Extra Space Storage Inc (EXR) — Q2 2021 Earnings Call Transcript

Thank you for waiting, and welcome to the Q2 2021 Extra Space Storage Earnings Conference Call. I would now like to introduce your host, Senior Vice President of Capital Markets, Jeff Norman. Please proceed.

Thanks, everyone, for joining the call. Before discussing the results, I want to congratulate the entire Extra Space team. One of our goals for this year was to reach 2021 stores in 2021, and we’ve accomplished that, which is fantastic. When I started with Extra Space, we had 12 stores, and it's remarkable to see the tremendous growth of this company and the value we've created for our shareholders. I appreciate everyone at Extra Space who helped us achieve this goal. I’m also pleased to share that we recently released our 2020 sustainability report, which includes details about our environmental, social, and governance initiatives. I encourage listeners to check out the report on the Sustainability page of our Investor Relations website. As we moved into the second quarter, our management team had high expectations based on our record occupancy levels, significant pricing power, and a relatively easy 2020 comparison, and our actual performance significantly exceeded these expectations. Same-store occupancy reached a new high at the end of June at 97%. This strong occupancy resulted in exceptional pricing power, with rates for new customers this quarter over 60% higher than 2020 levels. Although this was partly due to a low prior year comparison, achieved rates were also over 30% greater than 2019 levels and continued to trend upward during the quarter. Along with the benefits from new customer rates, we have been transitioning existing customers to current market rates as more emergency rate restrictions are lifted across the country. Other income is no longer hindering revenue as late fees have improved year-over-year and actually contributed 20 basis points to revenue growth this quarter. Additionally, higher discounts mainly due to increased rates were counterbalanced by lower bad debt. These factors led to a same-store revenue growth of 13.6%, a 900 basis point improvement from Q1, and same-store NOI growth of 20.2%, an acceleration of over 1,300 basis points. Furthermore, our external growth strategies yielded steady returns beyond the same-store metrics, resulting in FFO growth of 33.3%. Looking at external growth, we believe the acquisition market is still expensive. In light of current market pricing, we have listed an additional 17 stores for sale, which we anticipate closing in the latter half of 2021. We are actively pursuing acquisitions while maintaining discipline. Year-to-date, we have closed or contracted acquisitions amounting to $400 million in Extra Space investments, mostly consisting of lease-up properties, with several stemming from our Bridge Loan Program. We have raised our 2021 acquisition guidance to $500 million. Moving forward, many of our acquisitions will occur through joint ventures, and we have ample capital to invest should we find additional opportunities that offer long-term value for our shareholders. We were also active in third-party management, adding 39 stores this quarter and a total of 100 stores in the first half of the year. Our growth was partly balanced by dispositions as owners sold their properties. During the quarter, we purchased 11 of these stores either through the REIT or in one of our joint ventures. Our strong first-half results, combined with steady external growth and an optimistic outlook for the second half of 2021, enabled us to raise our annual FFO guidance by $0.50, or 8.3% at the midpoint. While we expect some seasonal occupancy decline of about 300 basis points from this summer's peak to the winter low, this decline will start from a higher level than we had previously anticipated. Consequently, we anticipate minimal impact on revenue growth from the expected drop in occupancy in the latter half of the year. Our guidance suggests a moderation in rate growth that remains strong for the remainder of 2021, which should lead to another successful year for Extra Space Storage.

