Essex Property Trust Inc (ESS) 2004 Q1 法說會逐字稿

Good day, and welcome to the Essex Property Trust, Inc. first-quarter 2004 earnings results conference call. Today's call is being recorded. With us today are Mr. Keith Guericke, chief executive officer, Mr. Robert Talbott, senior vice president of operations, and Mr. Michael Schall, chief financial officer. For opening remarks I will turn the call over to Mr. Guericke. Please go ahead, sir.

Thank you. Welcome to our first-quarter earnings call. This morning going to be making some comments on the call which are not historical facts, such as our expectations regarding markets, financial results, and real estate projects. These statements are forward-looking statements, which involve risks and uncertainty which could cause actual results to differ materially. Many of these risks are detailed in the company's filings with the SEC, and we encourage you to review them.

Last quarter our call got quite long and I was part of the culprit there, and as a result I'm going to reduce the length of some of my comments. As we stated in our last quarter call, in our metropolitan area, nonfarm industrial job growth forecasts are based on U.S. growth of .7 to .9 in 2004. Given the data through March, we expect U.S. job growth to meet or exceed the high end of the range. During the last six months, the unemployment rate in the U.S. increased by .2, during which same time the labor force grew by .2, which would indicate a stable level of employment.

For each of our markets, we construct our own estimates of job growth. The data we have seen through March indicates we are on or above expected growth path for each region. At this time, we are maintaining our expectations for job growth presented last quarter. To get those details, go to our web page under analyst resources for our forecast of 2004 job growth. You'll also find our forecast for total residential supply by market and, on that same sheet, our expectations for the market rent performance for each of the markets for the year.

Axiometrics, which I know many of you receive, has recently published labor statistics. The numbers that they have are year-over-year and are different than the numbers we are reporting, which are sequential for the current year. Also on the web page is a schedule titled "Permits/Home Prices," which includes total residential permit activity for the larger U.S. metros, as well as information on median home prices and affordability as compared to the Essex markets. Bob Talbott, in his comments, will give information on the percent of turnover, by market, attributable to home purchases. I'd just like to point out that home prices in our markets are of some of the highest in the nation, with the least affordability, and our new construction is generally less than 1% of existing stock.

Now, for additional information that we think supports our view that our markets are improving, starting with the northwest, which represents 22% of our portfolio, forecast for supply remains virtually unchanged from the previous quarter. In Seattle, over the last six months the unemployment rate has declined by 1.1%, during which time the labor force grew by 3.2%, indicating significant increases in employment. With respect to Boeing, it lost 7,900 jobs last year. Through the current period it has lost another 500 jobs, and in our job forecast for the area we anticipated 2,000 to 3,000 job losses in our projection.

Indication of a growing economy is the office and industrial market. The office market continued to show signs of improved absorption, with 500,000 square feet absorbed in the quarter, which is about a pace of 2.5% for the year. The industrial market, particularly the Kent Valley, showed significant improvement in leasing activity, with 800,000 feet being taken. Market rents have been stable over the last two quarters, as we anticipated. Occupancy remained flat over the last quarter at 93.5, however, it's up 1% over a year ago. I would point out the Essex portfolio has performed much better at 95.9% for the quarter. Again, Talbott will elaborate later in the call.

Over the last six months, in Portland the unemployment rate has declined by .4, and during the same period the labor force grew by 3.1%, again, indicating an increase in employment. Market rents were flat, concessions down from six weeks to four weeks, over the last -- and over the last six months, and occupancies increased a half a point in the first quarter, and is up 1% over last year.

Going to the Bay Area, where we have 17% of the portfolio, our forecast of new supply is less than 1% for both multifamily and single-family units. Each of our submarkets showed positive job growth, consistent with our forecast. In San Francisco, the office market experienced a second straight quarter of strong, positive absorption of 74 -- excuse me, 740,000 square feet, or 2.4% on an annual basis. The industrial market on the peninsula showed positive absorption for the first time in five quarters, with 1.3 million square feet absorbed, which is a 7% pace for the year. Market rents were flat from last quarter, and down 5% from a year ago. Occupancy remained flat at 95%, and up 1% from a year ago. In Oakland, office absorption was flat. Market rents for apartments were flat for the quarter, down 3% from a year ago. Occupancy remained flat at 95%, over last quarter, and flat from last year.

In San Jose, which is the market most heavily reliant on manufacturing jobs, over the last three years total jobs fell by 20%. However, manufacturing was 35%, or 93,000 jobs. Over the last six months the U.S. manufacturing sector has shown improvement. The San Jose manufacturing sector has joined in that recovery, and jobs were flat for the quarter after falling 4% and 3.3% in the previous two periods for the last two years. The industrial leasing activity returned to the market for the first time in two years. Over the last six months, the unemployment rate has declined by 1.1%, and during that same time period the labor force actually fell, but by a lesser amount, .8%. So we think this is an indication of a stabilizing employment situation.

The San Jose office market experienced slight negative absorption, after a strong performance last quarter. For the year, it's absorbed just over 2 million square feet. And the industrial market was essentially flat for this first quarter. Market rents were down 1% from the previous quarter, and 6% from a year ago. Occupancy was up a half point over last quarter, and up from 94% a year ago.

