Essex Property Trust Inc (ESS) 2010 Q3 法說會逐字稿

Greetings, and welcome to the Essex Property Trust Inc. third quarter 2010 earnings conference call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Keith Guericke, President and Chief Executive Officer. Thank you, Mr. Guericke, you may begin.

Thank you. Welcome to our third quarter earnings call. This morning, we'll 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. Joining me on today's call will be Michael Schall and Michael Dance. John Eudy and John Lopez will be available for Q&A.

Last night we issued two press releases. First, let me comment on the change of leadership at Essex. I've had the honor of leading an extraordinary group of executives and employees. With their skills and hard work, Essex has consistently performed at the top of the multifamily sector. Mike Schall and I have worked together for 24, 25 years, and we absolutely share a strong belief in our business strategy and the disciplined execution of that strategy. I'm very confident that Essex is going to continue to prosper under Mr. Schall's leadership.

Now on to the earnings results, we had a good quarter, with FFO beating consensus, sequential revenue growth turned positive, and market occupancy continued to increase. Much of the rent growth we have gained back in our markets is the reverse of the coupling up, moving home, and general fear of continued job losses that were part of the rent declines last year. The household survey is indicating better employment growth than the industry job survey. Usually these two surveys do not have such a large discrepancy. However, now the household survey is showing a 1.5% growth versus the industry survey at 0.4% in our markets. We suspect this may indicate some of the job markets are stronger than preliminary industry surveys indicate. Mike Schall is going to go into much more detail on each market as he makes his comments.

As noted in the press release, we have been very active in the acquisition area, having acquired $460 million of quality well located properties here. What is unique this cycle is that we have been able to buy higher end condos at large discounts to cost, to the cost to construct them, and at cap rates that would normally equate with an apartment property. We've sourced a significant number of these deals from construction lenders who had foreclosed or were in the process of foreclosing.

An example of this is the Magnolia property. The property has a condo map. The bank had filed a notice of default. We were able to purchase the property from the developer. The deal was structured where we made a payment to the developer and we paid the lender a small amount to get their cooperation. The combined payments represented about 70% of the cost to construct the property. The Muse, another property that was purchased from the construction lender, the lender in this case was one of our line lenders. We were able to do our due diligence very quickly and close in several days, making this a win-win transaction for the lender and ourselves. This is a new unoccupied project that will be completed and expect occupancy in the first quarter of 2011.

Cap rates for these transactions, for the transaction closed these quarters range from 4.8 to 5.5 with an average cap rate of 5.25. Cap rates in our market, we think they continue to ratchet down. We think that the A product is going at about 4.25 to 4.75 and the B product is 4.75 to 5.25.

Now, moving on to development quickly, with costs continuing to come down, we're evaluating our legacy deals. Several of the deals that are on our books, we can build at 5.5 to 5.75 yields. On current rents, these projects are fully entitled, ready to go, which eliminates much of the development risk. As far as new deals, our current, our development people are currently looking at new land parcels and we're targeting 6.5 to 7 yields on those new deals.

Now, let me turn the call over to Mike

Thanks, Keith. Thanks, everyone, for joining the call. Before reviewing our operating results, I would like to acknowledge Keith's remarkable success of leading Essex over the last 33 years. He is the glue that has held the Essex team together, as well as the discipline that has kept us on a prudent path. I look forward to leading our exceptional Essex team and assure you we will be following the path that was blazed by Keith.

We are pleased to report that Essex's portfolio continued its strong recovery in the third quarter. Starting with our 2010 job growth forecast on page S-14 of the supplemental financial package, we have reduced our estimates of 2010 job growth to reflect a weak third quarter and have included losses in state and local government jobs, mostly related to education and focused primarily on the Oakland and Los Angeles metro areas. Job growth is now expected to be 0.5% in the coastal metros, down from 1% in our forecast as of June 30, 2010. Even with lower job growth expectations for 2010, the forecasted growth in market rents for the West Coast metros increased from 3.7% last quarter to 4.3% this quarter.

The growing disconnect between job growth and rent growth is demonstrated in the Oakland MSA, where metro wide market rents are expected to grow at 3% at a time when we expect to lose 10,000 jobs. As stated before in previous calls, affordable rental rates improved consumer confidence, demographic factors and low levels of new housing have contributed to this result. However, as we evaluate our results, it is clear that economic activity has significantly increased in specific parts of each major metro area, and apartments in or near those hot beds of activity are benefiting disproportionately. In reviewing each region, I will comment on this activity.

