Extra Space Storage Inc. (EXR) Earnings Call Transcript & Summary

Welcome to the 11:00 session at Citi's 2020 Global Property CEO Conference. I'm Smedes Rose of Citi Research. We're pleased to have with us Joe Margolis, CEO of Extra Space. This session is for investing clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available up here and on the webcast on the disclosures tab. For those in the room or on the webcast, you can sign on to liveqa.com, enter code citi2020 to submit any questions or you can just raise your hand if you're here in the room. Joe, I'm going to turn it over to you to introduce your team and a couple of moments just on the company overview. And then if you could provide the audience with 3 reasons why investors should buy your stock today, and then we'll go into some Q&A.

Great. Thank you, Smedes. Thank you, everyone, for your interest in Extra Space Storage. With me today, I have Matt Herrington to my immediate left. Matt is Senior Vice President of Operations, runs all of our stores from Chicago West. So over 900 stores roll up to Matt. And we have Scott Stubbs, our CFO. Initial question, why invest in Extra Space, 3 reasons. First is we're in a great sector. Storage is a need-based sector that performs well in all economic cycles because the events in life that give rise to the need for self-storage tend to happen in good economic times or bad. And it is a recession-resistant sector as shown during the great financial crisis. We had revenues decrease by 2.9% for 1 year and then we're positive again next year. So we believe this is a great sector to be in, very granular investments, very granular tenant base, highly diversified portfolio. Second reason I would point out is our company, self. We have what we believe to be the premier operating platform in the industry driven by technology, both on the customer acquisition front, revenue management, data analytics, and we're able to drive better performance through our focus and resource allocation to technology. Secondly, our people are very important in our company. We have a great team. We are a values-driven company. We take that very seriously. And I think the proof is in the pudding. We were just named in 2020 by Glassdoor as the 90th best place to work in the country out of over 1 million companies. And we're very proud of the fact. And then last, last...

Yes, go ahead.

Okay. I thought you were going to ask me what the tenure was going to be next year.

No, going to end with that.

Oh, okay. Not Yet. And then last thing, we have a highly diversified portfolio as I mentioned earlier. We have over 1 million tenants. We have over 1,800 stores. We're in many, many primary and secondary markets across the country, and that diversification and granularity provides stability to our cash flows. And then the third reason, I would say, to invest in Extra Space Storage is our performance. We have provided industry-leading returns for many, many years. We were the top-performing REIT in any sector over the 10 years ending December 31, 1999, and we were the 11th best stock performance in the S&P 500. If you look at -- and that's all backward looking. But if you look forward, we're in the depth of a development cycle. We're in a very difficult point. You added the high end of our guidance. We're still projecting over 4% FFO growth for 2020.

Okay. Thank you for that. We'll return to some of those topics. But for each of our opening questions this year, we're asking the following question, which is that ESG is increasing -- of increasing importance for all company stakeholders. What is 1 thing your company is doing to improve your overall ESG score over the next 12 months?

So Smedes, I'll give you one thing in each category. On the environmental side, we have recently invested in some software that will help us -- allow us to report -- track and report our greenhouse gas emissions. So that would be important for us to first measure and then improve on that metric. On the governance side, we have just appointed in our February Board meeting another Director, independent director. That gets us to 2/3 independent director, which is an important metric for some people. And on the social side, I guess, I mentioned previously our recent Glassdoor award that's representative of the many things we're doing with our employees on the social side.

Great. I mean you mentioned in your opening remarks a little bit that we're in the depths of the current supply cycle -- increase in supply. You touched on it on your call, but maybe just for the benefit of those who weren't on your call, could you recap what you've seen from the supply perspective over the past couple of years and how it could play out over the course of this year and next year?

Sure. We are -- have previously stated and continue to be of the view that 2018 was the peak year for deliveries or moderately less deliveries of new self-storage facilities in 2019, and we see that trend continuing. In our markets, stores that will compete with our stores, we see as much as a 30% decline in new stores being delivered that would compete with our stores. And it's not perfect science, right, because you have to predict how much of what's in the pipeline is going to fall out. We've seen up to about 30% fallout rate in the last 2 years. But we do see that we're on the downward slide -- slope of the development cycle. Now that doesn't mean that things automatically get better, right, because you have stores that have delivered over the last [ 3 ] years that are still in lease-up that we still need to compete with. But we are seeing that we're in the better side of the mountain right now.

