Extra Space Storage Inc (EXR) — Q4 2021 Earnings Call Transcript

Thank you, Victor. Welcome to Extra Space Storage's fourth quarter 2021 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 24, 2022. The company assumes no obligation to revise or update any forward-looking statements because of changing market conditions or other circumstances after the date of this conference call. I'd now like to turn the time over to Joe Margolis, Chief Executive Officer.

Thanks, Jeff, and thank you, everyone, for joining today's call. It is incredibly sad to wake up this morning to news of war in Europe. Without ignoring the human loss and suffering this will entail, we are also thinking of how this tragic event will affect economic growth, oil prices, inflation, interest rates, and ultimately our business and our company. Events like this certainly give us some perspective on our business and our lives, and in some ways, make discussing the performance and outlook of our company less important. While we don't know how all of this will play out, we do know that historically self-storage has been a needed product in good and bad economic times, that the cash flow we produce is very stable, much more so than many other types of real estate, and that our company and balance sheet are structured and prepared to prosper in all economic conditions. Now turning to results. We had a remarkable fourth quarter to cap off another strong year at Extra Space Storage. Property-level performance was exceptional across the board. Same-store revenue growth in the quarter was 18.3%. Revenue growth was primarily driven by two factors: first, our same-store occupancy of 95.3%, which was a year-end high for Extra Space for the second year in a row. Secondly, strong new and existing customer rate growth. Expense growth remained in check at 2.5%, resulting in same-store NOI growth of 24.2%. We also had significant external growth in the quarter. We acquired 66 stores on a wholly owned basis or in joint ventures for a total investment from Extra Space of approximately $850 million. Total acquisition investment for the full year was $1.3 billion, primarily in relatively small transactions. We also closed $187 million in bridge loans in the quarter, bringing the annual total to $333 million. We continue to execute on our strategy to sell a significant portion of our lower-yielding first mortgage balances to our debt partners. We also continue to acquire properties originally sourced through our lending platform. To date, we have acquired 15 properties sourced through loans for $181 million. We added 69 stores to our management platform in the quarter for a total of 265 stores for the full year. To give context, including acquisitions, we onboarded 1.3 properties per business day in 2021. We experienced higher dispositions with more stores leaving our platform due to third-party owners selling properties, but we were able to buy 58 of these either wholly owned or with one of our joint venture partners. Our property NOI plus our external growth efforts resulted in core FFO growth of 29.1% in the quarter. I am proud of the Extra Space team. There are many contributions to our growth in 2021, and for how they have positioned us for another strong year in 2022. We are also proud to have been recognized not only for our performance, but the sustainable nature of the company we have built. For the second year in a row, we were named one of NAREIT's leaders in the light for our sustainability efforts, and we are proud to be the only storage company to have received this award. Looking forward, industry fundamentals remain very strong. Occupancy levels remain at historically high levels, resulting in elevated pricing power to new and existing customers. Despite very difficult comparables, the strong market fundamentals and our team's ability to execute give us the confidence to guide to double-digit same-store revenue growth again in 2022, and FFO growth of over 13% at the midpoint. In light of this strength, we raised our dividend to $1.50 per share, a 50% increase year-over-year. We are off to a great start in 2022, and we expect another exceptional year for Extra Space Storage. I would now like to turn the time over to Scott to walk through some of the details of performance in the fourth quarter as well as our 2022 guidance.

