All improvement: Essex Property Trust Management Discusses Q4 2013 Results

Executives

Barb Pak

Michael J. Schall - Chief Executive Officer, President, Director, Member of Executive Committee and Member of Pricing Committee

Erik J. Alexander - Senior Vice President of Property Operations

Michael T. Dance - Chief Financial Officer, Chief Accounting Officer and Executive Vice President

John D. Eudy - Executive Vice President of Development

Analysts

David Toti - Cantor Fitzgerald & Co., Research Division

Alexander David Goldfarb - Sandler O'Neill + Partners, L.P., Research Division

Richard C. Anderson - BMO Capital Markets U.S.

Omotayo T. Okusanya - Jefferies LLC, Research Division

Michael J. Salinsky - RBC Capital Markets, LLC, Research Division

Paula J. Poskon - Robert W. Baird & Co. Incorporated, Research Division

David Harris - Imperial Capital, LLC, Research Division

Haendel Emmanuel St. Juste - Morgan Stanley, Research Division

David Bragg - Green Street Advisors, Inc., Research Division

Nicholas Joseph - Citigroup Inc, Research Division

Essex Property Trust (ESS) Q4 2013 Earnings Call January 31, 2014 1:00 PM ET

Operator

Greetings, and welcome to the Essex Property Trust Fourth Quarter 2013 Financial Results and 2014 Guidance Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host Barb Pak, Director of Investor Relations. Thank you. You may now begin.

Barb Pak

Thank you, and welcome to our fourth quarter earnings conference Call. Before we begin, I would like to remind everyone that certain matters discussed in this conference call contain forward-looking statements within the meaning of federal securities laws. These forward-looking statements are subject to several assumptions, risks and uncertainties. The company assumes no obligation to update or supplement these statements that become untrue because of subsequent events. Please refer to the forward-looking statements section of the earnings release issued yesterday. Today, management will be making some prepared comments related to the post merger of assets of BRE properties.

At the advice of counsel, management will not be taking questions related to the proposed merger, given that the merger is subject to approval of both Essex and BREs stockholders. Comments related to possible financing sources such as property sales and joint ventures are in a preliminary stage, and we cannot assure you that they will be consummated. As attached file, a joint proxy statement/prospectus with regards to the proposed merger with the SEC on January 29. We refer investors to the information inventory proxy statement, regarding the merger and related transactions, and then other relevant information that we may file with the SEC.

The question-and-answer session at the end of the call will be limited to matters related to the fourth quarter earnings results, and the 2014 guidance, assumptions and outlook provided for Essex on a standalone basis.

I'll now turn the call over to our President and Chief Executive Officer, Mike Schall.

Michael J. Schall

Thank you, Barb. I would like to start by welcoming you to our fourth quarter earnings call. Mike Dance and Erik Alexander will follow me with comments. John Eudy and John Burkart are available for Q&A. I'll cover the following 2 topics on the call: Fourth quarter and annual results and our outlook for 2014; and secondly, the update on the merger integration process.

So under the first topic: Yesterday, we were pleased to report continued strong operating results for the fourth quarter and full year ended December 2013. The core FFO per share result for 2013, represents a 11% growth from the prior year and is $0.05 per share above the midpoint of the initial 2013 guidance range. In the three-year period from 2010 -- from the 2010 recessionary trough, we've grown core FFO per share by 51%. We ended 2013 with 6.3% same-property revenue growth near the high-end of the initial guidance range, lead by our Northern California region. Southern California was the only region that performed below the midpoint of our original 2013 revenue guidance range missing by 15 basis points.

With respect to Southern California, our expectation of slow but steady improvement in revenue growth proved accurate in 2013, as each of the four quarters generated slightly higher sequential growth, with Q4 achieving a respectable 4.7% revenue growth rate.

Looking back over the past several years, however, Southern California has fallen short of our high expectation for rental revenue. With respect to job growth, 2013 remains strong. And at 2.1% in our target markets was just above our initial forecast, with each MFA, except Oakland and Los Angeles, beating our estimate.

Turning to 2014. Our overall market outlook is reflected on Page S16 of the supplement and is based on U.S. job growth of 1.8% and 2.8% U.S. GDP growth. Both of which are near the middle of the range estimated by our economics data vendors. This information is materially consistent with our 3-year outlook at our Investor Day presentation in November. Our 2014 revenue guidance is very similar to our original 2013 estimates. Overall, the midpoint of our revenue guidance range of 5.6% is only 15 basis points below the comparable estimate for 2013. And each of our 3 primary regions are assumed to generate rental growth within 50 basis points of the comparable 2013 estimate.

