Extra Space Storage Inc. (EXR) Earnings Call Transcript
November 18, 2020
Earnings Call Speaker Segments
Joe, I think we'll start in about 10 seconds or so. Is that okay?
Great.
Great. All right. Why don't we start now? Good morning. I'm Steve Manaker from Stifel. Today, I'm moderating the NAREIT REIT world panel with Extra Space Storage. From the company, we have CEO, Joe Margolis. Joe has served as CEO since the beginning of [Technical Difficulty] Prior to 2015, he served on Extra Space' Board of Directors. Overall, Joe has been involved in real estate since 1988 with rooms like Prudential, Arsenal Real Estate Funds and Penzance Properties.
Great. Thanks, Steve. You're breaking up a little bit. I hope folks can hear me. I'm Joe Margolis from Extra Space Storage, and we are a second largest self-storage, public self-storage REIT based in Salt Lake City. We've been public since 2004. And a member of the S&P 500 since 2016. We have a very diverse portfolio of 1,900 -- over 1,900 properties, over 1.1 million tenants, we're in 40 states, the district of Colombia and Puerto Rico. Extra Space is known for strong same-store NOI growth. They're driven through acquisition, third-party property management and innovative use of technology. We have produced some of the highest long-term FFO growth not only in the storage sector, but of all REITs. Through the 10 years ending December 31, 2019, we were the top returning REIT in terms of total shareholder return and #11 in the S&P 500. We have an ownership structure divided into 3 verticals. We wholly own about half of our assets. We're in joint ventures where we have partial ownership interest in about 15% and the balance of our stores, we manage for third parties and have no ownership interest. This flexible structure allows us to not only bring whatever solution is necessary to a particular circumstance. But also to grow our company during different economic cycles. I'm sure we'll talk about 2020 performance. But we certainly were impacted by COVID as everyone else was. We had to quickly modify the way we do business, close our stores. Adopt safe measures for our customers and employees, work from home from the corporate office and the call center, and we were impacted fairly significantly from mid-March through May. However, very encouraged by the trends since then. We've recovered occupancy to the point where we are now at the highest occupancy our company has ever been on. With the recovery in occupancy, we've recovered pricing power. And we have largely gone through the various state and local restrictions on how we do business. Lastly, investment activity slowed almost to a halt during the height of COVID in the second quarter, but has since picked up, and we are very excited about some of the investments we've been executing across different structures and anticipate doing over $1 billion of investments this year. So that's a high-level overview, and we look forward to answering any questions you may have.
Sure. If anybody in the audience has any questions, please put them in the Q&A chat. And I'll ask him. I'll start off right now with a few. Joe, on your third quarter '20 conference call, you talked about stronger-than-expected tailwinds and weaker-than-expected headwinds. Could you go through your current assessment of those tail and headwinds? And any updates you may have? And given the increasing pace of COVID cases, are you seeing any recent changes in the wins?
Sure. It's a great question. So in terms of tailwinds, we've seen very steady and strong demand for our product. Leasing has been very strong. And interestingly, it's strong across all markets. Many people think are your suburban markets stronger than your urban markets because of people fleeing, New York or San Francisco, and it's really not the case. We see strong demand across all markets. Vacates are muted. Folks are not moving out of our facilities at historically normal rates. And that's led us to high occupancy, almost 96%, which is very high for this product type. We had to cut rates in April and May. But by July, we were flat in rates. And since then, we're 11% up in rates year by year. As we've recovered occupancy, we've regained pricing power. Our collections have normalized, and state restrictions on auctions, late fees, existing customer rate increases have largely gone away. We still deal with those in some jurisdictions. But to a large part, we're back to normal operations. So we're encouraged by all of those tailwinds. Now that's not to say that there's no risks or headwinds. The primary one, I'll mention is new supply. We were in a supply cycle before COVID started. And while COVID certainly has slowed down deliveries, projects that were previously delivered or under construction are still a challenge. And the greatest difference you'll see in markets performance to us is not urban suburban, different demographics, it's -- which markets are challenged by new supply versus markets that are. And then also, I'd point out, we're not done with this pandemic yet. We could still have a medical reversal, we are in a difficult economic times, stimulus, new stimulus has not been passed. And we, at some point, expect customer behavior to return to normal level of vacates, and we'll deal with that at the time. But overall, the tailwinds have been stronger than expected. The headwinds have not materialized. And it's produced very, very positive performance for us.
On the conference call, you were confident about seeing positive revenue growth in the fourth quarter after having positive growth in October. Normally, I wouldn't ask this question because it's only about 2 weeks since the call. But have you seen anything recently out in the field that's changing your confidence level?
