Public Storage. (PSA) — Q2 2018 Earnings Call Transcript

Thank you, everyone. Thank you for joining us for the second quarter 2018 earnings call. I’m here with Joe Russell and Tom Boyle. Before we begin, we want to remind you that all statements, other than statements of historical facts included on this call, are forward-looking statements that are subject to a number of risks and uncertainties that could cause actual results to differ materially from those projected by the statements. These risks and other factors that could adversely affect our business and future results that are described in yesterday’s earnings release and in our reports filed with the SEC. All forward-looking statements speak only as of today, August 2, 2018, 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 provide are included in our earnings release. You can find our press release, SEC reports, and audio webcast replay of this conference call on our website at www.publicstorage.com. With that, I'll turn the call over to Joe.

Thanks, Ryan, and thank you all for joining us. This quarter we continued to see the resiliency of our business in the face of the supply pressure impacting the self-storage industry. Before we open the call for questions, I want to highlight that we have lined up the timing of our earnings release and our 10-Q in this call. We feel that our 10-Q addresses a number of questions and data points that some of you have requested, and this will ensure the full disclosure package is in everyone's hands. Our 10-Q, particularly the MD&A section, is detailed, so please continue to look at that document as the guide to how we evaluate the status of the business. Now I would like to open up the call for questions.

There has been an increase in the number of deliveries and our expectations for deliveries, especially when comparing 2019 to 2018. It is important to approach this from a fundamental perspective, using a three-year rolling window considering the time required to lease new assets.

Juan, unfortunately, I missed the very first part of your question. But if you’re talking about our outlook and view of supply – but it was the context of the question, so let me give you a little bit of color on what we see. And that’s both deliveries and the timing that it would typically take place as we know in our business. With any given delivery, there's typically a three-year lease-up on a per property basis. So 2017 and 2018, we expect very similar, if not elevated, levels of deliveries this year over last. Going into ’19, there is some commentary and data out there that potentially points to a slowdown in deliveries. But realistically that, to some degree, is just the way the development business works. Some of the things that can prolong or delay deliveries include timing tied to entitlement approvals or permit approvals. There could also be delays based on any particular developer’s view of market conditions, costs tied to either labor or materials, particularly steel in the case of self-storage properties. But all that said, we’re still in an environment, more often than not and market-to-market, where developers are still seeing healthy returns when they can build the property that ultimately will yield anything from an 8% to 9% return and potentially flip it for five or six. And whether those development margins are more extreme or elevated at 80% or even taper down in half, there are still a lot of people out there, and capital that’s putting development dollars into the cycle. The thing that may happen that we would certainly look at as a positive is, with some of the potential headwinds tied to either the amount of supply hitting markets, some of the pro forma being changed, maybe some pushback from lenders, and frankly, just expectations of the overall return to properties, there could be some slowdown but too hard to see. And our view is, again, the amount of capital that continues to want to be placed in this sector is elevated; it's still a business that continues to produce very good returns on a property-by-property basis, and the development cycle is still with us. So with that, I really don't have a lot more specific color other than we'll continue to track and see what we see throughout our markets going into 2019.

And then any sense around what the street rates were year-over-year in the second quarter and maybe third quarter to date? And if we step back and think you've had declining numbers for a couple quarters at least. Do you think of that as a leading indicator for where same-store revenue should eventually migrate to?