On Essex's multifamily portfolio, market rents increased 2.3% during the third quarter, and 6.7% since December 31, 2009. As a result of rent growth and turnover, loss to lease, that is the extent to which market rents exceed in-place rents for the Essex portfolio, increased to $8.8 million, or 2.3% of scheduled rent at September 30, 2010 compared to a loss OF lease of $3.6 million, or 1.1% last quarter. Relative to expiring leases, effective renewal rent increases for the quarter grew almost 3% as compared to 1% in Q2. Again, relative to expiring leases, new leases were up 2.7%.

In the fourth quarter, we expect renewal rents to increase approximately 4%. With loss to lease at 2.3% pushing renewals much beyond 4% is not desirable, given its impact on turnover, which increases operating costs and pressures rental rates for new leases. Renewing leases above market can also potentially damage our relationship with residents. Our focus with respect to apartment pricing continues to be maximizing NOI growth.

Turnover remained low during the quarter. Same property delinquency was down 30% from a year ago. Concessions continued to trend downward, and are now at the low level of $116 per turned unit in the Essex same store portfolio, or about 40% less in prior year's level. Operating expenses declined 0.6%, which is better than our guidance.

Our results reflect occupancy declines of 50 basis points sequentially and 30 basis points year-over-year. We maintained superhigh occupancy during the weak market conditions in the last two years and are now focusing on growing rent rather than high occupancy as we price more aggressively. Ignoring the change in occupancy, sequential revenue growth for the quarter was plus 0.8%. As previously reported, we started the year with four unoccupied properties. Two of them, Jewel in downtown Seattle and Fourth and Union at Berkeley have now been stabilized. At Skyline, our 349-unit twin tower near Irvine CBD, we 189 units since beginning the lease-up in April, or 27 units per month. We completed leasing the north tower, and recently opened the south tower for leasing. Rents are consistent with our original expectations.

We started leasing our Axis 2300 project in mid-August and have since leased 84 units and are now 73% leased. We will soon begin leasing our newly acquired 152-unit Muse apartments and our 97-unit Magnolia Nest located in North Hollywood and Valley View districts respectively of Los Angeles. Muse will begin leasing in the December-January timeframe and we expect a four to six-month leasing period, with rents averaging $2.15 per square foot. Magnolia Nest, which will soon be renamed, will commence leasing again in the December-January period and we expect a four to five-month leasing period, with rents of approximately $1.85 per square foot. We expect to use one to two months of concessions in connection with both lease-ups to achieve the desired absorption rate.

Now, I would like to briefly review each major part of our portfolio, starting in Seattle. Deliveries of large scale condo projects have ended, and apartment development deliveries will be at historical lows for the foreseeable future. There continues to be rental overhang from condo projects, although it is being absorbed faster than anticipated. Approximately 1,100 new multifamily units were delivered during the quarter, and 4,100 year to date, leaving approximately 600 units to be delivered in Q4. We are beginning to see a few new multifamily development projects being proposed and under construction with deliveries beginning in 2012.

The Seattle office market is rebounding, with 1.1 million square feet. That's 1.1% of stock, of leasing in the third quarter, mostly in downtown Seattle and Bellevue. Amazon is consolidating 9,000 employees in Paul Allen's development in Southlake Union. The Gates Foundation will soon occupy its 900,000 square foot office in Lower Queen Anne area of Seattle early next year. Russell Investments is relocating 900 employees from Tacoma to the WaMu tower downtown. The Seattle CBD and east side are the strongest submarkets of the metro and in our portfolio. Where the Essex Seattle portfolio, markets are up 10.5% from December 2009 and 4.6% in the third quarter.

Now, on to Northern California, as with Q2, we are again lowering our 2010 job growth estimate from Northern California to 3,000. The change reflects 8,000 lost jobs in the Oakland MSA, the closing of the Numi plant in Fremont contributed 4,000 job losses in manufacturing in early Q2, which was followed by the loss of 6,000 state and local government jobs this quarter. San Jose's Tech Center is providing the majority of new jobs in the region. San Mateo County, which is the southern part of the San Francisco metro area, has also shown improvements and benefit from its proximity to Silicon Valley.