No, not at all. If anything, we remain as confident, if not more, confident that we will achieve positive revenue growth in the fourth quarter. The other kind of forward-looking statement I made on the conference call was that full year FFO growth for 2020 will comfortably exceed the high end of our initial pre-COVID guidance, and we still believe that as well.
Great. Occupancy across the industry increased a lot during the third quarter, more than most people expected in our view. Where do you see occupancy trending in the fourth quarter? And what does it mean for rental rates?
So as I mentioned earlier, we're currently at almost 96% occupancy. That's a very high and perhaps too high of a level of occupancy. We don't solve for occupancy in our formulas. We solve for revenue. So we are more than happy to give up some occupancy in exchange for higher rates lower or lower discounts or other economic benefits. So we're in a time of year when storage is seasonal. We're in a time of year where occupancy normally trails down. And I would not be surprised or alarmed at all if we see some degradation in occupancy. It's not what we're solving for.
And to your point, in that degradation of occupancy, the expectation then would be that rental rates will be moving up at a much higher rate than they previously have been. Is that a fair statement to make?
I don't know if I would say a much higher rate. I'm not sure what much means, but at a higher rate.
Okay. And as the company ever gone through a period like this where going into a seasonally weak period, occupancy, was at such a high level?
It is not, and it's a great question. And one thing that contributes to our confidence going into 2021 is December, January, February are typically low move out months, low vacate months. In many parts of the country, the colder snowier parts of the country, people just don't get out and deal with their stuff and take it out of storage during those months. So to be at a very high occupancy level going into the time of year where vacates are naturally muted in addition to being muted due to COVID is a positive trend for us.
One of the hallmarks of this part of the cycle for self-storage has been a decline in move-outs. Can you just talk about what you're seeing in your portfolio? Specifically, are there any geographies that are seeing less move-outs than typical or less move-outs than the average or more move-outs than the average and what's causing this? Or do you think it's causing it? And how long do you think it's going to be until move-outs become more normalized?
Yes. So it's pretty consistent across geographical areas. We can't identify markets or types of markets or parts of the country where there is materially different behavior by our customers. Some of it is just kind of COVID-related and will resolve itself when we get back to normal. And the easiest example of that is in March of 2020, the college students put their stuff in storage and went home. And until they go back to the dorms, their stuff, it's going to stay in storage. Usually, it comes out in August. And for the most part, this year, it didn't. Now we have businesses, restaurants who maybe are storing half of their tables and chairs because they have to socially distance inside the restaurant. And when they're allowed to go back to normal business, those chairs and tables will come out and they will vacate. What's more interesting and unknown to me is what -- the greatest increase in reasons given to us for storage is lack of space, too much stuff. So think of the home office where the spare bedroom has become a home office and the bed and the bureau and the dresser is in storage. Is it a permanent home office? When does it cease to be a home office? How does that happen? We don't know that. And that -- I think that's going to be more of a moderate change in customer behavior than the earlier examples I gave.
I mean, if that's the case, then would the implication be that demand, all things considered or all things held constant, except for that one variable, would be a little bit more because you'll have more people with home offices that don't have basically space for their extra stuff and they're going to go to one of your facilities and store it there.
That's certainly possible. And as we try to predict the future, that's one thing we think may happen.
And can you just talk a little bit about the business customer? I know it's hard to distinguish between an individual and the business. But can you get a sense of what's happening with business customers? Are they -- are you seeing more business customers than typical? And if so, what are they renting? And is there anything in their behavior that's different than typical?
Yes. One of the great things about storage is demand is generated in good economic times and in bad economic times by different events. That happen. And that contributes to our stability of cash flow, which we saw in 2008 and 2009, and we're seeing now. So in good economic times, folks start businesses and they start small and work out of a self-storage facility. And in bad economic times, people have to shutter their business and store their things for a while or they were operating out of a 2,500 square foot flex space and have to downsize into 10/20. So we're certainly seeing some demand -- increased business demand from those kind of negative events, just like we're seeing increased demand because people lose their homes and have to move back in with their parents or with their friend and want to store their stuff. And while it's not good to do well when other people are -- have misfortune, we are happy we're able to provide a solution to people in need of one during a difficult period of time.
Acquisition activity was picking up in the third quarter as buyers and sellers have more confidence in their underwriting projections. EXR purchased over $100 million in the third quarter. And while not a huge number, given the firm's almost $16 billion equity market cap, it is an increase over the last few quarters. What are you seeing now in the acquisition market? Are either buyers or sellers pulling back or becoming more aggressive?
