Essex Property Trust Inc (ESS) 2004 Q3 法說會逐字稿

Good day and welcome to the Essex Property Trust Incorporated third quarter 2004 earnings results conference call. Today's call is being recorded. With us are Mr. Keith Guericke, Chief Executive Officer, Bob Talbott, Senior Vice-President, John Burkart, First Vice-President, and Michael Shaw Chief Financial Officer. For opening remarks I'd like to turn the call over to Guericke. Please go ahead sir.

Thank you. I thank you all for joining our third quarter call. This morning we're 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 risk and uncertainty which could cause the 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. Again, joining me in today's call is Mike Schall, which you all know. Bob Talbott who is going to discuss the operating results by market. And John Burkart who is the First VP in charge of our fund business. And we've asked him to join and give some additional color on Fund I and Fund II. As in the past quarters, we've included a jobs forecast by market on our website. Also on the website is a schedule titled "Permit/Home Prices," which includes total residential permit for the larger U.S. metros as well as information on median home prices and affordability as compared to the Essex markets. Finally on the website you'll find our expectations for market rent performance of the year. To get those details, go to our website under "Analyst Resources." Generally I'm pleased with the third quarter results. Revenue on same property basis was up 2.9% year-over-year with improvement in all of our submarkets.

We made several very good opportunistic dispositions. Fund I as a portfolio was sold. The Essex on Lake Merit was sold to a condo converter at about a 4 cap. And the Palermo, a Fund I asset was sold on one-off basis also at around a 4 cap to a condo converter. Finally, we made good progress in filling up the acquisition pipeline. Currently, we have approximately $350 million of acquisitions in various stages with contingencies removed on approximately 110 million of property. Of that pipeline $290 million is located in northern California and Seattle and approximately 60 million in southern California. As in prior calls, I'll update you by submarket on significant developments, including commercial absorption which we view as a gauge of business expectations and job formation in the future. Starting with Seattle: Over the last 12 months the unemployment rate has declined by 2.2% during which time the labor force grew by 2.3%. Indicating significant increase in employment.

Going to Boeing, which has been sort of a bugaboo. Last year Boeing had cut its Seattle work force by 7900 jobs in the first half of 2004 there was another work force reduction of 770 employees. However, in the last 4 months employment at Boeing has increased by 11,060 jobs giving a net year to date of 390 positive jobs. The office market as continued to show signs of improvement, particularly on the east side were 520,000 square feet or about 8% annual growth rate. The industrial market showed strong absorption of approximately 1 million square feet which is about a 2% on annual rate, with particular strength in Kent Valley which absorbed about 700,000 square feet. And Snohomish County at about 200,000 square feet. New supply of both multi-family and single family was unchanged from last quarter. Going to the Bay Area where we have about 17% of the portfolio, our forecast of new supply is less than 1% for both multi-family and single family unit. Overall the Bay Area markets showed positive job growth. However, within that, San Jose was slightly off. Oakland and San Francisco were tracking above our expectations. After falling sharply over the last few years the Bay Area year over year labor force growth was flat in September. During this period the unemployment rate has fallen from 6.5% down to 4.9%.

Hitting each of the submarkets: San Francisco, office market experienced its third straight quarter of positive absorption. Year to date the market as absorbed almost 2 million square feet or 1.6%. And the industrial market experienced a strong third quarter. Year to date absorption stands at 2.5 million square which is about 3.4%. Oakland East Bay office market experienced strong absorption, about 540,000 square feet. And the industrial market experienced moderate absorption, about 740,000 square feet, or an annual rate of about 1.6%. San Jose, as we mentioned last quarter San Jose, MSA remains relatively more reliant on manufacturing jobs than our other markets. The manufacturing sector continued to improve during the third quarter. And just give you a sense of that, over the last 3 years the sector had lost 44,000, 32,000 and 15,000 jobs respectively. As of September year-over-year jobs were down 1800. So we expect this number to reach 0 or go slightly positive by December. As mentioned previously the Non-Farm Industry Jobs Survey is weaker than expected. However, as we've talked about previously there is a household survey which suggests more strength in the labor market. The labor force, as we've talked about previously, has fallen 1.9% over the last 12 months. However, the unemployment rate declined by 2.4% during this same period.

The mathematical result of that would suggest about 5800 jobs formed. The number of employed people in December 2000- - over 2003. The office and industrial markets both remained weak with small negative absorption in the third quarter of 0.7 - - negative 0.7 and negative 0.3 respectively. Going to southern California, after a strong first half of 2004, non-farm industry jobs data were weaker in the third quarter. The current level of jobs is slightly behind our projected levels through September. However, the unemployment rate has decreased from 6% to 5.1% and the labor force has grown by 1.1% indicating increasing employment. As of September year-over-year job growth for the region was up 42,000 jobs. The southern California office market remains strong, absorbing 2.8 million square feet an annualized rate of 3.4%. The strongest areas were San Diego, South Orange County and tri-cities area in LA or Los Angeles. The Southern California industrial market posted another solid quarter, absorbing 6 million square feet or about a 1.7% annual rate.

The strongest submarkets were central San Diego, South Bay Area of Los Angeles County, San Fernando Valley and the South Orange County area. In conclusion, jobs are being formed, the labor force is growing and unemployment is down. Commercial activity is on the rise in our markets, residential occupancies are improving and we're seeing rental revenue increase in all of our submarkets. We expect all of our markets to experience improving conditions in the successive quarters coming. Now, I'd like to turn the call over to Bob Talbott.

