Extra Space Storage Inc (EXR) — Q2 2023 Earnings Call Transcript

Thank you, Latif. Welcome to Extra Space Storage's second quarter 2023 earnings call. In addition to our press release, we have furnished unaudited supplemental financial information on our website. Please remember that management's prepared remarks and answers to your questions may contain forward-looking statements as defined in the Private Securities Litigation Reform Act. Actual results could differ materially from those stated or implied by our forward-looking statements due to risks and uncertainties associated with the company's business. These forward-looking statements are qualified by the cautionary statements contained in the company's latest filings with the SEC, which we encourage our listeners to review. Forward-looking statements represent management's estimates as of today, August 4, 2023. 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. And I would now like to turn the call over to Joe Margolis, Chief Executive Officer.

Thanks, Jeff, and thank you, everyone, for joining today's call. We have had a busy three months and a lot has happened since our first quarter earnings call. Operationally, same-store occupancy remained high through the second quarter. Although rental volume was down year-over-year, vacates also remain muted, allowing us to improve occupancy sequentially each month through the quarter, ending June at a very healthy 94.5%. The existing customer health remains strong with ARs and bad debt levels remaining low and customer acceptance of rate increases remains steady. Our strategy coming into the year was to maintain high occupancy in order to enhance pricing power to new customers as we moved into the leasing season. This strategy was effective through May, and we improved rental rates sequentially and started to tighten the year-over-year negative delta and achieved great growth to new customers. However, new customer rates have not improved meaningfully in June and July, both of which are typically high-volume rental months in a busy leasing season. The miss in same-store revenue in June was offset by lower-than-expected same-store expenses, allowing us to remain on budget for property NOI for the first half of the year. From an FFO perspective, we also met our internal budgets for the first and second quarter. As we look forward, we expect the impact of lower new customer rates in the summer months to weigh on revenue growth in the back half of the year. Our initial guidance assumed that we would fully close our negative year-over-year new customer rental rate growth gap by July, and that new customer rate growth would be positive through the end of the year. Year-to-date, we have not gained that pricing power and now believe new customer rate growth will remain negative year-over-year further into 2023. As a result, we have reduced our 2023 same-store revenue expectations. Our lower estimated property revenue, together with a higher forward interest rate curve also reduced our full year outlook for core FFO. Needless to say, we are disappointed that rental rate growth to new customers has been weaker this leasing season, and we never liked the idea of having to reduce our outlook. With that said, we are also careful to maintain perspective about where Extra Space and the storage industry actually sit today. First, occupancy levels remain just below 95%, which excluding the last couple of years, are as high as we have ever seen. Second, new customer rates, while not as strong as last year, remained 15% higher than 2019 pre-pandemic levels. Third, new supply continues to be manageable and the headwinds to future new development are increasing. And finally, our external growth drivers continue to fire on all cylinders with 54 additions to our third-party management platform in the quarter and 102 stores added through two quarters. On July 20, we closed our merger with Life Storage, adding over 1,200 stores to our portfolio, which today has over 3,500 stores spanning 43 states. I am proud of both teams who have worked tirelessly to complete the merger to create a stronger portfolio, platform and company. We are all focused and working hard to achieve a smooth integration. So far, I am very pleased with how seamlessly the integration is progressing and how we are already finding ways to create value and unlock synergies. Let me provide a couple of examples. In the two weeks since we closed the transactions, we have onboarded and trained over 2,700 LSI employees and already transitioned over 900 stores to our point-of-sale system with the remaining stores to follow next week. This move to our point-of-sale system is critical because, among other things, this platform allows us to implement our digital marketing and pricing strategies, which will allow us to begin to optimize performance at these stores. And second, last week, S&P Global raised our credit rating to a BBB+ to reflect our larger and stronger company, which will have an immediate and future benefit on our cost of debt capital. So while we have just closed and we know it is still early, we are excited as we begin to realize the many future opportunities this merger creates for Extra Space and our shareholders. We will continue to give updates on the integration and performance of the Life Storage assets as well as our progress towards our $100 million in minimum estimated synergies. After some short-term dilution expected during the remainder of 2023, we believe we will be at least in our underwritten synergy run rate early in 2024 with additional upside beyond, as we continue to optimize the performance of the combined company and capture additional synergies not quantified in the original underwriting. It is still a great time to be in storage, and I believe the future of Extra Space remains bright. I will now turn the time over to Scott.