Thanks, Joe, and hello, everyone. As Joe mentioned, we had a great fourth quarter and year with our 2021 core FFO coming in $0.06 above the high end of our guidance. Our outperformance relative to our guidance was driven by property performance and higher-than-expected interest income, partially offset by higher-than-expected interest expense. Our external growth in the quarter was capitalized by $210 million in sales proceeds from the disposition of 17 stores. We also issued $276 million in OP units, and we drew on our revolving lines of credit. Our balance sheet has never been stronger, and we will term out our revolving balances through future unsecured debt issuances. Currently, only 8% of our debt matures over the next two years. And our focus will be to lengthen our average debt maturity and to further ladder our maturing balances. Our unencumbered pool is now over $12 billion, and our net debt to trailing 12 EBITDA is at 5x. We continue to have access to many types of capital, giving us significant capacity for future growth. Last night, we provided guidance and annual assumptions for 2022. Our new same-store pool includes a total of 870 stores, a relatively small net increase from last year with new additions partially offset by sites removed due to disposition or redevelopment. Same-store revenue is expected to increase 10.5% to 12.5%, driven primarily by rate growth. Same-store expense growth is expected to be 6% to 7.5%, primarily driven by higher payroll, marketing expense, and property tax expense. Our revenue and expense guidance results in a same-store net NOI range of 11.5% to 14.5%. The acquisition market continues to be competitive, and we will remain disciplined but opportunistic. We plan to continue our strategy of looking for off-market opportunities and plan to capitalize a portion of our acquisition volume with joint venture partners. Our guidance assumes $500 million in Extra Space investment, approximately half of which is already closed or under contract. We also expect to close $400 million of bridge loans and plan to retain $120 million in new balances in 2022. We have plenty of capital to invest if we find additional opportunities that create long-term value for our shareholders, and we will continue to be creative as we deploy capital in the sector. To support our 2021 and 2022 property growth, we made significant investments in our people, our infrastructure, and our technology. This resulted in higher G&A expense in the fourth quarter, and we anticipate a higher run rate in 2022. This is primarily driven by payroll and technology research and development, which will advance initiatives that will support our growth for years to come. The return of historical G&A expenses temporarily paused during the pandemic also contributes to this increase. Our core FFO is estimated to be between $7.70 and $7.95 per share. We anticipate $0.23 of dilution from value-add acquisitions and Certificate of Occupancy stores, up $0.12 from 2021 due to the significant acquisition volume of non-stabilized properties in the fourth quarter. Interest income will be somewhat weighted to the first quarter due to the timing of note sales and potential modification of our NexPoint investment. 2021 was a great year for Extra Space, and we are already on our way to another strong year in 2022. With that, let's turn it over to Victor to start our Q&A.

Good morning everyone, and congratulations on the quarter and the year. Joe, I have a quick question regarding your acquisition strategy. If I remember correctly, you guided for about $700 million at the end of the third quarter, but you achieved $1.3 billion. What kinds of opportunities are you currently seeing and have already closed on, around $250 million so far this year? What gives you confidence or hesitation about the $500 million target you mentioned, and do you think you might exceed that as the year continues?

Great. Thank you, Elvis. We experienced a significant number of year-end tax motivated transactions in the fourth quarter, which we successfully executed. Most of these transactions involved single properties or small groups of properties. Additionally, we were able to complete one larger portfolio deal, even though we were not the highest bidder. By offering the seller some tax deferment through OP units and shares, we successfully captured that transaction as well. As we look ahead, our target of $500 million is an estimate, and we are well on our way to achieving it. If more deal opportunities arise, we have various capital sources and debt capacity ready to support those, and we will pursue them. However, our guidance remains at $500 million.

Then just as a follow-up, are you able to share a cap rate on your 4Q acquisitions?

Almost all of our acquisitions in the fourth quarter were in the lease-up stage. On a wholly owned basis, the first-year yield, which includes management costs, capital expenditures, tax reassessment, and our expense structure, was in the low to mid-3s for the first year. We stabilized in the mid-5s after about 15 to 17 months on average for those deals. When similar deals are structured as joint ventures, you can add 200 to 225 basis points to those figures, resulting in a first year yield in the mid-5s and stabilization in the high 7s.

Great. And then for my second question, maybe for Scott, can you talk about the floating rate debt in your portfolio? I know you mentioned potentially doing an unsecured deal sometime this year to term out some of the line of credit debt. But can you talk about the overall variable debt as a part of your structure, and how comfortable you are given the rise in rates?

Yes. I mean, obviously, you prefer rates to be falling, but they're rising today. So part of our strategy has always been to have some component of variable rate debt. We typically have operated 20% to 30% variable rate debt. It gets a little higher when we have more drawn on our lines of credit, and we are terming some things out. This year, we have about $535 million drawn at the end of the year. So that caused us to be about 25% variable rate debt. As we look forward in ways that we hedge, one of the natural hedges that we do have is we do loan money. We have these bridge loans and different types of investments that are variable rate instruments. So there is somewhat of a natural hedge on a portion of that, but we also will look to term out our draws on our line of credit this year through the bond market.