The street rates in the quarter were down roughly 4%. As we've talked about in the past and as we disclose in the 10-Q review, take rates or moving rates are more meaningful. So as you saw in the 10-Q that we filed last night, the move-in rates on a per square foot basis were down 2% in the quarter. Between the second quarter and first quarter, we did lower our rates high volumes during our kick-off to the summer sale. We were pleased by the demand response from the customer base during that sale versus prior years. Breaking the quarter down by month, April and May, we're down roughly 2% so similar to the first quarter performance. And then we clearly decided to lower rates during the sale to drive customer response. On a holistic basis looking at move-in revenue, so both the amount of space leased and the rate that contract rent for all move-ins was down 8% year-over-year in the second quarter. But the flipside was that the contract ramp in aggregate, again, volume and rate for move-outs was down 3.6% and that was driven by a reduction in move-out activity. So that just continues to point to existing customer base, stickiness and stability that we've talked about. And that's continued here as we've gone through the second quarter and into the third quarter as we send out our existing tenant rate increases. Speaking of move-ins and move-outs on a volume basis, occupancy trends improved because of the difference between move-in volumes and move-out volumes. So that's a good trend. The occupancy ended the quarter down 100 basis points and down 60 basis points on average, which compares to down 90 basis points on average in the first quarter. So we did see some occupancy improvement through the second quarter on a sequential basis.

Joe, the comments that you just made about potential positives to the development cycle either pro forma being changed or pushed back from lenders. Are you seeing changes to pro formas or are you changing your pro formas at all? And then on the lending side, I'm guessing you're not in the market talking to lenders. Was that comment hypothetical in nature, or is there any evidence that lenders are starting to push back or tighten up around development funding?

Todd, there are definitely some anecdotal impressions we get through a variety of conversations that we have with a lot of groups out there. One of the things that add to that is the dialogue we’re actually having on a reverse enquiry basis, where we are seeing more entitled land parcels coming to us through owners that were planning on taking a property through a development cycle and have now decided not to do. This would include circumstances like I alluded to where they’ve either shifted down their expectations from a rental rate and/or time to occupy the property. Interest rates haven’t moved materially but certainly, the opinion out there is that they’re likely to increase. There is likely more pressure coming from interest rate costs. With that, I think there is some tapering down from a dialogue standpoint—there could be either delays or intentional movement away from the level of full deliveries that statistically were predicted for 2019. I can’t tell you it’s going to be down 10%, 50% but there could be some of that in the mix. And again with other elements at hand, like construction costs, there’s market-to-market elements around labor and anecdotal evidence as I mentioned. Again, I think there is some rethinking relative to the pool of developers that were one, two, or three years ago just looking at everything being completely full steam ahead. They could build these properties, flip them very quickly, and not worry about achieving pro formas but now, all of a sudden, there’s a little bit more review and/or analysis going on, which I think holistically is very good for our overall industry and is good market-to-market. But I couldn’t tell you it’s really something that’s become acute just yet so we’ll have to see how those play forward.

And then I was wondering if you could talk about how conditions have trended through July, whether or not you can comment at all on occupancy or rent trends? And as you head into the off-peak season here and the summer winds down, any thoughts around your strategy as it pertains to discount and promotions?

I would call July trends very consistent with what we saw in the second quarter, both in terms of occupancy and rate, so nothing really to highlight there. I think in terms of moving through the summer, clearly, we’ll continue to monitor our existing tenant base and how they’re accepting the rental rate increases. So far to date, they continue to demonstrate the stickiness that we’ve observed in the second quarter. As it relates to pricing and promotion, that’s something we obviously dynamically adjust, but we’ve historically continued to offer dollar special discounts through the summer period and then sprinkling in sales as well. So we’d expect to do that similar to how we’ve done it over the past several years.

I realize it’s hard to maybe compare, or you don’t have a full understanding of what the peers do, but there are a couple of large markets where your revenue growth does seem to be trailing behind some of your peers. I’m just wondering if you’ve got any thoughts around that. I think Chicago and DC are two markets in particular where your revenue growth trailed noticeably behind. And I don’t know if that’s new supply specifically or if there is something else in those markets that’s pulling your performance down?