In Southern California, the job market has rebounded in the first quarter of 2004, with each of our markets posting positive job growth. Over the last six months, the unemployment rate has declined by .8%, and the labor force has increased by .1%, indicating increasing employment. The Los Angeles and Ventura office market absorbed 1.7 million square feet for the quarter, which is an annual rate of 4.8%. The strongest areas were the San Fernando Valley, Ventura, and west L.A. The Orange County office market absorbed 565,000 square feet, the strongest areas being the airport area in South County.

The San Diego office market absorbed 400,000 square feet, which is the annual rate of 3.3%. Industrial markets were also strong during the quarter. The L.A./Ventura market absorbed 3.3 million square feet. Orange County rebounded from a weak fourth quarter and absorbed 700,000 square feet, again, primarily in the airport area. And the San Diego industrial market absorbed 1.25 million square feet of space. Occupancy levels were flat to down .5%, depending on the area. Ventura, north Orange and the inland Los Angeles area were the weakest areas. We expect these markets to regain strength during the year as job growth increases. The San Diego market rents were flat from the previous quarter. Occupancy was down .5%, to 95%, from last quarter. We attribute this to the military deployment that's impacted some of the North County areas.

Going to the acquisition part, the goal for the year, as you may recall, was $200 million of acquisitions. During the first quarter we acquired $166 million in three separate transactions, all in southern California. All the assets were acquired on balance sheet and will not be contributed to the fund. Additional acquisitions for the year will be acquired in the Essex Apartment Value Fund 2, which is currently being finalized. As a result of the first-quarter activity, we are increasing the acquisition goal for the year to $325 million.

Now, a quick review of the cap rates by market, and I'm assuming B product in A locations. In Seattle, cap rates have actually gotten more aggressive since what I reported last quarter, and have ratcheted down to the 5.75 to 6.25 range. In the Bay Area, even though there's very little sales activity, what there is is going down in the 5.5 to 6.0 cap range. And in Southern California, despite being a quite large diverse market, cap rates seem to be fairly consistent in the 5.8 to 6.3 range.

The development pipeline, currently we have four things under construction, four projects under construction, San Marcos, Hidden Valley, River Terrace and Chesapeake, all being delivered in 2004. We're currently working on several potential opportunities. However, even if they underwrite, construction would not begin until 2005.

Let me just briefly talk about underwriting. In most of the better areas, in areas that we would want to own, the cost is ranging about $250,000 per unit. And we've said that we want a 150-basis-point spread over what we're able to acquire, so that will imply about a 7.5 cap. In order to do that, if you back into the numbers, that means you need average rents of about $2,300 per unit, or $2,100 for the one's, and $2,500 for the two's, assuming a 50/50 mix. We just aren't seeing those kind of rents, even in the better markets. And if you get down to the very, very best markets, you're talking about costs per unit in a construction of $350,000 to $400,000 and the rents have to be ratcheted up. So there are those kinds of rents in some selected markets, but in the markets, you know, the A -- sort of the A markets that are not primo, you're seeing cost per unit in the $250,000 range. And that's the struggle we're having.

In the disposition area, as I mentioned last time, we have a number of projects that have condo maps and we're evaluating, given the hot housing market, the potential for selling some of the stuff. We see that if we could sell it in the four cap range and reinvest in the six cap range, the accretion would be significant. There's a potential to sell $75 to $100 million of this stuff in the second half of the year.

And finally a comment on funds. The second fund is currently being finalized. We expect it to be $250 million, with Essex contributing $50 million. The leverage in the fund will be approximately 65%, which will allow for total acquisitions of approximately $700 million. The strategy for Fund II will be consistent with Fund I, however, the geographic focus will shift, with more of the activity in northern California and the Seattle market. We expect the fund to close in the second quarter of 2004.

Now, I'd like to turn the call over to Bob Talbott.

Good morning. As I've done on recent calls, I'll discuss current conditions in each of our major markets. First, just a reminder, the occupancy numbers I report are for a point in time, and the financial occupancy numbers noted in the release are the average financial occupancy for the quarter, so you may notice a slight difference. This week, our stabilized portfolio is 95% occupied, and our net availability, which we define as the sum of vacant and on-notice units available to rent, expressed as a percentage of the portfolio is 7%.

Now, let's look at the individual markets. Starting with Seattle, sales occupancies continue to remain stable at 96%, and net availability is 5%. Concessions are down, but they've not completely eliminated from the market. We're seeing up-front concessions of $300 to a month free, or an outright discount of $50 offered, in those cases that they are offered. Traffic for the first quarter was up 28% sequentially for the same quarter. One year ago traffic was up 5.5%. The sequential increase is consistent with the seasonal aspects of the Seattle market. The increase in traffic over last year is an encouraging sign about the direction the market's going. Just a word of caution, though, these traffic numbers I share as a way to give some perspective on the market, but alone traffic isn't going to necessarily indicate a trend.

As Keith mentioned, I'll provide information on our move-out activity caused by residents buying homes. For the first quarter, 15.8% of our move-outs portfolio-wide were due to home purchases. This is consistent with our 2003 experience. I'll report on each of the sub markets as I go through them.

For Seattle, 19.5% of our move-outs in the first quarter were due to home purchases. Portland is stabilizing, with occupancy at 95% and a net availability of 7%. However, given that this market was significantly hit harder than some of the others, we expect that its road to full recovery is going to take a little bit more time. Concession activity has declined but it's -- a month free is still very common. Traffic is up 19% from the fourth quarter, and it's up 4.75% from the same quarter last year. During the first quarter, 18.9% of our move-outs were due to home purchases.