Just wanted to ask what benefit, if any, is assumed or expected from the lifting of rent restrictions? Maybe if you can give us any color on where that represents the most upside?

Sure, Juan. So the short answer is we believe that the lifting of the state of emergencies in California will give us about 50 basis points across the portfolio in lift. And obviously, there's a lot of assumptions to go into this, primarily what's the length of stay, the future length of stay of the tenants who have gotten these increases. So our guidance assumes 50 basis points.

And that 50 is revenues, I'm assuming?

Yes.

Okay. And then just talking on the expense side, could you flush out a little bit about how much ballpark you're expecting kind of the major line items to move for '22 that's embedded into your guidance?

Juan, our guidance assumes close to 7% on the payroll number, and that is not only wage inflation, but that is operating more closer to fully staffed. Last year, you actually had negative payroll, so it's a really tough comp. And then property taxes, we're assuming about 5.5% growth. And then marketing, about 10% growth.

You had a very strong 2021, with nearly 20% same-store NOI growth and 14% same-store revenue growth. I'm curious about how much of last year's gains are impacting your guidance for the upcoming year. It's apparent from your insights and those of your peers that the solid performance in 2021 is shaping expectations for 2022. Based on your same-store revenue guidance of 10.5% to 12.5%, and considering that comparisons will be much tougher in the latter half of the year, how should we view the performance for the upcoming year when comparing the first half to the second half?

Yes, a strong performance in 2021 affects our results in 2022 for several reasons. One reason is our high occupancy rates, which provide us with pricing power, especially since demand remains strong. Additionally, as we raise rates and bring in new tenants, it takes time for that to reflect in our overall performance. The new tenants we added in the latter half of 2021 will contribute to our growth throughout 2022. We also noted the ECRI impact. However, while we anticipate solid performance throughout the year, the comparisons will be more challenging in the second half. As a result, growth rates will moderate, even though we expect to perform well overall. Can you help clarify whether we start the year at the high end or low end of guidance, or if there will be a larger difference?

Yes. So we obviously finished the fourth quarter really strong. So we would expect the first quarter to be our strongest quarter. We would expect our first quarter to be really good. I mean, we don't see it moving down significantly, partly because you had easier comps from last year. And then that rate of growth declines throughout the year as we get tougher comps. We don't expect rates necessarily to go backwards, and we expect to have pricing power, but the comp to be more difficult, therefore, the rate of growth to decline as we move through the year.

Understood. And as a follow-up, we touched on a little bit on existing customer rent increases. For 2022, is there any change in your approach to them given the environment, given the environment, are you looking to push the magnitude of rent increases harder or more frequently or maybe pull some rent increases up prior to the peak leasing season? Just trying to get better understand the level of confidence surrounding the same-store revenue growth that's driven by the rate piece.

So with respect to ECRI, we're coming off a period where it was really unusual, where we voluntarily stopped where we were restricted by the government for a long time, where we had outsized rent growth, which increased the gap between what people were paying in current street rate. I would imagine in '22, we would get back to a more normalized protocol for ECRI. What was the second half of the question? Do you remember, Scott? Can you repeat the second half of the question? I'm sorry.

It was about the frequency and size of rent increases. Would you consider implementing some rent increases before the peak leasing season to create vacancies, given that this is when you have the greatest potential for attracting the most tenants?

Yes, I apologize for making you repeat that question. We are always focused on maximizing revenue and avoiding vacancies. Therefore, we do not intend to create vacancies. We anticipate having more vacancies during peak leasing season, but we experience natural churn every month and have the opportunity to increase rates for existing customers. Our goal is to continuously maximize revenue without concentrating on specific months of the year.

So going back to your capital deployment, obviously, you guys had a pretty robust quarter in 4Q. Also just curious, high level, did you just end up seeing more deals fitting your bull's eye? Or did the size of your fully change? And similar question for your C of O deals, I noticed that your C of O pipeline really expanded noticeably, similar question there.

So I think if you look at the pattern of acquisitions in any year, it's back-end loaded. I think there is a seasonality. And it was probably more pronounced this year. And we just saw more deals that made sense. We didn't change our underwriting or our discipline. We just happened to be able to capture more opportunities. And we do have more Certificates of Occupancy now. We did see more of those opportunities that made sense for us. But again, nowhere near where we were in '16, '17, '18.