Thanks, Joe, and hello, everyone. As Joe mentioned, we had another solid quarter, meeting our internal same-store NOI and FFO projections. The slight shortfall in property revenue in June was compensated by savings in expenses, along with small increases in interest income, general and administrative costs, and higher management fees, though countered by increased interest expenses and lower tenant insurance. After reducing our year-over-year rates for new customers to negative 3% in March, we relaxed our rates slightly, averaging around negative 8% in April, which resulted in higher rental volumes. We experienced similar gains in May, but rental volume slowed in June and July, even though new customer rates remained about 10% lower year-over-year. On the expense side, we are doing well with minimal growth in payroll and property taxes, and marketing expenses are in line with expectations. However, we've faced increased pressure from rising insurance premiums in the property and casualty markets, with an average increase of around 50% in our June renewals. Regarding our balance sheet, we completed a $450 million bond offering during the quarter and revamped our credit facility, increasing our revolving capacity to about $2 billion in preparation for the Life Storage merger. We also secured a $1 billion term loan with a delayed draw that we accessed at closing to settle Life Storage's line of credit, private placement debt, and other closing costs. In last night's earnings report, we updated our 2023 guidance for same-store growth and core FFO, excluding the impact of the recently finalized merger with Life Storage. Due to the close timing between the merger's closure on July 20 and last night’s update, we provided standalone guidance for Extra Space, excluding the merger's impact, along with details on the expected dilution from the merger for the remainder of 2023. While we met our internal projections for same-store NOI and core FFO, we've adjusted our future estimates downward due to weaker-than-expected pricing power and rental volume in June and July, along with the increase in the forward interest rate curve. Our forecast for same-store revenue growth, excluding the LSI assets, is now 2.5% to 3.5%. We have also lowered our same-store expense range to 3.5% to 4.5% because of better-than-expected performance in payroll and property taxes, leading to a revised NOI range of 2% to 3.5%. We expect the rate of revenue growth deceleration to continue to stabilize in the latter half of the year with easier comparisons. Our core FFO range, not including the effects of the LSI merger, is now $8.15 to $8.35 per share, primarily due to lower property revenues and higher anticipated interest rates. For the Life Storage merger, we foresee initial dilution in 2023 as we integrate and optimize the portfolio to capture anticipated synergies, estimating a dilution of $0.10 to $0.15 per share in 2023, with expectations to reach our $100 million run rate by early 2024. We have included details of Life Storage's second-quarter performance in our supplemental package and will provide further updates on the performance of the LSI assets moving forward. We still believe that storage remains one of the most resilient asset classes in the REIT sector. We are confident that our operating platform and highly diverse portfolio have become even more robust through the Life Storage merger, positioning us for substantial growth. With that, Latif, let’s open the floor for questions.

Good afternoon. Thanks a lot for taking my questions. It seems like the largest driver of the reduced guidance is that street rates didn't converge with last year, which is weighing on results in the back half, so two-parter here. One, what's assumed for street rates for the back half of the year? And two, this is expected to weigh on the results in the back half of '23, what is the expected impact from this on 2024 operating metrics?

So I think we see - the biggest difference we see in the back half of the year, frankly, is the comps get a lot easier. So we kind of see a continuation of modest growth, but with much easier comps. What was the second question, Michael?

So you see any impact on the street rates are weighing on the second half of '23, is there any impact from that into 2024?

So we are not talking - we don't have any guidance. I'm not talking about guidance to 2024 yet. But clearly, where you end '23 is your... sorry to give a stupid answer, as a starting point for '24. So that will be the impact.