Now looking at the Bay Area, the Bay Area is stable, with occupancies in San Jose -- MSA and Oakland/San Francisco MSA's of 97%. With this high occupancy we're looking for some sustainable job growth to support some rent growth. Net availability for San Jose and San Francisco/Oakland is 5% and 4.5%, respectively. These are also noticeable improvements over the previous quarter, when availability was 7% and 6%, respectively.

Another positive indication is that concessions are showing signs of declining. Where we are seeing discounting activity, it's either a month free or a monthly discount of $50 to $100 per month. This activity is typically occurring in the south Bay and in the south end of Alameda County in the cities of Fremont and Newark. With their proximity to Silicon Valley, they tend to operate with similar elements. Traffic is down 35% from the fourth quarter, and is down 8.5% from a year ago. 17% of our move-outs this quarter were due to home purchases.

Now, in L.A./Ventura, coming off of a strong occupancy in the fourth quarter, these markets, Ventura County in particular, eased a bit in the first quarter, explaining our slight decline in sequential revenue. However, this appears to have been a temporary situation, fueled in part by a reduction in traffic of 12% compared to a year ago, and some isolated competition from neighboring properties that were discounting to fix occupancy problems. Today, occupancy is 95.5%, and net availability is 6.5%. Traffic compared to the fourth quarter is also up. Sorry, I don't have a percentage number at my fingertips here. Concession activity has been primarily limited to Ventura County and been in the range of $500 to $1,000 on stabilized properties. Home purchases contributed to 16% of our total move-outs in the first quarter.

Let me also update everyone on the status of our first-quarter acquisitions. We transitioned management on the Marina City Club, Mountain View, and Fountain Park during the quarter. Those transitions have gone as expected. Mountain View, located in Ventura County, is presently 95% occupied.

Marina City Club is in L.A. County and is a unique asset, located on the water in the Marina City del Ray harbor. The property's over 30 years old, and a number of the units have been occupied for many years. As they become vacant, we are renovating the interiors. Consequently, we have 10 units offline right now being renovated, and occupancy is 89%. By the way, the cost of these renovations is averaging about $8,000 a unit, and the scope varies, depending on the condition of the units, as some of these units are in original condition. We are earning an additional $200 per month, on average, after the renovation of the unit.

Finally, we transitioned management on Fountain Park at the end of February. When we purchased the property, it was still leasing up its second phase and occupancy was 82%. As of this week, the property is 91.5% leased and 87% occupied. We expect occupancy to fully stabilize over the next 60 days.

In Orange County, it continues to perform well, with reported occupancy this week of 95.5% and net availability of 6%. In a few situations, typically in South County, we're seeing concessions at $300 to $500, and occasionally we've seen a month free. In nearly all cases these are limited to vacant units only. Traffic is up 24% from the fourth quarter and is down 9% from the same quarter a year ago. 11.8% of our move-outs in the first quarter were due to home purchases.

And finally, in San Diego, San Diego continues to be relatively stable. However, recent troop rotations have softened occupancy at three properties, affected by the military. Occupancy at these properties is 91%, with net availability of 12.5%. These three assets, however, represent a small subset of our full portfolio in San Diego. Our military exposure portfolio-wide is 12.5%, and the portfolio occupancy is 95.5%, and net availability is 7%. Concession activity is limited to those properties with the lower occupancy, and we've seen a range of $500 to a month free. Traffic is up 25% compared to the fourth quarter, and is down 9% from the first quarter a year ago. 14.3% of our move-outs in the first quarter were due to home purchases.

Now, let me turn the call over to Mike Schall

Thank you, Bob. And thanks, everyone, for joining us today. I want to note that the press release and our supplemental reporting package are available on the website, as before, or you can call our investor relations department in Palo Alto. I'm going to talk about four topics on the call. The first is the quarterly financial results, the second is the impact of accounting pronouncements, third is the balance sheet, and fourth is estimates of FFO.

So first topic, quarterly FFO results. As you know, FFO for the quarter was $1.04 per share, which was 3 cents or a 2.8% decline from the $1.07 in the first quarter of 2003. I want to note that the prior year amounts were restated as a result of the adoption of FAS 123, which I'll discuss in a moment. We previously reported FFO of $1.08 per share for the quarter ended March 2003. The restated result of $1.07 includes the impact of expensing stock option, which impacted both the current and year-ago quarters.

For the quarter, our FFO result was as expected, and is consistent with the guidance range. As Keith and Bob indicated, our West Coast markets continue their slow but consistent improvement, given the overall high occupancy rates, improvement availability and reduction in concessions. This would lead us to believe that the company's FFO results experienced a low point in the fourth quarter of 2003, in which the company reported FFO per share of 97 cents per share, or $1.01 without regard to the 4-cent noncash write-off of the redemption of the preferred units costs related to that redemption.

I want to make a couple of notes about the quarter, about the first quarter of 2004. First, miscellaneous nonrecurring fee income did not materially contribute to our results. It was $9,000 for the quarter versus $242,000 a year ago. The prospects for generating nonrecurring fee income are improving with a better economic environment. And we still believe that we're on track for our $1.7 million expectation in miscellaneous nonrecurring fee income for the year.

