Public Storage. (PSA) — Q3 2015 Earnings Call Transcript

Good morning and thank you for joining us for our third quarter earnings call. Here with me today are Ron Havner and John Reyes. All statements other than statements of historical facts included in this conference call are forward-looking statements subject to a number of risks and uncertainties that could cause actual results to differ materially from those projected in these statements. These risks and other factors that could adversely affect our business and future results are described in today's earnings press release and in our reports filed with the SEC. All forward-looking statements speak only as of today, October 29, 2015, and we assume no obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise. A reconciliation to GAAP of the non-GAAP financial measures we are providing on this call is included in our earnings press release. You can find our press release, SEC reports and an audio Webcast replay of this conference call on our website at www.publicstorage.com. Now I'll turn the call over to Ron.

Thank you, Clem. And welcome everyone to the third-quarter call. We had a pretty solid quarter across all of our businesses. And our West Coast properties in particular, Denver, West, performed particularly strong this quarter, and make up a pretty good size of our portfolio. But overall it was a great quarter across all of our businesses. With that, we'll open it up for questions.

Ron, can you talk about your performance in Europe for the quarter?

Sure. Europe had a great quarter. It would have translated into a really good quarter for us were it not for the currency. But operating fundamentals were excellent. Same-store NOI in Europe was up 8.8%, led by the Netherlands, which was up 13.9% year-over-year. Occupancy for the period was 91%, up from 86.5% last year, so solid quarter in Europe. And then we did a couple of portfolio acquisitions, so I think overall NOI in Europe was up 15%, 16%.

Okay. And one more, if I may, what was the peak occupancy for your U.S. portfolio in the quarter?

You mean which months?

Yes, or how much.

For the quarter we peaked at July at 95.5%.

I don't want to get hung up on one quarter but when I look at the performance that you guys put up on same-store revenue, 10 basis points deceleration from last quarter. Not a big deal. But when I compare it relative to your peers that reported, the other guys were able to reaccelerate or continue acceleration this quarter. Just curious what your thoughts were on why your portfolio didn't reaccelerate?

This is Ron. I thought we had an exceptionally good quarter. Comparing us to others is a little hard, both because of geography mix as well as what people put in their same-stores versus what we put in our same-stores. So, it's a little apples and bananas.

Okay. And can you give me a quick update on what your street rates were this quarter in terms of year-over-year?

Our movement rates increased, which is more significant than street rates. The move-in rates rose approximately 5.3% year-over-year. To provide additional context, our move-ins saw an increase of about 1%, aligned with the higher move-in rates of 5.3%.

I see. It seems a little bit lower than last quarter's 8% number. Any particular reason why?

Last year we also had less move-ins, too. We had about 1% less move-ins with an 8% increase in move-in rates. I would say the second quarter was by far a very strong quarter for us. Third quarter was a great quarter, too, but not as strong, I think, as what we saw in the second quarter. The other thing that happened in the third quarter is we spent about 20% less in marketing costs. So, we didn't spend nearly as much as we spent last year on both the Internet on search terms as well as on television. So, that doesn't show up on the top line. It shows up in the expense line. But nonetheless, pretty happy that we got a 1% increase in move-ins with about 5.3% increase in rate without doing nearly as much marketing as we did last year.

During the quarter it looks like only two property acquisitions closed and you had a little bit of a larger pipeline at the end of last quarter. Is this just because most of those deals are C of O deals yet to close, or is there any sort of delay in closing deals going on?

No, they weren't C of O deals. The challenge with them is they had debt assumptions, CMBS debt assumptions, which, if you've ever done one of those, that's like getting a tooth extracted. So, it's taken a little longer to close. But I think we've got 10 or 11 queued up to close in Q4.

I just wanted to ask you, looking through the first nine months you've done an amazing job at keeping the total cost down, only up 1.3%, the cost of operating the properties. And as you look into next year, what are the key areas where you might be seeing more pressure? I would imagine property tax is one of them but are there any others that you see any particular upticks?