Office absorption year to date in Silicon Valley and San Mateo counties has been 1.7 million square feet, or 1.8%, whereas the rest of the region has been flat to negative. Despite lower job growth expectations, rents continued to increase in the region. We now estimate 2010 market average rent growth of 4.2% in Northern California, versus 2.5% last quarter. On the Essex Bay Area portfolio, market rents increased 4.5% during the quarter and 8.4% year to date. San Jose was the strongest market in the Bay Area portfolio, generating 9.5% increase in market rents since December 2009.

Now, on to Southern California. we have lowered our 2010 forecast for job growth from 70,500 to 36,000. The majority of the downward revision is in Los Angeles, where 22,000 jobs focused mostly on education are expected to be lost. Approximately 1,300 multifamily units were delivered in Q3, that's 5,600 year to date, leaving approximately 800 to be delivered for the remainder of 2010. We expect Orange County to have the best job growth, projected at 1.9% for 2010, but with the weakest rent growth. We believe the conditions will improve once the lease-up of condo projects, including our Skyline and Axis 2300 properties are completed. In addition, overhang of supply of apartments and condos still impacts downtown Los Angeles and Woodland Hills. We also lowered our 2010 market average rent forecast for all Southern California to 3.3% from 3.8% last quarter.

On Essex's Southern California portfolio, market rents rose 0.1% during the quarter, and 4.1% since Q4 2009. LA leads the Southern California recovery. Southern California office markets continued to perform poorly relative to other Pacific coast metros, even in the urban core. Southern Cal office markets saw limited positive absorption in Q3, and the suburban office markets remain very challenged.

Thank you for joining the call. I'll turn it over to Mike Dance.

Today I will provide comments on the non-core activity during the quarter and on the revised 2010 guidance. The third quarter's results for the same-property portfolio were in line with the forecast provided at our August investor day. Our revised year-over-year change in same-property revenues is now expected to be down 3.3% for the year ended 2010 compared to the year ended 2009 and we are forecasting a 4.6% decline in the same property year-over-year net operating income.

The third quarter FFO results of $1.24 a share, were $0.05 better than our August guidance, primarily from the strong lease-up activity from the communities in development. Non-core activity in the third quarter included three significant items that when netted only contributed $0.01 per share of funds from operations. The non-core activity in the quarter as shown on S-3 in the supplemental financial information consists of the following items.

As a result of the timing and the amount of forward-starting swaps that were settled in the third quarter, a portion of the swaps were deemed to be ineffective under complex accounting rules, which resulted in a $1.6 million charge to earnings. We plan on settling the majority of the swaps that we still have remaining, which could result in an additional expense from ineffectiveness in the fourth quarter, but at this point, we don't deem it to be that material. The second item relates to acquisition costs during the quarter, which totaled $600,000. The $600,000 in acquisition costs include only the amounts paid to third parties and does not include any time or expenses incurred by the Essex employees that underwrite and perform the due diligence on the acquisitions.

The last non-core item is the result of a change in the accounting estimate used on the note receivable that was secured by Santee Court. When Essex purchased the loan from the originating lender, our due diligence was limited to reviewing the lender's files and a cursory inspection of the asset. In the third quarter, the borrower listed the property and after we completed customary due diligence, we submitted a competitive offer with multiple other bids. Once it became apparent through the marketing process that the property was worth significantly more than the full principal amount of the loan, we amortized the remaining loan discount as interest income to the stated maturity date.

The additional interest income recognized as a result of this change in estimate was $2.5 million in the third quarter, and there still is an additional $750,000 of interest income to be recognized in the fourth quarter that was not in our previous guidance. As disclosed on the press release in late October, Essex closed on the acquisition of Santee Court for $31.1 million and the $25.7 million note was retired by Essex. The expected year one cap rate on the Santee Court community on the $31 million cost basis is expected to be 5.5%.

In October, we have recognized a $3.4 million gain on the sale of marketable securities, which will increase non-core funds from operations by $0.10 over the $1.24 in the core FFO guidance we provided in August. The midpoint of our new FFO guidance of $5.40 per share for the year ended 2010 is an increase of $0.18 over the prior guidance. $0.10 from the fourth quarter gains on marketable securities, $0.02 from additional interest income to be recognized in the fourth quarter on the Santee Court loan, net of non-core charges, and a $0.06 increase in core results from external growth activities on developments and the increased level of acquisitions disclosed in the press release.