Got it. And implicit in your 2022 same-store revenue guidance, what are you thinking for street rate growth compared to what it was in 4Q?

So we'll see in terms of street rate growth for the year. I can tell you a little bit about our assumptions and what we're seeing in the first quarter. So our achieved rates in the first quarter so far have been very similar to the fourth quarter. Our achieved rates were up 20% in the fourth quarter. We're seeing that into this year. We haven't seen significant degradation in occupancy. Our occupancy is slightly below where we were before. Our rate of growth will slow in terms of street rates. And what I mean by that is we pushed rates as much as 20% to 40% depending on the month, depending on the comp from the prior year. We don't expect that in 2022. So we don't necessarily think that we will decrease rates, but we do not expect that kind of growth in 2022.

Could you provide a bit more detail or any kind of range you can share?

They're going to be better in the first quarter than in the back half of the year. I think that's really all we can provide. And part of that has to do with the comp in the front half versus the back half of the year.

I was just wondering, so you sold like $200 million of properties. I was just wondering if the reason for selling them was it just really good pricing? Or was there any strategic reason for that?

I would say both. I mean, we always look to optimize our portfolio and either select markets or individual assets where we prefer to have less exposure. And to do so in a period of time where cap rates are at historic lows is very advantageous. We sold about half of our sales we did last year into a venture where we were able to keep management, and some exposure to those assets. And the other half we sold outright, but we're able to keep management of 12 of the 14 properties. So I think it's both a strategic play and also happened to be good market timing.

I was wondering if you could talk about the contribution to FFO that's embedded in the guidance from non-same-store growth in '22? And can you share how much of an NOI yield, the increase that you're anticipating on the non-same-store?

So to make sure I understand the question, you're trying to understand where the growth is coming from in addition to the property NOI. Is that regarding the contribution outside of non-same-store or the property?

Yes. Outside of the same-store, I think in the prepared remarks, you mentioned sort of a mid-3 initial yield stabilizing in the mid-5s on what was acquired during the full year, plus some other non-same-store assets, C of O deals, etc. What's sort of embedded in the guidance for NOI yield uptick that you're anticipating on the non-same-store in ‘22?

Yes. A good way to consider this, Todd, is by looking at the same-store performance, where our NOI is at the midpoint which is 13, and then comparing it to our slightly higher FFO growth. Essentially, the non-same-store properties are responsible for the increases in G&A and interest expense. It balances out overall. So while G&A and interest expenses are rising, there is also some dilution from the lease-up stores we acquired at the end of last year. This year, we are looking at $0.23 compared to the dilution we experienced last year.

Okay. And for the management fee and tenant reinsurance income growth, the guidance there. What's that based on in terms of net growth to the third-party management platform? I mean how many ads are you anticipating throughout the year?

So management fees and tenant insurance both increased by the increase in joint ventures from last year, as well as an additional 100 stores net is what our guidance assumes for next year.

Okay. So up 100 stores net in '22. Got it. Okay. And then just lastly, I think, Scott, you mentioned when you were talking about where achieved rates were year-to-date and similar to the fourth quarter, I think you mentioned that occupancy slipped just a little bit here to start the year. Can you just tell us where occupancy is today and what that year-over-year spread looks like?

Your spread is slightly negative. To clarify, you're around negative 40 basis points year-over-year, but you're also looking at a new same-store pool. We want to ensure we're not trying to pinpoint the exact amount. Additionally, occupancy isn't our main focus. We believe this is still a strong position for us. Currently, with 94.6% occupancy and pushing rates as heavily as we are, occupancy is just one aspect of this.

Scott, just on the occupancy question. I mean, what are you baking in sort of in the second half of the year, sort of that summer peak to end of the year decline?

Yes. While I cannot provide specific occupancy figures, I can share some insights. We do not expect to see any benefits from occupancy in 2022. Last year, in 2021, we experienced a 250 basis point improvement from occupancy. I believe we are finishing this year slightly down compared to where we started. However, we did not gain any benefits in occupancy this year, and we still view occupancy as remaining strong in 2022.

