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Extra Space Storage Inc
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Good day, ladies and gentlemen. And welcome to the Q3 2018 Extra Space Storage Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time [Operator Instructions]. As a reminder, this conference call is being recorded.
I would now like to turn the conference over to Mr. Jeff Norman. Sir, you may begin.
Thank you, Lisa. Welcome to Extra Space Storage’s third quarter 2018 earnings call. In addition to our press release, we have furnished unaudited supplemental financial information on our Web site. 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 statement 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, Wednesday, October 31, 2018. 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.
Thank you, Jeff. Good morning, everyone. Thank you for joining us for our third quarter call and for your interest Extra Space Storage. 2018 is playing out as we expected as we move into the last couple of months of the year. Revenue, NOI and FFO growth are all start remained within guidance and expectations. Occupancy continues to be strong ending the quarter at 93.9%, 20 basis points above 2017’s mark. This is especially encouraging, because last year’s quarter end occupancy benefited from the hurricanes.
We continue to have solid rate growth, which was partially offset by increased but expected discounts, resulting in same-store revenue growth of 3.2%. The year-over-year impact from discounts should taper off in the fourth quarter. And we project higher same-store revenue growth.
External growth was also strong in the quarter. We continue to be selective and disciplined in our acquisition efforts, but have been able to find acquisitions with acceptable risk adjusted returns, primarily through existing relationships. By year end, we expect to have acquired over $1 billion in properties with Extra Space investing approximately $600 million. Between acquisitions and third-party management contracts, we have added 140 stores through the quarter. We have more than 500 third-party properties and a total of 734 stores, including joint ventures.
Our report related to new supply remains generally unchanged. We are seeing an impact from new supply in certain sub-markets, and its impact varies by location. New stars appear to be down in many MSAs already saturated with new development and activity is migrating to markets where there may be a better yield. We continue to see delays in deliveries and see many proposed projects being abandoned. Our highly diversified portfolio, while certainly not immune to the effects of new supply, reduces volatility. And our sophisticated platform is better prepared to respond to competition than ever before.
At this time last year, we were reporting the impact hurricanes had on our customers, our employees and our properties. Unfortunately, the Southeast experienced severe weather again, but I am happy to report that our portfolio was relatively unscathed. We did not have any material disruption with customers or employees, and damage to our properties was minimal.
I would now like to turn the time over to Scott.
Thanks, Joe, and happy Halloween, everyone. Last night, we reported core FFO for the quarter of $1.20 per share. Rental rates to new customers continue to be solid. Throughout the quarter, our achieve rental rate was up approximately 3% to 4% year-over-year. As expected and as discussed on our last call, discounts as a percentage of revenue were also up, partially offsetting revenue growth.
As Joe mentioned, we anticipate the impact from discounts to decrease in the fourth quarter, resulting in an increase in same-store revenue growth. We saw expense growth normalize in the third quarter, and we were successful in minimizing increases in our controllable expenses. Property taxes, while elevated, were in line with our expectations. The increase in insurance premiums was not a surprise due to the elevated level of property claims caused by last year's hurricane.
We also chose to invest more in marketing in the quarter, allowing us to grow rates and keep our stores full heading into the fall and winter. We continue to execute our leverage neutral balance sheet strategy. During the quarter, we increased the percentage of unsecured debt and the size of our unencumbered pool and further laddered our maturities. We're also in the process of increasing and extending our credit facility. In the quarter, we sold $34 million on or ATM at an average price for $99.75 per share. We also disposed off one property in California for $40.7 million. The property was sold at a below market cap rate for an alternative use and we anticipate the reinvested proceeds will produce a significantly higher yield.
This store as well as three other stores with large expansions or redevelopment projects were removed from our same store pool, consistent with our guide -- with our same store definition, changing our total same store number to 783 properties. We’ve updated our guidance and annual assumptions for 2018. Our same store revenue guidance remains unchanged. We’ve increased the bottom end of our same store expense growth by 25 basis points. We’ve tightened same store NOI guidance by 25 basis points at both the top and bottom end of the range with the midpoint unchanged. We increased our core FFO guidance by $0.50 at the midpoint. FFO guidance includes $0.06 of dilution from value-add acquisitions and an additional $0.14 of dilution from C of O stores for total dilution of $0.20. The lease-up of these properties continues to exceed underwriting expectations as a portfolio and will generate long-term growth for our shareholders.
