Extra Space Storage Inc

Hello, and welcome to Q1 2019 Extra Space Storage, Inc. Earnings Conference Call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touchtone telephone. As a reminder, this conference is being recorded. I now would like to introduce your host for today's call, Jeff Norman. You may begin.

Thank you, Tawanda. Welcome to Extra Space Storage's first quarter 2019 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 risk 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, May 1, 2019. 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.

Hello, everyone. Thank you for joining us for our first quarter call and for your interest in extra space storage. We had a good first quarter with positive rate growth and high occupancies, resulting in same-store revenue growth of 4.2% and same-store NOI growth of 4.8%. This contributed to better-than-expected FFO growth, which was two cents above the top end of our guidance. Performance continues to be steady despite new supply, and we are well-positioned heading into the summer leasing season. While we are very pleased with the better-than-expected first quarter results, our views for the balance of 2019 remain generally unchanged. We still believe 2018 was likely the high watermark for total deliveries, and we expect 2019 deliveries to be only modestly lower. Further, we expect the total impact on performance from new supply to be greater in 2019 than it was in 2018 due to the cumulative impact of several years of elevated development. We are seeing this impact in the lease up of our CFO stores. LeaseUp has slowed from a pace that was well above pro formas in 2015 through 17 to trends that today are more in line with historic norms and with our underwriting. That being said, our people and our systems are working hard to maximize performance in a challenging operating environment. Our digital marketing platform continues to drive qualified traffic to our stores. We have maintained occupancies above the market averages in MSAs with new supply, but it comes at a cost. Costs per click are elevated due to a competitive bidding environment, and we are choosing to pull the advertising lever harder in order to ensure web visibility. In the current environment, large operators like Extra Space are best positioned for success on the web. In the quarter, we invested $270 million in acquisitions. We continue to have success acquiring properties through off market transactions. For example, and as we mentioned last quarter, we bought a joint venture partners interest in 12 properties in Los Angeles and the Bay Area for $192 million. We continue to explore other opportunities to enhance shareholder returns through mutually beneficial partnerships. We also continue to see significant growth in our third-party management platform. In the quarter, we added 46 stores, while only two stores left the platform, both due to a property sale. Additions to our third-party platform continue to be a mix of newly constructed and existing properties, bringing high-quality stores into our system, as well as additional income. Between our third-party program and our JV stores, we have 805 managed stores with a strong remaining pipeline for the year. I would now like to turn the time over to Scott.

Thanks, Joe, and hello, everyone. Our core FFO for the quarter was $1.16 per share, exceeding the high end of our guidance by two cents. The beat was primarily due to stronger-than-expected same-store property performance, and lower than anticipated G&A in income tax expenses. We continue to see solid performance in the majority of our markets. Revenue growth was primarily driven by achieved street rate growth. Discounts were also down as a percentage of revenue in Q1, providing a modest tailwind that we don't necessarily expect in future quarters. Our same-store revenue growth includes a change in pool benefit of 30 basis points in the quarter. and we anticipate that it will provide a benefit of 15 to 20 basis points for the full year. This quarter, we've added an additional disclosure to our financial supplemental showing a third year of same-store pool performance. This disclosure should help further reconcile differences in same-store pool definitions in the industry. Same-store expenses were a mixed bag, with increases in property tax and marketing spend which were partially offset by savings in payroll and utilities expense. We expect continued pressure on property tax and marketing expense, but we are comfortable with our ability to operate within our guidance. We have not made changes to our annual same store revenue expense or NOI guidance, which imply moderating revenue growth. As we said in our last call, the moderation will result will be a result of increased impact of new supply, along with the difficult comps in markets that have performed well above the portfolio average for multiple years. We have increased our full-year core FFO guidance to $4.76 to $4.85 per share, which includes the two-cent beat from the first quarter. We also made minor changes to our G&A interest expense income tax, and share count guidance. Our FFO guidance includes $0.07 of dilution from value-add acquisitions and an additional $0.16 of dilution from our CFO stores, a total dilution of $0.23, which has not changed from our initial guidance. We believe these acquisitions provide significant long-term value for our shareholders and improve the overall quality of our portfolio. With that, let's turn it over to Tawanda to start our Q&A.

