Extra Space Storage Inc (EXR) — Q3 2023 Earnings Call Transcript

Thank you, Kevin. Welcome to Extra Space Storage's Third 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, November 8, 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. 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 had a busy third quarter. In July, we successfully completed our merger with Life Storage, adding over 1,200 stores to our portfolio and over 2,300 new members to Team Extra Space. The transition is going very smoothly, and I am proud of the teamwork and innovation our employees are demonstrating through the merger. Our combined portfolio of 3,651 stores provides greater diversification, stability, revenue opportunities, and operational efficiencies that I believe will improve our property level and external growth for years to come. From a performance standpoint, the third quarter was generally in line with expectations. Revenue growth moderation for the Extra Space same-store pool flattened meaningfully during the third quarter and our 1.9% same-store revenue increase was modestly ahead of our expectations. Revenue growth was driven by high average occupancy in the quarter of 94.4%. Existing customer behavior continued to be strong with solid length of stay, muted vacates, and continued acceptance of rate increases. Rental volume was also steady year-over-year, albeit at lower new customer rates. Expenses came in higher than our estimates, offsetting the revenue outperformance. This was driven by higher-than-expected property tax increases. The higher-than-projected expenses resulted in a modest miss in our same-store NOI, which was offset by a beat in G&A, resulting in core FFO of $2.02. This was in line with our internal forecast. Short-term dilution from the merger with LSI was consistent with our estimates for the third quarter. We have achieved our target G&A synergy run rate of $23 million and we'll continue to gain additional synergies as we further integrate the team, platform, and portfolio. We have also started a property-level revenue synergies as we move existing LSI customers to rates more consistent with the Extra Space portfolio. The incremental FFO contribution from these improvements is partially offset initially by lower occupancy at the LSI properties due to catch-up auctions and lower new customer rates to drive rental demand. However, once we achieve stronger new customer rates and build occupancy, the benefit to FFO will ramp up and we remain confident we will reach our total expected synergy run rate in the first quarter of 2024. We have slowed our acquisition pace given the LSI merger, but we continue to be very active in third-party management, adding 49 new stores gross in the third quarter, not including the LSI managed stores. Year-to-date, outside of the LSI merger, we have added 151 stores gross to the managed platform with only 17 departures. We have also continued to have steady bridge loan volume despite the difficult interest rate environment. In short, property-level performance is in line with expectations. The integration of the Life Storage properties is on track, and we continue to be active in our capital-light external growth channels. As a result, we have tightened our annual core FFO guidance for 2023, maintaining the same midpoint. We will remain focused on maximizing performance at all of our stores and executing our integration plan in the fourth quarter. As we have interacted with our shareholders throughout the quarter, it has been hard to miss the serious concerns people have about wars, the economy, interest rates, consumer health, sector demand, and our stock price. We absolutely share those concerns. That said, I think it is important to step back and not lose sight of where we stand today. Storage has consistently proven to be a remarkably durable asset class and Extra Space Storage has the largest and most diverse portfolio in the industry. Occupancy averaged over 94% in the quarter, and it remains very healthy. New customer rates, while not as strong as last year, remained 12% higher than 2019 pre-pandemic levels and customer health remains strong. New supply continues to moderate and the headwinds to future new development are substantial and increasing. Our external growth drivers continue to fire on all cylinders, and I am confident in our ability to further scale our platform. And finally, I believe we have the strongest team and operating platform in the industry. It is still a great time to be in storage, and I believe the future of Extra Space remains very bright. I will now turn the call over to Scott.