With that, let’s turn the call back over to Jeff to start our Q&A.
Thank you, Scott. In order to ensure that we’ve adequate time to address everyone's questions, I would ask that everyone keep your initial questions brief. If time allows, we will address follow-on questions once everyone has had an opportunity to ask their initial question.
With that, Lisa, we will start our Q&A.
Thank you [Operator Instructions]. I have first question that’s coming from Jeremy Metz of BMO Capital. Your line is open.
Joe, on the supply front in your opening remarks, you mentioned delays and deliveries and some projects being abandoned, but you also noted no change to your expectations. So just trying to reconcile those. Because it sounds like some of the items you’re pointing to would lead to arguably feeling better about the supply outlook for next year if there are deals starting to fall out?
So I think generally our view is unchanged that we’re in a supply cycle, a development cycle and that it’s having impact on our operations in stores. There’s some new supply being added and there's some falling out. But I would say last quarter, I was asked about 2019 and I said that we -- subject to what is scheduled for 2018 getting pushed into 2019, I said we thought 2019 would be flat to moderately down in new deliveries.
Now based on the data we have now and what we're seeing, I would say 2019 is going to be down. So, we are seeing a slowing in the development cycle and -- but it's not a material change. I mean, we’re still going to have impact on our operations from new supply in 2019. You have the cumulative effect of what's being delivered but I do see the delivery slowing.
And can you tie that into maybe just some of your bigger measures in terms of where you maybe see supply pressures getting worse even just from deliveries of ones where you maybe see it abating more than others and feel more better?
So the Florida markets, I think are going to get worse before they get better. We’ve seen the acceleration in Dallas, Portland, I think it's going to get worse; Washington DC, it may get worse; Chicago is a market that’s on the other end of the spectrum where we’re seeing some improvement.
Last one for me. Scott, you mentioned the achieved rates holding in that mid-single-digit range. I think you said 3% to 4% this quarter. Discounting has been a drag, which you noted. So if you factor all that in, where are your net effective rates and how has that been trending?
So our achieved rates for the quarter were 3% to 4%. If you look at the impact of discounts in the quarter, discounts decreased our revenue by about 80 basis points in the quarter. So without discounts, our revenue would have been -- had discussed been flat year-over-year, our revenue would have been 80 basis points higher.
Next question is coming from Todd Thomas of KeyBanc Capital Markets. Your line is open.
Scott, Joe, your comments about the discounts being lower year-over-year in the fourth quarter and revenue growth being higher. It seems like the comps overall beginning in late 3Q the hurricanes last year and over the next couple quarters, would be a little bit more difficult. I understand the discounting dynamic. But I was just hoping you could provide some additional context around that comment and maybe provide some insight around some of those factors heading into 2019?
Yes. So the discounting strategy is just part of our overall revenue maximization strategy. So discounts are the lever that we have chosen to pull this year. And the difference this year versus last year is last year, we did not discount as heavily in the third quarter. So during the summer months of last year, our discounts were low. This year they were high as we chose to keep rate and use discount. So it was more of a comparable from last year than a change in what we’re doing overall.
So, we expect this year’s discounts pretty comparable to last year. So a portion of that 80 basis points that we’re -- we saw discounts impact our revenue by about 80 basis points this last quarter. We expect to a big portion of that to not be there in the fourth quarter. So while overall revenue -- year-over-year or sequentially continues to get tougher, revenue -- the rate of growth slows the impact of discounts less than in the fourth quarter.
And then how should we think about that? So you’re anticipating your model shows revenue growth being higher in the fourth quarter versus the third quarter here. Any insight into how we should think about 2019 just in terms of maybe setting expectations?