Second, the proceeds from our 1.6 million common share offering in October of 2003 were fully invested with the acquisitions that were completed in the first quarter. Up to that point, up to their investment, the point at which they're invested, the offering proceeds had been used to effectively reduce the lines of credit, which was diluted to FFO per share. The delay in investing these funds until mid-quarter reduced FFO by approximately 1 cent a share. One of the acquisitions that we completed during the quarter is Fountain Park, which is a new 705-unit property adjacent to Marina del Ray. Fountain Park has not completed its lease-up, as Bob indicated, and we are not capitalizing interest on the offline units. Since the closing of the acquisition through the end of the quarter, the property averaged 81% financial occupancy.

Concessions continued a steady decline, with Northern California and the northwest leading the portfolio. Turnover was down in each market, averaging an annualized 47% for the quarter, versus 54% in the same quarter the prior year. Concessions per turn increased modestly in Southern California and Northern California, while dropping significantly 43% in the northwest. On a year-over-year basis, the Southern California region continues to lead the portfolio with a 4.4% same-store revenue growth.

However, on a sequential basis, Southern California revenue declined .3%, mostly attributable to the 2.8% drop in Ventura County. The sequential drop is primarily attributable to occupancy, which increased year-over-year but declined .8% compared to the quarter ended December 31, 2003. The decrease in occupancy is largely influenced by three large properties in Ventura County comprising almost 1,500 units, which average 93.4% financial occupancy for the quarter. Bob alluded to the occupancy in Ventura County, which has since recovered to approximately 95%.

The performance of Northern California properties was, as expected, disappointing on a year-over-year basis, and was .7% lower on a sequential basis. The last quarter that Northern California experienced year-over-year growth in same-property revenue was the third quarter of 2001, September 30, 2001, and at that time the same-property portfolio generated $14.1 million in revenue for the quarter, as compared to in the first quarter of 2004, $12.6 million, an 11% reduction over the last positive quarter.

Our view continues to be that the northwest markets are improving, and are a step ahead of the Northern California markets in that regard. In the northwest, same-property gross income for the quarter declined .1%. the best results since September -- again, September 2001. The northwest sequential result led the company with a 1.5% increase. Continued strong occupancy, lower concessions, and lower turnover contributed to that result.

A note on G&A, which increased 51% according to the supplement. Most of this increase is due to the consolidation of EM -- of Essex Management Corp., or EMC, which was previously accounted for under the equity method of accounting. The consolidation of EMC increased fee income, recurrent fee income by $725,000, and it also -- we also consolidated EMC's G&A, which had previously been netted against net income in arriving at its equity method profit. The EMC G&A was $710,000 for the quarter. Also, in the prior year we had very limited incentive compensation accruals, and we have increased those accruals in the current year.

Second topic is the impact of accounting pronouncements. As indicated in the press release, we adopted FIN 46R and FAS 123 during the quarter. FIN 46R requires consolidation of certain variable interest entities where the company is deemed to be the primary beneficiary. As defined in FIN 46R, a variable interest entity is an entity that lacks an essential characteristic of a controlling financial interest and/or the entity has insufficient equity to permit it to finance its activities without the financial support of another party.

In applying FIN 46R to the company, we consolidated ten properties owned by DownREIT entities, the company's two taxable REIT subsidiaries, and the owner of an office building subject to loans made by the company where the third-party owner has an insufficient financial commitment to avoid consolidation. In aggregate, these entities that have been consolidated in accordance with FIN 46R had a aggregate book value of $203.9 million, and mortgage notes payable of $119.5 million. The consolidation of the income statements of the entities consolidated pursuant to FIN 46R added $6.9 million to the company's consolidated revenue. As you notice, we did not restate the prior year related to the adoption of FIN 46R.

Other than the noncash charge of $5 million, as indicated in the press release, the adoption of FIN 46R had a limited impact on net income. The noncash charge includes the elimination of interest income recognized previously from the third-party owner upon the consolidation of the entity owning the Darian [ph] office property. Essentially, the accruals that we made while accounting for the property of the note receivable were reversed to reflect what would have happened had we been the building owner over that period of time.

Also indicated in the press release, the company and its auditor, KPMG LLP, had not completed the review of FIN 46R as it relates to two additional ventures in which Essex has entered into a land lease with unrelated investors and is still reviewing the accounting from minority interests of entities now being consolidated. We expect that review to be completed in the next two weeks. As a result of FIN 46R, we have concluded that the investments indicated on page S-11 of the supplement do not require consolidation, and continue to be accounted for using the equity method of accounting. We have removed from page S-11 the investments that are now being consolidated in accordance with FIN 46R.

The company also adopted FAS 123, accounting for stock-based compensation. In accordance with FAS 123, the estimated costs associated with the company's stock option plans will now be expensed as options are vested. The company utilized the retroactive restatement method of adopting FAS 123, which resulted in stock-based compensation expense of less than 1 cent per share in the first quarters of 2003 and 2004.

Third topic is the balance sheet. Capex per unit in 2004 is expected to be approximately $390 to $400 per weighted unit. The increase in interest expense and amortization of deferred financing costs for the quarter was $3,031,000, and it had the following components. Number 1, the cost of debt consolidated pursuant to FIN 46 was a $1.985 million. Second, the balance, or most of the balance of $1.1 million is due to a weighted-average increase in the notes payable balance of $131 million. And that -- and another contributing factor was the write-off of a prepayment fee of $175,000. And then finally, we had a 70-basis-point reduction in the line of credit interest rate.