Thanks, Joe, and hello, everyone. As Joe mentioned, we would characterize the third quarter as in line, meeting our internal FFO projections. The modest miss in property NOI due to higher noncontrollable expenses was offset by beats in interest income and G&A. Achieved rates to new customers were down an average of 11.8% year-over-year in the third quarter, gapping widest in August and tightening modestly in September and further in October to a negative 10.8%. Given the easier September and October comps, we would have liked to have seen that gap narrow more, but we continue to have a headwind from new customer rates. Fortunately, lower year-over-year vacates and strong existing customer health continue to more than offset the headwind, and revenue performance as a whole continues to hold up. Weighing these factors as we forecast revenue for the fourth quarter, new customer rate improvement hasn't been compelling enough for us to raise the high end of our same-store revenue guidance range, but existing customer performance has been steady enough to remove our most cautious scenarios from our full-year revenue guide. As a result, we increased the bottom end of our same-store revenue by 25 basis points to a range of 2.75% to 3.5% for the full year. On the expense front, we felt greater-than-expected pressure from property taxes, primarily in Georgia and Florida. We also had significant increases in property insurance premiums. We updated our annual same-store expense guidance to recognize actual expenses as well as a higher run rate for property taxes, resulting in a revised same-store expense range of 4% to 5% for the full year. This results in a tightening of the same-store NOI range of 25 basis points both at the low end of the range, maintaining a midpoint of 2.75%. Turning to the balance sheet, we drew on our line of credit and an undrawn term loan of $1 billion to pay closing costs and retire Life Storage's debt that we did not assume. With the merger, we assume $2.4 billion in Life Storage's publicly traded bonds at the same coupons and maturities. Upon completion of the merger and the assumption of debt, S&P Global upgraded its credit rating on Extra Space to BBB+, which will drive future interest expense savings for the company. Details on our updated debt stack and revised interest rate spreads on our credit facility are included in our supplemental. Last quarter, we provided freestanding guidance for Extra Space Storage and then provided separate details related to the anticipated dilution associated with the merger. In last night's earnings release, we updated our 2023 FFO guidance ranges for the combined portfolio. The same-store performance ranges I previously referenced applied to the Extra Space same-store pool as we have not added the Life Storage properties to the pool. Separate disclosures related to the performance of the Life Storage stores are included in our supplemental financials. Our core FFO range, which includes the short-term dilutive impact of the LSI merger as well as an add-back for transaction and transition expenses, was tightened to $8.05 to $8.20 per share, maintaining the previous midpoint. We have also provided updates to key assumptions for the combined company. As Joe mentioned, our performance was in line with our expectations coming into the quarter and the integration of Life Storage remains on track. We continue to believe storage as an asset class is among the most resilient in the REIT space. We believe our operating platform and highly diversified portfolio has become even stronger through the Life Storage merger and is positioned for outsized future growth. And with that, Kevin, let's open it up for questions.

Your updated same-store revenue outlook implies positive fourth quarter same-store revenue growth of 0.8% at the midpoint. And you took the low end of the full-year guidance range up slightly. So should we interpret the increase in guidance as confidence that you will hit this range? And what have you seen from street rates in October and expect in November and December to meet this range?

Yes, Michael, your assumptions are correct. It does imply at the midpoint that it's positive for the entire quarter. And we obviously have October, largely we know what October was. And so we're confident that we should hit those numbers.

My next question is about how Life Storage portfolio is responding to the Extra Space strategy in part of the revenue synergies from the deal is based on the ability to roll out the Extra Space rental growth algorithm. So can you walk through how the Life Storage customer is responding to lower street rates and also how the Life Storage customer is responding to the elevated ECRIs?

Great question. So the short answer is everything is going as planned. We have begun sending out the ECRI notices to the Life Storage customers, and they are accepting them at the same rate or maybe even slightly better rate than Extra Space customers. We have headwinds of catch-up auctions and the slightly elevated vacates from the CRI notices, the occupancy on the LSI portfolio. So we have discounted rates on the web, in particular, to protect that occupancy while we do that. And that's been very successful, and we've actually seen a slight uptick in occupancy in the LSI portfolio. So we're really happy with how the strategy is playing out, and we continue to monitor it and make sure there's no bumps in the road.

Joe, you mentioned that as you're integrating and now operating the LSI assets, you're using street rate to build up that occupancy. How should we think about that over the coming months? How long will that take place? And given the existing overlap with the EXR portfolio, is that creating some of the drag, let's say, on street rate in markets?

So I might describe it a little differently. We're using rate, I think, to protect occupancy more. We don't really expect to make significant gains in occupancy until we're done correcting the rates and getting through the auctions. So we gained some occupancy, but it's certainly not spiking, and we probably don't expect that until next rental season. With respect to the effect on Extra Space stores, that's very market-specific, and I don't think very significant.