So obviously, we can begin with something that we’ve talked to you about in the past, which is the way that we hold properties in or not into same-store. There likely is some gap of performance tied to that. There could be market-to-market distinctions based on location of assets. Again, you would also need to take a look at levels of occupancy and what’s going on there market-to-market. Clearly, our goal has always been to maximize revenue per square foot on a per property basis. So even though in some markets, you may look at those distinctions like we highlighted, we would also want you to take a look at what's trending and it’s all reported. Again, peer-to-peer, the cash flow per market that takes place across our various portfolios and I think you there would see a distinct difference. Now, you mentioned Chicago—we’ve talked about Chicago; it’s one of our toughest markets. And for many reasons not supply as much but more economic and overall migrations either out or not flowing into that particular Metro area has continued to be a tough market. So in that case, there's definitely more of a factor there. DC has a little bit more supply coming into the market. But again, as you mentioned, for us, Chicago has been a market we’ve talked about now for several quarters, it’s one of our weakest.

So there you might think it's a submarket differential perhaps between some of the peers and just different parts in town maybe?

That could be a component.

And then just flipping gears here maybe a little bit on the technology side, some of your peers were doing some different things to attract tenants and to lease space, some are almost automated leasing. What are you guys doing, if any, and is there anything you can share with us about some of those programs and some of the effectiveness that you might be having?

So we continue to invest and optimize all the things that we do to attract and learn about customer behavior. There are many things that are proprietary that we continue to do that we don't talk thoroughly or transparently about. But we clearly have a number of committed initiatives that continue to enhance our ability to attract and find what we feel are good quality customers and customers that we think fit our locations well and that again lead us to being able to do many things on a per-property basis. We have now fully integrated a new point-of-sale system that took us several years to develop that was integrated and fully implemented across the company at the end of 2017. Not only is that a more vibrant system, but it's giving us much more clarity relative to the things that we can do to enhance customer experience and customer knowledge. So from a focus and technology standpoint, we continue to do a variety of things. We continue to see good traction from both investment and our techniques that come from that.

And lastly for me, could you just maybe speak to the third-party management business that you rolled out, I guess, a couple of quarters ago and some of the traction that you may be having with existing owners in the marketplace today?

Steve, just as you said, we obviously launched and made the announcement that we're going to go into the third-party management business earlier in the year. I'd say overall, we've been very pleased with the reaction and frankly, it's been better than expected. Pete Panos has now hired his team. We have a team around Pete that focuses on business development, customer relations, and brand integration. Up until this point, the efforts that we've had have been primarily tied to dealing with reverse enquiries, which has been strong and healthy. We really haven't even started our major outbound initiatives yet, but that's coming. The point we're at right now is we have 48 signed properties, and the program and the backlog continues to grow. If you combine that with our 26 legacy properties that we've run for several years, we've now got 74 properties in the program. What we're seeing is, again, a lot of the strong reaction tied to the value of our brand, the amount of consistent cash flow and revenue we produce on a per-property basis, because I can tell you owners are very fixated on that. They also like the scale and market knowledge that we have market-to-market. Our ongoing capabilities again that we continue to drive through our technology, just like you were asking. Overall, the program’s off to a great start and we're encouraged by what we're going to be able to see going forward.

Just piggybacking off that question, those 48 newly signed third-party management deals. Are you able to provide color on how many of those were previously managed by other third-party managers and how many of them are just maybe new projects?

George, I'll talk to maybe holistically the entire pool that we're dealing with. Not surprisingly but encouragingly, we are seeing a variety of different types of situations come to us. So it includes properties that are in development. It includes properties that are currently flagged by other operators, both public and private. And it includes operators that are just running the properties themselves, so we're seeing a good combination. As I mentioned, this has really been without us actually going intentionally out to markets yet in an outbound way. So again out of the gates, we've had very good strong reaction from a good collection of different types of situations. We are pleased with the quality of the assets that are coming into the pool. Based on what we're seeing right now, we can fold them into our operational platform pretty easily. That’s another advantage that many of these owners look for right out of the gate once we again put the Public Storage brand on the property.

And then also going back to development, are you seeing more development migrate into the secondary markets? If so, which areas are you seeing more flow to?