So, obviously we’re not ready to give 2019 guidance, we’ll give that on the first quarter. I think with the supply cycle, we expect things to continue to moderate. But I don’t think that we expect things to go negative by any mean. So we’ll give our guidance in first quarter of this next year.
And just last question for me, the decrease in net tenant insurance income, I don’t know if I missed this in your prepared remarks. But was that attributable to the hurricane expenses or is that something else? And how much expense that's not non-recurring, what was in that number?
It actually was not attributable to the hurricanes. We had some claims from the hurricanes but not significantly higher. It was primarily due to some water claims from the tough weather during the winter months of this past year.
And how much was that in the quarter?
In the quarter, we were $1 million to $2 million high, and some of that was -- some of those claims were made late processed late. So while they happened in the winter months, they didn't get processed or adjusted until third quarter.
Next question comes from Samir Khanal of Evercore. Your line is open.
Scott or Joe, I guess, where do you stand on your views on property taxes for '19 based on where you sit today? I mean, you had -- if I look at your numbers, you had higher taxes, especially in the first half of this year and primarily in 2Q. So if that doesn't repeat, comps could be easier, may be better NOI growth and especially in the first half of '19. It feels like with some of the other companies in our coverage universe, these onetime items of higher taxes, they say it's one-time but then they continue to repeat. So, I want to get your view as we think about '19 growth here?
So certain states are pretty fixed in property tax growth. I mean California is relatively fixed. Other states like Texas or Florida reassess quite frequently and are quite aggressive. As those values approach what things are trading for, they typically slow in their reassessments. So, I think property taxes are potentially your biggest risk on expenses and potentially the biggest benefit in expenses as year-over-year comps become easier or as some of these states flow down in their reassessment.
And I guess my second question is just looking at your debt maturity, I know you've got roughly $300 million of debt that's maturing between now and in '19. How should we think about that piece? How will you address that?
We'll continue to do more unsecured debts as we move things forward in '19. If you look at it with extensions, it's actually pretty low in terms of the amount of maturities we have. So we'll extend a portion of that and then we'll continue to fund things with primarily unsecured debt as we move more towards an unsecured balance sheet.
Next question comes from Smedes Rose of Citi. Your line is open.
I wanted to ask you just for the fourth quarter a year ago. Do you have a sense as to -- was there any impact, lingering impact of higher occupancies due to the hurricanes and maybe what you think what we should be adjusting for this year? And then my second question, I just wanted to ask you on the acquisitions front if you're seeing any changes in pricing and the private market just given the upper bias in interest rates? And if you're not yet, do you have a sense of how long that takes to follow through?
Smedes, I'll address the Florida Houston question and then Joe will take the acquisitions one. Florida really provided no benefit for us last year in terms of upside from the hurricanes. What we saw is lot of people moved in, most of those people moved in the first month free and then moved out 30 days later. Houston was a little bit different. Houston we saw a fairly benefit. Our occupancy jumped quite quickly. But Houston is less than 2% of our portfolio. So I wouldn’t tell you it’s going to impact it significantly.
And if you look at our occupancy overall as a portfolio at the end of the third quarter, we are 20 basis points ahead of where we were last year. Even though a market like Houston is 400 basis points behind in our occupancy, Florida is actually slightly behind as of the end of September. Florida will come back in October in terms of occupancy. But we expect Houston to be a tough comp for the year, but a small percentage of our income.
Smedes, on the acquisition question. We really have not seen any material change in pricing. We have not seen cap rates increasing. Although, you would expect them to as interest rates go up. I guess as interest rates started to go up, lenders tightened spreads a little bit that made up the difference. But that can't go on forever. So, if there are several rate increases next year, at some point, you would expect cap rates to react but we haven’t seen it yet.
So I mean do you guys remain primarily focused I guess on your third-party managed as a potential pipeline of acquisitions, or I guess where do you stand on external growth at this point?