And then on the existing customer, you mentioned again the strength there. Can you characterize pricing power today versus, let's say, 6 months ago? And then can you quantify the length of stay versus the vacates?

So I don't think pricing power to new customers is significantly different than 6 months ago. And I guess I'd say the same thing about pricing power to existing customers, which is very strong. It is also the same, right? We're not seeing a greater amount of ECRI induced vacates. And I'm sorry, what was the second part of the question?

If you were able to quantify the vacates versus the length of stay?

I'm not sure I understand the question.

Where is length of stay today? You had mentioned that the length of stay remains strong and vacates are down.

I should have understood what you were saying. So lots of different ways to measure length of stay. Our average in-place customer is about 34.4 months, which is up a month year-over-year. Our existing customers who have been in the store for 12 months is 61%. That's done a little bit as we continue to normalize from those COVID highs at that metric. We've also lost a little bit of our 24-month customers. That's about 45% now, but still higher than pre-COVID. Is that helpful?

So in the quarter, you showed an improved pace of same-store revenue and same-store NOI deceleration. Is that because of easier comps? Or do you think rates have somewhat stabilized at current levels? I'm just trying to better understand if this improved deceleration is sustainable? Or if we should expect a steeper deceleration in 2024?

Yes. So comps throughout this year have gotten easier as we've moved through. In terms of how it came out versus what we were expecting, it was pretty similar to what we were expecting. As we mentioned earlier, we don't expect things to go negative in the fourth quarter and that sets us up for what we hope to be a good 2024. I think our occupancy is holding up well and not going negative, I think, is a positive thing.

This is A.J. on for Todd. Real quick, could you just provide an occupancy update for October and what that looks like year-over-year?

For the two portfolios, Extra Space, the same-store ended October at 93.9%. It's a 1% gap from where we were last year. The Life Storage occupancy is 90.8% compared to last year, and that has actually narrowed the gap slightly. Our occupancy calculation is slightly different than the way Life Storage calculated. We're going with this calculation going forward as they excluded or made adjustments that we don't make on an ongoing basis.

And what is that year-over-year?

It's narrowing and I actually don't have last year's in front of me right now.

We haven't adjusted last year's Life Storage occupancy to reflect our methodology.

Good to know. And then my second question. So you provided a little color around the $100 million of synergies. You noted that you have met the $23 million in G&A synergies. We see some gains in tenant insurance. How should we think about the opportunity to meet or exceed the $100 million guidance over the next several months?

So I think we have a significant opportunity to exceed the G&A synergy of $23 million. Our original guidance for that was $140 million. Our current midpoint guidance for G&A is $150 million. So it's not quite $10 million every 6 months of additional G&A because we closed the merger on July 20. G&A is not smooth. G&A is higher in the first quarter. It's not perfectly spread out through the 4 quarters. And we still have some hiring to do to fill in some spots. But clearly, we're going to be ahead of our $23 million run rate.

And then regarding the tenant insurance synergies, what additional potential do you anticipate there? Additionally, can you provide an update on the transition of LSI customers to the Extra Space policy and pricing?

So we've achieved very little of that synergy because the only Extra Space tenant insurance policies we're selling now are to new customers. Existing customers will not convert from the Life Storage insurance policy to the Extra Space insurance policy until starting January 1 of 2024, and that was for both regulatory and contractual reasons. But that will be somewhat of a light switch, right? We'll send out the notice, people get them and beyond the Extra Space policy, which is more robust in terms of coverage but also has a higher premium.

Just wanted to kind of piggyback on a couple of questions that have already been asked. I guess on the sequential deceleration that it moderated in the third quarter, is expected to moderate even further. Should we think that that continues into 2024 as you stand here today based on what you know? And I'm not asking you to give 2024 guidance. But I guess what the market is really wondering is have we passed the worst particularly given where comps are as we look into '24. Just curious on your thoughts on what you could share there.