Okay. Regarding the guidance for general and administrative expenses, it did increase by around $20 million. I'm trying to determine if there are any one-time costs included in that. I understand you mentioned the payroll adjustments as we return to normal and also talked about technology investments. Is there anything one-time in nature that we should consider as we look ahead to 2023?

I'm not sure if they're onetime in nature, but we're certainly making longer-term investments that don't have an immediate payoff. So our company is growing very fast. And we're making investments in infrastructure that will facilitate continued growth at the pace that we want. And we're also making certain technology and research and development investments that won't add anything in 2022. It will be long-term beneficial and accretive. The flip side, which I don't think is temporary or is the increasing payroll. I think we're just in a new payroll environment, and that's going to be ongoing in my opinion.

I wanted to ask more about the outlook for acquisitions, as you and others have noticed a market slowdown compared to last year's heightened activity. I'm curious if you're observing any changes in the quality of the assets available for sale, whether there's simply less available, if this is a strategic pullback on your part, or if you could discuss what you're seeing and how things have changed since last year.

Smedes, as I said earlier, I think there's a seasonality to this, and there's a natural slowdown early in the year. We are still the market for sale. I don't think quality is very different than it was last year and prior years. There's some stuff of good quality and some stuff of less quality. But I think your overall thesis is right. It's hard to imagine that the volume in 2022 will match 2021. That was just an enormous year in number of transactions. I'm talking about the industry, not necessarily for us. The length of stay has steadily increased from the beginning of the pandemic to now. We're now at about two-thirds of our customers have been with us over one year, and maybe 42% or 43% of our customers have been with us longer than two years, and those are absolute all-time highs. We've never had that level of long-term customers in the portfolio.

Maybe just a question on supply. Wondering if you guys could go through your current expectation for supply in '22 and maybe even '23? And how much visibility you think you have at this point? And what's shaping those views?

We are observing a decrease in supply. When we consider new deliveries affecting our stores, we are not looking at national statistics or markets outside our reach. Over the past three years leading into 2022, there has been a consistent decline. In 2019, 28% of our stores were impacted by new supply; that figure dropped to 23% in 2020 and 20% in 2021. Our best estimate for 2022 is around 18%. New supply is still present, as stores continue to be delivered, and we have the opportunity to manage a significant number of these, which is beneficial for us. However, the trend is moderating. I cannot make predictions for 2023 yet, but I am worried that due to the impressive performance of the asset class and the influx of capital seeking storage opportunities, we might see an increase in new development. We are prepared to manage through this, as we have done in the past, and it will create opportunities for us, either through managing stores, participating in Certificate of Occupancy deals, or providing bridge loans. That said, I wouldn't be surprised to see the current trend of decreasing deliveries change in 2023.

Got it. Okay. And then maybe just following up on some prior points. I know you mentioned you don't expect the same amount of rent growth in '22 as '21. But with such high occupancy and rents, what are you currently seeing in terms of price sensitivity of customers? And maybe how that ends up impacting whether they decide to stay or go?

Well, we certainly track folks who vacate after they get rent increase notices from us, and that has increased over time. So as we have sent out these notices, we see more tenants vacating because of that. But that's not problematic for us because it's not to a number yet that it doesn't make sense to hand out the rate increases. And demand is so strong. We're very easily able to backfill those tenants.

Just wanted to touch on interest rates and cap rates. The market is certainly expecting a number of rate hikes this year. I imagine you haven't seen that bleed into the transaction market just yet. But how quickly would you expect cap rates to rise in a rising rate environment, just given as you mentioned before, there is a lot of new capital that's seeking storage exposure.

Well, it's the right question, right? And traditionally, as interest rates go up, cap rates go up. But the fact that you mentioned that there's so much capital looking to invest in self-storage may cause that to lag, may cause rates to go up and cap rates not to react immediately. But it's an unknown and a very important question.

And to that extent, if we were to see cap rates rise and perhaps your cost of equity capital mostly unchanged, would that entice you to be a little bit more aggressive on the acquisition front?

Sure. If our cost of capital was the same and cap rates went up, that would spur us to be more active.