We still expect to redeem our 9.25% Series E preferred units, which are callable in September 2004. We have not been successful in negotiating or renegotiating the existing terms with the investor, which means that it is likely that we will incur a noncash charge of approximately 5 cents in connection with that redemption. As indicated previously in our guidance, we have not considered that charge in the guidance amounts. Balance sheet remains strong overall and, as indicated by interest coverage 3.3 times EBITDA and ratio of debt to market cap at 37.6%, and again, that includes the debt that is now being consolidated pursuant to FIN 46R as of March 31.

Fourth topic, FFO expectations. In our press release dated December 15, 2003, we provided our FFO guidance for 2004. This press release contains many of the key assumptions underlying our 2004 guidance, and it's available on our website. We continue to expect FFO to range from $4.19 to $4.29 in 2004, based on an overall .5% increase in same-property NOI at the mid-point of the guidance range. We have no change to that previous guidance at this time. For the second quarter of 2004, we expect FFO of between $1.04 to $1.06 per share.

Again, I'd like to thank you for joining us. And now we'd like to give you an opportunity to ask any questions that you might have. Operator, are you there?

Yes, sir. Today's question-and-answer session will be conducted electronically. If you care to ask a question, you may do so by pressing the star key, followed by the digit one on your touchtone telephone. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, it's star one to ask a question. And we will go first to Andrew Rosivach of Credit Suisse First Boston.

Good morning still, guys. Mike, I wanted to ask you, you know, you did have that great earnings breakdown that you put out in December, but I'm guessing now the G&A assumption that you gave back then is apples-to-oranges to what you have to report now, post-FIN 46. What's G&A going to look like now on a go-forward basis relative to the first quarter?

Let's see. Well, clearly, what was happening before is the results for EMC were being shown as one item, you know, the net income basically of EMC was shown as one item. And now that's being grossed up so that the bottom-line impact is to the company is zero. In other words, what we recorded under the equity method is the same, essentially, as what we are consolidating, it's just broken into different pieces. So for the quarter, I think the number was, related to the EMC G&A, was $710,000. So I would just amend the previous guidance by approximately that amount per quarter, and I think that gets you back to where you need to be.

Got it. So that would make it $2.3 million, which would mean that you're running at about the run rate of the annual level. So sequentially, this is a decent run rate. Does that sound right?

That's right.

Okay. And just, I think you mentioned that second quarter you're looking to -- for a buck four to a buck six, which implies a little bit of a crescendo in the back end, and I just wanted to get some of the pieces of that. What kind of earnings pickup do you think you'll get when you end up closing Fund II?

Well, the Fund II closing will not, in and of itself, have a huge impact. There will potentially be an asset management fee that we would start recognizing. But we will need to invest -- a lot of the earnings from that come from investment, either from, certainly the asset management fee which we get either way, but the profit on property management fees and the spread on the investment. And so we need to make investments in order for those things to kick in.

And you've got nothing warehoused now? That would be completely new properties you haven't bought already?

No, we do not.

Okay.

We're looking at a number of properties, but we don't have anything that's, you know, that's imminently ready to close.

Got it. And a couple other pieces. What's your assumption? Where do you think you can refi the preferred that's tied into your guidance? Is that that -- still 7, 7-1/8?

Yeah, we're still looking at options related to that, because there's not an assurance that we're going to use another preferred to take that out, so we want to leave that as an open issue. But if -- the most recent -- the most recent discussions I've had are in the 7.25 to 7.5 range. I think the guidance implies 7-7/8, so it implies the rate of some of our other preferreds.

Got it. And then you mentioned just that one project that's already off the capped interest clock, it's about 80% occupied. Where do you think its current yield is relative to where it could be stabilized?

I don't have the current yield based on its current occupancy. I think that in the numbers I was running before -- well, I think its stabilized yield is somewhere in the mid-five's, it's a bond finance property that was bought at that type of cap rate. Where its current yield was in the first quarter, I don't have that number.

Okay. And a last one. That Darian project, I think it's 50% leased now. Is it producing any NOI at this point? And is there any potential for it to get leased up any further and give you some pickup in the second half of the year?

Yeah, it's actually about 60% leased. And right now, we are completing the tenant improvements related to the leases that were signed previously. We have held off on leasing the last 40% of the building, because we think that, you know, the reception in the market will be better once we have tenants in place in the property. So we're going to hold here at 60%, at least for the foreseeable future, get those tenants in and happy and stabilized, and then we'll go out to lease the remaining part of the building. Obviously the market has improved and, you know, I think we're in much better shape there than we have been over the last couple years, to be sure. Now, we did have some, I don't remember exactly what was in the guidance, but we did have an assumption for leasing in the guidance. So I think that the Darian would be a, maybe a modest pickup versus what we expected previously.

Got it. And then finally those two -- the two entities that you discussed, you're still discussing with KPMG, what would be the impact to your balance sheet and your income statement if you had to consolidate them?

They would be -- well, income statement zero.

Great.

For the most part, the only thing that impacted the income statement as a result of FIN 46 was the conversion of the accounting on Darian. So the rest of them, we were picking up our pro-rata share of the income pursuant to the equity method, now we're just consolidating them. So income statement would have zero effect. The liabilities associated with those are about $50 million -- $60 million mark? Yeah. $50 million range.

Got it. Okay, thank you.

Brian Legg of Merrill Lynch is next.