So little over 80% of the $1 billion of acquisitions gross that we’ll do this year came from relationships, either joint venture partners or third-party management of relationships, we’ve had less than a fifth that were brokered deals where we’re competing in the market. And I think that's going to continue. We find very few situations where we can be the high bidder in a brokered situation and we're very lucky and fortunate to have these great relationships and some are proprietary pipeline that allows us to continue our external growth.
Next question is from Jonathan Hughes of Raymond James. Your line is open.
Joe, just wanted to clarify what you said earlier when you mentioned seeing new supply activity, migrating to markets with better yields. Are those secondary tertiary markets you are talking about, or suburbs and primary markets?
I would say secondary tertiary markets. A lot of suburbs are primary market I think of the secondary markets too. So, I would include all of those. But moving out of the main downtown or primary suburbs or excerpts of the maiden markets and moving to these other secondary type markets.
And then going back to Smedes's question about external growth, your percentage of assets or acquisitions bought out of the third party platform, you said 80% are already managed that was maybe 30% a few years ago. And it get underwriting perfect on those assets. So lower risk. But the strength of your platform is pretty impressive. And why not try to go out and buy more non-managed stores with more operational upside? I mean of course, assuming you can buy them. I am just looking at the integration of these third-party assets -- third-party managed properties into your same store pool going forward and the growth that’s going to be lower in the future, because there is not much upside. Is that a fair assessment?
For the most part, yes. So, not all of that 80% were manage. Some of it is truly from relationships we have with people and we don’t actually manage the properties at the time. Secondly, we’ve been buying this year more than ever before many of these stores in joint ventures, which even though they are maximized from a management standpoint because we do manage them, we do get outsized returns, because we’re not investing 100% of the capital but we get a management fee, we get the insurance proceeds and we have the opportunity to earn or promote.
In a perfect world, I would love to buy more from the mom and pops and from under managed properties and get them more juice out of the deals, but I want to pay for it. So, we’ll do that when the pricing is right. And when the pricing isn’t right, we need to remain disciplined and patient.
And then just one more and I’ll jump off. But could you just maybe give us details on the yields on the operating store acquisition this quarter scheduled to close by year-end? I know you said transactions market hasn’t seen any change but curious what you paid for those couple stores? Thanks.
So the stores were in different stages of stabilization with the Fort Lauderdale store was fully stabilized and the other stores we underwrote between 10 and 22 months to get the stabilization. So they’re not -- so the initial yield was not always the stabilized yield. But if you average them all together, first year was in the low 5s and stabilized was in the mid-6s.
And maybe what was the stabilized yield on the Lauderdale acquisition if that one was fully occupied?
6.5…
The next question is coming from Eric Frankel of Green Street Advisors. Your line is open.
Joe, could you comment a little bit on the cause of some of the supply decreases or the drops in attentive starts?
So one thing is that, there is better information out there in the market today now than there was a couple years ago, there is some third-party providers that are doing a pretty good job of putting together information. So when a developer or an equity source or bank is looking at a proposal to build the next door in North Dallas, it’s fairly easy to see there’s a lot there already. And that may not be the smartest thing to build the next store in North Dallas.
Secondly, costs are up; interest rates are up, we talked about that; land pricing is up; labor is certainly up; material is up. So you have an increased cost. And then the other side, you have moderating operating projections. If someone honestly underwrites a deal, they’re not going to underwrite 8% rent growth. And so a few that you have increased costs and moderating projections that squeezes your development yield. And then you have lenders that are somewhat more cautious where you have a little bit more difficulty getting loans. So I think all those factors make it harder these days to stick the next shovel in the ground.
Is it fair to say that a lot of developers were underwriting a lease up time of say two years, three years or is it most, which is maybe common a couple of years. But that's turned out to be what has historically been a three to five year range?
I don’t know if it was lease up time or rate. But in general, developers are optimists and they will create a pro forma that has an aggressive lease up rate and aggressive lease up time period, and an aggressive unit mix too, which is what we frequently see where the unit mix is meant to maximize revenue, but may not actually work in the market. And the equity providers and the lenders and the operators, the manager's job to try to make sure that developer has an realistic pro forma and if that can get financed then the deal typically goes forward. And if not, sometimes it gets put on the shelf.