Thank you. Ladies and gentlemen, if you have a question at this time, please press star, then the one key on your touchstone telephone. That's star one if you have a question. Our first question comes from the line of Shirley Wu with Bank of America. Your line is open. Your line is open. Our next question comes from the line of Jeremy Metz with BMO Capital. Your line is open.

Hey, guys. Good morning. I was wondering if you could discuss the crossover between discounting and marketing. I recognize this is maybe a little dated, but if I look at your discounting trends from your last slide deck and assume those more or less carried through the first quarter, It looks like there's perhaps maybe call it a 40 basis points give or take benefit to revenue growth from the lower discounting as a percentage of revenues relative to last year on a dollar basis. It's about equivalent to the increase we're seeing in the marketing spend, which is up 24%. So I'm just wondering, you know, it all gets you to the same place in terms of NOI and earnings, but is there any toggling between those two items?

Jeremy, during the quarter, we didn't have a significant change in our discounting strategy. it was actually impacted a little bit by the lower number of rentals. So if we had fewer rentals, your discounts are down a little bit. And then we gave a slightly fewer number of discounts to rentals coming in the door. So it wasn't a significant change. In terms of marketing, we did choose to pull the marketing lever to maintain our market share and to continue to move the needle in terms of rentals.

But they're not, Jeremy, this is Joe, they're not one-to-one correlated as discounts go up market. marketing goes down or vice versa. They're just two of several factors that all interplay together to achieve our goal of maximizing revenue.

All right. And then, Scott, you know, obviously the balance sheet's in good shape. Your stock is out there hitting all-times high. It's well above the leasework consensus any of you is at. How do you think about raising equity here, whether to get more active on new investments or even just warehouse and capital for the stuff you have in the pipeline?

Yeah, so we, you know, obviously it'll depend on where we have, if we have a use for that money. So we've always said we want to remain leverage neutral in terms of our balance sheet. And if we have a use for the capital, then equity is an option. But how we underwrite a deal doesn't change. How we capitalize a deal doesn't. you know, could depend on where our stock is trading versus where interest rates are, but it is an option for us.

And maybe just to go with that, Joe, can you just talk about how active the market is for acquisitions right now and anything notable on the pricing front that you're seeing?

Sure. So, you know, to date we've invested $270 million, so we feel that's a good number. We're happy with that. We're happy with the deals that we had. There's not as much activity in the market in the first quarter as there was, say, in the second half of last year. It's been somewhat quiet. We hope that's seasonal and the market will pick up and there's more opportunities either in the broad brokered market or, more importantly, through our relationships, which is where we usually have the most success. And I've seen absolutely no changes in pricing. There is still lots and lots of equity of all different flavors seeking exposure to storage, and that is keeping cap rates where they are.

Thanks for your time, guys.

Thank you.

Thank you. Our next question comes from the line of Shirley Wu with Bank of America.

Hi, guys. Sorry about that before. That wasn't working. So my first question is on street rate trends in 1Q of 19th. I think in your prepared remarks, you mentioned that it was up. Could you give a little bit of color on to how much that was?

Yeah, our achieved street rates in the first quarter were between 2% and 3% on average for the first, you know, to new incoming tenants.

And how has that changed in April?

It's closer to 2%, but it's still solid.

Okay. And so on the flip side, for discounts, You mentioned that you don't expect the discounts coming down as percentage of revenue to continue. So how do you see concessions kind of trending throughout 2019?

Our guidance and our budgets for the year don't assume any benefits, so flat year over year compared to where they were last year.

Great. Thank you for that, Collar.