Smedes, I think property taxes, they were up 6.1% for the quarter on our same-store properties, 5.1% year to date. That will continue to be a challenge. John can elaborate on that. Payroll will probably be 2% to 3%. We've enjoyed for the last two or three years declining advertising Internet cost because the portfolio's been full. We've been able to extend customer duration. So, we just have not needed to spend as much on promotion. I would be surprised if that number continues to decline in 2016. And then the other categories, I'd just assume a general inflation rate. Quarter to date, for the quarter our advertising promotion was down 19% year to date. It's down 18%. And that's really contributed to the big decline or flat-lining of expenses. And again, I wouldn't expect that to continue, John, any comments on property taxes?

There isn't anything specific to mention, but we're all observing an increase in property taxes. Many local governments are becoming increasingly assertive, particularly in how they reassess property values in relation to our portfolio. Although we make every effort to contest these valuations, it becomes progressively more difficult as they adopt a more aggressive stance. Therefore, I anticipate that for the next year, we could see an increase, likely moving from approximately 5% this year to around 6% next year.

Could you please clarify what the current length of stay or duration is and how it has changed over the course of the year?

Sure. For the quarter we had 56.6% of our customers with us greater than a year. That is up from 55.8% at the same time last year, so a 0.8% absolute increase in the percentage of customers greater than a year. To put that in perspective, in 2012 that number was 54.5%. If you could look at it over the last two or three years, each quarter, quarter over quarter and year-over-year we've been able to move the length of stay up, the percentage of customers, greater than a year. That translates into this year versus last year we've got 13,400 more customers greater than a year in the portfolio, a 2.2% improvement.

Ron, you've been at this 20, 25-plus years. I'm pretty sure this is as good as you've ever seen it in the business. What's keeping you up at night? It looks like, at least for the time being, as we look ahead to 2016, there doesn't seem to be anything that's going to throw a wrench into the system. Other than the supply number ticking up, is there anything that worries you about the ability to maintain pricing power?

A couple of things, Ross, new supply is coming and I believe it will continue to accelerate for the right reasons. You can build far cheaper than you can buy. The operating fundamentals in the business are exceptionally strong due to factors like full employment, job creation, a thriving economy, and low interest rates. New supply is on the way, and eventually, that will affect pricing power. With increased supply, pricing power will be impacted. I don't anticipate that becoming a significant challenge for at least another year, but it is on the way. Regarding the economy, I can't predict it, but it has been doing well. Economic disruptions usually arise from shocks, which can lead to a rise in unemployment and layoffs. These events typically have a limited impact on us, but they could slow down growth. Overall, the fundamentals of our business remain strong due to employment levels and the lack of new supply over the past four to five years.

I just had a quick one on discounts. It feels like the gains from the lower discounting may be largely behind us at this point. But I just wonder if you can give us an update on where they trend in 3Q relative to last year, and just how you're viewing discounting here going into the slower season.

Jeremy, this is John. In terms of the number of tenants getting discounts during the third quarter, I think we were giving them to about 70% of the move-ins versus about, I think, 73% or 75% last year. But the absolute dollars of discounts are actually up because our rental rates are higher than that, than the percentage decrease in the absolute number. So, we are giving less but it's translating into more dollars because our rental rates are up. I think for the quarter our discounting, just to give you some numbers we gave away about $23 million of discounts. That's versus $22 million last year. So we're up about 5% there.

Going back to Europe can you talk about any additional opportunities there? There's a bunch of smaller players. Clearly they don't have the platform you guys have or many of the other U.S. players have. Just if you could give us some sense of any incremental opportunity there you see.