And just to clarify on the first question, like by growth, you mean you're expecting a slow convergence of '23 street rates to '22 levels and you expect that to converge sometime in the back half? Do you have any visibility? Like is that early? Is that late? Like just ticking for sort of just relative placement there.

Yes. We had thought by June, July, we would have had that conversion point, and now we think it's further into 2023.

Okay. Got it. And then my second question here is that given that a majority of the revenue synergies are driven from revenue - or given that a majority of the entire synergies are driven from revenue. What gives you confidence that you can achieve your $100 million of run rate synergies in early 2024? Thanks.

So on the revenue side, as I mentioned in my comments, we have 900-plus stores on our point-of-sale software, and the ECRI notices have started going out. And we have a very detailed plan customer-by-customer, when do they get their last one, where their rate is, on street rate, not to overload any store, but that has started. And next week, we'll have all the rest of the stores on the breeze and those ECRI notices will go out. And the confidence we have is because we've done this all the time. We take over stores all the time that have rates below where we want them and we send out ECRI notices, and we know the acceptance rate and the churn rate, and it gives us a high degree of confidence that's going to work. On the insurance side, once we're on breeze, new customers will purchase insurance from our platform, which is at a higher rate than LSI's program was and existing customers won't be converted until January 2024. Those notices will go out. And that delay is for both regulatory reasons and notice requirements in the existing LSI contract with their insurance provider. And then the third biggest kind of segment of the $100 million is the G&A side. And we've now sharpened our pencils, hired who we want to hire, redone budgets department by department and have greatly increased confidence we will exceed the underwritten G&A savings.

And apologies for keeping that going. But just to clarify on the ECRIs. I think you said in the script that customers are continuing to absorb them. That said, easier eyes can be highly dependent on the trajectory of street rates. So is it a trajectory of street rates? Is that going to impact your ability to pass along ECRIs in the near to intermediate term?

So I don't think that's going to be a significant impact. So you're right that street rate is a factor in the quantum of the ECRI that's given. But the gap between the rate at the LSI stores and the rate at the competitive Extra Space stores gives us confidence that there's still plenty of meat on that bone.

Got it. Thank you very much.

Great. Thank you. First question, I guess just taking a step back, and listening to the comments on what you thought would happen versus what actually happened to understand and feel comfortable with the new guidance? Like why did you - what were the systems telling you, let's say, in the spring or early summer, that you would close the gap to actually what happened and then compare that to now what the systems are saying for the rest of the year?

Yes, Jeff. So what we were seeing earlier in the year was we were seeing our street rates or our achieved rates to new customers steadily moving up, and we were seeing that our occupancy gap was maintaining what we were expecting. That was pretty consistent through May. As we moved into June, we found that in order to maintain our occupancy, we needed the lower rates. And that continued into July. And so into July, we were negative 10.5% whereas in the second quarter, our rates were averaged about 8% negative to new customers. So just that change in customers being shopping more and being much more rate sensitive is what caused us to change our outlook going forward.

Okay. Thanks. And then on the rental volume comment, Scott, I think you said rental volumes slowed in June and July, obviously. I guess trying to tie that into one of your competitors' comments on record move-ins, I guess what is the health of the top of the funnel, like new customer traffic? Like what are we seeing today, let's say, as we started August? And how should we think about that in terms of seasonality as we head into the coming months?

So there's plenty of self-storage customers out there for the larger operators to capture, right? We're at 94.5% occupied. Obviously, we can keep our stores full. The challenge is there's not sufficient enough customers to give us pricing power. We can't move rates and maintain that type of occupancy to the level we wanted to. So our year-over-year rentals were down 9% in the second quarter, so were Life Storage for comparison purposes. But vacates were also down a little less than that, but a similar number. So there's customers out there, our platform can capture them, but we don't have the pricing power we expected.

And Jeff, maybe where we vary a little bit from some of the other reports that have been out there is while they may see increases in rental, some of it could be what happened last year and also what their new rate is moving in. And I think some of them reported a wider gap than what we have even experienced.