Overall, 2014 supply is estimated to be -- multifamily supply is estimated to be 1.1% of stock, up from our estimate of 0.8% for 2013. The higher level of supply in 2014 is offset by higher job growth, consistent with an improved U.S. economy, leading us to expect that the overall demand-supply relationship remains favorable to landlords.

Apartment demand continues to be anchored by job growth, demographic factors and limited to an expensive alternative to rental housing. Medium priced homes are expensive on the West Coast with median prices ranging from $389,000 in King County, Washington and $813,000 in San Francisco County. In addition, wholesale housing values are increasing substantially faster than apartment rents, making apartments a more affordable -- making apartments more affordable relative to homes.

We believe that Southern California will continue to report good job growth and solid results. The dilemma of Southern California jobs versus rent growth is depicted in an AXIOMetrics chart for Los Angeles, and we've reproduced with permission as Page S17 of the supplement. While we believe that Southern California has the potential for higher rental growth, we don't see the catalyst for that to incur in 2014, and thus, it assumes the continuation of solid, but relatively flat revenue growth rates.

We completed approximately $462 million in acquisitions in 2013, down from nearly $800,000 2012. Overall, we expect to acquire approximately $400 million again in 2014, with emphasis on well located B property, and on Southern California, but adds in a way that maximizes accretion. We have 11 development communities that are under construction or in the initial leasing phase. Going forward, we will continue to be selective for new apartment development opportunities. There are many development deals being discussed and most of the merchant builders need equity to satisfy lender requirements.

Other impediments to new apartment construction include concerns about the economy, future rent growth expectations, construction cost increases and the need for concessions from the reluctant local governments. With this in mind, we continue to believe that new apartment deliveries will peak in late 2014 to early 2015, in Seattle and in Northern California.

Now to my second topic, the merger integration update. Since signing the agreement to merge Essex and BRE on December 19, 2013, both companies have worked with great focus and effort to make the transition as smooth as possible. Earlier this week, we filed Form S4 with the SEC, in connection with the proposed merger and necessary shareholder bolster from both Essex and BRE shareholders. If the process proceeds without delay, we could close the merger in March. We have enjoyed working with Coney Moore [ph] and her team as we seek our common objective of forming a primitive West Coast apartment REITs.

We appreciate the incredible effort of both the Essex and BRE employees in realizing this vision and offer them our continued thanks. Merger integration planning remains in full swing and significant progress has been made. The merger agreement provides for a cash component of $12.33 per BRE share, of roughly $1 billion. The financing of the cash component is supported by $1 billion financing commitment from UBS and Citigroup, which can be relied upon if our preferred funding sources, which are a combination of institutional joint ventures, property sales and borrowings does not occur.

We currently have nonbinding term sheets related to the formation of institutional joint ventures, involving properties valued at -- between $800 million and $900 million. In addition, we believe that $100 million to $200 million in property sales could occur before or shortly after the merger, and that most of the cash required to close the merger can be generated by these activities. We realized that the market desires greater visibility into our long-term expectations for the merger, as asked for additional information. As noted on the call following the announcement of the merger, we cannot provide the details of our underwriting and assumption, as advised by our attorneys. We refer everyone to the investor presentation, previously filed with the SEC and posted on our website, and to the Form S4 recently filed for details of the transaction.

We recognize the importance of articulating our vision with respect to the merger. Recall from the conference call and answering the merger that are baseline financial assumptions where that the merger would be NAV neutral, accretive to core FFO in the range of $0.05 to $0.08 per share in the year following the merger closing, and that the annual synergies will approximately will impact of Prop. 13.

In the Q&A, we noted that the vast majorities of the assumed synergies are on the expense side of which property and corporate level expense reductions were roughly similar amounts. We continue to believe these assumptions are achievable. Our key question is what opportunities are available over and above the baseline scenario outlined above.

As previously noted, we are in the midst of evaluating these opportunities, and so conclusions have not been reached. However, we like to share with you our list of priorities related to synergies and efficiencies to be pursued following merger confirmation as follows:

First, we will reconcile pricing philosophies, which are materially different despite our geographic and portfolio similarities. Based on that reconciliation, we will adopt one company-wide standard best practice to include the renewal process, targeted turnover rates and costs, traffic and traffic sources, amenity charges and occupancy/availability ranges.