Hi. Mike, can you sort of help me follow the bouncing ball? I can see on your page, I guess S-2, just comparing that to the past quarter, the lines that moved a lot were the equity income and coinvestments, the fee income, and then your total G&A expenses, the first line. All those sort of bounced around. I'm just trying to get a sense of, is the first quarter a good run rate for all these numbers? And is it just the fact that you're moving some items to other line items where they were in other line items the quarter before?

Yeah, I think with the possible exception of, I made a comment about miscellaneous nonrecurring, we had $9,000 for the quarter and it's going to likely increase over the next three.

Right, so that $710,000 allocated to Management Corp., does that go up into the equity income and coinvestments or the fee income line?

It went into the fee income line.

Okay. And the equity income and coinvestments and lease income, what caused the jump from less than $900,000 to $3.4 million?

Brian, it's Mark. A component of that was the RV mobile home park leases that were completed. And then also just removing the DownREIT's out of that equation caused it to come up. Because we were getting allocated 100% of the depreciation there. And that's now getting moved or grossed up into the financial statement, the profit and loss statement. So I'm not sure if that helps explain that, but it's -- the down resmoothing out of the book income component -- if you notice, the joint venture depreciation add-back number dropped off significantly.

Okay. All right. So bottom line is that that's a good run rate number, the 4937, plus add some miscellaneous income for some other income. And total general and administrative, just the gross figure went up by about $700,000? Why was that again?

It has to do with the -- comp accrual of approximately $600,000, and then FAS 123, at $125,000 approximately, and those are the two main components there.

Okay. And then you have, you talk about in your debt section that you have interest rate protection on the variable rate debt. Can you sort of go over the protection there?

Yeah, we have interest rate protection on mainly the tax exempt variable rate debt.

Right.

And it's capped at somewhere around 7 -- the underlying bond rate is capped at somewhere around 7%. 6 1/2, 7%. It depends on -- it's different depending upon which bond we're talking about, somewhere in that range.

Okay, so it's more a cap and not necessarily a swap?

No, it is a cap.

Okay, but what I'm saying is that it can float up to that level?

It can. But the historical -- those bond rates, obviously in the decision to acquire Fountain Park, we spent a lot of time -- we know bond rates, what the bond rates have averaged and they have been very attractive over a long period of time, and I think we went back about 15 years in connection with that, and I think the average bond rate was about 3.4% over that period. So they can, you know, the bond rates do not move as quickly as taxable rates, primarily because the investor gets a tax deduction equal to plus or minus 40% of the taxable rate. So they had been a very attractive long-term source of financing, and one that we are very interested in.

Can you convert hat to a fixed, though? I mean, if we assume that the economy's starting to recover and the interest rate back up 200 basis points, is there any reason why you wouldn't just flip those into a fixed-rate security instead of a variable?

Yeah, there is, actually. I mean if I were going to -- because they are inherently less risky, I would rather flip a LIBOR-based security into a fixed than a tax-exempt variable into a fixed. In other words, I don't think the risk/reward quotient varies because of the taxable element. So we would be much more likely to take a -- flip something out of the line and, you know, put a long-term fixed-rate mortgage on it than we will to convert a tax-exempt deal to a fixed rate.

Okay, and long those lines you have -- 34% of your debt is floating. So do you expect to start fixing out some of your debt?

We do have a -- one long-term fixed-rate mortgage that we're going to record in the approximate amount of $30 million. And that is for sure. Again, we take that number and split it into its two pieces, one being the tax-exempt variable piece, which we don't look at as, you know, having a huge amount of risk associated with it. If you look at where those rates have varied over the years. So we're going to keep that component and we believe in that component. And the other half essentially are line interest. We want to maintain some flexibility that if we do sell some assets -- not in the guidance, but if we do decide to sell some assets, we want to have some debt that we can repay without incurring a large prepayment penalty. So we want to have some outstandings on the line. And so to answer your question, we're pretty comfortable with where we're at, with the exception of the $30 million that we're in the process of refinancing.

Okay, last question. Keith, you talked about potentially selling some properties to a condo converter. Can you be more specific as far as which markets? Are you looking to sell Lake Merit, or are there just issues that that's recently constructed?

Well, Brian, as soon as we finalize one of these things, we will get a press release out, but we are looking at, I said, we've got six properties that have condo maps on them generally. The condos are -- because of the crazy housing market, you're able to sell those in the four cap or even less range. You know, certainly Lake Merit is one of those that we're analyzing and potentially could be one of the properties that we take advantage of.

Okay. Thank you.

We will now go to Jay Leupp of RBC Capital Markets.

Hi, here with David Ronco. Just to follow-up on your comments on concessions being reduced over time. In your estimation, what scenario do you see that would effectively eliminate concessions in the Bay Area over the next couple of quarters during the moving season, in terms of occupancy levels, job growth, and interest rates that gets you to the point where, say, by the end of the third quarter you can actually have a little pricing power here?

Well, Jay, it's Bob. Of the scenario, I think that would actually -- for this market to stay its course, I mean, the job growth that we're counting on really hasn't materialized yet. Particularly in the south Bay. You're starting to see some signs that some of the tech firms are doing some more hiring. But, you know, we don't expect it to be a lot of job growth, but it's got to start moving positively. I think, you know, our expectation is if we started approaching the levels that we've published, then by the third, fourth quarter, we would hope that nearly all of that concession activity would start to dry out. I mean, if we got a spike in jobs, you'd expect it to go up pretty quickly.