So what's -- so a 30% decline in new stores in your market. So I guess what percentage of your portfolio, I guess, has significant competition coming online over the next year or so if you think of it that way?

So last year, we saw 27% -- let me first caveat this. We do this measurement using a 3-mile radius, which is kind of the standard radius people use to measure markets. It's also very rough measurement and in many, many instances, is not the appropriate measurement. And we have all kinds of examples of stores that only drop from the north or don't drop across the highway or high demographic. People don't go to a low demographic area to rent. So with that caveat, in 2019, 27% of our stores had new deliveries within that 3-mile radius, and we think that number is going to be about 17% in 2020.

All right. So significantly dropping off. I mean and I guess, this is sort of true probably across the overall industry as well that I was seeing the supply cycle peak. I mean do you think it's just because developer returns have declined? Do you think there's anything going on in the capital side that's tougher to access capital for this sector?

I think it's probably a little of everything. I mean there's better data now in our sector than there ever has been before. And it's no secret if you want to go build a new self-storage facility in data -- in North Dallas that there's a lot of self-storage being delivered in North Dallas. And people can see that, and there is data, and you can see the performance de-acceleration and that helps people underwrite a little more realistically. And whether that's the developer, the equity partner or the bank, it all puts some constraints on new development.

We have a question on supply from an audience member. How do you reconcile the view that supply deliveries peaked in 2018 despite government construction data and you're already continuing to increase? Is there different data that we as investors should be looking at?

So the Yardi data that I've seen has the new deliveries peaking in 2018. I'm not sure what data they're looking at.

Okay. Well, Yardi shows a pretty deep supply growth, but a lot of concerns are that they're not accounting for what would typically fall out, which I wanted to ask you. You mentioned you saw 30% fallout rate over the last 2 years. If you look at prior cycles, what kind of typically is the fallout rate? And what is it sort of just on average in normal supply times?

Yes. Unfortunately, we don't have good data for prior development cycles. So I can't tell you. I can tell you the last 2 years based on what we have been tracking both Yardi and our internal data that we used to supplement that. We've seen about a 30% drop out rate of stores to be delivered in our markets.

Okay. We have a few questions coming in. So I'll just kind of work some of these quickly. How has lease-up periods changed with the elevated supply and high penetration levels? Presumably, they're longer than 3 years now.

So we're able to fill our stores in 3 years, 3 to 3.5 years, depending on the size of the store. What's changed is rate. So we will fill our stores. We're -- our machine is able to put customers into the units. The problem is we have to drop rate to do so. So while we may get to occupancy stabilization in 3 years, it may take 4, 4-plus years to get the economic stabilization.

So it's really -- I mean there seems to be a large industry move, really, that's kind of drop rate occupancy driven and with the famous saying, "You can't raise rate on an empty box," that kind of feel like you've adopted that as well?

Yes. I would put it a little differently. We have adopted a strategy to maximize revenue, and we believe the way to maximize revenue is to get people into the units, not at any price but at an acceptable price. So yes, in general, we have dropped rate to gain occupancy. We've also increased marketing spend, done different things with discounts, used the tools that are available to us to maximize revenue.

I think someone was looking for some clarification here. Did you say construction fallout was 30% over the past 2 years? Wasn't it closer to 50% historically? What has brought that down? And does it remain that low?

So again, what we're looking at is we track -- what we're looking at for that statistic is we are tracking stores that we believe are going to be delivered in any 1 year within a 3-mile radius of our stores. And then at the end of the year, approximately 30% fewer of those stores have actually delivered. Some of them end up being delivered in January or February of the next year, so they just get delayed and some of them end up not being delivered. 50% fallout rate, which we have cited before in previous comments, has to do with our management plus pipeline. Right now, we have anywhere between 450 and 500 stores in our management pipeline, and we find -- and 3/4 of those are new developments. We find that about 50% of those stores never get built.

Okay, okay. Another question on supply, just kind of looking at it over a rolling 3-year period. What would you say, what percent of your portfolio has seen new deliveries within the 3-mile radius that you talked about? And how does that change in 2020 versus '19?

So we're probably at 60%, maybe a little bit more now, and we're in the upper 60s to 70% as of the year before.

Okay. When you provided your guidance -- or actually, the last couple of quarters, your same-store expense growth has been running over 6%. Part of that's marketing expenses, which we can talk about maybe a little bit more. But you also -- even though labor costs aren't a huge part of the model, we've definitely seen increases in wages over the past couple of years. In the couple of other industries that are users of kind of lower skilled labor, if you will, they think 2020 is the peak year for labor costs. Are you seeing that in your space at all? Or any thoughts on how labor costs will trend?