Second, we will look for opportunities to improve the financial structure of the combined companies from the perspective of risk, reward, cost to capital and core FFO accretion. This could, for example, involve new institutional co-investment relationships for development communities, and possibly, existing properties.

Third, we will implement best practices identified during the merger integration process. Detailed recommendations and opportunities have been compiled as we evaluate each functional area to be the basis for action plans. For example, we expect to implement BRE's RUBS reimbursement methodology, website and procurement practices at Essex communities. Similarly, we expect to implement Essex's approach to Craigslist promotion, resource management, redevelopment and asset management plans at BRE communities.

Fourth, we will use our larger footprint and community proximity to negotiate lower cost relationships with vendors, create on-site operating savings and revenue management synergies.

And fifth, we will kickoff a major human resource initiative focused on creating career path that will develop talent from within the company, improve hiring practices, provide greater regional coordination staff and related topics. We believe that these areas will significantly improve the overall efficiency and results of the combined entity.

That concludes my comments. Thank you for joining in the call today. I'll now turn the call over to Erik.

Erik J. Alexander

Thank you, Mike. The strong fourth quarter in operations helped Essex cap off another good year and set us up for continued growth in 2014. The Bay Area in Seattle continued to report strong economic growth, which resulted in healthy demand throughout the period. Leasing activity met or exceeded expectations in all of our markets, highlighted by strong renewal activity, improving occupancy and better than expected schedule of rent growth. For the quarter, renewal rates grew at 5.5% over expiring rates, while January renewals improved to 6%.

With higher expiring rate comps ahead, February and March renewals are expected to achieve rent growth around 5.5% for the portfolio. Given our low availability and improving demand, we should see strong, sustainable rent growth for new lease activity in all markets.

Turnover remained low and within expectations during the quarter. But we did see a seasonal pickup in move outs due to home purchases during the quarter as this metric hit 12.2%. However, this is consistent with the last 2 years. Solid fundamentals helped sequential scheduled rent growth improve, and we believe our tempered focus on occupancy during the period allowed us to realize schedule rent growth double that of December 2012.

We are off to a good start in the new year and scheduled rent in January outpaced December's growth and occupancy stands at 96.6% with a 5.4% net availability for all stabilized assets. Activity at our lease-up projects, Epic at San Jose and Connolly Station at Dublin, reflects strong market conditions. Both projects are leasing ahead of expectations and are expected to be stabilized in September and March respectively.

Leasing activity at the new developments in the broader market also demonstrates strong demand. And the average monthly absorption for all projects of North San Jose was 38 units per month for 2013.

Next quarter, I will comment on Avery, Dylan, Huxley and Mosso, as we begin pre-leasing activities for all 4 projects over the next several weeks. And I'll share some highlights from each region beginning with Seattle. While new buildings continue to come to market in the region, we believe that slower absorption and moderating rents are more a function of seasonality than too much supply. Deliveries are largely concentrated downtown and would remain vigilant in our strategy to maximize revenues by meeting market expectations and proactively managing lease explorations. Economic rents on the east side, the north end and the south end of Seattle, were the majority of our portfolio is located, held up better than downtown during the fourth quarter, and we expect these submarkets to outperform the downtown in 2014.

Employment growth in the region improved to a year-over-year rate of 3% in December with unemployment below 5%. The most important employment news of the quarter was the labor resolution between the Machinist and Boeing that the allow the world's largest airplane manufacturers to keep 20,000 direct and indirect jobs in Seattle working on the 777 Dreamliners for the next decade.

Office absorption moderated the fourth quarter with 313,000 square feet lease, but 2.9% of total stock was leased for the full year. Office vacancy remained low and deal flow continues to be brisk, including Amazon's purchase via another significant property in Downtown.

Turning to Northern California. With the year-over-year job growth of 3.4% in San Jose, and 2.2% for the broader regions, the Bay Area continues to lead the way for Essex, with the highest growth in rental rates and revenue for the portfolio. Office leasing and development continues to be strong in virtually all parts of the Bay Area with another 1.5 million square feet absorbed during the quarter. Additionally, other significant Bellevue's projects like Apple's 2.8 million square foot headquarters, and Netflix expansion began construction during the quarter.

Investment and transportation and infrastructure also continues to grow. The new Eastern span at the Bay Bridge and the fourth floor of the Colvaca tunnel opened in the latter part of 2013. Barge open airport connector is set to open later this year and the first phase of the Transbay Terminal remains on schedule to open in 2017.