Thanks Keith. Good morning everyone. I'd also like to thank you all for joining us today. Today as I've previously done I'll be discussing current conditions in each of our major markets. Let me first remind everyone that the occupancy numbers that I'm reporting are as of this past Monday for a point in time. The financial occupancies in our earnings release are the average for the quarter. My comments are intended to provide you with some color on what we're currently experiencing out in the market.

As of Monday, our stabilized portfolio was 96% occupied. And our net availability, which is the sum of vacant and unnoticed units available to rent expressed as a percentage of the portfolio was 6%. Also, as I've begun recently doing; I'll be commenting on move out activity related to home purchases in each of our markets. For the portfolio as a whole, 17% of our third quarter move outs were due to home purchases. Which is consistent with our typical results. Now, let us look at some of the individual markets starting with Seattle. Seattle continues to perform well. It has an occupancy of 95% and net availability of 7%. Concessions have continued to decline in the market but they've not been completely eliminated. With that said, to point out that availability has increased approximately 100 to 200 basis points in the past few weeks as we entered the seasonably slower fourth quarter. Consequently, I would expect the possibility of a sequential increase in concessions in the fourth quarter as we respond to this availability.

Traffic for the quarter was up 3% sequentially and for the same quarter one year ago, traffic was up 2%. Home purchases for the third quarter accounted for 19% of our move outs down from the second quarter's 22%. Also as was mentioned in the press release, during the quarter we acquired our partner's interest in Park Hill. Let me just update you on how we're doing there. We took over management of the property in early September. And it's currently 94% occupied and transition has gone well. In Portland, Portland is stabilizing with occupancy as of this week of 95% a net availability of 6.5%. Concession activity is also declining in the market but it has not been eliminated. We're seeing approximately $500 to a month free on a year lease. Traffic is down 4% from the second quarter but up 2% from the same quarter last year. During the third quarter 29% of our move outs were due to home purchases compared to last quarter's 23%. This increase was caused by an increase at one particular property in Vancouver area and given the small size of our portfolio there, this one property skewed the total.

In the Bay Area, that market continues to remain stable with occupancies in the San Jose MSA of 96% and in the Oakland-San Francisco MSA of 95%. Net availability for San Jose is 6% and in San Francisco-Oakland MSA it is 8%. Concessions are declining. However they've not been completely eliminated from the market. Going into this seasonally slower fourth quarter, we're seeing increased concession activity of up to a month free in San Jose and in parts of the East Bay, particularly Fremont and San Ramon. Again as we respond to the market I would expect a possible increase in our fourth quarter sequential concessions. Traffic was up 2% from last quarter and flat when compared to a year ago. 19% of our move out this quarter were due to home purchases. In August, as you know, we closed on Vista Belvedere in Tiburon. This is a great little property with views of the Bay. It's transitioned to the portfolio well and it's presently 95% occupied. Turning to the south land, LA, Ventura, that market is doing quite well with occupancy at 97% and net availability of 5%.

Traffic compared to the second quarter was down 4% and was up 13% from one year ago. Concession activity has declined but has not been eliminated. Where used they're primarily limited to Ventura County and it's been in the range of $250 to $500 on an available vacant. Home purchases contributed 15% of our total move outs in the third quarter. Orange County is performing quite well with reported occupancy this week of 97% and availability of only 5%. Concessions are virtually 0. You might find an exception out there. But it will likely be limited to a property with a unique vacancy problem. Traffic is down 5% from the second quarter and is up 5.7% from the same quarter a year ago. 15.5% of our move outs in the third quarter were due to home purchases. And lastly in San Diego, that market is also performing well, occupancy this week is 96% and availability is 6.5%. Concession activity has declined but can still be found on those properties with lower occupancy and is typically to $500 on a half month on a year lease. Traffic was down 21% compared to the second quarter and was down 6.4% from one year ago.

This traffic pattern appears to be seasonal. Looking back to last year traffic in the third quarter fell sequentially 16% from the second quarter. The third quarter decline is also not unexpected given that occupancy improved during the quarter. 12% of our move outs in the third quarter were due to home purchases. Now I'll turn the call over to John Burkart.

Thank you Bob. Starting with Fund I, which we formed in July of 2001, our goals - - one of our goals was to broaden our capital resources to include strong relationships with major financial institutions. Benefiting our shareholders by increasing our access to capital and by providing superior returns on our invested capital. We raised a total of $250 million in equity of which 196,500,000 was from third party investors. We then invested in 20 assets over the course of about 2 years and added value via development, renovation, management and asset improvements. After several assets were sold, in one off transactions, we have sold the remaining portfolio with the exception of the Kelvin Land to United Dominion Realty. Yesterday we had our second set of closings yesterday which completes the dispositions of the Fund's assets, with exception of Kelvin, Coronado and River Mark. Coronado South should close upon the completion of the renovation in the second quarter of 2005. And River Mark is expected to close in the third quarter of 2005. Based upon the returns which our investors have received to date and they expected completion of the disposition and other reasonable assumptions, our investors will achieve over a 25% IRR on their investment in this venture.

The Company is also being appropriately compensated for its time and effort. As the total promote is projected to be about 22.2 million which is in addition to its returns as a co-investor in the Fund. The details of the time of the promote are identified in the press release. In a difficult investment environment we were able to achieve above average returns as a result of being disciplined, identifying and investing in the right markets at the right time, mostly southern California as rental rates in the Bay Area, Portland and Seattle declined. Additionally, we added value via management, renovation, improvements and by opportunistically taking advantage of the strong market and low debt rates. As for Fund II, we have completed our final close of the equity having raised a total of 265,900,000, of which 190,900,000 is from third party investors. 6 of the 7 third party investors are reups from Fund I. The targeted leverage is approximately 65% and therefore the Fund is projected to reach approximately 750 million in assets. The focus of the Fund is value added multi-family assets located on The West Coast with an emphasis in the Bay Area and Seattle.