Thanks, Joe, and hello everyone. As Joe mentioned, we had an excellent quarter with accelerating same-store revenue growth driven by all-time high occupancy and strong rental rate growth to new and existing customers. Core FFO for the quarter was $1.64 per share, a year-over-year increase of 33.3%. Property performance was the primary driver of the beat with additional contribution coming from growth in tenant insurance income and management fees. Despite property tax increases of 6%, we delivered a reduction in same-store expenses in the quarter. These increases were offset primarily by 13% savings in payroll and 31% savings in marketing. Our guidance assumes payroll savings will continue throughout the year; however, at lower levels due to wage pressure across the U.S. Marketing spend will depend on our use of this lever to drive top line revenue, but it should also remain down for the year. In May, we completed our inaugural investment-grade public bond offering issuing $450 million in 10-year bonds at 2.55%. Access to the investment-grade bond market provides another deep capital source at low rates and will allow us to further extend our average maturities. Our year-to-date dispositions, equity issuances, and NOI have resulted in a reduction in our leverage. Our quarter-end net debt-to-EBITDA was 4.8x, giving us significant dry powder for investment opportunities since we generally target a range of 5.5x to 6x on this metric. Last night, we revised our 2021 guidance and annual assumptions. We raised our same-store revenue range to 10% to 11%. Same-store expense growth was reduced to 0% to 1%, resulting in same-store NOI growth of 13.5% to 15.5%, a 750-basis-point increase at the midpoint. These improvements in our same-store expectations are due to better-than-expected achieved rates, higher occupancy, and lower payroll and marketing expense. We raised our full-year core FFO range to be $6.45 to $6.60 per share, a $0.50 or 8.3% increase at the midpoint. Due to stronger lease-up performance, we dropped our anticipated dilution from value-add acquisitions and C of O stores from $0.14 to $0.12. We're excited by our strong performance year-to-date and the success of our customer acquisition, revenue management, operational and growth strategies across our highly diversified portfolio. With that, let's turn it over to Latif to start our Q&A.

Congratulations on the quarter. Joe, my first question is on the point you discussed on seasonal occupancy and the moderation. You're still building into guidance of 300 basis points. Are there any signposts right now pointing to that or to be fair, would you say that there's still some conservatism here?

Thanks, Jeff. Thanks for the question and for your kind words. So far, we don't see any signs of it, and we are actually over 97% occupied in July. So, we're still waiting for that moderation to begin, but we do believe that slowly over time, customer behavior will revert to normal.

Okay. I guess let's flip the question then on the other side in customer acquisition. I mean where are the surprises coming from because we've been talking about the moderation. And of course, this past year has been much stronger than expected. I guess let's talk about customer acquisitions. Is it particular regions? Where are they coming from? Any changes? What are the nice surprises you've seen just even in, let's say, the last quarter or last month?

Yes, it's really on the vacate side. Our Q2 vacates were 10% below the levels seen in 2019. Using 2020 as a comparison isn't particularly helpful. We continue to observe that people are staying in their units, which reduces the number of units available for rent and gives us greater pricing power, and that's all positive.

Just hoping we could touch on rate growth. How are you guys thinking about that growth going forward? The year-over-year comps have been clearly impacted by COVID discounting, but your in-place rents are at record levels, near $18 a square foot. If we look back to 2015, 2016, you had kind of two years of rate growth of about 6.5%. Do you think we could see something similar in terms of the quantum and duration of the year-over-year growth in in-place rates?

Yes. Juan, I can maybe walk you through some of our assumptions, and I'm not sure I can tell you exactly what's going to happen. I think that's the big question here. We've seen very good rate growth. If you look at our rates year-over-year, we mentioned that we're 60% ahead of where we were last year. Last year was an odd comp. If you look at it compared to 2019, you're 30% ahead. So, we continue to push our street rates, and the expectation is that we will continue to push them through the year. We do come up against a more difficult comp at the end of this year as we started pushing rates at the end of last year. So, that is one thing that we're looking at as we move into the fall. A couple of other maybe data points, discounts are up slightly in the quarter, mainly due to rates being higher. Our discounting strategy hasn't changed significantly. We'll continue to use them as a tool, but we'll continue to monitor those also. Our existing customer rate increases are running above where they've historically been, and part of that is an odd comp again from last year where last year you had many state of emergencies where we paused rate increases. And so, from a year-over-year perspective, those existing customer rate increases are contributing more than they were last year.

And if you guys just look at the net street rates for new customers, have you seen any sequential deceleration in the pace of that growth through July?

No significant change in July from what we've seen in June.

In terms of the revised guidance, and Joe I appreciate the comments around revenue growth in the back half of the year, but I'm just curious and maybe Scott can chime in here, but what are you anticipating for same-store revenue and same-store NOI growth as you exit the year? If you can maybe provide some detail around the trajectory throughout the balance of the year based on what's implied by the revised guidance that would be helpful.