If you examine our slowdown throughout the year, it's evident that we have improved that slowdown. Our guidance for the fourth quarter suggests it will remain relatively stable from our current position. We will be prepared to provide full-year guidance for 2024 in February. Overall, I believe we are in a favorable position. We would like to see an increase in new customer rates, but our existing customers are performing well. Additionally, 2024 should have simpler comparisons compared to this year.

Can I ask about the LSI occupancy? Are the synergies you're assuming aimed at bridging the occupancy gap between the EXR and LSI portfolios? If so, what steps will be taken to close that gap, or are you comfortable maintaining different occupancy levels for the portfolios? I'm curious about how you see this evolving.

I'll explain how we assessed the transaction to identify underwritten synergies and how we arrived at that point. Our focus is primarily on achieving the dollar amounts rather than the specifics of occupancy and revenue. During our assessment, we noted an average gap of 2% in occupancy and approximately 15% in rate. To reach our target of $65 million in property synergies, we assumed no improvement in occupancy and about a 7% increase in rate. Therefore, our potential to exceed those expectations hinges on achieving better results than what we have assumed.

Would you consider offering further discounts at LSI to narrow that gap, or are you satisfied managing two different occupancy levels across the various portfolios?

Thank you, everyone, for your patience. I'm not sure where the misunderstanding occurred during Joe's response. Could you please repeat the question before we proceed with the answer?

Sure. My addendum was is the goal to close eventually that occupancy gap? Or are you happy, I guess, running different levels of occupancy across the two portfolios?

So the portfolios will be run on the same platform, right, despite the two brands, it's going to be the same customer acquisition systems, the same pricing algorithms, the same sales process. So eventually, the two portfolios should run very similarly. We don't have a strategy of running a higher occupancy Extra Space store and a lower occupancy Life Storage store. Everything is going to be run on one platform to maximize revenue.

I know you commented in your opening remarks that you're focused on your asset-light initiatives right now. But can you just walk through where you're seeing specifically the best returns in terms of your use of capital right now?

So the best returns on capital continue to be a redevelopment of existing stores. Those returns are high single, low double-digit returns. You can add units where you already own the land, you already have the office, you already have entitlements and we are very excited to now have 1,200 more stores to look at and try to find additional opportunities to put storage in parking lots or make single stores into multistory storage. The challenge with those is they're relatively small in terms of dollar investment, so you have to do a lot of them, but we have a team and a process and a program and we expect to do a lot more of those in the future. Another bridge loan program also provides very high returns on capital. The whole note rate is 10% now, average is 10% now. And when we sell the A note, the rate on the B notes is into the teens, and that does not include the economic benefit of managing the property, which we lend on. So that also is a very good use of capital, particularly because we can control the capital by selling or not selling the A note.

And then do you have a sense for ESR assets that are now in a competing radius of newly acquired LSI assets, do you have a sense of what the average delta would be for the in-place rents for the EXR versus the legacy LSI assets?

So I think our best sense is one of the ways we underwrote this transaction is. We identified 106 or 109 LSI stores that had one or more Extra Space store that was in a very tight geographical radius that was a similar type store in terms of single-story drive-up or multistory and we felt it was a truly competitive store. And at the time of underwriting, the delta in rate was about 15% for those stores.

I just wanted to ask you about the LSI portfolio, you mentioned a number of catch-up options. And just I'm a little less familiar with that, I'm just wondering, is that a significant part of the portfolio? Will that make a significant difference, I guess, as those customers are, I guess, cleared out who are non-paying and putting in new customers?

I mean it's a standard practice when we buy a store not to rely on the prior owner's auction process because we don't want to get caught up in a noncompliant auction. So we start the auction process over again, and that leads to a several-month lag. So we have several months of non-paying units we have to auction out, recover those units, and we let them. It provides some occupancy pressure in the short run, but in the overall scheme of things, I think it's not significant.

You mentioned higher property taxes in the quarter. As you look into next year, how are you thinking about wages and benefits as the growth rate slows down? What are your expectations for the pace of property tax increases? Any insights you could share?

Yes. So we actually thought it had decreased some in the 6-month numbers. I think we were looking pretty good. We won some appeals. We were a little bit surprised by how our actuals came in for Florida and Georgia and Illinois versus the estimates we've made using property tax consultants. We hope that the worst of the property tax reassessments are behind us, but every year is a new year with the local municipalities.

