll, which are the largest contributors? Thank you.

Yes. I can share our assumptions in our guidance. About 55% of the increase is related to property tax increases, which we anticipate will be approximately 5.5% higher than in 2020. Our payroll is projected to increase by about 2% year-over-year, contributing another 10%. Additionally, we expect repair and maintenance costs to rise. After a couple of years of decline, we've benefited from lower comparisons due to snow removal costs, so we believe that will be a challenging comparison. We've already observed some of this trend in the Northeast to date. These are some of the key assumptions in our 2021 guidance.

Got it. My second question was just on the four assets that were sold. Just any color around there, maybe cap rates or why was it sold? Was it just a great offer? Just curious what the situations where there. Thanks.

I would tell you, we thought the pricing was very good otherwise we wouldn't have sold. We retain management of the stores. We retain certain right of first refusals to buy them if they ever want to sell. I would tell you it was a tax motivated buyer and we were able to drive what I thought was very attractive terms because they have that motivation.

Hi guys. Thanks for taking my question. Just a quick follow-up on supply, how much of your outlook includes the possibility of conversions from retail to storage given the increasing reliance on e-commerce?

When we become aware of such opportunities, they are definitely factored into our projections. Our team in the field is responsible for staying informed about developments in their local markets and identifying what can be transformed. That said, we've undertaken several conversions. We have several locations that used to be retail centers, which present various challenges. I don't anticipate this will lead to a significant source of new self-storage facilities. Some retail spaces are underperforming for a reason, and we wouldn't want to establish a storage site in such locations. Additionally, some of these spaces may not even be zoned for storage, and there are many physical obstacles to address. While there may be a few conversions, I do not expect a substantial influx of new supply from retail transformations.

I didn't expect to be back so soon. I wanted to discuss the overall outlook for your bridge loan program, not just the guidance for 2021, but also looking further ahead. Should we consider this program to be a long-term initiative, or is it primarily a response to a current market opportunity that might diminish in a few years? I'm looking to gain a better understanding of the program's long-term scope.

So, we don't have a perfect crystal ball. Our belief is that there will be a demand for what we're doing now into the future. I also believe that it's incumbent on us to always understand where the capital voids are in the market and how we can make good risk-adjusted returns based on those capital voids. So if our current program gets smaller in the future because that capital need is not as great, I hope that our team and I expect that our team to find the next opportunity. One thing I think Extra Space has done well over the years is being innovative with the external growth and that means not executing the same strategy regardless of where you are in the market cycle. It's trying to understand that market cycle and see where you can make outsized returns at acceptable levels of risk. Right now that's bridge loans and I hope it continues forever, but if it doesn't, we'll find something else.

Right. I assume there's a wide range of opportunities, but what you actually end up closing is quite selective. I'm just curious if you can describe the deals you've turned down and how large that opportunity pool is at the top.

Sure. I think the two biggest limitations at the top of the funnel are that we won't make construction loans and we could make many loans if we were open to construction financing. However, the advantage of the bridge loan program is that if things go wrong and we need to take over the property, it's at 75% or 80% of the underwritten value. We already run those properties and are willing to own them, which is a better situation than taking on an incomplete, defaulted construction project that we have no interest in. That's one limitation on the top of the funnel. The second limitation is related to management; some property owners prefer to self-manage and do not want us to take on that role, which means we won't proceed with those deals. Beyond that, we consider property quality, location, and underwriting to meet the borrower's requested proceeds, but we have a substantial pipeline and are confident we can meet our guidance for this year.

Great. Thanks everyone for your interest in Extra Space and your support over the years. We're really looking forward to a strong 2021 strong double-digit core FFO growth. And appreciate your interest. I hope everyone in your families are well. Thank you very much.