Yes. Without providing exact kind of monthly sequential here, I'll just give you a few data points. We are seeing rate contributing more in terms of the overall percentage as the occupancy delta wears off. By the end of the year, occupancy won't be benefiting us, and it's all coming from rate, but we do not expect it to accelerate significantly through the rest of the year, but we also contribute through the remainder of the year as we come up against these tougher comps.

Okay. And what's the spread right now between rates for customers moving out and the achieved rates on customers moving in?

Yes, the disclosure we've given may be a little bit different than that. What we've typically disclosed is our in-place rents compared to our new move-ins, and that right now is high teens, which I would tell you right now is exceptional. And typically in the summer months, it's flat to slightly positive, meaning customers moving in pay slightly more than our in-place rents. And this year, it's high teens which is as good as we've seen.

Okay. And just one last question for Joe. You talked about investments and mentioned that the market seems expensive, indicating that you would prefer to pursue more investments through joint ventures. The joint venture platform used to be larger, and you've been purchasing assets from within that platform. Given the significant capital available for investment in storage, are you considering undertaking a sizable initiative that could potentially yield premium returns and also help replenish the pipeline?

So, we are kind of governor of what we're willing to do; it isn't how big or small it is. It’s what we view the risk-adjusted returns to be. So we'll do as big a deal, and we have capital to do as big a deal as necessary or is available, provided the risk-adjusted returns are good or we'll buy one-off storage, and historically we've done both, and we're not focused on what's too big or what's too small, we’re just fully focused on what we believe the risk-adjusted returns to our shareholders are.

Okay. Should we expect investments going forward to be primarily weighted towards joint ventures versus on-balance sheet investments?

I believe that's a reasonable expectation considering current pricing. We can greatly enhance shareholder returns by investing in joint ventures, which allows us to consider deals that would typically be dilutive if fully owned, but are beneficial when structured as joint ventures.

I was curious about your comment on existing customers aligning more closely with overall market levels. If that's the case, what percentage of the portfolio might still experience rent increases as restrictions lift, or is that mostly in the past now?

So we only have a few markets that have restrictions in place. So they're very limited to a few specific California markets that have restrictions that go back to buyers from several years ago. You have a few others across the U.S. that are between 10% and 20%. So the majority of the portfolio is open to rate increases. There are a few that still have some limits.

Okay. Can you provide more details about what you're observing in terms of labor? You mentioned some savings and updated information, but are you experiencing higher wages or difficulties in staffing? I would appreciate more context on how that is developing.

Yes, it's a significant issue that we're addressing. We have fewer applicants for open positions, it takes longer to hire, and it's more costly. We're putting in considerable effort to ensure we are properly staffed with quality individuals. We do notice that as supplemental unemployment insurance decreases in certain states, the situation improves. We're optimistic that this trend will continue, but we are definitely aware of wage pressures, which we are experiencing, and it's a challenge we need to manage.

Okay. Okay. And then just last question, I was just interested to see that you did not re-up your ATM in the second quarter, and you mentioned that you would do it in the third quarter. Was there a reason for not doing it during the second quarter?

Yes, we were focused on getting our inaugural bond offering done. We then turned to recasting our credit facility. Both projects were done during the quarter. We feel like we had a great quarter of getting those done, and then we'll refile the ATM as we finish the quarter and file the Q.

How are you thinking about managing the interplay between occupancy and rate? I understand the goal is to maximize revenue. But like how are your models thinking about pushing rate maybe at the expense of occupancy in this environment?

Yes. So it's a great question, and you're right to focus on the different levers that lead to maximizing revenue. But I would suggest there's many others. It's not just occupancy and rate; it's marketing spend, it's discounting, it's days you allow customers to reserve a unit. There's many other tools we can use to maximize revenue. And the data scientists and the algorithms take all of these factors into play in setting daily pricing and occupancy targets to try to maximize revenue.

That's helpful. And what are you seeing on the supply front? Given the strength of trends and they've remained strong, does supply pressure inevitably come back? And if so, how far away are we from that?