All of these projects and others will continue to help few economic growth in the Bay Area. Finally, in Southern California. Southern California continues to grow at a more moderate pace compared to Seattle and the Bay Area, with Orange County and Ventura have shown signs of accelerating. All overall job growth in Los Angeles was 1.2% during December. Orange County job growth was 2.4% and Ventura hit 2%. Orange County bows the lowest unemployment in Southern California at 5.2%, but Los Angeles has dropped below 9% for the first time since November 2008.

Encouraging news is that the 1.4% year-over-year decline in employment in Los Angeles -- unemployment in Los Angeles was due to employment growth and not shrinkage in labor force. The impact of the military in San Diego essentially remains unchanged with the resident exposure hovering around 13%. However, with federal funds flowing again, there has been an increase in shipyard activity and military contract work.

Commercial leasing activity in the region was positive during the fourth quarter with another 850,000 square feet absorbed mostly in Los Angeles. Orange County was flat, however, Hyundai and Pemco delivered their headquarter facilities during the period. So overall, economic and rental market conditions remain strong across the portfolio, and a solid December and January give us good reason to be confident about 2014. Thank you for your time, and I'll now turn the call over to Mike Dance.

Michael T. Dance

Thanks, Erik. Today, I will provide some color to the assumptions behind our 2014 guidance. Then provide a brief update on the proposed merger with BRE. For more details on our guidance, assumptions, please read Page 6 of the press release. And on S-14 of the supplemental package, we have provided a detailed roadmap, how these assumptions are expected to impact our 2014 financial results. The assumptions and projections are for Essex on a stand-alone basis and exclude any impact from the proposed BRE transaction and the merger-related costs associated with the deal.

For 2014, we expect consolidated same-property net operating income to grow by 6.5% at the mid point, driven by a 5.6% increase in same-property revenues. The 2014 same-property portfolio will increase by over 2,000 apartment homes and will exclude the 6 properties that were acquired in 2013 and those undergoing major redevelopments. We expect our same-property operating expenses to increase 3.5% of the midpoint. The biggest factor driving our expense growth is higher property taxes. Our budget assumes property tax increases by $3.7 million or 7%. This tax increase relates to higher assessed values in Seattle, which are 18% higher than last year's assessed value.

In California, we still had favorable Prop 8 adjustments in 2013, totaling $1.2 million in tax savings. And we expect $600,000 of additional California property taxes in the second half of 2014, as a result of losing these Prop 8 savings on July 1. The controllable expenses for the same-property portfolio are expected to grow by less than 2%.

Now, I'll provide an update on the proposed BRE merger. Assuming the merger closes in March, we expect to benefit from the operating efficiencies of adopting the best practices that Mike outlined in his prepared remarks after a six-month integration period. The operating platform accretion will begin to add accretion to our 2014 core FFO guidance in Q4, and continuing into 2015.

In connection with our financing plans for the cash components of the proposed merger, we expanded our unsecured credit facility from $600 million to $1 billion at the end of January, and added an important feature pursuant to which we have the flexibility to expand to $1.5 billion. We reduced the pricing on the expanded facility by 12.5 basis points to 95 basis points of the LIBOR.

In addition, we renegotiated the pricing on our $350 million term loan reducing the spread over LIBOR by 15 basis points. We believe, this demonstrates some of the initial costs of capital advantages we can achieve with the larger platform.

At the closing of the merger, the net debt-to-EBITDA of the combined company will increase by one turn as the result of creating joint venture which will form the cash component of the deal. At this time, we do not expect to use the $1 billion bridge loan to close the merger. We expect the debt-to-EBITDA ratio will return to approximately 7x in the first half of 2015 to grow the net operating income and stabilizing the development pipelines for both companies. As a result, after the merger, we will maintain the strength of our balance sheet and will be opportunistic when considering alternative sources of capital, including asset sales, additional joint ventures, unsecured debt and common equity to finance the buildout of the development pipeline.

As disclosed in our press release, our Board of Directors declared a first quarter dividend of $1.21 per share to shareholders of record on March 14. The timing of the first quarter dividend is coordinated with BRE's first quarter dividend pursuant to the merger agreement. The board will reveal any increase to the annual dividend during its February board meeting, and an increase if any approved by the board will be effective for the second quarter dividend payment.

I'll now turn the call over to the operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is coming from the line of David Toti with Cantor Firzgerald.