And one last question real quick on migratory patterns and just national mobility is sort of a number of market participants cite that as a demand driver in the last several quarters. There also seems to be some data out there from the residential side that seems to suggest that moving activity really hasn't materially changed since pre-COVID levels. Is there something specifically sensitive was brought on about moving activity that has led to customers being a little bit stickier than they have in the past?

So I would posit that the stickier customers are not the moving customers. The customers where we've seen length of stay increase the most are the customers that cite lack of space as a reason for storing, not those who cite moving. So kind of a simple example is the individual who turned the extra bedroom into a home office or room for kids to go to school, and tend to be slower to turn that back to what it was. If they do it at all, then someone who's moving at some point doesn't need the storage anymore.

Most of my questions have been asked, but I just wanted to go back to the comment on sort of the expiration and the contribution to same-store revenue. I think you talked about 50 basis points. Hoping we can get a little bit more color. Is that mostly L.A.? And maybe what do you think is sort of the mark-to-market on that part of the business with these expirations?

Yes, I apologize for any confusion. The 50 basis points came from California, primarily due to the lifting of the state of emergencies in L.A.

Got it. Can you provide any insight into the level of conservatism reflected in that? Do you have any estimates for the mark-to-market on that portfolio and how it compares to the rest?

The mark-to-market being the gap between in-place and what we're raising people to? So we sent out rate increase notices for those tenants. And we obviously know what that all adds up, but it's not a number we're revealing this year.

Yes. Just a couple of quick ones here. First of all, I know you talked about yields on fourth quarter acquisitions, but what was the average occupancy for what you acquired in the fourth quarter? And then is the focus in '22 to buy assets with a lot of lease-up potential as well?

I will address those questions in the order they were asked. Yes, I believe most of our opportunities in 2022 will involve stores that have some lease-up potential and value-add aspects. I will check the average occupancy quickly, but I don’t expect it to be a significant figure. Often, stores with high occupancies may appear to be stabilizing, but they aren't economically stabilized. High occupancy can result from leasing at below-market rates, so the real potential lies in increasing rates to market rather than significantly improving occupancy.

Got it. That makes sense. I have one more question. When you're considering a Certificate of Occupancy deal, how does the target return compare to what you would typically see in an operating property that has a significant amount of lease-up potential?

So it kind of depends on time, right? So if you are looking at a C of O property that you think is going to stabilize three years out, just to be simplistic, and you compare that to a lease-up property that stabilizes 24 months out or lease-up properties that stabilizes 12 months out. Obviously, for each of those, you want to be compensated a little bit more for the additional time that it takes you to get there. So your yield will be highest on the Certificate of Occupancy and lowest on the property that stabilizes in 9 months or 6 months. And then the other factor is our view of the risk of achieving those numbers and other maybe strategic factors to buy in the store or not buy this.

Just wondering if we could dive in a little bit more of the R&D expense side of things for tech. Can you some more color on the investment, how it's being allocated, and maybe how it compares to your historical average?

Could you ask that question again, please?

Yes. So with regards to your tech spending on R&D, just kind of curious if you can give us any color on how it's being allocated and how it relates to your historical average.

So I would say it is higher than it has been historically. And in terms of getting into the details of what we're investing in things like that, we feel like it's probably not something we'd talk about on a public call because we feel like it's something that gives us a potentially competitive advantage.

Got it. I guess just from our seat then, I mean is it fair to assume that maybe some of these investments over the longer term can sort of mitigate and offset some of your future payroll expenses that you're expecting to be permanent?

So I would say that's a part of it. We certainly are looking to become more efficient and have the right amount of staffing at various stores. But in no way are we giving up on store managers or don't value our store managers or understand the importance they have on the revenue line item, and what they add in terms of increased revenue at the store and taking care of the store, etc. I would also say that's probably a minority of what we're focused on in terms of kind of innovative ways to participate in this business.

Scott, just a quick follow-up on the marketing spend. You said plus 10% year-over-year. Can you share how the impact of the privacy changes that are happening with cookies, etc., are impacting sort of your online word search spend?

Yes. It's not impacting us as of now.

Great. I want to thank everyone for your interest in Extra Space, and for your good questions today. Clearly, we are in a very healthy business. We're set up very well for 2022, and we're excited to talk to you about our performance throughout the year. Thank you very much, and have a great day.