And on wages and benefits, how is that pacing?

Wages and benefits, we've actually had it slow some. We don't see the wage pressure that we saw in the last couple of years. We saw higher slightly earlier in the year as we had more hours compared to prior years when it was difficult to hire. Today, it's much easier to hire. Our applicant flow is significantly better and we're not seeing the wage pressure we've seen over the last couple of years.

I have two quick questions. Regarding the same-store revenue number of almost 1% in the fourth quarter, is the message that unless there is a noticeable downturn, we shouldn't expect that figure to decline going into next year? Or is it still a wait-and-see situation? I'm trying to determine if the fourth quarter is a reasonable benchmark to consider moving forward without specifically asking for guidance.

Yes. So we think it's a good run rate, the estimate we've given for the quarter. Obviously, October is done. It's too early to tell for next year.

Great. And then doubling back on the sort of the expense line items. Obviously, you took the same-store up for EXR. I see sort of LSI at 4.5% as well. Maybe can you talk about just doubling down on whether it's marketing expenses or insurance. Is there anything either one timing in nature this year that we should be mindful of? Or are these sort of decent run rates.

So storage, the big increase year-over-year came from more personnel and the payroll line item. Our managers, on average, make more, and we have more hours allocated to us, and that's how we get the premium rates that we get. So we are operating them more like we operate our stores. The other thing that's different from their historical same-store numbers is we have allocated call center and technology charges to the stores that they historically had in their G&A. So we went back to their historical numbers and added those in, too.

I was curious about the supply situation since it has declined in other sectors and new projects. Can you share your observations on this? Have you noticed any projects taking longer, being delayed, or any new ones starting? What is your perspective on the new supply side?

Sure, great question. So we continue to see moderation in new supply. The peak was maybe 2018 and every year since then, it's moderated. We expect deliveries in 2023 to be kind of similar to 2022. But after that, likely to be more moderation. The headwinds to new supply in terms of interest rates and debt capital, equity capital availability, construction costs, entitlement periods, underwriting forward revenue growth are pretty significant and drop our rates for projects that you can see on yard and all those other reports are really high, and a lot of projects we see in these reports end up not getting built.

And just to that last point, would you say that the dropout rate is more significant today than it has been in like the past? Because of maybe those factors you mentioned?

Many of us were at a conference in New York a couple of weeks ago where one of the leading brokers in the industry said, he thinks the dropout rate is 70% to 90%. I don't have the statistics for that, but that's an observation from someone who's very, very close to the industry.

Got it. And then maybe just a quick one on the transaction side. You mentioned that EXR has pulled out recently, especially to focus on the merger, which makes sense. I guess, could you comment more broadly on the transaction market? Kind of our properties trading have cap rates stabilized? Has the bid-ask spread closed? Or is it still pretty quiet in storage also?

Yes, I would characterize it as quiet. There are very few transactions that we see end up making many transactions. People bring our portfolios and they don't end up transacting. That's an indication of a bid-ask spread. And the transactions we do see that happen, there seems to be some story either on the buyer side, why it was a special buy for them or on the seller side. But I don't think there's enough of a market where I could tell you what market cap rates are. It's just very quiet and very circumstantial.

Joe, when I look at some of your top markets, the Texas markets, Florida, they're holding up quite well this year and from a revenue growth perspective? And I guess how are you thinking about those Sunbelt markets into next year, the markets which got a boost in the last few years? I mean, do they give back in '24? How are you thinking about that?

There are two things, I think, to think about. One is maybe three things. One is job growth. Job growth is maybe the #1 indicator of storage performance. And those Sunbelt markets still have job growth, and that's an important factor. On the flip side, when a market has a couple of years of 20%, 30% plus revenue growth, it's really difficult to keep up. So it may look like it's giving back because it's not growing as fast, but it's still a healthy market, and it's just coming up against a tough comp. And then lastly, which is a little bit of the wildcard is the housing market. I firmly believe the housing market will come back. It's got two people can't stay in their houses forever, life events happen, just when and how quickly is going to be a factor that will inform our performance next year.