Thanks, Shirley.

Thank you. Our next question comes from the line of Sleet Rose with Citi. Your line is open.

Hi, thanks. I was just wondering if you could provide a little bit of color on the performance in a couple of your larger markets like L.A. and New York, which look to put up, you know, pretty – I mean, well, more than pretty good, very, very good results. And I think if I'm remembering right, it sounds like maybe in markets like L.A. that were more mature, you were sort of maybe bumping up against sort of an absolute dollar – increase in pricing that you felt you could achieve. So could you just maybe talk about how things are trending there and maybe you were surprised too in the first quarter?

Yeah, LA continues to perform very well. We are concerned, as you point out, that in these markets where we've had year after year of above inflationary, significantly above inflationary rent increases, that that's not sustainable. But we had a great quarter in L.A., and there's only – if you look at the L.A. MSA, there's only certain kind of subpockets where supply is an issue. But for the most part, supply is not an issue, and we're continuing to be able to move rates in a pretty healthy manner.

Okay. And then in same – I guess sort of same observation in New York?

Yeah. So the New York MSA, I will tell you we were surprised that it did perform better, particularly in northern New Jersey and Long Island than we anticipated and in the face of some new supply, particularly in northern New Jersey. So, you know, our systems, our ability to attract customers, part of that a result of increased marketing spend has allowed us to increase revenue at a greater rate than we thought we'd be able to in that market.

Okay, thanks. And then just for the last question, I just want to ask you, are you seeing any change in behavior of new competitors where there is, you know, maybe an overabundance of supply, at least in the near term, sort of differences between independent operators versus, you know, the larger players? any sort of change, you know, the way that they're driving pricing or occupancy?

I'm not sure if it's a change. It is competitive out there. I would tell you I think the large operators are more rational in their pricing movements, and sometimes the small operators can do things that we would consider ill-advised. But I don't think there's been any significant change.

Okay, thank you.

Thank you.

Our next question comes from the line of Todd Thomas with KeyBank Capital. Your line is open.

Hi, thanks. First question, Joe, over the last few months, it seemed like there was an expectation that there would be some opportunity around some distressed development deals, maybe some lease-up projects. And you commented that the pace of lease-up on some CFOs in your portfolio is slowing. It's now back to historical norms, which is consistent with what you're underwriting. So it doesn't sound so bad. Are you still expecting to see some distress and some opportunity or is that not the case? Maybe conditions are improving a little more broadly across the industry relative to your prior expectations?

Yeah, I hope you didn't take from our comments that conditions are improving across the industry. Obviously, this is a market-by-market business and there are some markets that may be later in the development cycle that are improving. but there's also many markets that the development cycle is hitting full force and will de-accelerate in the future. I'm still hoping for the distress or the disappointment deals. We didn't see them in the first quarter, but I'm still hopeful and anticipate in a challenging environment that those acquisition opportunities will appear.

Okay, and then... Scott, I know your guidance implies growth slowing throughout the balance of the year, and you commented on that a little bit. I may have missed some of the ins and outs here, but right now growth is heading in the other direction. So maybe you could just provide a little bit of additional color around what you're expecting to change that trajectory and maybe pressure growth a little bit in the portfolio throughout the balance of the year.

Yeah, our first quarter obviously was a strong quarter. You know, we had it budgeted, but our first quarter actually exceeded our budget slightly. Throughout the year, we're assuming that it continues to – the rate of growth continues to decline throughout the year. That's our assumption in our budget. It's impacted heavily by certain markets that have a lot of new supply. You know, Florida is a tough market, you know. And as we look forward, we think that many of these stores continue to slow in terms of their rate of growth, you know, whether it's a same-store pool or a lease-up store. So, overall, our guidance and our budgets continue to slow. We'd like to get into the second quarter and see where that goes before, you know, we change guidance or do anything of that sort.