The high end of the guidance can be achieved if we are successful maintaining higher than market occupancies throughout the fourth quarter, while we continue to push rents. The low end of the range in the guidance is for any additional charges for ineffectiveness that may occur on the settlement of the forward starting swaps and possible FFO dilution from the lease-ups from the two assets that we acquired in October. The majority of the forward starting swaps will be settled in early 2011, so there will be no swap ineffectiveness for next year.

We have used our after market equity program to match five external growth initiatives. The year to date acquisitions of $460 million includes the $128 million purchase price of the Skyline At MacArthur Place, which was financed in a co-investment partnership. The remaining $332 million has been financed with the $171 million in proceeds from issuing 1.6 million shares of common stock and by using debt. With our current liquidity, our expectations for future growth and net operating income and a favorable environment for obtaining long-term debt, we have been financing investments that are on the Company's balance sheet with up to 50% debt and 50% equity. Off balance sheet investments will use slightly higher leverage, with up to 60% debt in order to accommodate the yield hurdles required to earn the risk adjusted returns acceptable to the private equity investors and for Essex to earn a promoted interest.

This ends my comments and I'll turn the call back to Christine for questions. Christine?

(Operator Instructions) Our first question is from Eric Wolf with Citigroup. Please proceed with your question.

Thanks. Michael is also on the line with me. Can you tell us where your turnover due to financial reasons and home purchases have been trending relative to historical averages. And as you look out to next year, is there anything that makes you think that your overall turnover might go up from the current depressed level?

Sure. This is Mike Schall to answer that question. Neither were exceptional this quarter, and I don't have the specific data on the financial reasons. But I remembered looking at it at one point in time. When it comes to homeownership, again, also unexciting. It was 11.2% of move-outs in Seattle. It was 11.8% in Northern Cal, and it was 8% in southern Cal. Again, the year-over-year numbers are not -- there's not a material change.

Okay, and I guess looking at the next year, you don't see anything on the horizon in terms of some of your peers have said that the turnover due to financial reasons has picked up lately, more people losing jobs, obviously home sales are at a fairly depressed level. Are you just looking at the next year, you think turnover's going to stay depressed?

I think it will stay somewhat depressed. We're not that concerned about the turnover to homeownership primarily because someone probably becomes a renter in that transaction and someone else becomes a homeowner. So we don't see that as being a major factor. We prefer to look at overall supply of housing as being the really critical factor, both single family and multifamily. So if we see, for example, a whole bunch of single family homes being built, new single family homes being built, that concerns us more than the fact that someone's becoming a renter and someone else is becoming a homeowner.

So obviously with 30-year mortgage rates and some of the just amazing mortgage programs out there, I think FHA, which I believe has roughly 50% of the purchase money financing at 96.5% financing, sub-5, sounds pretty good to me. Having said that, I think there's widespread concern about the sustainability of recovery in some of the single-family markets, although we've seen on the West Coast, again, in the Coastal markets, I think you have to really separate California into two buckets. The Coastal markets versus the inland markets. In the Coastal markets, we've seen a pretty solid single-family home transaction marketplace, and I don't think that changes.

So I think it's more business as usual. I don't see any major changes when it comes to financial distress. Obviously the other indicator of financial distress would be delinquency. I don't see that. It hasn't changed. It's down significantly from a year ago, as I said before in my comments. And therefore, maybe it gets a little worse, but I don't see any trends at this point in time.

Got you. And just on the acquisitions, you've purchased about $460 million year to date and like you said in your comments, you sold about $170 million of stock and $60 million of marketable securities to fund these purchases. And the other 50% has been on your line of credit. I'm just wondering going out to next year, whether we could expect this balance to shift to where you're issuing a bit more equity on your ATM to fund the investment activity in keeping capacity on your lines of credit.

It would really depend on the, what we could get 10-year debt at relative to where our stock price is and we'll pick the right blend of the two.

So where it is today, I mean obviously you can get 4% on 10-year debt from the agency, so you're looking at probably run a little bit higher leverage, is that what I can get from that, probably 50% leverage?

Yes, we're targeting for most of our acquisitions and development, underwriting now, about 50% leverage. And we're comfortable with that, given at current leverage and expectation for future net operating income growth.