Okay. And then, Mike, just one follow-up question. In terms of the fund activity, if you're buying at cap rates in the 5.5 to 6.5 range, maybe a little bit higher than that, what is the range of return on equity that you're receiving to the Essex-invested capital in the funds that you manage?

Well -- we've spent a fair amount of time analyzing that recently. You know, we tend to be, Jay -- I'm not going to talk about the 5.5 to 6.5 necessarily, because what tends to happen is we see opportunities in the marketplace, we try to jump on board those opportunities as quickly as we can. We try to be, you know, we try to be opportunistic and look at how we make money. We are committed to our partners to generate an 18% levered return on those funds. In Fund I we think we are at that level. And it's come from a variety of different places. But I will cite things that we said previously, which is in, you know, about this time last year, we saw a couple of transactions where we were about 6.25 caps, and, you know, but the underlying treasury rates allowed to us lock in 70%, plus or minus, financing at about, you know, 4.75 to 4.9%, which, if you do the math on that, that applies an FFO yield of somewhere in the 8 to 9% range. And then there's a little bit, if you get a little bit of growth on top of that, you're above a 10, which is the rate at which the promote kicks in. So essentially I think we've gotten there in different ways on different assets, depending upon what we're talking about. But overall we're generating about a -- in the range of a FFO yield on our investment, without the fee piece of it, in the 10% range on Fund I.

Thanks, Mike.

We will now go to Tony Paolone of J.P. Morgan.

Hi. Just a question on the acquisition volume. You talked about the $325 million as your new goal, you did about $166. So just the balance, I guess about $160 million, how much of that is Essex's versus partners in the fund? How does that work with the fund?

Well, the goal, it's going -- the fund we're hoping will get closed in the next few weeks, and if that happens, as you know, we dedicate 100% of the flow to the fund. So all of that would go to the fund. Now, if the fund held off for a week or two, a little bit of that could end up in the company, but the really the intent is to have it all go to the fund. The only caveat would be in the -- if at the end of the year we do sell some of these condo projects, and we do have the right in the fund document to do 1031. So in that case, whatever we sold via condo sales, you might expect us to take that, cover that with a 1031 exchange.

Okay. But if the $160 -- if it all goes into the fund, then that means that Essex, your portion, is the $40 million?

Correct.

Well, $160 would be leveraged.

Well, yeah.

Say 60% leverage and then we would be 20 to possibly a little bit more, but let's say 20% of the equity.

Yeah.

So, right, your actual equity would be less than the $40 million?

Correct. But at the gross price. We're at -- we're actually at 50 on 250, we're actually 20%, so that would be $32 million would be our share of the gross purchase price.

Okay, and then your equity would be obviously less. Then it seem like if you do do the condo conversions, depending on how you 1031 those assets, you could be net sellers almost this year? Does that seem like a possibility? Or --

Um --

Or I guess in the back three-quarters of the year for that matter?

Well, no, because in a 1031 if we sell $100 million, we're going to 1031 into $100 million. So we're going to have whatever our piece of the fund is, plus we're going to replace the assets in a 1031. So we should be net positive any way you look at it.

Okay. Thank you.

And our final question comes from Bill Crow of Raymond James.

Good afternoon, guys. Just a couple of questions. First of all, I'm trying to reconcile your comments that the markets are improving with, you know, the traffic, year-over-year traffic counts. You said Bay Area down 8.5%, L.A./Ventura down 12%, Orange down 9%, San Diego down 9%. I'm just trying to -- is it just a lag or what are you seeing that aren't in your numbers yet?

I don't necessarily that it would be a lag. I think, you know, when you've got availability higher like you have, you potentially have less traffic because less people are coming in the door and we haven't necessarily cut back a lot of advertising, but you're hot beating the bushes as much to try and generate that traffic. You know, I mean, I think that could be part of it. It's always tough for me to try and pick the trend off what's happened with the traffic on that year-over-year basis, because, you know, at this point, our occupancies are in pretty good shape. I'd like to see them a little higher in southern Cal in a few spots, but generally they're in pretty good shape. And our availability is down.

I would just -- I think Bob at the beginning of the first part of his comment, he said availability was up. I think he meant to say availability was down.

I'm sorry.

That we are seeing concessions, as can you can tell from the release, concessions are backing up, or being reduced, you know, occupancies are generally pretty strong relative to the most of the markets in the country. So -- and there is some job -- each of the markets did have some positive job formations for the quarter, which is, you know, in Northern California, is the first time that's happened. In Seattle, it was quite strong and, as Bob said, Seattle had very good strengths in, you know, reducing concessions, as well as increasing occupancy. So, you know, I don't think you can look at occupancy -- or excuse me, look at traffic and just say given that, everything's wonderful, or given that, everything's horrible. You got to look at everything in conjunction. And then you look at where our home prices are and what we're losing to new purchases. It's relatively manageable, again, compared to -- and since this is relative gain, I think you have to compare us to the rest of the world, the rest of the country. And our loss to new home purchases, because of expensive homes and lack of new supply, is relatively low. So I think that's, you know, that's the strength of our comments.

All right. Let me just, Keith, if I could, change the topic briefly, this is something that we've really been scratching our heads about, whether it's Essex or Archstone or Equity Residential, for that matter. But it seems like the acquisition volume has picked up here, and yet the acquisitions are being done in cap rates in the 5's. And at a time when, as we look out in the landscape, it certainly seems more probable than that that interest rates are going to rise and cap rates will reverse trend eventually and head back up. And we understand spread investing, but it's tough to make a living in the 5's, isn't it? And what are you go looking at there that gives you, you know, the certainty to go ahead and spend $200 million with 5 cap rates, instead of maybe just holding off a little while, say, 6, 12 months, and see what the landscape looks like?