I really couldn’t tell you, George, that there is a fee change that would lead you to say now into either secondary or more markets because frankly, we have a very fragmented industry as a whole. There are developers out there across the country that are looking to build this type of product. So I think the currents that are out there indicate that, no question, in some of the more highly urbanized markets that’s going to be more difficult entitlement situations, land is not going to be available. Again, there are more headwinds that you’re going to hit there, whether a storage facility can be built on a particular site because of pressure and community relative to caps and the amount of storage products that might be already in place; those properties typically are going to be more expensive. But again I wouldn’t tell you there’s any overall fee change in where the development is happening because again it continues to be pronounced.

And just the last one from me. On the acquisition front, are you seeing an increase in opportunities out there? Are there going to be or do you see more opportunities from development projects?

So this disconnect between what seller expectations and buyer pro formas or buyer expectations are still wide, so based on that we're not seeing a healthy or high level of trading that’s going on out there. There really hasn’t been much of a change. Cap rates for the most part are relatively in the same type zone, they hover around say a 5% or so handle. Again, we’re not really seeing a lot of volume coming into the market. Now what we’ve done in this environment, both last year and this year, is we continue to look at opportunities where we can buy really good properties at good values, we’re able to round out our presence in a number of markets where we’d like to have more scale. More recently this year, you’ve seen us do it with some of the one-off acquisitions and communities like Louisville, Omaha, Columbia, South Carolina; you saw in our press release we’ve got 14 properties under contract. Those 14 properties totaled about $95 million, a little over 840,000 square feet. Again, as part of that portfolio does include a small portfolio in Minneapolis. But again, we’re not seeing a new range or a healthy level of portfolio volume getting traded right now.

I was hoping you can just touch upon the development opportunity in your portfolio. I understand you took four properties out of your same-store pool presumably to enter into expansion projects. Maybe you can touch upon given some of your sites are older and a little bit less utilized. What redevelopment opportunities are available over the long-term? Thank you.

If you look at the Q on page 45, we have a little bit more color on some of the activity that we have and our expansion efforts. One of the things that we've been able to do since we started our development program in 2013, as opportunities have evolved in our own portfolio, we’re starting to shift even more dollars into redevelopment and expansion. On page 45, it’s actually footnote A, you can see what we highlighted relative to some of the demolished properties that we’ve touched this year, which total about 665,000 square feet of rentable square footage. Over the next 18 months, we’ve got another 150,000 or so. That pool, as we speak today, is a little over 800,000 square feet. To put a little color on that and give you a view of how we look at that economically: on an annual basis, that generates about $8.2 million in NOI. Now, we’re taking that 800,000 pool property set and expanding it almost by 4, little over 4 times to 3.9 million square feet. We’re investing $364 million into those properties’ expansion. Comparing the yields we continue to see on our mainline development program, where ultimately we can get these properties conservatively into say an A or higher yield, that pool alone once stabilized is going to generate, instead of $8.2 million in NOI, it will generate if you assume a 5% or if you assume an 8% to 10% yield, you're going to see $55 million NOI level. Again, a very strong and healthy level of continued performance and opportunity. We’ve just begun to look at this and with the amount of properties that we’ve got throughout many markets, we think we’ve got good long-term opportunities with that pool.

Geographically, where have you found these redevelopment opportunities thus far?

It’s a little bit, I wouldn’t say everywhere, but we were encouraged because some of the areas that make the most sense is where we can easily just again add a facility to a property without touching existing inventory or existing building. In many markets, say with some of our legacy assets, we might have extra land or a parking area that's pretty simple to expand and convert. In other areas, like one we just finished up in Milpitas in the Silicon Valley, again same thing, but it's an infill location. Literally, we could never buy that property again because, again, there is no land available in that market. If it were to become available, it would trade for something extreme. So we've got those pockets of opportunities throughout the portfolio. Again, we’re encouraged by what we can continue to do long-term in many of our markets.