Really good question. So based on what we see on the ground that affects our same-store pool, so not national statistics, things we care about. We continue to believe that there is going to be some moderation of deliveries in 2021 from 2020, just like there was from 2019 to 2020. But that being said, I think we're going to see more development in the future. Just this week, I talked to two developers who had projects that did not hit underwriting, they were making no money, and they're selling them and they're getting bailed out by current pricing. And I asked both of them what they're going to do with the proceeds, and they said, we're going to go stick shovels in the ground. So between great fundamentals, low interest rates, lots of capital floating into the space, albeit I get that costs are higher, I think we're going to continue to see development, and it's going to be something we're going to have to deal with just like we've been dealing with for the past four or five years, no difference. That being said, I'd point out that one of the advantages of having a broadly diversified portfolio like Extra Space is we have exposures to many, many different markets, some of which are heading into a development cycle, some of which are coming out of a development cycle, some of which have never been affected by development. And all those markets are in some different stage. And because of that diversification, our returns are smoothed out.

Very helpful. And just if I can squeeze one last in. On the acquisition front, has there been any change in market conditions from the first to the second quarter? And are you seeing any new bidders?

I'm not sure there's new bidders from the first to the second quarter. I mean there's certainly a lot of new entrants in the market. It's hard for me on the top of my head to think about one that appeared in the second quarter. I don't see any material change. I think there's a lot of capital, interest rates are low, and self-storage has proven itself to be a great investment.

Are there any specific markets where you might be noticing initial concerns?

I think our list of markets is pretty similar to the list of markets we've had in the past. The boroughs of New York, we continue to be concerned about. And we continue because of that new development have results there that are below our portfolio average. Northern New Jersey, Atlanta, Vegas maybe a new market on the list we're starting to watch. Philadelphia also maybe a new market. Those are, I would say, the markets that where we have significant exposure that we're focused on right now.

I have a second question regarding the disposition side. Do you anticipate bringing more assets to market given the strong pricing trends?

So we closed the disposition of 16 assets into a joint venture. And we expect to close the second half of that transaction shortly to reduce our interest in the venture further. We have another 17 assets on the market now for outright sale. We have a couple ordinance that we're working on to get in a position to sell, but nothing major. And we're constantly looking at the portfolio and trying to decide what moves would be optimal to rebalance to have the right amount of exposure in different markets. So we'll always consider it, but that's what we have on the plate now.

Maybe just a question on the Bridge Loan Program. The guidance now assumes that you retain $100 million of Bridge loans this year, but it seems like you're running below that pace considering what you've closed and sold so far this year. So wondering if you can go through the outlook there and what visibility you have to activity in the second half?

Yes. That's a great question. So yes, we are behind initial projections in terms of timing. We are confident we're going to achieve our guidance. It is going to be more back-end loaded. We currently have $200 million worth of loans with signed term sheets and deposits to close in the back half of this year and the beginning of next year. So nothing is guaranteed, but I'm pretty comfortable we will get to our guidance.

Got it. Okay. And then just in terms of the customers, I know you mentioned that you're finding that there's lower vacates than you've had in the past. But just wondering if you could talk a little bit about the new interest that you're seeing for space that's helping that occupancy too. Do you have any insight into what's driving customer storage needs this year and how that compares to the past?

This response addresses a longer-term trend rather than just this year. During the pandemic, the primary reason people sought storage was due to moving, but that has changed. The main reason now has become lack of space, driven by needs such as creating a bedroom for in-home schooling, a workspace, or even organizing a garage. Customers facing lack of space tend to remain in storage for a longer duration compared to those who are just moving. This may explain the current decline in vacates. I believe not all customers will eventually remove their items from storage and revert their spaces back; some of them may continue to be long-term renters.

Just going back to the transaction market once more. Have you guys observed any shift in pricing spreads just in terms of quality or any notable outliers in terms of geography?

So we're not very, very active in tertiary markets. So it's hard for me to comment about that. I would tell you that for good stores in primary and secondary markets, there's very, very little spread in pricing.