The investment period runs through October 2006. Similar to Fund 1, Essex will receive fees for property management, renovation, development and asset management in addition to receiving a promoted interest, if the fund meets certain financial hurdles. In conclusion, the fund business which we entered into in the summer of 2001 has been a success business venture for the investors and the REIT. Based upon the returns achieved by all parties and based upon the capital relationships that have been formed with solid institutional partners. I now would like to turn the call over to Michael Schall.

Thank you, John, and thanks everyone for joining us today. I just want to note that our press release and the supplemental reporting package is available on our website, www.essexpropertytrust.com. Or you can call our corporate offices here in Palo Alto. We've all tried to reduce our comments given that we added John Burkart to the lineup here. And an overall comment from all of you that the call is too long. So I'm going to follow that format and try to hit the highlights. Most of the things that I typically discuss are included in the supplement or the press release, in any event. So again I'm going to comment sort of randomly on 3 topics; quarterly financial results, the balance sheet and estimates of FFO. First topic, quarterly FFO results: I have several comments on FFO for the quarter. First one is the sale of the Essex at Lake Merit to a condo converter was at a price that equated to about a 4% cap rate on normalized and annualized operations. And this is using our lower tax base and the buyer's property tax base. So using our property tax base. The sales proceeds were used to redeem the $55 million in outstanding 9.25% Preferred units, that exited its non-call window on September 3, 2004. And further to reduce - - or the remaining balance was used to reduce a line of credit.

Our original earnings guidance back in the December of 2003 did not consider the sale of the Essex and assumed that the Preferred units were replaced with newly issued preferred stock having a 7 7/8% fixed annual distribution. Our guidance following the second quarter, which is on track, considered the sale of the Essex and indicated that the transaction was 1 cent dilutive in Q3 and 3 cents accretive in Q4 and going forward. The Q3 dilution was due to the lost NOI from the Essex for - - during the period we waited for the redemption window to open on the Preferred Stock. Next comment, as of July 28, 2004, the effective rate on our $50 million, 9.3% series D Preferred Stock was lowered to 7 7/8 pursuant to restructuring agreement that was announced in a press release on January 8, 2004. The annualized FFO impact or Increase in FFO is 712,000 per year. And next topic in previous press releases we've indicated that the distribution of Fund I which as you know is included in FFO was estimated at 18 million. Given that the sale of Fund I was marginally better than originally expected, we now believe that the promote distribution will aggregate 22.2 million. As indicated in the press release we went into the year with limited incentive compensation accruals. And given our expected results we have now increased these accruals by 4 million directly related to the Fund I sales of - - or the sale of Fund I.

John Burkart just indicated that we've completed the final closing of Fund II as expected. However, accounting rules did not allow us to accrual allocation for our asset management fee which was 470,000 for the quarter and that was included in our guidance. So that was a deviation from our guidance. However, we expect the payment of both Q3 and Q4 and the recognition of that fee income in the fourth quarter. Next point operating expenses increased by 4.4% for the quarter. Most of this was related to the adoption of a new expense accrual policy that came out of our SOX 404 process. The particularly large increase for the quarter in the Pacific Northwest region is due to both the new accrual procedure and timing of invoices. I will note that on the year to date basis operating expenses have increased by 2.2%, which compares favorably to our guidance of 2.7%. Next point, lower concessions and marginally higher occupancy levels supported year-over-year and sequential revenue increases in all of our regions. The first time I recall this happening in a long time. This supports our premise that the markets continue their slow recovery.

I want to also have a note here on G&A expense. So excluding the accrual for incentive comp related to the Fund I sale, G&A was 3,761,000 or approximately 300,000 higher than our expected run rate, including the SOX 404 impact that was discussed on the last call. Most of the higher G&A run rate is attributable to accounting and related costs. In the first quarter, we adopted FIN 46R which due to its complexity and the lack of historical guidance on its application, caused our accounting fees to increase substantially. In addition our SOX 404 compliance costs to third party vendors were nearly 400,000 for the quarter which is greater than expected. Again, complexity and scope of SOX 404 audit is much greater than we had anticipated. And again there is very little practical guidance on its application. I think we are all trying to get through unchartered waters there. As a result of that, we are once again increasing our estimate for the SOX 404 compliance work. And our new estimate is 900,000 for this year, of which about 500,000 is expected to be timed into Q4 for again, this year's activities. So fourth quarter G&A is therefore expected to be around 3.9 million.

Second topic, balance sheet: Indicated previously that the net proceeds from the sale of the Essex were used to redeemed 9.25% Preferred Units on September 3, 2004. The balance of approximately 30 million was used to reduce our lines of credit. The full funds from the sale of Fund I and the related sales of the Company's 49.8% interest in Coronado north and south, will - - when all those assets close will aggregate approximately 140 million. These proceeds are expected to be utilized as follows: Approximately 33 million to repay loans that mature in the first quarter of 2005 that have interest rates of approximately 7%. And 110 million to be redeployed in the 1031 exchange at a cap rate of approximately 5.25%. The formation of Fund II, means that our deal flow is dedicated to Fund II through October 31, 2006. Before proceeding with Fund II, the group here, the senior management team, analyzed the expected returns available from the acquisitions and development of real estate in our markets. And essentially what we do is we consider 2 scenarios. The first is what happens if we fund these real estate investments on our balance sheet, essentially holding our percentages of leverage, Preferred Stock and common stock, constant.