Yes. Thank you for the opportunity to talk about external growth. So the acquisition market, I would divide into 2 broad categories. The stable cash flowing store in a good market, a good story, a good market, is highly sought after by lots and lots of different types of capital. All the positives of self-storage, stability of cash flow are sought at people and rates are really low. People who can leverage up can be very aggressive. So those assets are trading at prices, which we believe are not accretive for our investors, but we have not been successful in going into the open market and being the high bidder and buying those assets. The other type of asset that's on the market is the unstabilized storm. Maybe it's 10% leased or 30% leased and the developer or owner or equity partner, a bank, has had enough and wants to take their chips off the table. And those are assets that we see there is opportunity for. We've closed or approved 22 of those assets for investment this year. They have an average first year yield in the low 3s, so temporarily dilutive, but a stabilized yield in the mid 6s, unlevered mid 6s. So that's a good use of capital, good risk-adjusted return for our investors. In addition to buying stores, we also invest in storage in other ways, we have a active bridge loan program. We've made what I consider a pretty exciting preferred equity investment recently. And we will continue, as we have in the past, to see creative ways to: one, provide great risk-adjusted returns to our investors, but two, advance our strategic goals of expanding our management platform, getting rights to purchase assets and forming deep relationships with industry participants that lead more transactions in the future.
Can you just give a comment on where you see cap rates trending?
So I would, again, split that answer into 2 for stabilized assets in good markets, there's a lot of pressure on cap rates. And as long as interest rates are low and there's lots and lots of equity seeking exposure to storage. I think there's going to be pressure on those cap rates, and we're seeing 5s and sub 5s on those assets. For lease-up assets, where the stabilized cap rate is really the number you want to look at, I think it varies widely. Everyone will have a very different view of how long it's going to take to get to stabilization. And what rates will be upon stabilization. I told you what our view is for the deals we've done, but I'm sure everyone has a different view of their future in those cases.
Are there any common characteristics or trends in the assets for sale or the sellers of those assets?
I don't think so. I think you do see, I guess, in the latter category, you do see sales by more recent entrants into the storage mark, storage who maybe are disappointed with their ultimate results, not hitting initial underwriting and want to calling into it.
For those types of sellers, do you think -- is it the equity more likely pulling the trigger on that? Or is it the debt providers plan to charter? What's your sense?
I think it's more often than not the equity.
And you talked about the preferred equity investment. Can you give us a little bit more detail on that? And how do you view these different types of investments in storage that the firm is making?
Sure. So we invested $300 million to assist NexPoint in their acquisition of Jernigan Capital, which was a public self-storage company. Their strategy was to provide high loan-to-value participating loans to developers and also get rights of first refusal so they could buy those assets into the platform after they were built and achieved some leasing. The $300 million has a blend. There's 2 tranches, but it has a blended rate of 10.7%. We're in a very comfortable point in the capital stack. We have a partial guarantee from the funds. And in addition to that, on day 1, we'll get management of 37 new stores. So we'll get management fees and tenant insurance from that. We have certain rights to purchase the assets on the back end. We have a profit participation. And just as importantly, we are forming a new relationship with smart, active industry participant, and we hope to do a lot more with them. How do we look at these kind of alternative investments? We're always looking to be -- to provide good risk-adjusted returns. So when I say that it's our opinion that buying wholly-owned assets is too expensive at that time, we'll seek to do other stuff. In 2015 and '16, we spent over $2.5 billion on existing assets because we felt that was the right point in the market cycle. And these investments, be it our bridge loan program or this preferred investment, they will all provide both good risk-adjusted return, but also some strategic value in terms of expanding our management platform, ultimately being able to buy the properties, perhaps forming deeper relationships. So we killed 2 birds with 1 stone in terms of both returns and advancing the strategic interest of the company.
How is the third-party management business going?
So great. We are the largest third-party manager in the country. We -- through the end of the third quarter, we have added 72 stores to the platform. The -- it's a great way for us to both earn some fees and tenant insurance revenue. It's a very profitable business. But we also buy assets out of that program. Since the program started, we bought $1.2 billion worth of assets on our third-party management business. And it also gives us additional scale, right? We have a third more customer transactions for our data scientists to analyze because we have these stores. And analyzing data is very important to us. It's how we make all our decisions. We get cost efficiencies because of the scale. We get better web presence and customer acquisition power. So it's a good business for us, again, in more than one way.
Can you also just talk about your -- the mezz loan program as well?