I'm sorry, but could you clarify the specific month or time frame regarding the easier comparisons you mentioned towards the end of this year? Will the easier comparisons extend into 2024?

Yes. So the easier comps do continue into '24 as rates moderated in the back half of last year in terms of our rates to new customers, they continue to moderate it back half of last year and into this year. In addition, you have an easier revenue comp this year than you had from last year. Our revenue growth in the first half of 2022 was almost 22%.

Thank you.

Thanks Jeff.

Thanks Jeff.

Thanks. I guess, good morning. It seems like the light switch went off in June or July. And I'm just curious, can you guys put your finger on what sort of changed customer behavior that much to change the pricing dynamic in June?

I don't think we can. We had an odd March. We couldn't figure that out as well. We've talked about that. We were feeling really good at the end of May, and there was a distinct change in customer behavior in June and July, and I would be guessing if I told you I knew what it was.

I mean, do you think it's housing related? Is that maybe just the lack of movement in housing creating more less demand than you would have thought?

I think housing is certainly a factor, right? That's one important component of demand for self-storage, and we all know the housing market story. I think another factor is consumers don't have as much money in their pocket, right? If the savings rate is way down, all the extra COVID dollars that were floating around have gone away. There's inflation in the economy. I think consumers have fewer dollars as well.

Okay. And I guess, secondly, if you kind of look at the implied guidance for the second half of the year. If I'm doing my math right, I think the revenue growth is kind of 0% to 2%, which compares to the 2.7% you did in the second quarter. So maybe, Scott, just help us think through like what gets you to kind of the upper end of the range and what gets you to the lower end of the range? Is it more occupancy driven? Is it more the new rates, the customers, the slowdown in ECRI? Like what are the big drivers between kind of the low end and high end, do you think from -

The biggest drivers, I think, are when we move positive in terms of achieved rates to new customers. And as we mentioned before, we do have an easier comp from last year. But I think that where you fall in that guidance is when those new customer rates move positive and you start to have a little bit of pricing power to new customers.

So, I'm sorry, is there any of that embedded in the guidance for the back half of the year? Or is it like at the high end that assumes that and the low end it doesn't?

Yes. So, the low end assumes that you don't get pricing power, the high end assumes that you start to get some of that pricing power. And it's probably more in the back half of - the end of the year where you start to see the benefit of it. Any pricing power you got in August, you might start to see some benefit later in the year. If you don't get pricing power until November, December, you're not going to see anything this year.

Got it. Okay. Thank you. That's it.

Thanks Steve.

Hi. Just a quick follow-up to start on Steve's last question. When you say pricing power is that you're able to raise street rates sequentially or more just benefiting from easier comps and you will the decline year-over-year will go away?

It's more of the year-over-year comp. We have actually been able to move street rates sequentially, as we've moved through this year, but the year-over-year comp has made them negative.

Okay. And then just a regular rate question. Just curious, is there anything by MSA or region that's - where you saw softness like are the cost performing better than some of the previously high-flying Sunbelt markets? Or just curious on any commentary you could provide around that?

So, I think it's too much of a generalization to say the Sunbelt is weak and the coast are strong or anything like that, right? Some of our best markets, Orlando, Tampa, Miami, continue to outperform portfolio averages. Those are Sunbelt markets. L.A. continues to be good. And some of the weaker markets, frankly, are markets that put up 30% growth last year. So, they - it's hard to do that several years in a row. So they appear weaker. But I think the important thing to remember is markets will cycle in a non-correlated manner. And because of that, it's important to be as diversified as possible. So, you always have some markets that are on the upswing, and you always have some markets that maybe are coming off of the upswing. And one of the reasons we like the LSI merger is because it further diversifies our portfolio and reduces our concentration in our top markets.

And then just one last one if you humor me. Anything on the churn front in terms of length of stay, you're seeing be impacted as you've seen kind of less top of funnel demand throughout the system worth note either with the one or two-year length of stay, decreasing or anything to that out?