And then just as a follow-up from prior questions. You mentioned the 15% gap I think, between rents for the LSI and the XR portfolio on underwriting. And I just want to clarify, did you say the gap is about 7% today?

No, I said we underwrote 7% to achieve our underwritten synergies. So we underwrote not closing the occupancy gap at all and only closing about half of the rate gap, and that if we can do those two things, that will give us our $65 million synergies from the properties.

And then finally, on just maybe ECRIs. I mean, how much has that pace of, I guess, increases moderated at this point? I mean I'm just trying to think if you have macro conditions that sort of stay similar as it is, I mean, do you think that moderates further in '24? How are you thinking about that?

The impact may not be as significant as one might expect, mainly because a key factor for ECRI is the difference between the discounted web rate that customers see when they arrive and the actual market rate for that unit. Currently, we are in a phase where we're providing substantial discounts for customers to engage with the web, which allows us to align them more closely with ECRI and ultimately bring them to the true market rate.

I'm curious, what are the early observations on operating two brands versus one brand so far?

So it's very early. We don't have any firm conclusions. I think the most important thing that we see is we have increased our digital footprint. So when you're in one of those saturated markets where we're operating two brands and you search for storage near me or whatever generic storage terms to use, you will find both Extra Space and Life Storage branded stores come up on the search, sometimes also a Storage Express store. So we are getting more digital real estate. That's kind of the main assumption to the success of the program, but it's very early, and we have quite a ways to go before we can draw definitive conclusions.

And then maybe one other quick expense question. And I know this isn't a huge line item in the grand scheme of things. But the growth in insurance expenses, how should we think about that over the next few years in terms of how outsized they could be or relative to the overall expense pool?

I think it will depend a little bit on claims. You had a really rough year in Florida this past year. Overall, if you had anything wind-related in Florida, you saw a 100-plus percent increase in lots of areas. So I think it will depend some on events that happen but you've also seen a rise in interest rates causing those pools not to be as deep as they've found other sources to put that money versus. So making sure that we have competitive bids, adding the Life Storage properties will help us because we have a new group of insurers that we haven't used in the past. And so hopefully, we should be able to bring that down and not see the kind of increases we've seen this year.

I guess maybe first on occupancy, where do you expect your year-over-year occupancy delta various last year to trend for the balance of the year?

We're assuming about a 100 basis point gap through this year. And then obviously, moving into 2024, I think that gap gets easier.

And then shifting gears here, I feel like these two platforms have kind of gotten shuffled just given the Life Storage. I'm just curious if you could provide any update on the Bar Gold and Storage Express platforms. What are you guys seeing as far as internal and external growth opportunities?

For Bar Gold, I would say it’s a mixed situation. On the positive side, we've done an excellent job of institutionalizing and integrating the operations. We are significantly outperforming our expense budget, but we need to focus on growth. We're seeing Bar Gold grow at historical rates similar to how it flourished before we acquired it, and we aim to accelerate that growth. Part of this involves better understanding the business and the team, while some focus has been diverted to Storage Express and Life Storage. We've made substantial progress with Storage Express, although it has been more challenging to integrate due to its different operational platform. We successfully transitioned all 1,200 Life Stores to our operating system in just 19 days, while it took six months to integrate 107 Storage Express locations because of differing systems and procedures. We are performing well in terms of integration and have acquired several small remotely managed stores in our traditional markets, which are yielding around 7%, making them good investments. We are learning what attributes lead to successful remotely managed stores, such as their proximity to Extra Space stores, demographics, rental rates, and market saturation. We've also launched our third-party management platform, recently signing a 60-property portfolio for remote management, and we have a strong pipeline for our Management Plus platform. Similar to Bar Gold, growth for this platform was slowed down by our focus on the Life Storage deal, but we used this period to gain valuable insights, and I anticipate that growth will pick up moving forward.

Great. Thank you, everyone, for your time today. I hope the message was clear that things are going as expected. Our integration is realization of synergies are proceeding very well, and we look forward to seeing many, many of you in Los Angeles next week. Thank you very much.