Well, the $163 million we just did, $83 -- I mean, matched up with that, $83 million was low-floater debt which was at very -- I mean, that was a significant spread over what we would typically do. That was really what skewed those numbers. I mean, the goal for the rest of the year is $150 million. I would tell you, though, that if we saw things getting real dicey, we would act as Mike described us and we'd act very prudently and very opportunistically, and back off.

What sort of cap rates are you looking at, at an exit basis, as you model out your IRRs?

Well, frankly, we're assuming that cap rates do back up. But what we're looking at is two things. Going in cap rates are an issue, matching of long-term financing is another issue, and then the third thing is what's the growth in the marketplace? If cap rates back up 100 basis points from a 5.5 to 6.5, just to stay even you need to, over a five-year period, you need to have 18% rental growth. So, you know, the assumption is in that place, if the economy comes back in what these markets had done, again relative to other markets in the country in good times, we think that 18% rental growth is very achievable, and we can surpass that in order to compensate for that cap rate potential backup. The other piece is if we can lock in long-term rates in the 5% range, 5.25%, which is still doable, 5.25% is doable today, in five years from now, with 10-year financing, you still have five years left, that loan, if rates are 7% or higher, that loan has value which will mitigate some of the value lost in the cap rate. So again, we're looking at all those factors, and we believe that it's prudent to be active in the market.

Hey, Keith, this is Paul Puryear.

Paul?

What's happening with replacement cost? What sort of escalation curve in the apartment sector are you seeing?

Well, are you talking about cost per unit on --

Right, right.

On new construction?

Yeah.

New construction in the Bay Area, I mean, we have been trying to underwrite stuff and my comments with respect to our lack of new supply in the development pipeline is anything in a decent market is costing, at a minimum, $250,000 a unit. And again, if you just do the math, if you say we're willing to build at a 7.5 cap, we need some spread over acquisitions, but if we're willing to take a 7.5 cap, you take a 7.5 cap on that, you add back about $7,000 per unit in expenses, you take 95%, you've got average rents that are, you know, $2,300, and it's just not there. So -- but that hasn't -- I mean, that hasn't stopped people completely. I think it's going to slow them down, but there's just not a lot of new stuff happening in Northern California yet until we see some significant rent growth.

What about Southern California, and again, the escalation rate, if you can -- ?

Well, Southern California, we are -- our deal in Semi Valley that we're delivering now, I think we're in the $145,000, $146,000 a unit, and that's based on land prices that we were able to tie up three or four years ago. If you look at just generally A areas, the Pasadenas, the Orange Counties, the coastal areas, again you're in the $220 to $250 range. Building products, I don't think -- lumber hasn't gone up significantly and the garden-style stuff doesn't have much steel, steel's gone up a lot but that's not really an issue. What we're seeing is we think that condo maps add value, and if we can build something with condo map on it, we would do that because we think that that's a safety net for us. But the escalation in costs is really coming from a couple things. Number one is the land price. Number two is the city fees. Because everybody's scrambling right now with the budget situation, and city fees and building fees in all these municipalities are, especially in a lot of the newer municipalities, are going up like crazy and $20,000 to $30,000 is not an unusual number. You put that on top of $50,000 or $60,000 land, you're into it $100,000 before you turn a spade of dirt. So it's not -- it's just very difficult to be in a decent area and have something built for a cap rate that makes any sense.

All right. Thanks, guys.

Okay.

And our last question comes from David Rodgers of Key/ McDonald.

First question for Bob. In terms of the next six to nine months, any submarkets that worry you in terms of supply, similar to what you were seeing in Ventura that you talked about earlier?

Not really, no.

Okay. The military impact in Southern California, I think you said 12.5% exposure, if I caught that number right. What's -- can you quantify the impact on those assets? At all?

Well, it's really -- that's the total overall blended rate. The three assets that we have are the ones that are most significantly impacted, and their total exposure ranges -- I think on one its 25% and the other is maybe 30 or 40%. Those are the three assets that I reported had 91% occupancy at this time.

Okay. Sorry, I didn't hear the 91.

No problem.

And last question, just for Keith, on the condo map. Is there an incremental cost for mapping some of the new developments that make it prohibitive?

No. I mean, well -- yeah, there is an incremental cost and you're going -- if you're going to build it to a condo standard you're going to upgrade the interiors a little bit, you're probably going to use granite countertops instead of tile or some other material. And there are some costs for the map, the map itself is really an incidental cost, it's really -- it's the upgrade to the unit that's more expensive. And I would guess that you would spend anywhere from $8,000 to $10,000 to improve the kitchen, primarily, and maybe some of the flooring. Yeah, but for the most part, most of California is not very supportive, and if you're in the city you're not real supportive of doing condos, so I think feasibility becomes a huge issue throughout most of California. There were a couple of exceptions to that, but even San Diego, but which was an advocate of condominiums a year or so ago, has tightened its view of condo conversions or condos in general, and is requiring more -- requiring low-income units and that type of thing, and it's making it generally more difficult for developers to make those work.

Thank you.

There are no further questions. I'll turn it over to you, Mr. Guericke.

Thank you. I appreciate all of you joining us on the call, and talk to you next quarter. Thanks a lot.

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