Got you. And just one last question, and just so I'm clear on the guidance, $0.02 is due to the additional interest income. $0.10 is due to the marketable securities gain in the fourth quarter. And the remaining $0.06 is due to the increased investment activity?

Yes.

Okay, great. Thank you.

Our next question is from Michelle co, with Banc of America Merrill Lynch. Please proceed with your question.

Hi, guys. I was just wondering if you could help me bridge the gap a little bit. I know you talked about this before between some of those markets where you're seeing job loss and where the market rents are actually increasing, like in San Francisco. Can you just talk about it a little bit more? Is that where you're seeing economic activity increased in specific markets that you were commenting on and what other places are you seeing that and what do you make of it?

It's Mike, Michelle. Yes, we do see a correlation. As we commented, the office markets are doing best, take the San Francisco Bay area and Silicon Valley and up the peninsula. A lot of that is tech-driven. And so it's not surprising that our market rent growth in San Jose at 9.5% led the portfolio.

Same is true in Seattle, where, again, that Lower Queen Anne area, we commented on previous calls about the Broadway area and our Jewel project that leased up at about 50 units a month over the last, the first seven or eight months of the year. And so we've just seen a tremendous amount of activity in those areas. And again, market rents are increasing to the greatest extent there.

If you look at each asset that is comprising the market rent growth, you will see that it's far from the same across these metro areas. Some are up very significantly, while others are lagging very significantly, and so we're trying to describe what we see out there as it relates to this economic activity.

Southern Cal is again, it's not that surprising when you look at the absorption numbers in the office space. It's not surprising that we had a relatively flat quarter in Southern California and we have an overall trend sort of lagging Northern California in Seattle. So, again, we see a very strong correlation between office absorption and just economic activity. That would be a pretty good barometer for economic activity. And what's really happening on the ground with rents.

And Michelle, let me just add, this is John Lopez, a lot of those recent losses were in local education jobs, and even within our metro, for example, the East Bay and parts of Silicon Valley and Seattle, we're closer to the urban core. There's just less of those exposure to those jobs. So it's sort of a disproportionate growth within the marketplace.

No, that's a good point. The education jobs, which I think are predominantly K through 12, right, John, are sort of spread across the marketplaces, whereas the tech jobs, for example, are in very specific locations. So you have sort of a broad impact as it relates to the state and local, and you have a very focused impact as it relates to the tech jobs and the tech employers.

Great. That's helpful, thank you. And also, I was just wondering if you could comment on since you've had this improvement this quarter, how much your total portfolio is off from peak rents in some of the major markets.

I should know that the peak rent question is going to come. Do you want to handle that?

Yes, right now overall in our portfolio we are 8% below the, currently below the previous peak, and that distribution goes from we're still 12.7% below in Seattle, 9.6% in Orange, 9.6% in San Jose, so those are the way above. Then LA we're still 7.9% below, Oakland 7.7%, San Francisco 6.9%, Ventura at 2.5% below and San Diego at 2.2% below.

Okay, great.

So roughly the areas where we expected the higher growth, we're still significantly below the peak.

Right, okay. Great. Thank you.

Our next question comes from David Khani with FBR Capital Markets. Please proceed with your question.

Great. First of all, congratulations on the change. The first question I have is related to the external growth strategy of the company, maybe take it back a little bit more high level, along the lines of Eric's questions. Where do you see this maxing out? If we assume that the market conditions stay relatively similar to today for the next 12 months, in terms of the opportunity sets available to you, can we expect this philosophy of asset growth going forward?

David, it's Mike. We certainly hope so. It's hard to predict what's going to happen going 12 months out. What we see now is the long awaited reconciliation of some of the distress in the financial area actually hitting the marketplace. We've all speculated that would be out over there the last couple of years and finally we're seeing it. It's hard to tell exactly how deep that is. But we are seeing some transactions.

What we haven't seen a lot of is a lot of the 30-year-old very well located property hitting the marketplace. So there's certain pieces of it that we're seeing and it's hard to gauge exactly how deep it is. So we certainly hope so. We pursue what we consider to be a match funding type of program, where we look at the balance sheet and we essentially replicate the balance sheet as it relates to each acquisition and try to gauge its accretion to NAV, FFO, and our growth rate.

So that's how we look at the world. We are able to make those deals right now and the acquisition environment looks very attractive to us. So I would certainly hope that we would be able to maintain that pace going into 2011. That's certainly what we hope and expect to happen.