So look at the per share impact from holding, from acquiring on balance sheet and holding our balance sheet at consistent levels of debt and equity. And then we take a look at what happens if we assume that we close the real estate investments in the fund format and look at the earnings potential to Essex on a per-share basis. Essentially primarily because going in yield and debt rates are at all-time lows and the Fund is able to utilize more leverage in this attractive rate environment, the return potential of the Fund was considered superior as compared to expanding the Company. Hence, the decision was made to form Fund II. Obviously, this relationship can change over time. So we will continue to try to keep the period for dedication of deals to the fund as short as possible. Our $75 million capital commitment to Fund II, will be funded via additional borrowing, including the $30 million pay-down on the line of credit for the sale of the Essex at Lake Merit. We don't currently expect to pay a special dividend related to this year's operations. Although that analysis has not been finalized.

And finally third topic, FFO expectations: The press release indicates a guidance range for the fourth quarter of 2004, $1.14 to $1.17, as compared to the guidance range discussed on last quarter's call of $1.08 to $1.13. The new guidance range includes a previously mentioned increase for the promote distribution related to Fund I sales in Q4, which closed yesterday. And I believe were press released earlier this morning. And the deferral of a land sale which was originally expected to close in Q4 '04 and now is expected to be closed in the second quarter of 2005. The fourth quarter guidance considers additional Sarbanes-Oxley 404 costs which were just discussed. And that is essentially offset by the payment of the third and fourth quarter asset management fees for Fund II. Accordingly for 2004 we expect FFO to range from 449 to 452 a share. We are in the process of finalizing our business plans for 2005. Similar to last year we expect to release 2005 guidance in a press release in mid-December of this year. I'd like to - - we all would like to thank you joining us and now would like to give you an opportunity to ask any questions you might have. Thanks again.

[Caller instructions.] Your first question comes from Jay Leupp, RBC Capital.

Hi, good morning here with David [Ronco]. A couple follow up questions on your commentary. First, can you talk little bit about what the sale of the Essex at Lake Merit? This $5 million participating loan; some of the basic terms as to how you're going to possible share in the upside of this condo conversion. And maybe your anticipation of when you're going to realize some additional gains from that conversion and sale? And then following on that, just if you can give us, your going in cap rate expectations for the Vista Belvedere acquisition? And if we can assume from that property that you're going to be doing some condo either a condo conversion type sale later on or some type of improvements?

Sure, why don't I handle the Essex. Keith and you handle Vista Belvedere maybe? On the Essex, as you know we originated a $5 million loan to the group that we sold the Essex to, the conversion - - the condo conversion group. And that is structured with a 14% pay rate. However, the way that it works when you boil everything down is we will receive approximately a third of the net gain that is created through the conversion process. So we're essentially a third of that group going forward. We, again, we believe that that is condo proceeds or sale of inventory. So to the extent that we receive, as you know there is $5 million deferred gain from the sale of the Essex. So as we receive principal payments on that note, we will record a gain on sale the $5 million in deferred gain. We will reclassify it from deferred to realized gain. That will not be an FFO item. However, to the extent that our proceeds are greater than 5 million, we will have what is in effect condo sale proceeds, and sale of inventory, and we believe that that will- - that is FFO, and will be likely timed into next year's, you know, will be included in next year's results. So currently we can tell you that they have sold more than half of the project have been sold as condos. So the condo conversion process is well on the way. And they are hitting their, you know, the targeted returns. So we think that that $5 million investment will have significant value next year. And before - - I don't think we're quite ready. We're going to hold off on giving you exact numbers until the press release in December. At which time we'll put a number into our guidance.

And, Mike, just before we move on to Vista Belvidere, will those proceeds have to be run through a taxable subs, so that we can assume that they're actually taxed at current income rates? Or can those be shielded gains?

I think we will assume they will be taxed. It is - - the loan was originated by a taxable resub. So you can assume that they will be taxed. Obviously if we cannot pay the tax, we will. But I think the assumption at this point should be that they're taxed.

And then getting to the acquisition in Tiburon, with respect to the cap rate, it wasn't a typical northern California deal. And cap rate was almost a 6 which is significantly better than what we're seeing and the reason was is because that it was a Oakey trade and there was some tax considerations for the seller. And so it was a win-win on all parts. With respect to condo conversion, that is not part of our thinking at this point. We think it is a great asset and even though it is small it can have a good growth possibility. You know, with respect to the condo conversions that we did, I mean, the deal in San Diego was a fund asset. And the fund was going to sell its assets and so that made perfect sense. In the Essex, had we not been able to participate in the future, I'm not sure - - we're just not into doing a lot of conversions and selling a lot of our assets. Because even though you sell these things at 4 or sub-4 caps, it is very difficult to reinvest in good core markets if you have good core assets. As I mentioned in the past, we probably have 5 or 6 assets left in the portfolio that have condo maps on them. It is not necessarily our intent to sell those because the spread on the reinvestment just isn't that great. If we could invest it, you know, sell it, 3's and invest it at 6's or 7's, that would be more exciting. But to sell at 4's and then to try and reinvest at 5.5, it is just the spread isn't that great. So, we're not going to do a lot of it unless we get just some absolute sweet opportunities.

Just one last follow-up question for Bob. The sequential pickup of traffic you saw in the third quarter, do you expect that to continue or do you expect it to be tempered by seasonality in the fourth quarter? Can you give some thoughts as to how you think the fourth quarter or maybe the first quarter are going to look in terms of traffic?

Jay I think you're right. I think that traffic will likely fall in the fourth quarter. And probably I would expect it to be consistent in the first quarter. You know, the caveat might be here in the Bay Area if we start seeing job growth we could see a little earlier bounce back. But at this point I'm suspecting that it will start to continue to slow as we're already seeing as I mentioned earlier in a couple of the submarkets.