Okay. And just lastly, I was just wondering if you could tell us where our occupancy was, April 30, what that looked like year over year.

At the end of April, our occupancy was up from March by about 40 basis points, but it was slightly, if you take year over year comparison, we were down 20 basis points at the end of March. It was down 40 basis points at the end of April. So slightly different, but again, within our guidance and no big surprises there. April was still a solid month.

Got it. Thank you. Thank you.

Our next question comes from the line of Alan Way with Goldman Sachs. Your line is open.

Good afternoon. I guess a bit of a follow-up on the last question here. We noticed in the last couple years that you had a steep 2Q same-source slowdown versus the first quarter. Just curious what the mechanics were for this to happen, and do you think this pattern will repeat for the rest of the year?

So Q2 is typically better than Q1. Obviously, it's kind of you're moving into the leasing season, but it's going to be somewhat a comp year over year and how we did the prior year. So that could potentially be what you're seeing a little bit there.

I'm thinking last year was primarily discounting.

Correct. And then the other thing is Q1 typically has more benefit from our change in same store pool. So Q1 is this year we had 30 basis points in the first quarter, and we are estimating for the year that to be 15 to 20, which would assume by Q4 it's very little benefit.

Thanks. That's helpful. And you did mention in your guidance that you don't expect any benefit or track from discounts. Do you think you'll need to reintroduce discounts at some point, or do you think the environment for pricing has improved as of late?

So we continue to use discounts. Most new rentals get a discount. Well over 50% of our new rentals coming in the door are going to get some type of discount.

Got it. Your peer PSA has announced a property of tomorrow initiative, which requires a significant investment and will take several years to complete. Just curious, how do you think your portfolio compares with the newer generation product currently on the market?

I think we've done a good job of continuing to invest and upgrade our properties to keep them relevant and attractive to customers, and we spend money every year doing that, and we'll continue to do that.

Cool. Thank you very much.

Our next question comes from the line of Todd Spender with Wealth Fargo. Your line is open.

Hi, thanks. Just looking at the California properties that you bought from your JV partner, can you characterize the properties, maybe just to look into the submarkets and maybe share any CapEx that's required, I guess, just to look inside that portfolio? Thanks.

So these were all properties that we built. They're in infill areas, 10 in Los Angeles, 2 in the San Francisco area. They've been, we've owned them in partnership for many years with our partner. They've been well-maintained. Capital's been spent every year. They've been part of our seven-year rebranding program that we started three or four years ago. We're about halfway through the portfolio, a little more than that so far. So these are not stores that need a lot of capital. They're great, solid, steady, core acquisitions.

And you've been managing them on a third-party basis, is that right?

No, we were about a 95-5 joint venture partner, but we did manage them, not on a third-party basis, on a joint venture basis.

Okay. Thanks. And then how about pricing on this? How do you look at pricing? You take out your JV partner. They're obviously stabilized, getting market rates. What kind of pricing do you ascribe to this?

So on the gross value that was negotiated for the portfolio, the purchase price for forward 12-month yield after tax reassessment was sub-5, which is market for these types of assets in these markets in California. But we had an embedded promote in the venture of $72.8 million that we couldn't realize without a capital transaction. So putting that promote towards the purchase price, the first year yield after tax reassessment was 6.3.

Okay. Thank you, Joe.

Sure. Thanks, Doug.

Next question comes from the line of Ronald Camden with Morgan Stanley.

Hey, just a couple quick ones from me. Just wondering if you could provide a little bit more color on the marketing spend, meaning are there any specific markets or regions that really drove the increased spend? And also, I think you touched on that bid pricing are going up every year. Is there a way to quantify that? Is that high single digits? Is it double digits? How should we think about that?

Our spend for the year, our original budgets were 15% increase, which was what we were thinking we were going to need to spend to kind of keep up with the inflationary pay per click spend. We have spent a number higher than that in the first quarter, and we're assuming we'll have to spend at an accelerated level throughout the year. It's across the country, the additional spend, but it is probably a little more focused on new supply markets or markets where we're struggling.