That's helpful. And then a question that I think you probably get asked every three or four quarters, is the interest level in expanding beyond three platforms. Given that the environment's a little bit different today and you're seeing a widening pool of assets, especially on the distressed side, is that something that you're considering, given the volumes you're seeing?

Are you talking about moving to other markets besides the West Coast?

Well, not necessarily beyond the West Coast, but certainly another -- let's say a fourth footprint, not being market specific per se.

Well, I think as we've commented, there's probably -- not probably. There are no markets west of the Mississippi that we're not in that we want to be in, so we certainly don't see the Inland Empire as an attractive place, don't see the Sacramento market as an attractive place, Phoenix, Las Vegas, none of those markets are attractive to us, so if we were to do something, it would have to be East Coast and it would have to be a sizable transaction and frankly we're not focusing on that right now primarily because this idea that growth, that we have a greater potential growth on the West Coast markets because frankly the Virginia, DC, Baltimore markets have not -- frankly their rents have recovered, and their trough to peak is much different than we have. We would actually slow our growth if we tried to expand our portfolio at this point in time. So not to say that Mr. Schall isn't going to pursue that sometime in the future, but right now it is nothing -- it's not on our, our radar screen.

Okay. That's very helpful. Thank you. Then my last question just has to do with the pipeline of the coinvestment opportunities. I think you've mentioned previously that there were increasing numbers of opportunities in the second half and we saw a little bit. Can we expect more of that going forward? And can we assume that the returns would be relatively similar to what you've reported?

What are you calling coinvestment? Are you talking about the--

The pref.

Oh, I think given recovery in values, where the long-term sponsors that have done construction and were looking at a case where they might not have enough financing proceeds, you know, one of two ways we can do that, we can buy the property or we can do mezz financing. We have pretty high return hurdles for that program and I think with compression and yields right now, they are probably in some cases able to find other lenders that have a lower cost of funds than we have. So we, we are very selective in what properties we're willing to put into the mezz program. They need to be in markets that we are very comfortable in underwriting. So I think a lot of that is behind us, but we continue to look for opportunities in that area. Nothing imminent in the pipeline.

Okay, that's helpful. Thanks for the detail today.

Our next question comes from Alex Goldfarb with Sandler O'Neill. Please proceed with your question.

Good morning.

Good morning.

I just want to go to the transition for a minute. One, just curious if the consulting part of the arrangement, Keith, if that's open end or if that's for a set period. And then, two, as the discussion of transition was being discussed, sometimes we see companies where the retiring CEO leaves and goes O other times they stay on the Board. Maybe -- and other times they stick around the office halls. Just sort of curious what the thoughts were when the decision was being made.

Alex, I'm going to stay on the Board. I'm committed to Essex long-term. As far as the agreement, we haven't sat down and put anything in concrete. The goal is for me to be involved here, some sort of special projects opportunity maybe, as long as I can be productive and bring value to Essex, I'm going to be here. If I can't do that, I'm not going to be here. So I would guess it's a two to 20-year commitment.

Hey, Alex, I have a little bit to add to that probably. I think it's probably closer to 20 years. I went out and bought some heavy gauge chains and locks. I'm going to chain Keith to his chair somewhere. We spent a lot of this year restructuring the organization, specifically in operations, there's a couple of guys that will be at NAREIT in a couple of weeks, John Burkhart and Eric Alexander that are a big part of this team.

And then of course I have -- one of the legacies Keith leaves is people tend to like to work at Essex and they stay for a long time. So I have John Eudy sitting next to me, who has been here for the last 25 years and Craig Zimmerman, who leads acquisitions. I bought three chains. I'm chaining them to their desks as well. So we've got a pretty deep bench and we have effectively gone through most of our restructuring earlier this year, so we've been operating sort of in this format.

So the idea is that we, we will give Keith some specific assignments and there's, I think a very good opportunity out there trying to grow externally, and that is what he loves, and that is his first love, I guess, when it comes to this business. And so we'll turn him loose in addition to John and Craig, and hopefully, I'm very confident that we'll do even better. So I'm excited about that part and Keith and I have been both very close friends and partners for a long time and we drink the same Kool-Aid and all that stuff. So I don't expect a whole lot of change when it comes to what Essex does and how it looks at the world.

Okay, and hopefully there's some padding to go with those chains.