Just another developing financing related question, I think when you're public peers as take on the strategy of underwriting a construction mezzanine loan business. Whereas, I think what you and some of your peers, do more of the certificate of occupancy type acquisitions, those are available. Would you consider being in the lending business as well if it led to more investment opportunities?
So we do not wanted to be in the lending business for development. And the primary reason for that is because if you make a loan, you have to be willing to own that project. And we don't want to own a brokered development deal where we have to continue development take the project to completion, there's obviously already problems, that's not a risk we're willing to take. We are willing to make loans on completed buildings that we want managed and to be willing to own.
Next question comes from Tayo Okusanya from Jefferies. Your line is open.
My first question has to do with the comment made earlier about discounts declining in 4Q. I'm just again wondering how the confidence level you have in that just given some of the supply issues that are still out there, why you wouldn't keep discounts and to try to maximize revenue?
So, I don't think we're necessarily cutting back on discounts. It's more a comp issue. So, we will discount in October, November, December, but the difference is as we also discounted last year in October, November, December. So just seasonally, you typically have more discounts in the fall winter than you do in the summer whereas this year, we increase our discounts in the summer month. So our strategy year-over-year is much more similar this year.
And then the second question. Just given your meaningful exposure to L.A., as well as San Francisco and some of the talks happening around prop 13, potentially hitting the ballot in 2020. Just wondering what you're hearing about that, what you're thinking about that? And if you've done any homework about what impact that could have on EXR?
So obviously we recognize that it as a risk. Some of our properties are legacy properties that we've owned for quite a while that have just had the 3% raises every year. We have done some math. It's pretty simple math where you’re basically comparing what you're paying in taxes today compared to if they were assessed at full value. We understand what that is. Clearly, it's an impact. It will depend a little bit on; one, if it gets passed; and then two, how they phase that in. So, very difficult to really comment on the impact at this point, but it's a risk we’re monitoring. I think the Self Storage Association is aware of that. I think that there you'll probably see some lobbying efforts around that.
Is there anything you’ve done in regards just the worst case analysis like if at all shows up straightaway?
We have, but it’s probably not something we would want to disclose on the call today.
The next question comes from Wes Golladay of RBC Capital Markets. Your line is open.
I just want to go back to the $0.20 dilution this year from acquisitions and C of O deals. Will those be still dilutive next year? I know you might have some more roll in, but just for this comp set here. Will you get to, I guess, a no dilution point next year? And has there been any change in stabilization of C of O deals as far as timing goes?
So we’ll continue to add C of O deals, you can see that in our supplement. So, as the value-add and C/O deals that are causing that $0.20 lease-up, we'll have others added into the pool.
And it depends a little bit on what stage they’re at in terms of their lease-up. So a property they opened fourth quarter of this year, clearly, will be dilutive next year. And acquisition that we bought that was 70% full and we bought it in January of this year, it likely is not dilutive next year. So overall, I would tell you, part of that $0.20 continues into next year but it's a different pool, a different group.
And then what is still the typical underwriting and what I'd recall before was up to three years, but they were stabilizing maybe one to one-and-a-half-years. Has that changed at all?
So we are underwriting C/O deals between 36 and 42 months to achieve economic stabilization, depending on the size of the property in the market that it's in. And we’re currently doing maybe slightly better than 36 months, maybe 30 to 36 months to get the economic stabilization and we’re getting to occupancy stabilization earlier than that.
Next question comes from Todd Stender of Wells Fargo. Your line is open.
Probably for Joe just around that your last thoughts there on the C of O and lease-up duration, I wanted to just get a sense of how you're incorporating maybe potentially higher risk in your underwriting assumptions. It just depends on -- it's being acquired within a joint venture wholly owned. Are your yield expectations upfront coming up? Is leverage assumed for these portfolio deals coming up? I just want to get some color maybe -- you’re going to expect a little more yield upfront, because the NOI strain going forward might slowdown. Just getting a sense of the risk there?