The bridge loan program?
Sorry, the bridge loan -- yes, the bridge loan program.
So we got into this business in early 2019 because we saw -- we perceived a void in the capital markets. We will make loans up to 80% loan-to-value on completed self-storage facilities only. And as we'd be happy to buy them for 100%, we're comfortable lending at 80%. We require that we manage all of the stores, so we get the management benefit that I just described on that. And then to both control the amount of capital we have dedicated to this program and increase our returns, we divide the loans into an A and a B piece. We will sell or replace the A piece with a lending partner or debt fund that leverages or enhances the return on the B piece to 9%, 10% or 11%, not including the management economics. And it's -- again, it's a great way to get some return in advanced strategic interest. We bought 3 assets out of this program already. We'll close or approve almost $500 million gross of loans this year. And we're very excited to have this other avenue to grow our business.
Looking at the expense side real fast. Internet marketing costs went up really high, went up at a very fast rate over the last couple of quarters. It's moderated recently. How is it trending? And how does the high occupancy affect this line item?
So it's trending down due to the high occupancy. We think we'll have a good quarter in that respect in fourth quarter. But that being said, we look at Internet marketing spend as an investment. If we need to spend $1 on Internet marketing, and we're confident we can get a positive ROI in it, we're more than happy to spend that dollar.
Great. And can you comment about development? What are you seeing out there? Is it easy or hard for developers to get capital to start new projects right now?
I think it's harder than it was pre-COVID. I think lenders have pulled back. Lenders were pulling back pre-COVID because now it's clearly obvious that there were certain markets that were overdeveloped and didn't need more storage currently. I think with COVID, it just made it increasingly difficult for developers to get financing. Now that doesn't mean development is going to grind to a halt. We don't believe that. We believe development is going to moderate, but will continue, it's a great asset type. It's performing well. It's proven itself through another crisis. It's going to attract money in development.
And you have obviously a lot of stores. And are you seeing a significant level of local or state governments shifting towards emergency measures due to the increase in COVID cases?
So earlier in the pandemic, we saw more state and local restrictions on how we operate our business, whether that's ability to auction off delinquent tenants' goods, ability to charge late fees, restrictions on how much we can increase pricing. Most of those restrictions have expired or gone away. Although we still have restrictions in certain jurisdictions. And one thing we're keeping our eye on, one risk of the future is, if things do get worse and municipalities reimpose those restrictions that would have a negative impact on our business. But I'm sure we'd work through it, just like we worked through the ones in the past.
Great. Regarding specific markets, are there any ones that stand out right now as you look across the country?
So when you look at markets and what are the factors that are affecting performance, it's not kind of what we all would think, which is COVID-related patterns of migration or people moving. The biggest determinant of how a market is performing is how much new supply has been delivered in the last several years. On those markets, such as Florida, Portland, the Boroughs of New York that have supply issues are the markets where we can fill our stores up, but we have the least amount of pricing power. Markets like many of the California markets, where there are true barriers to entry and there hasn't been this new supply, we have the greatest pricing well.
Are you seeing any additional entrants come into the space? We just had Blackstone or BREIT just purchase Simply Self Storage. So are you hearing or seeing others looking for platforms, looking to grow their storage business out there? We should say, large players doing -- trying to do that.
It's the reverse side of the coin of being such a great business that performs well during all cycles is it attracts capital. And it's attracting capital from everything from the local doctor and dentist, who can put a few bucks together to buy a self-storage facility to the largest sovereign wealth funds in the world and everything in between. So one of the reasons prices are so high, as I mentioned earlier, there's lots of capital seeking exposure to storage. But the key to this business, this is an operating business. And the important thing is or to have an operating platform and to have scale. And very few people have to scale that public storage or redo or some of the other public REITs. And the advantages that provides -- puts us head and shoulders above everyone else.
And Joe, any closing comments?
I guess, we did post a deck on our website, and there's a lot of good information in there that folks are interested could see. The one thing I would point out is, we had a tough second quarter, we started to recover in the third quarter, but we have negative same-store NOI to date, which is not a great thing. But notwithstanding having negative NOI growth, we have 5% positive FFO growth this year. So to have a structure in a business where you can have negative NOI growth, but because of how you manage your balance sheet and your insurance business and your management business, and these other investments we talk about and how we've been able to control G&A, we can deliver positive FFO growth to our investors during the worst of the COVID period is something we're really proud of. So that's it. I appreciate the time to talk about self-storage and Extra Space, which I love, and I hope everyone and their families are well.
Thanks, Joe. Take care, everybody.
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