Great. That's helpful. And then sort of touching back on some of the bigger markets, just looking at Dallas, we're still seeing a lot of products in the pipeline. Just curious if you can remind us how you guys are thinking about that and maybe how your assets are positioned versus the new supply coming in.

Yeah. Dallas is a market that is challenged. And, you know, if you look at our supplements and see our revenue growth there, which was less than 1% is, you know, is below portfolio average. Our stores, you know, the North Dallas area is the most challenged. And those are our stores that we're focused more on. And in South Dallas and other areas, we're doing slightly better.

Great. And then the last question I had was just if you could remind us what the spread between the asking rate and the existing tenant rate was maybe during the quarter and how that's trending in April.

So the quarter is actually our worst time of year. You know, on average, we're mid-single digits in terms of where our ask rates are and our in-place rates. The worst time of the year is the winter months, so kind of January, February. The best time of year is the summer months when they're essentially flat. But on average, it's mid-single digits, so You know, this is the worst time of year, so higher than that. Also, thanks so much. Thanks.

Our next question comes from Milan with Jeffrey. Your line is open.

Yes, good afternoon. You guys, you know, typically, you know, you're always kind of doing very interesting things, trying to figure out the best way to maximize profits. between pricing and as well as our volume. Just kind of curious if you could talk a little bit about maybe some of the tests you may have done this quarter or maybe even the last few quarters or what that might be telling you about just the elasticity of demand from customers.

So I'm happy to say that we continue to do tests every quarter, every month. We're a very data-driven shop. We don't make any decisions without having the data analyzed and testing based on that, but not comfortable telling you what are the things we're actually testing.

Could you tell us anything about what it may be telling you about customer demand or elasticity of demand?

So, we don't see any significant difference in customer behavior. Demand is steady to increasing. The fear that folks had that millennials weren't going to rent has proven incorrect. Millennials make up a higher percentage of our renters than they do of the population. We see the stickiness, if you will, of the customers once they get in in the face of rate increases to be the same. So we don't see significant changes in customer behavior.

Gotcha. Okay, that's helpful. And then anything incrementally you could talk about also in regards to just business demand for storage?

So business demand has been pretty steady for many, many years here, and we don't see any significant increase or decrease in business demand.

Thank you. Good quarter.

Thank you very much.

Our next question comes from the line of Samuel Canole with Evercore. Your line is open.

Yeah, good afternoon, guys. Joe, thanks for your view on supply. You know, you talked about 18, which was the high-water mark on deliveries, but then you continue to see impact from sort of developments, you know, kind of the cumulative impact. So you're kind of taking those two and generally it doesn't have to be for your company but generally as part of the industry where do you think the trough and revenue growth will be? People say it's 20 but do you think it gets further pushed out into even 21 at this point with all the delivery and the impact of what's come on in the last couple of years?

You have So we don't have perfect transparency into the future. We don't know if development is going to continue its moderating trend that we see. That's what we would expect given the economics of development. But we don't know. We don't know if people with lower yield requirements or higher risk tolerances are going to keep sticking shovels in the ground. you know, when the inflection point will occur depends on things that we currently don't know.

Okay. And just switching gears a little bit on the disposition side, considering where cap rates are, and it sounds like, you know, cap rates are fairly low and for well-stabilized assets, do you consider even maybe selling into this market where pricing is favorable?

We just closed the disposition of a store in upstate New York this quarter. I guess after the quarter it actually closed. And we, you know, every year we look at our portfolio and look for assets that would make sense to dispose of either outright or into a joint venture to reduce our exposure to those assets or markets. And we'll continue to do so and execute when it makes sense.

Okay. Thanks so much.

Samir. Thank you.

Our next question comes from the line of Ryan Lum with Green Street Advisors. Your line is open.