So I think that you'll see us be a repeat issuer going forward. There's two or three things driving that. I mean, obviously, you're always looking at the rate, and you're trying to get the lowest rate possible. I think that we're looking to extend the tenure of our debt. And then we want to have as many capital sources as possible. So we are going to access the capital source that we feel like is the most advantageous to us at this time.

You talked about buying lease-up assets. So I was curious for the $500 million that's baked into acquisition guidance. Can you give us a sense as to what an average going-in cap rate or average occupancy would be?

I will discuss our recent deals because mentioning the deals we signed last year that closed this year may not accurately reflect current pricing. For the wholly-owned lease-up deals we have recently approved, the first-year yield is 3.1%, in the low 3s, with an average of 17 months to stabilization and an average stabilized cap rate of 6%. We are comfortable accepting this initial dilution because we are confident in our ability to underwrite lease-up and achieve those accretive returns. For the deals we've completed in ventures, the first-year yield to Extra Space, not at the deal level, is 7.2%, with an average of 13 months to stabilization and a stabilized yield of nearly 11%. This clearly demonstrates how the venture structure significantly enhances our returns.

Got it. And what's the typical occupancy on the wholly owned properties where you're seeing that 3% initial rate compared to the 7% for the joint venture? Is it similar in terms of going-in occupancy?

The occupancies were higher than expected, many in the 60s or 80s range. However, that's just physical occupancy, and we consider stabilization when both physical occupancy and rate stabilization are achieved. We have a few facilities with physical occupancies in the 90s, but they still require significant rate growth before reaching economic stabilization. Does that make sense? Did I explain that clearly?

Just going back to the ECRI questions that was asked earlier. Maybe thinking about the entire portfolio, number one, just what percentage does still have some sort of restrictions on it? Is it sort of 5%? Is it 10%? And the second question is, are you able to sort of charge even higher ECRI than you have historically given the rate environment?

I don't have the exact percent in front of me, but it's a small percent, a very low percent. So even in California, it's not a majority.

Got it. And then on the ability to push the rate increases, are you seeing sort of an ability to do it at a higher and faster level than historical, given sort of the record rate environment?

That is what we are currently doing. We're pushing things more towards street rate today, and part of that has to do with the fact that sometimes you've had rate caps in place or state of emergencies that have been in place that have hindered our ability to raise rates for the past 12 to 18 months depending on the location. And so we have brought them up more significantly as well as the fact that many of these customers moved in with very steep discounts that were unprecedented also.

So one of the things we've changed in our guidance this year is there is a $100 million piece of the preferred to JCAP that opens in the end of October, I believe. And our initial guidance had assumed that was outstanding for the entire year. And given how well the properties are doing, the company is doing, we have changed our assumption that, that gets paid off prior to year-end, reducing our dividend income from that. So I think it's a safe assumption that that company will want to retire 12% money as soon as it can.

I have two quick questions. First, I've noticed that the number of assets under management in the third-party managed platform dropped sequentially on a net basis. Do you view this as a regular fluctuation in the business, or was there something specific that happened during the quarter? Second, could you discuss the length of stay? In your previous call, you mentioned that it had shortened slightly. Is it starting to return to the historical levels you have seen?

So Smedes, I think you're right to observe that we have a lot of churn in our management platform. A lot of people are taking advantage of pricing in the market and selling. But even given that churn, we continue to grow that platform. We ended the year at 724 properties. We ended the first quarter at 763. We ended the second quarter at 768. And that includes 19 properties that left the platform that we bought. So we continue to grow that. We have a very, very healthy pipeline. We project to add net 100 to 130 properties this year. It's not guaranteed. We don't know what else is going to sell. But we continue to grow that quarter after quarter and expect to continue to do that.

Smedes, I think that also might be a little confusing when you look at the buckets. We're moving sometimes between buckets. And so when you take the total of JV and third party, it actually did move slightly as we had some JV partners sell some of the assets in the quarter. But the third-party management business, just the third-party management, actually saw a net increase. And then the second question, Smedes, on the length of stay. Our length of stay is now back up. We saw a tick down slightly and then it's back up today.