We'll go to Andrew Rosivach CSFB.

Mike I just wanted to run through and I appreciate the comments that the 143 million I think you had in proceeds. What I'm trying to do is figure out in your fourth quarter guidance, how much of that money you have if you will: that's waiting to get reinvested? Is that full 143 really kind of drawing down your line or sitting in cash for the entire fourth quarter?

Well, the 110 million, that is the 1031 exchange, is expected to occur in November. So it will be roughly several days, I suppose, sitting around. And then the repayment piece will happen in January.

Okay. So kind of a mid-quarter convention for the one. I guess the 110 is money that is from the second closing, so not much dead money there. And then the first quarter stuff, the 33 million will be just kind of sitting out there for the quarter?

Yes, that's right.

Okay. And then, does that mean that your investment in Fund II, whatever money you have to put in there, is going to be above and beyond the proceeds from Fund I?

That's correct. I mean, you have 30 million that, you know, so you sold the Essex for net 85 and redeemed the Preferred for 55. So you have 30 million there that, theoretically could be your Fund II contribution. But, yes, you're essentially right.

Okay. And did the acquisitions you did this quarter kind of outside of that equation? Belvedere and the little thing you did at Park Hill?

Yes exactly. The exchange money, 110 exchange money are deals that have not been announced.

Okay. Just quickly if you could talk about the background behind the incentive compensation that was tied to the Fund and how that was calculated.

Well, you know, that we spent a lot of time talking about that, actually. I guess the background is that when we as a group believe that, you know, we're not having a great year. A great year is considered growing FFO per share. You know, we expect our compensation to be at relatively low levels. And what surprises us is that all of the other REIT's don't seem to follow that same equation. So we seem to fall behind on a relative basis compensation wise. To answer your question, we underestimated the incentive compensation in our normal operations, and relative to market. And the $4 million essentially brings us back to what we think is somewhere closer to what the market comp should be for the executive group. I mean, obviously we have an obligation to treat executives fairly and, you know, competitively, or else we're going to lose some good people. So it is just essentially that difference. The difference between sort of estimating the tough year, and keeping compensation levels and accruals low. And going to a relatively good year, or a very good year, actually and adjusting what gets paid out.

Let me ask you this one: If I try to model the '05 numbers and I know you haven't given any guidance yet, but since we have to do this, should we building a full-year growth rate off of G&A including that 4 million bucks in '05?

You know, I think you probably should, actually. Because I think that, you know, just like this year, there is some other income components. There will be next year. We talked about the deferral of the land sale until next year. That is highly likely to occur. And, you know, certainly the potential benefit from the Essex and the condo sale proceeds. So I would expect that you should probably keep the sales about that that level as well.

Okay. And one more question on the dead money. How much in items of fund fees are not going to be around this quarter, the fourth quarter of '04, that could pick up in the first quarter of '05?

Well, I think if you take the profit potential from the - - if you take the profit potential out of the property management piece. And you take the asset management piece. It is approximately an an annualized, probably about 600,000. So, again, our announcement, just to be a little more candid about this, we kind of break this down into 2 pieces. We've got the promote which had no yield, versus the fees that we lost. And if you put those 2 together, it is around 6.5% type relationship. So there is sort of 6.5%, and this is still kind of average 5-year look at it. So 6.5% promote, or, you know, the annualized fee income divided by the promote is about 6.5%. And then you look at what happened on the capital side which is roughly 5.25%. So our replacement yield is really the function of those 2 things. Now, obviously the asset management and thee property management fees will go way over time as we sell Fund I which is a certainty. So, what we're trying to do here is accretably, you know, reinvest out of both the - - that of both Fund I and the Essex, into, you know, sources of FFO that will be, you know, going forever. So and we think that we have accomplished that. But so, anyway, to answer a direct question it is about 600,000 a quarter, related to Fund I fees that will be lost as a result of this.

Which will be replaced by Fund II when that gets started which I'm guessing is going to what, the quarter of '05.

No, Fund II started accruing - - its asset management fee accrues on commitments. Obviously property management fees accrue as investments are made. So, in Q4 we'll pick up the Q3 as a management fee which was not included in the numbers and all of Q4.

Okay. So really net from Fund I to Fund II you're not losing that much in fees in the fourth quarter?

No.

We'll go next to David Harris, Lehman Brothers.

Mike, could I just draw you a little bit further on this compensation question? How widely disbursed is the compensation amongst the staff at Essex?

Well I'd love to say it all goes to me and Keith but I don't think anyone else in this room is going to go for that. No, I'm kidding. It is very widely disbursed, it will go down to essentially to everyone that is involved in the into the creation of those gains. It will go into operations, into development acquisitions, redevelopment. It's truly - - and this is our view it's a team effort. And every part of the team shares in the success of the Company. So it is, I don't know how many, 20 people, or something like that.

Okay. I don't recall any prior disclosure on this, is my memory failing me? Or is this not something that you previously spoke about?

Prior disclosure of what?

Of the compensation arrangement.

No, we have not previously discussed it. However, I mean, you know that, you know, we previously said that promote was 18 million, and you know this net of the promote is 18 million. So we don't think it is in any way something that should be unanticipated.

Oh, okay. Can we assume there is a similar arrangement in place if you were to be as successful with Fund II?

Yes, I think you could assume that.

Okay. Sorry?