Thanks. First, I'd appreciate the additional disclosure around your older vintage same-floor pools. But just one simple question. Can you elaborate on the brief or the small adjustment to G&A expense guidance? Thanks.

Yeah, part of it has to do with just the timing of some hires that we had, and so we are estimating the majority of that should flow through, and then some consulting expenses that did not come to fruition.

Thank you. Our next question comes from the line of Jonathan Hughes. With Raymond James, your line is open.

Hey, good afternoon. Looking at the broader stabilized stores data, just to give a larger sample size for performance, in L.A. and San Francisco specifically, it looks like revenue growth is flat sequentially, but the number of facilities in those pools were down from fourth quarter. Just curious what's going on there. Did you maybe lose some of those third-party managed stores? Because I think the same store pool was up a little bit.

I'd have to go back and look at that because I'm not sure we were down in LA or San Francisco. We could look at that and get back to you.

Okay, fair enough. And then I guess going on the other coast in New York, and that stabilized pool saw a pretty nice sequential increase in revenue growth. I guess what was the benefit from the new ads to that same store pool? Was it similar to the 30 basis point? boost to the overall portfolio on things for revenue growth?

It's really market by market. It'll depend on how many properties we have in it. So I mean, a market that only had 10 properties, obviously, and you add one, it's going to get impacted more versus, you know, Los Angeles, where you have a larger number of properties and you add one, it will impact it very little. So tough to really give you on a market by market basis here.

Okay, fair enough. I'll follow up offline.

Thanks, Jonathan.

Our next question comes from the line of Kibeen Kim with SunTrust. The line is open.

Thanks. Just a bigger picture, what do you think were the couple things that positively surprised you during this quarter?

I would tell you discounts being down, I think were a surprise to us in the positive aspect. I think the fact that some of these markets that have been hit by supply so hard have held on as well as they have. So, for instance, Dallas. And then the last one is I think our payroll was a little lower than we expected. And so, we've done some things there to try to get some more efficiencies, but we don't expect that to continue through the year. So, more of a one-time benefit in Q1 than rather an ongoing thing through the year.

I think certain markets performed better than we anticipated. Atlanta certainly performed better. than we thought some of the Florida markets that we thought were going to be impacted either through delays in delivery or otherwise are performing a little better.

Okay. And going back to your comments about seeing elevated marketing spend throughout the year and payroll, like you said, maybe it was a one-time benefit in the first quarter and that normalizes higher. How does that make you feel about your same sort of expense guidance, especially at the higher end?

So we're still comfortable with our guidance. You know, I think that it'll depend a little bit on your marketing spend on where you are in that range.

All right. And the last question, you probably saw the news that MakeSpace is partnering up with Iron Mountain. Does that change your views at all about the long-term efficacy of value storage companies?

I know it's quite early, but... It doesn't. I mean, when we look at current pricing for to a valet customer using valet versus storage it's kind of played out as we expected it's hard to it seems like they have not been able to pay for the logistical piece of that and still make storage an economical choice not to say some people aren't going to use it but it's not competitive with what we have that being said We think there is a segment of customers, elderly or whatever, who don't want to move their own boxes. And we would expect, as our business evolves, to be able to offer some type of service to customers who want it. All right. Thank you. Thanks, Keevan. Thanks, Keevan.

Thank you. I'm sure no further questions at this time. I would like to turn the call back over to Joe Margolis. CEO for closing remarks.

Thank you, everyone, for joining us today. As we discussed, we continue to experience solid property level NOI growth despite new supply. We expect that we're going to have a very solid summer season and another strong year for extra space. We're off to a good start on the acquisition front, on the external growth front, both through acquisitions and third-party management. And what's most encouraging is that I feel that our teams and our systems are tested mostly during competitive times, and they're performing very well and delivering the results for our shareholders. I look forward to seeing many of you at NAIRI. Thank you, and have a good day.