In Western Europe, there are about 1,600 to 1,800 properties, with 800 to 900 located in Great Britain, many of which are outside of London. We are not particularly interested in expanding outside London for Great Britain. Consequently, many of those properties do not fit our growth strategy. In markets where we are active, such as Stockholm and Belgium, we hold a dominant market share of 70% to 80%. As for the rest of Europe, there are a few hundred million in potential opportunities, but not many. For example, in Berlin, which has a population of 3.5 million, there are only 15 self-storage properties. In such markets, the best strategy is to develop rather than acquire, as acquisition options are limited. We are increasing our development efforts in Europe. We successfully made two acquisitions earlier this year, and there may be an additional $100 million or $150 million available. However, our growth in Europe will primarily come from development activities.

And to clarify, you're looking to maybe develop some additional assets there?

Yes. We opened one in London this quarter and we've got two more coming out of the ground in the next six months. We've hired a person to help us in Germany, and in particular Berlin, so you should expect some development activity in that market next year.

Just a follow-up to Jeremy's question, you ran through the discounting in the quarter but I think you've previously talked about that as the overall customer acquisition cost. I was just wondering if you could share with us where that cost is today and how that's trended over the last year.

Sure. For the quarter, Todd, our marketing costs were down $1 million. Our discounts were up $800,000. So net-net, we were flat on promotional cost. Move-ins were up 1%, up 2,000, as John said. So our cost to acquire a customer went down $1 from $126 to $125. The move-in rate was up 5% or $7. The move-in fees were up $1. So net-net for each customer we made $35 upon move-in versus $26 last year. So, that's a 35% improvement in our customer acquisition cost for the quarter. Year-to-date numbers are somewhat comparable. We have a 31% improvement in customer acquisition costs from $26 to $34, again due to lower spend, greater volume, higher rates.

Is 35 a peak for the portfolio?

In terms of profitability upon move-in?

Sorry, is that the highest number, the most profitable quarter that you've seen?

Since we've been tracking this, yes, our overall promotional and marketing cost, to put it in a different light for you, in 2011 we spent 9.2% of revenues on promotional discounts and marketing cost and year to date we're at 5.7%.

And then just a question on development, it sounds like the C of O portfolios within the REIT portfolios are growing rather quickly here, and developers are bringing sites to the market and you're talking about new supply accelerating. What's happening to land prices? And is the competition for development impacting your ability to start new projects? Is the pipeline potentially going to thin out a little bit?

It hasn't so far but my guess, my expectation, is that it will change as development is ramped up and more people start to do it. But that really hasn't been an impediment for us. The thing that we are seeing is an uptick in construction cost and it's harder in some markets to get contractors available to perform the construction. Guys are building apartments and hotels and retail. So, the construction business is pretty good now, so we've seen a little more challenge on the labor contractor side and then an uptick in material cost. Again, not big enough to slow us down but we have seen that versus two years ago when we started.

G&A saw another pretty large increase again this quarter. We assume that it's again driven by legal costs. Can you talk about when we should expect to receive more clarity on the nature of these costs?

There's legal fees, and in this quarter we booked a $3.5 million reserve for a proposed settlement. Dave, if you recall, in our 10-Q we break out in a fair amount of granularity the components of G&A.

Yes, we've seen that. We'll look forward to it this quarter. Okay. And as far as you can see, the outlook for 2016 legal expenses relative to 2015, does it look like this will subside?

I hope so.

Second question, although you've been pretty clear in recent quarters that you continue to pursue debt options, how about a commercial paper program, which a couple other very large REITs have pursued? Is that on your radar screen?

No. It's not even thinking that way.

Okay. Last question is on property taxes. You talked about the outlook there. Relative to prior cycles, what's your view on the extent to which assessments are below market? And outside of California, is there any big variability?

This is John, David. I think California's probably, as you pointed, because of Prop 13 is probably the biggest variable. I think most other states, depending on what you think market is or what assessors think market is, I think most of our properties are either assessed each year or every other year, at the worst. So, they're probably for the most part fairly close to market, but I'm guessing at that. I don't know because, again, I don't know what the assessors are looking at.