I'm sorry. I was going to just mention that part of it is, again, we did not model this year at the beginning of the year we did not model the sale of Fund I. That is something that happened during the year. So you know it was clearly not in the original guidance. The impact of Fund I sale had a relatively dramatic impact on our financial statements and our financial position and results of operations. So, you know, from that perspective I think it is clearly something that is different than happened. Than what we had expected. When we press released the $18 million fee estimate that was largely related to the fact that there were - - I was hearing some pretty wide ranges of numbers out there in the public markets as people were trying to guess what that might be. So I said, gee, we need to basically tie this down and, you know, get a number out there. So that there's not, you know, huge deviations in estimates in the investment community. So, you know, that's how it happened. And could we or should we have, you know, thrown in a compensation number out at that time? Perhaps so, and we'll do that in the future.

If I look line by line through last year's proxy, I'm not going to find any reference to this?

Last year's proxy?

In terms of the compensation arrangement to senior executives related to --?

It's not a contractual thing, David.

Okay.

It's not a contractual arrangement. It is the - - you know, we've got, you know, objectives that we give the Board, and you know, a variety of objectives that we give the Board. One of them is FFO target rates and, you know, I mean, it is principally FFO rates and other goals that are consistent with growing the business. So this sale had a dramatic impact on our result and on those objectives. And so I think it follows directly.

David, not to belabor this point, but you just mentioned the proxy, if you look at the proxies, you'll know that our executive team has been the least of the pigs at the trough. All we want to do is bring our compensation up closer to something that is normal and we do not at all think that this is inappropriate.

Okay.

Now, just moving on, the fee arrangement on Fund II, if I cast my memory back, I seem to remember there was a fee payable to I related to management? Maybe asset management specified it, regarding commitments on Fund I as opposed to invested funds. Is that arrangement in place for Fund II that existed for Fund I?

Yes, third-party commitments, not paid on Essex's capital commitment.

Okay. So third party commitments. Is why you're basically telling us in answer to the prior question, they should be a wash fairly quickly? What you're losing by the way of the sale of Fund I you're going to pick up quite quickly related to this element of the fee?

As it relates to the Essex management fee, absolutely. You know, we - - obviously to generate a property management fee, we need to have properties being managed. So as Keith indicated, we're pretty active out there in the investment market so I think that will change relatively quickly.

Now, the 1031 transaction, maybe I missed some color on this. Do you give any specificity about location or any property type, any more details? Are you able to disclose anything about that?

In the past, we've generally not disclosed acquisitions until we closed them. But if you missed my earlier comments, right now we have $350 million of acquisitions in the pipeline. Of that 350 million 290 million is northern California and Seattle. And 60 million is in southern California with 100 of that, 350 million, 110 million has contingencies removed with closings expected within the next couple of weeks. So that is going to replace the, you know a large part of the 1031 coming out of the fund.

Is this pork belly acquisition which would get you out of the conflict with obviously your commitment to give first right of refusal to the fund.

Going back to refresh you, the fund, one of the exceptions we have with respect to the fund is that any time we have a 1031 need, that is an exception. And we have first rights to those properties. So this is not a portfolio, it is a number of separate properties that will be closed in different markets.

Okay. How would you characterize these properties, Keith? Are these undermanaged properties where you can see you can increase that 10 5.25 through your management or do you feel that for the most part you might characterize this as just a market price and being driven more by 1031 needs than anything else?

Well, these are primarily - - actually they're in 3 different markets. The Northern California piece, which we've discussed in the past which is actually the bigger piece, we believe that they're going to be very significant rental rates. So we're in anticipation of the market rental growth, are buying into that market. And one property is, you know, market that we're buying at a superior cap rate in the 6-plus range. And the other one is, you know, we think there is some opportunity to increase operating results.

So no real big redo development angle on any of these things? Not playing the market in anticipation of better times ahead.

That is basically correct.

We'll go to William Atchison, Merrill Lynch.

I want to ask a question on the timing of the promotes and on the sales. The first tranche of the sales, that 264 million, generated in excess of 14 million. The second tranche, about 429 million of assets generates promotes about half of that level. And I'm just wondering, did you prerecognize promotes from the latter sales in the fourth quarter or are just the parameters different for determining the promotes between the tranches?

This is John Burkart, it is not a difference in parameters. It is how the promote gets calculated and ultimately allocated based on the capital cost of the assets, et cetera. It is a formula-driven item, and that's ultimately how it worked out.

It is formula-driven on an asset by asset basis. So essentially the first tranche has some higher profit properties in it and as a result the size of the promote was greater.

Actually in the first tranche, you know, you essentially pay back the capital related to those assets and then if you have any reserves that you need to have for future things, you pay that back. We did not have that. That did not occur. And then you bring current the 10% return income element or the 10% that is paid to the limited partners to bring them current as to their capital. So, essentially there are just more gains in the first tranche because you actually had to get over those - - the 10% hurdle, as well, in the first tranche. So size of gain and timing of gain were the key parameters there.

And in the last piece to add which we shouldn't have skipped over, but there is a catch-up feature in the promote structure. And so at that point of the first tranche of assets being sold, the catch-up feature was in action, so to speak, until a larger portion of profits were coming through.

The catch-up is 40% allocation to the GP.

Good point.

Okay. Okay. I just wanted to be clear on that. Anyway, I had to get off the call for just a second there, excuse me, if this was asked, but are there going to be further G&R accruals related to promotes next year?

Bill, lets see, we told - - someone asked if we should just continue the incentive comp accrual this year. So assuming an annualized $4 million rate on top of the G&A number and I said that would be an appropriate given the promotes that are going to be timed in the next year plus the land sale is likely to happen. And we have some expected proceeds from the sale of our condo inventory through our participation in the conversion group on the Essex. So given that level of other income, I think we would continue the, you know, essentially adding $4 million to the G&A run rate.

Okay. That's the annual?

Annualized, yes.