So the one or two-year length of stay has decreased very slightly. We're still in the low 60% on the one year and 46% or so on the two-year - I think we are losing some of those long-term COVID tenants, but not all of them. But length of stay is still healthy. Our average vacating customer is almost 18 months, and the median is about 7.5 months. Those are great numbers as compared to pre-COVID.

Thanks guys. Good luck.

Thanks, Juan.

Hi. Thanks. I appreciate the disclosure on LSI same-store. It looked like revenue and NOI growth decelerated quite a bit more than we would have anticipated. I'm not sure how that compares to what you were anticipating, but it was about 1,000 basis points sequentially during the quarter before the merger closed. Any sense on what happened during the quarter? And can you speak to the integration there and first steps around stabilizing growth in the Life Storage portfolio?

And maybe I'll speak to the results, and Joe can take the integration piece. First of all, they were still managing their properties. So clearly, we couldn't go in and manage them the way we would have liked to. I think that what we saw was occupancy fell off more than we would have expected, and we would attribute that to them keeping rates too high in May and June. When they've lowered them, you've seen it move in the positive direction in the month of July. They finished the month of July around 91%. So it ticked up slightly, but they did not see that busy season bump than we would have expected. And then in terms of the integration, Joe?

So, I spoke a little bit about the systems integration. That's going well, and we'll continue to work on that. Data transmission is going well. We still have some work to do there, but no hiccups. People is not something you can just do in a couple of weeks. It will take us a while to fully train the Life Storage managers on our way of doing things. They can all take rentals now and do the basics, if you will. But they'll continue to get better and better. And as they do, the performance will improve.

Okay. Do you expect to continue providing a breakout of the Life Storage same-store portfolio and performance going forward through '24, I guess, until it's included in the same-store in '25?

So have not fully determined '24. We think it is likely because it's probably the best way to show the improvement. If you compare our same-store pool to theirs, you should be able to see them outperforming due to them being on our systems. But I think it's likely, but no final decision yet.

Okay. And then I had a question around this environment here as it pertains to new supply. We've heard that starts are likely declining and could be materially lower moving forward here in the near term, which would be good for absorption of existing stores. But as it pertains to the supply added over the last few years, a lot of that product leased up at an accelerated rate during the pandemic from some of the new demand related to the pandemic. Are assets in your system that leased up with a disproportionate amount of, I guess, COVID demand customers? Are you seeing more pressure on move-outs or different customer behavior than the stores that you've operated and that were stabilized for a period of time before the pandemic?

No. I don't think customers pay differently if they moved into a new store that just opened or whether they moved into a store that's been up and stabilized for a long time, right? They leave some point after their need for storage goes away. I think your thesis is right, right? We see a moderation of new supply, but at the same time, we see markets that had kind of excess COVID demand that's going away that build up new supply and now that may be moderating, creating more availability.

Right. I guess that's my question. The latter point that you just made, are the assets over the last several years, a couple of thousand stores that were delivered beginning maybe in 2018 or 2019 through 2022? Or are you seeing those stores either a little bit more challenged? Or are they even in some markets, maybe still struggling to find equilibrium in terms of rate as demand moderates and some of those renters move out?

So, I'm sorry if I didn't answer that question clearly. I think it's an asset-by-asset analysis. Certainly, there are markets that are struggling because they had a lot of new supply delivered. It all got filled up during COVID. Now there's lesser demand. So maybe those markets are under a little more pressure. And I would give you Phoenix as a really good example of that. But I think it's a market analysis, not an asset analysis. It's not like all the excess COVID demand customers moved into the new property and the other - all the regular customers moved into the existing properties. So, the new properties are struggling more, the customers go everywhere, and the markets perform similarly. I hope that makes sense.

Yes, Todd, you're probably seeing it a little bit more in rate than you are occupancy. We have been able to maintain the occupancy at those newer stores, but you have - the ability to push rates has not been there.

Okay. Got it. Thank you.