First question on your rent rolls and Q2 being typically flat to slightly positive, and then Q2 last year was a little bit negative, and this year it fell off. So I'm just curious, is that something that worries you guys? Could the rent increase program that was once a tailwind become a headwind?

There is some seasonality and the difference between our move-in rates and our move-out rates. If you go back several years, you’ll see that seasonality play out. Looking back longer-term, I think there was a quarter back in 2015 where we rolled up in the difference between move-ins and move-outs. But for the most part, you do see some rent roll down for some of the reasons you highlighted. As I mentioned earlier, we did see good traction on move-ins with our reduced rate in the month of June and the end of May, and that certainly contributed to the rent roll down increase year-over-year. But as you pointed out, last year we saw rent roll down as well. So it's a component of our revenue, which is balanced with the revenue benefit from the stickiness of our existing tenant base and the existing tenant rate increase that we do send out.

If I look at your end-of-period occupancy, which is down about 100 bps and then contract trends were about 1.7 in the quarter. That would imply sub-1% same-store revenue in 3Q. Is that a fair way to think of it? Are you going to be below 1% or right around there in the back half? I'm just curious if I'm missing something.

That is a metric we've referenced in previous calls as an indication of where contract rents and occupancy stand at the end of the quarter based on the most recent data. At the end of the period, occupancy was down 110 basis points, and the contract rent suggests about 0.6% revenue for the next quarter. We've also discussed the distinction between end-of-period and average occupancy due to the changes in our customer move-out patterns. Considering an average occupancy over the quarter of 0.6% would indicate a little over 1% for another data point. Last quarter, those same metrics pointed to a rental income growth of 1.5% to 1.8%, and we ended up at 1.7%. Historically, there has been some correlation between these figures. While it's not an exact number for the quarter, it's the most data we have on rent and occupancy that we've shared.

Tom, you just touched on the existing customer rate increases a bit, and you talked about looking at the importance of take rate. In terms of looking at revenue growth, the 1.5%, can you talk about how much is being driven by existing customer rate increases at this point? Any changes in the amount of increase, your frequency, or number of customers getting those?

The increase in the rent roll down was certainly a negative to rental rate growth through the quarter. So the existing tenant rate increases was a meaningful portion of the revenue growth. There has been no change, from a strategy standpoint, to how we send those out. As I’ve talked about in the past, we do send out more of those through the summer months; rates are high as activity in terms of backfilling any vacancies is good during this time period, so it makes a lot of sense to send out those existing tenant rate increases around this time of year. And we’ve seen good receptivity to those so no changes there, but that is driving our revenue growth at this point.

Switching to supply, your predecessor talked a lot about the impact of certificate of occupancy deals we’re having on development activity. As you look at the market today, are you still seeing a fair amount of activity out there? And is there any insight on the pricing trends relative to cap rates you can give just in terms of what you’re seeing? I know you guys obviously don’t do any of those, but just wondering how aggressive folks still are being on that front.

Jeremy, I think thematically, it’s the same set of issues that I talked about before, which is there is a healthy development community out there that continues to see good returns when they’re able to develop these properties. If they can build into an eight or nine and they can flip them full or unoccupied at a rent level that would yield off of full occupancy or close to it or five or six, I mean they’re going to keep doing it. But we do engage and have—we have actually bought here and there some deals; I wouldn’t tell you that those are necessarily becoming more stressed, but they’re out there. I think some are going to continue to come into the market, but it’s too soon yet to tell if there is any overall stress that’s coming with those properties that are coming into the market.

And just the last one from me, and I was wondering if you could just comment on advertising and selling costs, they were down again this quarter. I know some of that was driven by TV spend, but I would just think with supply and the demand pressure you’ve talked about here that maybe we’d see you try to ramp that and create more demand into the funnel. Any color you can provide on that line?