And then the wholly owned acquisitions outside of Fund II in the fourth quarter, what was the number there?

Approximately 110 million.

110. How about just a rough quarterly timetable for growth and assets in Fund II?

You know what, that's so difficult. We expect that coming out of the chute probably within the next quarter, close, around 130 to 150 million. And thereafter, I mean, if you were to look back at our history on Fund I, we were, you know, getting back to - - hearkening back to John's comments, if we didn't see anything we didn't close it. We literally went 9 months without closing a single thing. It is very difficult. We're going to stay disciplined and if debt markets and opportunities line up, we're going to be very active. And if they don't, you can see us be very, you know, maybe not close anything for 6 to 9 months.

Let me just add something. I think you're asking a modelling question, so. It can be exactly what Keith said. So, we go from some period of time it won't do anything and then we'll do, you know, 200 million in a quarter. And so, you know, it's just a variety of factors that influence how that occurs. But for modelling purposes I think what you would assume over a year's time is 250 to 300 million in acquisitions. You know, that's been a level at which we have been able to acquire over many years and maybe in a good year it goes to 350 on the acquisition side. And then maybe I think development is going to be perhaps, you know, averaged about 100 million a year, previously. Its very, very difficult, development cap rates are unbelievably low in these markets. I would cut that back to maybe 50 million a year. And that's sort of what I used from a modelling perspective.

Okay. That's great. Another modelling question. What about the interest rate on the Fund II debt? ?

Yeah, Fund II debt I would assume around 5%, you know, currently. I mean, obviously rates can - - everyone in the world I think is expecting rates to go up. But with that hopefully with that cap rates go up as well. So, assuming those two kind of follow one another, you should still be in the same relative position.

Okay. The Palermo sale, was that formally the Chesapeake development?

Yes, it was.

You decided to change the name.

Yes. Sorry about that.

The increase in interest expenses in the third quarter, just it seemed just disproportionate to the change in the debt level. What was going on there? It was going up fairly sharply and debt wasn't.

You know, I'm going to have to get back to you on that one. I don't have that immediately analyzed, or at my fingertips. So I'll call you back on that one.

Okay. I'd appreciate that. I believe you addressed this before, but Pacific Northwest operating expenses, up 13.9% in the quarter, what was that? Was that tax a accrual?

That was actually it is really something much simpler, which is we adopted a new expense accrual policy. And their invoices were a bit behind relative to everyone else's. So it was just a catch-up of outstanding items. So nothing unusual from an operating perspective.

Okay. So the same story NOI should look improved versus the third quarter and then going forward?

Yes.

We'll go to Anthony Paolone, J.P. Morgan.

Hi, just down to one thing. I was curious if you can comment on the types of returns you went and guided a potential investors towards when you went out into the market with Fund I? And how those kind of compare with maybe what you're telling them when raising Fund II.

John Burkart again. With Fund I we went out telling investors that our target was basically an 18% return with a net to investors of approximately 14%. That hasn't changed much. We've lowered it a little bit to 16% to 18% overall for Fund II. And as we mentioned in the context of this last transaction, Fund I's returns to our investors will be over 25% as compared to what we had told them target of about 14.

Okay. Thanks, guys.

We'll go next to [Asad Kavan, Reefe]

Hey, guys. On the land held for sale, are there any other land parcels in the balance sheet that may be held for sale? And then secondly, on the fund, could you kind of give us somewhat of an acquisition philosophy? Are these underperforming assets that you can do some redevelopment on, majority of these? And then is that how you kind of get solid IRRs by turning them around? Or is it just mostly then as Keith said earlier just a function of pickup in rental rates?

I'll jump in this and I mean our philosophy is to be able to anticipate opportunities and those opportunities show themselves in many ways. I mean, those of you who have followed Essex for 10 years know that what we - - our primary operating philosophy is to understand markets and get ahead of the markets. And we think that we've made the most money for our investors in that way. And as we anticipated southern California we got southern California. Now we're anticipating that we're going to see superior growth in a couple of other markets. And we're trying to get ahead of those markets. However, within that we are going to be looking for redevelopment opportunities. Redevelopment has been, you know, a big part of what we've done. You know, again, as Michael said, we're going to be looking for development. However, I would tell you that despite what others have said, development cap rates are not much better than acquisition. And I don't see any reason to take - - to do development when the risk adjusted - - when there is no risk adjusted yield difference. So it's going to be looking for opportunities, whether it be just underperforming, where we can do a better job of management. Whether it is a redevelopment. Or a good significant part will be trying to get ahead of a market and anticipating superior growth rates in the rental market.

And Asad there are no other land parcels on the balance sheet.

Okay. Thanks, guys.

[Caller instructions.] We'll go to Richard Paoli, ABP Investments.

Hey, guys, couple questions on the fund and then just one Essex Property Trust question. How much did you - - remind me how much did you initially invest in the fund?

53,500,000.

Okay. And in total what are you getting out of it? Is it 140 or 170?

You know, 140 includes, you know, as part of this sale, Essex is selling its 49.9% interest in Coronado. And so that is included in the 140 and so Mike, can you take that back out?

I don't have it with me.

We'll do some quick calculations and let you know in 2 minutes or we'll call you back.

Okay. I was just kind of curious to see. You guys gave the IRR for the fund investors, what is the Essex shareholders IRR, have you calculated that?

Yeah, that actually is in the neighborhood of 50%.

5 zero?

Five zero.

Great. That sounds pretty attractive to me. Question on the main business, what is your characterization of what you're looking for same-store to do sequentially in the fourth quarter? Because I think I got markets kind of - - can you roll them up for me so we have just a - - sort of a number in mind next quarter? Or for this quarter?