So clearly, we're in a very, very low unemployment environment, and that puts pressure on wages. And we believe that people who are in our stores, who are dealing with the customers, who are helping them use a product that the majority of them have never used before that are making retail sales are very important people, and we want to have good, qualified, engaged, motivated people in those stores. So we do expect to see pressure on wages. Now that's not to say we can't seek efficiencies, try to centralize functions in Salt Lake City, make sure we're using technology where we can and try to be as smart as our -- with our wage dollars as we can, but we do expect to see continued pressure.

On the technology side, it's something that you guys have emphasized a lot using. It sounds like one of your competitors is having a lot of -- getting a fair amount of traction with kind of a skip-the-counter approach that they're using. Is that something you guys would look at to drive incremental efficiencies?

We will look at that, and we will use that at some point in the future but not for efficiencies. I think that's misunderstood. We average about 38 rentals a month at a store. A competitor you're talking about said 11% of their rentals are coming to that function. So that's about 4 rentals a month, takes about 15 to 30 minutes to do a rental. So you're saving 1 to 2 hours a month by doing that. And that's -- doesn't count the person who uses that but got the wrong unit size or doesn't understand something. So I think that type of technology needs to be provided to customers when they demand it. We will provide that tech -- that access to our units to customers when they want it, when we can integrate it with our system seamlessly and when it's revenue positive. But it's not, in our view, due respect to our competitor, it's not an efficiency driver.

Okay. I mean I -- because I think U-Haul is introducing something -- sort of a similar product as well. So I mean it seems like maybe it's not now, but maybe it seems like they have sort of some traction over time, that kind of offering.

Again, we believe our duty is to provide our product to the customer the way they want it. The customer wants to go in and talk to the store manager, they should do that. If they want to transact with the call center, they should do that. If they want to do something online without ever talking to a human being, we should provide that to them. Right now, today, we don't see a customer need to transact with -- totally online. We don't -- we are not losing customers, losing opportunities because of that, and that shows up in our performance. Now in the future, is that going to be a customer requirement? Probably so, and we will provide it at that point.

Okay. I'm going back to another question from the audience. What are development yields now with the cost of capital coming down? Couldn't we see another development cycle given the attractiveness, particularly relative to other sectors as well as the new capital that has come into the sector?

So it's really 2 questions, right? What are underwritten development yields and what are actual development yields. And I think what we're seeing now is a lot of people have underwritten 7.5-plus percent development yields and feeling they can get a 200 to 250 basis point spread and that that's acceptable to compensate them for the risk of development. And then going forward -- but then when we look at those numbers, we don't believe it's a 7% or 7.5%. We believe it's something way south of that and are unwilling to invest in that development or manage that store based on that budget. And I think as operating fundamentals continue to moderate, more and more people will understand what actual results are going to be and not these projected results.

You talked on your call a little bit about revenues moderating over the course of the year and I think flattening out by the end of the year. In terms of the pace of declines, would you say that's sort of a better setup going into 2021 at this point? Or maybe you can kind of elaborate on what you saw the cadence of revenues over the course of the year?

I don't think we're ready to comment in on 2021. We certainly hope, given this pattern, that it continues and, at some point, reaccelerates. When we have more visibility into 2021, we'll be able to say whether that occurs then or not.

Well, I mean, you did feel -- I mean you did say then that revenues would moderate and not be going down further by year-end. Did I read that right on your -- okay.

Yes. That's what we expect.

Flat by year-end.

That is what we expect.

I have another question here on a couple of your MSAs. We often hear about MSA level supply and demand numbers drilling down further. In which submarkets do you see the best and the worst supply/demand, for example, North Dallas that you mentioned earlier?

So North Dallas is interesting because even with all the supply, there has been sufficient economic growth in that market that we're still positive and actually slightly increased over the year in 2019. The markets I'm more concerned about, frankly, are many of these Florida markets here, where there just seems to be excessive development and we have a significant exposure to these markets.

Are there any changes from a sort of local legislative perspective that might make it more difficult to construct?

I mean there's very localized moratoriums in some markets, but it's not widespread and very local.