Thanks, Todd.

Hi guys. I just wanted to ask you, the implied guidance through the back half for your same-store portfolio. Is that sort of a similar guideline for what you're seeing for the LSI portfolio as well? Or could you - is it something meaningfully different?

We would expect the LSI portfolio to do better as we get their stores on our platform, that uplift to begin to occur.

Okay. So embedded in your dilution is better same-store NOI for that portfolio through the back half of the year offset the some of the things that you've called out?

So, there is some growth there, but not significant. Typically, what happens is you bring things onto our portfolio is it takes a month or two as you bring things on. And so not a significant amount of increase, but we would expect those stores to start to benefit from the ECRI.

Okay. And then I just wanted to ask you on your third-party management platform, maybe it's too soon. But I know that the economics were different for the LSI tenants. And I'm just wondering if you would expect most of them to come on board, either your - I think you take a higher share? Or do you think some will leave? Or kind of what's embedded into your kind of - your outlook on that side?

Yes. I think that's a good description. So we talked to all of the managed owners that had LSI managing their stores. And our expectation is that everyone will migrate to our economics, which are significantly better than LSI's economics and also our kind of service levels. We run one program. Everyone is on the same program. LSI ran more of a customized program for their managed partners. And we will absolutely separate with some of those managed partners who don't want to work on our system, and that's fine because our goal is not to have the most stores, but to have an efficient profitable management program that works well for both parties. So, we'll continue to - we'll keep most, I think, and lose many, I think, as you said. But I'm very confident we'll continue to grow our management platform faster than anyone else in the industry.

Smedes, one other point I would make there is, I think there's been some narrative that we are going to lose some of these customers, and Life Storage actually added 17 stores during the quarter. So, they've continued to add to their management portfolio through Q2.

Hi. Just a couple of quick follow-ups. Firstly, is there any update on Storage Express and how that transition is going and then the rollout of the strategy?

Yes. So Storage Express was a little harder, frankly, to put onto our systems than Life Storage because we had to put it on a system with a different operating model that we hadn't had program. But once they got on to our system, everything is working very well. And one of the reasons we're confident with the ECRI program for life storages, we just went through that ECRI program for Storage Express, and we saw how their customers accepted it. So in terms of integration, very well. Operating through six months of the year ahead of underwriting, which is good. Growth is a little slower than we underwrote as we scaled that back while we were focused on the LSI merger. So we bought five or we've approved for purchase five remote stores, less than $30 million, so smaller stores, $130 a foot, but 7% yields in the first year. So once we can turn our full attention to growing this, we're excited about it. So the summary would be, everything on track or ahead of track going well, just slower growth than we thought as we turned our attention to integrating Life Storage.

And just one more question for me. And I appreciate you guys are focused on maximizing revenue, but a lot of the conversation today has seemed to have talked about occupancy and maintaining occupancy and the importance of that. So I was just hoping you could square it here. I mean is there a chance that maybe you're kind of hooked on the high occupancy? I know that's not the most elegant way to phrase, but just would appreciate your thoughts there.

Yes. So as I mentioned earlier, our strategies are based on results of testing that we do. And our - the results of those tests have led us to have a strong conviction that we want to have incrementally higher occupancies. We want to seek the longer-term customers, and both of those things come at the expense of initial rate and try to make that up through ECRI. So I apologize if we've spoken too much about occupancy, but it is a tool to maximize revenue. Great. Thank you, everyone, for your time today. I want to emphasize and assure everyone that everyone here at our combined teams is very focused not only on integrating the companies, but maximizing performance at our stores as a difficult time. We are very, very excited about the future. We see a lot of tailwinds in 2024 and beyond as the underwritten and non-underwritten synergies from LSI hit the books, given the moderating delivery of new stores, given that we have $0.23 of dilution from lease-up stores that will come to the bottom line, that eventually interest rates will be lower. Eventually, the housing market will recover, and we will continue to grow our ancillary management bridge loan and insurance businesses. Thank you very much.