I'm sorry, could you just please restate that.

Sure, what are you guys looking for in total for sequential NOI for fourth quarter from third quarter? If you have a range.

Well, I would suspect that we're going to be approximately where we were for the third quarter. So I would guess it's going to be - - I would not expect significant improvement. Our occupancies are going to still stay strong. But as Bob mentioned in his calls, there may be slightly greater concessions this quarter because it's fourth quarter. So I would not expect anything better than we currently have and kind of safely would hope that it's last was third quarter.

Okay. And one last question. I've not heard much about this for a while. The office building, what's the status of that? I guess you were having some issues with getting paid on from the sale of that?

The office building, Darian office building, as you know, there was in accordance with adoption of FIN 1046, it was a variable-interest entity, it was consolidated on our balance sheet. In the process of consolidating it we eliminated all of the interest accruals retroactively going back, so now it's, you know, basically at its original book value. It's currently approximately 80% leased and so those operations and move-ins started approximately May. And so that will start having a positive impact on our results going forward.

We'll go to Chris Pike, UBS.

Yes, good afternoon. Mike, I just want to make sure I understood things properly from earlier in the call. You indicated in determining whether or not you put the acquisitions on the balance sheet or through the JV, you looked at a procedure. And given the level of rates, the level at which rates are at right now, that pretty much drove your decision. Is that correct?

Right, yes, no, we do this - - that is kind of a normal, you know, our normal process.

So the question then is, did you do any scenario analysis to say, okay, you know, in the next 12 months, if rates go to here, it is maybe better time to put it on balance sheet than to JV? And if you did, what would that level be?

Yes, you know, it's- - we- - to answer your question, we did not do that type of scenario. What we try to do is, you know, we, from the beginning, this has been sort of a capital strategy and recognizing over the last 10 years our stock is traded at discount. Gee, we'd better have a strategy or we'd better have some source of capital that makes sense for periods of time where it is dilutive to our operations to raise money on balance sheets. So that was the genesis of where this came from. But as part of that process we determined that, you know, we're going to try to keep the investment period very short so that we don't get caught into a situation where, exactly what you're referring to, things change very quickly. And, you know, we can't invest in the fund format. And we can't invest on balance sheet. And, you know, I think a 2 year commitment period is both a reasonable period to try to, you know, get this amount of money invested. But at the same time it sort of protects us from, you know, sea change of conditions that gee we would be a lot better off going on balance sheet. So practically speaking, I guess from my perspective there is more to the equation than just interest rates. It is investment yields on the one hand versus interest rates on the other hand. As again long as they kind of move up together, you know, ie, it is a spread, between them is so critical. As long as they move up together, I don't think you're going to have, you know, a change in whether that works or not. I think a key here is, is it beneficial to be 65% levered or 39% levered? I mean that is the fundamental issue. And I don't see anything changing that relationship in the short term in the current rate environment. It would take a huge change in interest rate to change that relationship.

I guess in your opinion and the way you guys looked at it, you pretty much see a steady state in the cost of leverage going forward.

Again, it is not just the cost of leverage. I think it is cost of leverage will go up , but it is the investment yields relative to the cost of leverage.

Okay.

And so I don't see that relationship changing that much or to--you know, nearly to the point at which it would be much better for us to invest on balance sheet. Now, if the stock goes to 150 overnight, or something like that, that could change it. But I don't think any of us see that happening.

Okay. Thanks. And I guess maybe just a question for Bob. Looking at the supplemental, the way I figured it, and tell me if my math is off, but maybe in southern California, given the lost to lease numbers you guys are putting up, it is maybe 50 bucks that you're below market. Is that about right?

Yes. Lost to lease is relationship between scheduled or in place and end markets.

How much on renewals, I remember last time I was our there visiting some of your properties, lot of the managers said, hey we are having 35 to 40 hour in lost leases but we just can't get that entire amount. So maybe we're only pushing rents 10 or 15 bucks a unit. Given the concession comments that you had in southern California, I guess where you said there was pretty much no concession, it seems to me that you can maybe get a bigger portion of that lost to lease than previous. Are you guys seeing that?

We're starting to. Our expectation would be that we try to get about half of that in this environment back and that is kind of how we're planning it. It is kind of an asset by asset decision based on individual set markets.

Way to go, Chris. We ask Bob that question at least 3 times a day.

We'll take a follow-up question from David Harris, Lehman Brothers.

Hi, it's David Shulman here with David. First, a question on investment strategy. It seems that there is a shift in investment strategy to go north, and up the Pacific coast than to be in southern California. Is that a correct way of reading what you're saying.

Yes. Yes.

And the next question is, is on comp. Having to do with the $4 million. If at some future time a fund goes awry, FFO goes down, is this going to be a 2 way street?

I think that's the point David. It's always been a 2 way street. Go back and compare financial results or FFO results with executive comp going back, you'll see higher correlation than I think any other Company.

And a point we try to make, and I didn't do it very eloquently earlier, and I apologize for that, is that we have generally tried to align ourselves with our investors, our shareholders, and we have kept our comp low and anybody - - obviously it is a public Company. You can look at the proxies and verify that. Over this last year where we saw horrible results, as you will recall, at least Michael and I didn't take any cash bonuses if you look at the rest of our peers, that was not the case. In fact on most cases they took more. So we said, hey we had a very good year and we're going to participate in that good year with our shareholders. And that's what has happened. There is no contractual calculation there. Gentlemen, it appears there are no further questions.

I'd like to turn the call back over to Mr. Guericke for any additional or closing comments.

I want to thank all of you for joining us and talk to you next quarter. Thank you.

That does conclude the program for today. Thank you all for your participation. You may now disconnect.