You're suggesting he needs a padded cell?

No, just want to make sure everyone's comfortable out there. Next, switching, this is probably more for Mike Dance, the swaps, I think you said the breaking of them won't be material in the fourth quarter, but given your guys' small share count, I just want to get a sense for how much that would be. And then second, just given where rates dropped and you took some swaps that now you're paying the price for, does it change the way you guys think about your forward financing or your view is just we don't want to take interest rate risk and we're willing to bear the brunt if rates go up or down, but our strategy is just to eliminate that and where we're still going to go forward and do the swap strategy?

Well, I think we need to get out of the swaps we're currently in. I think we're going to be gun shy and more thoughtful on future swaps we enter into to make sure they are accomplishing what we intended to do. And for the most part, when we entered into these contracts, we thought 6% rate was a pretty prudent investment when we were looking at the refinancings and the rates that we're refinancing the debt. We thought we were locking in arbitrage based on the debt we were refinancing.

I think no decisions have been made. And I think practically speaking with some of the financial regulations out there, a collateral is often now required to be in these types of arrangements, where in the past we were not required to have collateral. So I think the cost of doing these from a practical standpoint will go up so it will be harder to do. I guess in a roundabout way to answer your question, if we do them, it won't be to the same extent we've done them in the past.

Okay, and the materiality of the fourth quarter, sounds like it's only a few thousand dollars. It's not like hundreds of thousands.

It depends on where interest rates are. We're looking at a large cross collateralized mortgage right now that we'll settle the swaps, so it really relates to where the rates are when we lock in the settlement of the mortgage that we're currently working on.

Okay, thank you.

Our next question comes from Saroop Purewal with Morgan Stanley. Please proceed with your question.

Hi, good morning. I was wondering if you actually track the reasons for the move-ins. Just on a high level, wanted to find out what do you think is the percentage of demand coming from former homeowners or condo owners into your buildings, whether you track that during the credit checks or so on.

I'm sure we do. I don't -- it's not one of the things that I look at every quarter, and so I don't know the answer to that. I can try to see if I can find it and call you off line and give you any color on that.

Sure. And then the other questions I had was on the acquisitions, the Magnolia and the Muse. Can you tell us what is the discount replacement costs on these, maybe on a price per unit basis?

On the Magnolia -- excuse me. Yes, on the Magnolia, it was about -- we were buying it for about 70% of what it cost to construct. So it was a, it was a condominium. It had high end finishes, and the Muse was built as an apartment and we bought it at probably I would guess $35,000 to $40,000 discount to the, to the cost of building it. Per unit, on a per unit basis.

Okay, and the same for the Muse, I guess?

Well, the Muse was 70% -- Muse would have been a little bit more.

Okay, and just to touch upon, you mentioned, Mike, that you'll be originating mezz loans of approximately $40 million in the second half of the year. I think you mentioned that last quarter. Just wondering if that's still in the guidance.

A lot of that has been taken out of the guidance. We are not as optimistic of doing as much of that as we were at the end of the second quarter.

Okay. That's very helpful. Thank you.

Our next question is from David Harris with Gleacher & Company. Please proceed with your question.

Yes, hi, thanks. Keith, look at all the advantages. You don't have to pitch up at NAREIT any longer.

Hey, that's a wonderful time. I enjoyed it.

You're looking backwards now. That's the thing, looking backwards.

These things always look a little rose-colored spectacles on the times. Anyway, congratulations to you and to the President-elect. He will keep to the, going down the same path. We'll keep his feet to the fire. A question on that, President-elect, sir, why don't you sell a few properties to offset some of this acquisition instead of expanding the equity base? After all, if you expand the equity base, you're raising the hurdle on yourself, Mike.

Thanks for pointing that out, David. We actually are looking at selling some properties, and as you can appreciate, this year has evolved very rapidly and there was a point in time where we were not all that interested in selling properties, but as cap rates compress and as we look at our portfolio, there are some markets that don't have this steep discount to what rents were a couple years ago, and therefore the growth rate expectation is somewhat less and we are looking at that.

So having said that, if you look at the way we look at acquisitions, which is, again, this match funding type of arrangement where we're looking at each deal with a slice of the balance sheet, slice of debt, slice of equity and we look at the aggression that remains in that analysis, it's pretty compelling to use the capital to grow externally. I don't see right now the proceeds from sales being a huge source of money for future investment. It will be a secondary source, but nonetheless, we will definitely pursue it.