Going to development for a second, if you put aside a project like Gerard or something, can you talk about what you're seeing in terms of the time to lease up new developments today compared to underwriting? I guess per expansion that's really going to be a function of size. So, just on the new development side what you're seeing.

Yes, Mike, the new developments are leasing up much faster than we underwrite. Now, part of that's attributable to the fact that we're opening them with lower rates than we're underwriting and probably a few more discounts. We opened a property here in Glendale in May, 2,000 units, it's about a mile and a half here from corporate headquarters, and it's already 72% occupied, which is phenomenal. We underwrote it for three-, three-and-a-half year fill-up. And that one's actually pretty close in terms of rates that we underwrote. That's filling up at rates pretty close to what we underwrote. In general, for developments, depending on the size of the property, we underwrite a three- to four-year fill-up and a reserve in terms of the cost to carry that property until it stabilizes. So, so far, knock on wood, developments are filling up much faster than anticipated.

And then for the projects where you really cut the rent and fill it up, can you bring everybody to market the year after that or close to it, or do you have to stagger? What's the dynamic there?

It will take a couple of years. It depends on how far below quoted market we brought them in at. So, it will take a couple of years of rental rate increases to get them close to market. And then once the property stabilizes, we'll bring the rents closer to market. So, it will take a couple of years of rent roll-up for it to get to the targeted or underwritten rental rate, in-place rents.

Hi, guys, I tried to hop out of the queue. I had a question on Glendale, which you successfully anticipated. Maybe I'll ask one more on the balance sheet. You mentioned not wanting to do commercial paper. But would the preference be for tenured debt or maybe even pushing it out to 30 years? What's the mindset on the debt market?

Currently, we have assessed 7, 10, 12, 15, and 30-year debt options. When we decide to issue debt again, we will focus on properly structuring it to ensure we are comfortable with future maturity schedules. At this moment, we are not prepared to take that step, but when the time comes, we will consider various maturity dates.

Just looking at the acquisitions, the two in Colorado, you have a few teed up to close, it looks like, in the near term, California, Florida and Texas, can you just talk about the difference in cap rates you're seeing, if there is any, really on a stabilized basis?

Todd, I don't think there's a material difference. For the most part, stuff is trading at trailing 4 to 5 yields on previous owners' NOI. And that seems to be the market or the market expectation. The thing that we, given that we pay a lot of attention to, is what is replacement cost and asset location. So, what do we think we can do in terms of rental rates and then how much does this property cost versus what does it cost to build, out of those 11 properties, 800,000 square feet, just over 800,000 square feet, you're at about $132 a foot, which is within plus/minus 5%, 10% of what we think we can build the properties for.

And any details on the MSAs you're buying in? Are these the top 25? And what's your appetite to go within the top 50?

We're identifying the top 50 properties. These specific locations complement our portfolio effectively, particularly in Florida where the properties are mainly in Orlando, aligning well with our presence there, along with those in Dallas and Houston. In markets such as Dallas, Houston, or Orlando, where we have between 50 and 120 properties, our goal is to acquire assets that enhance our franchise and address areas where we currently lack offerings but would like to expand.

And then, finally, if you could just shed some light on how your underwriting assumptions, particularly for the Glendale property you said is leasing up at 72% occupied, how does that relate to what your underwriting yield was relative to how quickly you can lease it up?

Five months into it we would have underwritten about 20%, 24% occupancy. It's at 72%. So, even though the rates may be slightly low, the cash we're getting and the net cash flow, the property's already breaking even and generating a profit. We would have underwritten to not make a profit for six to nine months, so we're already net positive cash. It will take a couple of years, when it stabilizes, to really sit back and say what is the cash on cash return, and how much extra money do we make by filling up faster versus taking a more traditional approach of starting rates higher and filling it up slower. I'd also say that property is rather iconic and there is a lot of great things going on in Glendale. The market was undersupplied. So, there's another aspect of building the right product in the right submarket and certainly that property fits the bill there.