So we -- everything needs to make sense on an unleveraged basis. We underwrite on an unleveraged basis. And if it doesn’t make sense, we don't try to do the deal by adding leverage to it. So that’s an easy answer. We’ve been underwriting pretty consistently at 90% occupancy, 36 to 42 months lease-up and 3% rental rate growth. And some of those -- given where you see our current occupancy and revenue rate growth, some of those maybe conservative numbers. But that’s -- we feel that’s the right way to underwrite these deals.
Our target stabilized yield on C of O deal is and has been for some time 8%, plus and minus, if someone brings us one in a great location and bear temporary market where we take a little less? Yes, probably and a little more another markets; but that’s our target yield that we think compensates us for taking the dilution during the lease-up period; and we bring in joint venture partners; so we can stay within our dilution target and we don’t have too much dilution; so we can de-risk these deals; so, we’re doing more of them and spreading our equity out further; and so we can enhance our returns.
And then lastly, the Menlo Park property sold, you got a huge gain but it’s also high barrier very affluent market. Is that just an offer you couldn’t refuse?
So we sold that to in adjacent corporate -- large corporation that wanted the property for an alternative use and we sold around a three cap. So we can take those dollars even though, it’s probably impossible to build storage in Menlo Park, we can take those dollars and double the yield from them like reinvesting them, which we have done through reverse 1031 exchange. So every property is for sale if someone offers us enough money.
Next question is from Juan Sanabria of Bank of America. Your line is open.
So I just wanted to touch back on supply? Do you have a sense of what percentage of your portfolio is going to be exposed to that three year rolling supplier '19 versus what that number is in '18, and if that delta is going to be a greater percentage and to what extent?
So let’s start by looking at '18. About a third of our portfolio moved -- of our own portfolio of 841 stores, will be facing new supply in 2018. But of those stores, almost half of them had not yet been delivered. So, some of those are under construction. So they will be delivered, but there’ll be pushed into 2019. And others are under the proposed list. So they may or may not be delivered. Under -- in 2019, that number is less than half of that, of what we’ve identified. So that’s where we see the drop off into 2019. Did I answer your question?
Yes. When you say less than half, so 15% if ’18, is that fair?
14%...
But do you have a sense of what that is on a three year rolling window, not necessarily new deliveries -- three year rolling window of deliveries. Is that more or less?
So it actually goes up. The three year rolling goes up by 9%, because you're dropping off 2016, which was a relatively small number and adding the 2019, which is while a smaller number than 2018, a bigger number than 2016.
And that's up 9% to what or from what base? Just to be get sense of the total portfolio exposed on three year basis?
So, a three year ending in 2018, is probably close to 50%. And then you're closer to 60% in the three year ending in 2019. Is that the right question?
Yes sir. Thank you very much, that was perfect. And then just on from a same-store perspective. How should we think about the benefit of the new stores being added next year to pull and relative to the benefit you've had this year, which is come down as the year is gone?
So we haven't completed the 2019 budgets. But I think the majority to benefit will come from C of O stores that are moving into that pool and less from acquisitions. I think that -- I would tell you it's going to be somewhat minimal. It's a big enough same-store pool and you're not bringing that many properties in that the number is not going to be that significant.
And one last question for me. So you said that the concessions were about any an 80 basis points drag to the third quarter same-store revenues. And you've described the fourth quarter given an easier comp has not been an issue. Does that mean that that 80 point delta goes away to zero in terms of a drag on a year-over-year basis?
Not sure it goes to zero, but a significant portion of it goes away.
There are no remaining questions. I would like to turn the call back over for further remarks.
Thank you. Thank you for joining us today. We are pleased with our platform and our team's ability to continue to drive rental rates and occupancy. We have always invested in our platform, our portfolio and our people and it is paying dividends in the current competitive environment. 2018 is following our expectations and our diversified portfolio is performing well. We're excited about our outsized external growth as we enhance our size, scale and brand. We thank you for your interest in and support of Extra Space Storage. We look forward to seeing you and speaking with everyone at NAREIT. Have a great rest of the day. Thank you.
Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.