Okay. You've talked in the past about being able to pass along pretty high single-digit increases to in-place customers and the take rate has been fairly consistent. I mean do you -- I guess you've -- by market, particularly more expensive markets, do you think there's still a lot of runway there? Any reason to think that people will sort of hit a wall in terms of what they're paying?

So we've not seen the customers hit a wall, so to speak, with respect to existing customer rate increases, and we track it very, very carefully. We send out almost 100,000 rate increase notices every month. And we will keep a control group out of that 100,000 of folks who were eligible to get a rate increase, and we will not send them a rate increase. And then we'll track their move-out rate versus the move-out rate of the customers who did get a rate increase to make sure we're not pushing too hard. And to date, very, very consistently, the increased move-out rate is about 1% to 3%. So we're comfortable with our program as it stands.

Just on that, L.A. performance has been particularly strong for you guys, and it is one of your more expensive markets. And it's performed well relative to peers. And I was just wondering if you could provide a little sort of color around your positioning in L.A. Do you think you're just in better locations? Or are you thinking you're just revenue managing better?

Yes. I'm happy to have Matt here to answer that question as he's based in L.A.

Yes. So I would tell you that the fundamentals in L.A. remains strong. We're very happy with the market, new supplies muted for the most part. Our biggest challenge there is we're just -- we're going up against tough year-over-year numbers, where we've grown revenue by the high single digits year after year. And so we have more moderating type of revenue growth there now.

Well, it sounds like from what you just said that, that doesn't become much of an issue. So I guess we'll have another year of high single-digit increases for in-place customers. I mean there's not a lot of supply growth out there, right? So that helps. Right. One of the questions we have coming in here is -- and maybe we can just talk about marketing for a little bit because it's come up over the course of the last several quarters, lots of significant increases on that platform. How do you measure the success of marketing spend? And is it supply-driven?

We're able to -- depending on what type of marketing spend you're asking about, we're able to track the effectiveness of our Google spend very, very well. We can track which keywords convert and compare that to the cost. And we have a very clear path of return on our Google spend. Other marketing spend like YouTube is not so clear. So we can put a YouTube ad up in a specific market, and we can track visits to our website after the YouTube video goes up and see that it spikes. But we have a much harder time tracking than converting those people to rentals, right, because really, what we're doing there is building a brand and trying to increase our organic search and we have a more difficult time making that connection. But on the majority, vast, vast majority of our spend, which is Google, we can track that very closely, very accurately.

And I was reading in one of the storage companies' 10-K, there's a lot of information on how Google is providing platforms for smaller operators as well to be able to bid more competitively. I mean do you think that changes the scenario that has for a long time been that mom-and-pops will fall into the arms of the larger operators because they can't compete? Do you think that changes anything? Or this is such a big market, it doesn't matter?

I think our advantage is over the smaller operators are so vast and so much more than just Google and continues on customer acquisition that the consolidation in the industry and the smaller operators wanting to seek professional management is going to increase.

Okay. I wanted to ask you a little bit about -- you've been pretty creative over the years of growing your distribution platform, either through wholly owned acquisitions, I guess, is the most straightforward. But CFO deals, JVs, your bank -- your bridge lending program. I guess, going forward, where do you see kind of the best kind of risk return right now? You've talked about JVs. Maybe it's still out or...

Yes. I think JVs still provide a very attractive way for us to continue to grow externally while both decreasing our risk and increasing our returns. So it's a great tool that we've used since 1998 and that we will continue to use in the future. We have great partner relationships and no shortage of capital if we want to execute that strategy. I think the bridge loan strategy is a great place to be in this part of the market cycle. It's a great part of the capital stack to be in, right? Again to -- when you're in this part of the cycle, a lot of it is about de-risking things and try to address risk appropriately. And as more and more properties are challenged, we think that program will continue to grow probably significantly. And then what's next? What's new? Time will tell. We're always talking to people. We're always working on things, and we hope to continue to be innovative and creative in the way we place capital for our investors.

Well, if you go into a JV, I mean, is it your goal essentially to 1 day own it at a 100%? Would that be the ideal outcome for your joint ventures?

So we have -- yes and no, I guess, is the answer. I mean we have joint venture relationships that are over 20 years old and it may continue to own these same assets for the next 20 years in their perpetual light vehicles and they want exposure to storage. And there is no way to replace it if they get rid of it. So those will go on indefinitely. And then we have other relationships where we do hope to be the owner in the end. And we've been very successful. If you look at the sources of our acquisitions over the past 5 or 6 years, a good chunk of it has come from the joint ventures. And one advantage we've had in the past is, in our ventures, we get promoted both on the cash flow and on exit. So on exit, we have this -- the last few deals we've done, we've had these large embedded promotes that we can effectively use on our purchase price. So it helps us to acquire those assets.