A trend we're seeing in apartments currently is smaller MSAs are experiencing stronger rent growth than the larger markets. I was curious if you're seeing that in storage as well, or does rate and demand continue to be primarily driven by submarket density?

I'm looking here at the revenue growth for most of our markets. Our top revenue grower for the quarter was Portland at 15.7%, followed by Orlando at 13.5%, Sacramento at 13.8%. Nashville was 12.1%. Dallas was 11.9%, Houston was 11%. Does that give you a sense of things? The flip side is Philadelphia at 4.3%, DC at 3.2%, Chicago at 3.2%.

Hi, it's Ross again. Is there any thought of potentially using some equity funding here, given the potential run-up in the stock this year? How are you thinking about cost of capital on the equity side relative to your alternatives?

Ross, I certainly like the stock price. It certainly reflects the great fundamental trends in our business. But one of the things you have to ask yourself is does it really make sense to issue equity when we have such an unlevered balance sheet. We did the euro deal at 2.7 or 2.17 and we can probably do a 10-year deal at sub-4%. Does it really make sense to go issue equity, John, do you have any other comments on that?

No. You need to consider the cost of capital when issuing common stock. There's growth to think about; for example, if you're estimating a 4 cap rate, it will likely grow around 3.5% to 4% on an unlevered basis. This suggests that the cost of capital for issuing common stock would be about 6% to 7%. Therefore, combined with a de-levered balance sheet, our current preference is to leverage the balance sheet with debt and use that to fund acquisitions and development first moving forward. However, we would consider issuing equity for the right transaction if it presented itself.

Have you ever considered increasing the Company's leverage to align more with the REIT average, perhaps by undertaking a multi-billion dollar debt issuance, issuing a special dividend, and recapitalizing the Company?

Not at this time.

Okay. And then the last follow-up I had, I drive by a number of your facilities quite often. Some of them look beautiful, spectacular, new, shiny, and some of them look 30-plus years old. Some of them have the toll-free number on them, some of them have the Internet site on them. Maybe can you talk a little about branding and consistency of branding and how important do you think that is going forward? When I drive by a McDonald's they're usually the same. I drive by a Public Storage and increasingly they're not. Maybe talk a little bit about how much of an issue that is or is not.

Given our current occupancies I would say it's not too much of an impediment. The key for the branding are the orange doors and the name, Public Storage. And that is so dominant and so powerful, it's just unbelievable. We can talk for an hour about what it does for us on the Internet, customer awareness, et cetera. The point you raise in terms of the dichotomy of our, I'll call it, property image is certainly true. One of the things that we've been doing for several years is redeveloping properties. It's a little harder than you think because in many of those infill locations where you're probably driving by, self-storage has been zoned out and we can't get the city to even reconsider redeveloping the property because they just as soon it wasn't there. If you're down in Florida, there's a property down there in Aventura that we redeveloped. It took us four years to get that done. So, while we'd like to go through and change up the image of the properties and standardize it, it's a lot more challenging than on the surface. And combined with that, there's a dichotomy in the portfolio because a lot of it's been acquired from other people that built it to different standards or different specs, so it's going to look different. That's also attributable to different zoning regulations. So, even some of the new stuff that we build, I think we've got one property where we can't have any orange on it. Not our choice but that's the zoning regulations.

Sorry to jump on at the end like this. A prior question, I just want to make sure I heard this correctly, that obviously your G&A's been elevated, as you mentioned, because of the Q because of legal expenses, but that the primary case associated with those legal expenses has now been settled?

There's a reserve that we made in Q3 for about $3.5 million and it's a tentative settlement. We have other ongoing litigation.

So I shouldn't presume that's the primary one. That's not the case? Because it just sounded like you could get some relief in the legal expenses going forward.

The question was will they be lower next year and I said I hope so.

I want to thank everybody for attending our call this morning and we look forward to speaking to you next quarter. Bye.