Just a follow-up on the balance sheet, which you noted is in a very strong position, 4.8x at the end of June. How should we expect that to trend? And where do you see capital going? And as a kind of a side question, how much in proceeds should we expect from the 17 assets that are now being marketed for disposition?

So the 17 assets that are being marketed for disposition are over $200 million. In terms of where we expect to spend our next dollar or where we expect to borrow, I think it will depend on the opportunities to invest. I think that we'll look at the cheapest cost of capital, whether that's debt. I think that we typically want to operate in that 5.5 to 6x. Today, we're sub-5. So we do have a lot of capacity there. And I think depending on the size of the deal, you would also consider equity at times. But right now, we do have a leverage capacity.

Okay. But the focus for incremental spend sounds like it's on acquisitions via the joint ventures, there's not necessarily new investments that could be used as you think about kind of taking the balance sheet to where you want to from a target leverage perspective?

So with the exception of the second half of the joint venture sale, that recapitalization, if you will, that I mentioned earlier, we believe future joint venture acquisitions will not be out of our portfolio; they'll be from the market. So it won't produce additional investable dollars for us. We'll invest a portion of the acquisition price.

I was just wondering on the expense side. I know marketing and payroll expenses were down. I was just wondering if you could give us some color on what's driving that and how sustainable that is going forward?

Yes. We have observed an increase in property taxes, which are currently running about 6% year-over-year. However, on the payroll side, there has been a decrease. This decline is attributed to a relatively easy year-over-year comparison from last year, where we were fully staffed for the first half and provided generous COVID benefits to ensure our employees were supported. Looking ahead, it remains to be seen how sustainable this decline in payroll will be. While we anticipate some benefits, it may not reach the levels we experienced in the first and second quarters due to expected wage pressure and tougher comparisons in the latter half of the year. For marketing, we also expect some benefits, but it can be unpredictable. If we identify opportunities to invest in marketing, we will take advantage of them if we believe it will lead to improved rates and occupancy.

I had a follow-up question again on the acquisitions. You guys gave some detail earlier about how in the, I think, wholly owned properties you were looking at the initial yield was 3.1%, stabilized was 6%, and then in the JV properties, it was 7.2% initial and stabilized almost 11%. I was just wondering if there was any real detail you could give us into what's driving that difference? Is it just fees that you earn in the joint venture or something else?

The main reason is that we receive the management fee from the joint venture and keep 100% of the tenant insurance income. This means we are holding onto all that income while making a much smaller capital investment compared to a full capital investment. In some ventures, we also earn acquisition fees or other types of fees. Additionally, we have the chance to earn promotes, and in some of our earlier ventures, we are indeed earning cash flow promotes, but this is not included in any of the numbers provided.

Got it. Okay. And then just maybe obvious, but in raising the acquisition guidance to the $500 million, then that just means that this year volume of transaction will be that much higher, just your portion is going to be $500 million. Is that it?

Correct. That's correct.

Two quick follow-ups here. First, I think the comments from earlier were that rate growth does not accelerate in the second half of the year, but the revenue growth for guidance for the second half of the year implies an increase versus the first half. And you talked about the contribution from occupancy gains diminishing as we move further into the back half of the year. So it would seem that rate growth is expected to accelerate. Can you just clarify those comments, or perhaps I misheard?

Yes. What I'm saying is that Q3 will perform better than Q1, which is holding it back. Q4 will also be an improvement over Q1. However, I'm indicating that growth won't be accelerating from where we are currently in June into July.

Okay. Okay. And then seasonally, what's typically the beginning of the off-peak season for you where move-outs are higher than move-ins? And are you expecting anything different from a seasonality standpoint this year with schools and return to schools relative to last year?

Peak occupancy typically occurs at the end of July. However, the actual peak is in mid-August. After that, we anticipate some decline as students move out, which is common given the usual student turnover.

Thank you. Thanks, everyone, for participating in the call and your interest and support of Extra Space. I mean, obviously, we're having a fantastic year. We have all-time high occupancy, exceptional new customer rate growth. We're continuing our innovative external growth strategies as well as innovating at the store level, and we expect to have a very strong same-store and core FFO growth this year. Thank you again, and have a good day.