And do you set up potential exits when you go into the JVs?

So we have rights of first refusal, and we have similar rights like that to make sure that we're at the table, but our joint venture partner doesn't have any -- we don't have a call. Our joint venture partner doesn't have any obligation to sell to us.

I had a question basically asking about the spreads between move-in and move-out rates and how they trended over the last couple of years.

Scott?

So our spread compared to our -- if you look at our in-place rents today and compare that to our move-in rates in January and into the month of February, they are lower year-over-year by teens. And that is the low point of the year. On average, if you compare our existing in-place rents compared to our move-in rates, they're typically mid-single-digit -- flat to mid-single digits negative. But I think what people need to realize is that is average in-place versus average move-in rate. It's not who's moving in and who's moving out. We have a whole group of tenants that are in our properties today that have been there for years. And they have a much higher rate than someone moving in today. But we also have a whole group of people that moved in 3 or 4 months ago and churn quite often. Our average length of stay today is over 15 months if you take everyone that has moved in and has actually moved out. But our median length of stay is more -- is between 6 and 7 months. So you have a whole group of tenants that churn quite often. And many of those tenants actually never receive a rate increase.

Okay. And a couple of other questions coming in from the audience here. If a 1% to 3% higher move-out rate is acceptable for customers getting a rate increase, at what point does that figure concern you? I think that was in relation to you talking about your control groups.

We would -- if it got considerably over 3%, we would start to look at the customer behavior and what we have to do differently. I don't have a specific answer that at 6.7% we stop. But if it ever moved out of that range, we would start to look seriously at the program.

Okay. With -- question about Proposition 13. PSA provides investors disclosure in their 10-K around NOI from California, taxes they currently pay. People can run scenarios and what it would look like if Prop 13 goes away. Has EXR provided a similar level of disclosure? And can you provide any color around the potential impact of Prop 13 in your tax burden in California?

Where we haven't, and it hurts me to say PSA has provided more disclosure than us on anything. But yes, we have not done that. So a couple of reasons. One is we don't know how Proposition 13 is going to change, whether it's going to be implemented -- whether it's going to change at all, whether it's going to be implemented immediately, whether it's going to be phased in over time. We also don't know how much of that drops to the bottom line, right? So I would have no qualms if Proposition 13 changes, sending a postcard to every of our tenants saying, "As you're well aware, Proposition 13 has been amended. Your rent just went up by $2." So it's hard for us to know exactly what that's going to mean to the company, although we have done the math on a worst-case basis.

What percent of NOI comes out of California?

About 12%. Is that right?

Actually, a little higher. That's L.A.

Oh, 12% is L.A. Sorry. Yes.

Well, what's the whole state?

Excuse me?

What is for the whole state of California?

It's closer to 20%. And back to Joe's point. It all depends if it passes too. I think there's a pretty big scenario here where it doesn't pass.

Yes. Okay. And then just a final one from the audience here. Any interest in having any non-U.S. exposure? Have you looked at international opportunities?

We have looked at international opportunities. We were in Mexico for a while. We got out because we couldn't scale it. And if there's an opportunity to go international, where we get the return that compensates us for the taxation currency complication and we can scale it, we absolutely would look at that. But absent those 2 factors, we're going to continue to grow in this country.

Is there a market that would stand out to you that would be of interest like maybe Canada -- Mexico didn't work out -- north?

So Canada, cap rates are as low as Canada as they are here and difficult to scale as well. So it certainly makes sense because it's close and we're familiar with it. But we don't see a current opportunity there.

Okay. As we come towards the end of our session, we like to close with 4 questions. You named one of them earlier when you were sitting down. So the first one is will your property sector have more or fewer public companies 1 year from now?

I'm going to say the same.

Will the same-store NOI growth be for the self-storage sector in 2021?

Yes, I've never answered that question for you, Smedes.

What?

I've never answered that question when you've asked it. So I'm going to continue my non-answer.

Okay. What will the 10-year treasury yield be 1 year from today? It's about 1.1% now, I think, 1.16%.

I'd say 1.5%.

And what year will the U.S. enter a recession?

2021.

Okay. That's soon. Thanks. Thanks for your time.

Thank you very much, Smedes.