So advertising was down 5% in the quarter, but as you point out, that was driven by TV spend in the prior year. Our Internet spend was up in the quarter, up 33%; that’s primarily Google, and that’s a combination of that landscape remaining competitive and cost per click moving higher, as well as our pushing on that to drive volume. That’s a channel of advertising that we like; it can be very targeted and trackable down to the property level. We have a lot of ability to use technology and our systems to drive demand on a very granular basis. We’ve been doing that more and more. In addition, we do have an advantage online, which is our brand. We drive a significant amount of volume on the Internet even away from the page search, and so our focus there remains very strong coming through channels like local maps. There’s certainly a focus there on driving customer volume, and this is the last quarter that you’ll hear us talking about TV in the prior year. So we won’t have that of a reduction in TV; it’s something that we continue to monitor. TV is going through transition, but we’re monitoring television and television-like advertising media as potentials to drive traffic to our stores as well, but no immediate plans there.

Just a couple quick ones, just following up on that stimulating demand question. If you can just help us understand a little bit for that incremental dollar when you're deciding between Internet spend versus reducing rates versus increasing discounts. If you can provide a little bit more color on what goes into each bucket and how you decide how to allocate those dollars that would be helpful?

That's a pretty dynamic judgment that’s made on a very local basis, depending on both the traffic, the characteristics of that local market and its response, both in the past and currently to those different tools that we have in our toolkit. I don’t want to talk about that at a high level, but just say that that’s a property-by-property judgment made through our technology and our systems. They are certainly integrated, i.e., moving the levers between discounting, lower asking rates, high channel pricing, and advertising are all different tools we have in our toolkit.

And then if I could go back to the revenue growth expectations, I think you already mentioned on the revenue growth for the rest of the year. Just try to understand what the upside or downside risks could be for the end of the year. Is it through rents or is it through occupancy where there's more leverage to either surprise on the upside or the downside?

Again I think that really is a market-by-market judgment. I want to see how the rest of the year plays out. But there are certainly markets where we view that there is occupancy potential to improve, and there’s other markets where occupancy is actually really quite healthy; you look at Los Angeles where we have 95% occupancy, same with San Francisco or New York, those are places where occupancy is really quite good. So the opportunity is probably more on a rate basis once you get into those types of occupancies. But not all our markets are at 95% so there’s occupancy potential as well.

I just want to ask you, you received a large cash payment from Shurgard. Does that change anything around acquired dividend distributions or does that count as part of your taxable income, or is that different from a redistribution perspective?

So we did receive a dividend and in terms of rationale for that dividend and the drivers there, the cash reform that was passed at the end of last year required us in 2017 to recognize income associated with our international operations like other multinational companies. That is at an advantageous grade, so from a taxable income standpoint, there is an advantage to that recognition but we needed to recognize that in 2017. So this cash dividend is in effect the cash associated with that income and we took our 49% share and our partner took the remainder.

When you look at the percent supply increases in the markets that you’re in, I guess across your portfolio. I mean do you have a sense of what your own development or expansion activities are as a percent of that total supply coming into the market? I mean is it significant or is it a relatively small piece of the whole?

Smedes, that’s going to vary market-to-market but again, in 2017, nationally around $3.5 billion, our own development program was about $300 million. This year, development activities are likely to be around $4 billion, and our development platform is going to be about $400 million. So again, it's not a significant percentage. The thing that we will continue to take advantage of is that we may in certain markets be a higher percentage of the development activity, but that’s often intentional—that's a good thing. Meaning, we’ve got one of these infill sites, whether it’s an own property that we’re expanding or we’ve been able to acquire a great piece of property. We continually look at the competitive activity that’s going on in a particular submarket, the competition ratio, as well as the population dynamics, and we put a lot of analysis into the way we make those decisions to literally launch either a new development or redevelopment property.

Thanks, everyone, for joining us today. We look forward to connecting with you in this venue again next quarter. Have a good day.