Isn't there also a question of sort of rationalizing the portfolio? I mean, there must be assets in the portfolio, even of your size, which is not obviously that huge, but there must be assets where the optimum use of capital -- you can redeploy the capital to better effect somewhere else. It's a question of pruning the least attractive assets off the bottom of the portfolio.

Yes, I totally agree. Yes, culling the portfolio and identifying the slow growers and improving the overall growth rate is absolutely what we want to do. But it becomes a timing issue in effect, and doing it at the right time and maximizing proceeds are, you know, minimizing any dilution from the sale to the reinvestment is pretty critical. You see it out there doing, selling at the bottom of the cycle can be pretty painful.

At the top of the cycle, cap rates tend to compress between As and Bs and lots of things happen that help you sell these secondary areas. At the bottom of the cycle, cap rates decompress and they are wider spreads, and so that reinvestment is much more difficult. I think you see that in some of the peer groups. We are very cognizant of that phenomena and we're going to be careful about this whole reinvestment concept. But I agree with your point completely, that culling the portfolio and paring off the slow growers, the assets that are more difficult to manage is something that we have to do and we're looking at it. We're looking at it to a much greater extent than we did, you know, just nine months ago.

Okay. I'm an Englishman here in New York, so you'll forgive the naivety of this question, but couple years ago--

Yes, right.

I'm a bit slow.

We know you.

Yes, yes. Couple years ago when rents were being pushed pretty hard, there seemed to be a political counterreaction in some jurisdictions. We've just been through a sort of political season. Any whispers of any rent control or any towns getting a little antsy about the rate that rents are being pushed by some landlords?

Remember, David, we still have rents that are well below the peak and a few years have gone by here. So I don't hear that yet. Haven't heard it yet. John, I don't know if you have any inkling about that one. But rents are still affordable by West Coast standards, let's say and when you look at the overall metrics, rent to median income levels and those types of measurements, it doesn't -- we don't appear to be out of whack at all at this point in time.

But I think the peak reference is Shamira, it's really a question of where are you coming from that tends to relate to.

I totally agree with you. So the answer is not yet, but we share your concern. As you know, in certain other times over the last 20 years, we've limited renewal rent increases to 10%, for example, because of the potential for political backlash. We operate in several rent control markets, fortunately California has statewide vacancy decontrol. So we are working it and understand it. But to your specific point, have we heard rumblings of more restrictive rent control coming our way, the answer is no, not at this point.

Okay.

And this is John Lopez, just to add to your point about the peak to trough is good. I think the more important metric is where the rents are relative to incomes, and even with the growth that we've had recently, that relationship is still very low. When that's high, you tent to get more of the rumblings.

Okay, great. Thank you. Congratulations once again.

Our next question is from Rich Anderson with BMO Capital Markets. Please proceed with your question.

Thank you, and good morning, everybody. And I, too, want to congratulate Keith. I can't wait myself so I can become a quote, unquote, consultant, one of the best jobs on the earth. Could you maybe describe for me what you think over the next two to three years, what's more exciting to you guys, the potential for internal growth or the potential for external growth at Essex?

Rich, it's Mike Schall. Internal growth has built the company, and I don't see that changing over the next couple of years. If you just look at the size of the Company and how it's changed over time, we're $250 million and we could buy $400 million and double the size of the Company, the external piece was very significant. Now, with a $5 billion Company, that relationship has changed. I think we still and will always remain an internal growth company, which, going back to what David Harris suggested, which is culling the weak and, focusing the portfolio in a certain way to enhance the internal growth, I think that's what we spent a lot of time thinking about and working on. But having said that, right now, the external growth is pretty exciting and probably more so, Keith correct me if I'm wrong, seems like this is one of the best times for external growth in the last 20 years.

Absolutely, yes.

I think you're going to have a period of time for the next couple years, hopefully, depends on where cap rates go and if cap rates compress to 4, everything I'm saying now will not be applicable, but based on what we see right now, they are both pretty exciting.

Okay, thanks. On the job adjustments that you made this past quarter, are you kind of surprised that you still are having these pockets of weakness and requiring you to reduce your job forecast? Are you surprised by how long it's taken? Or is it proceeding about what you thought it was going to take? Describe for me what you think about the lingeringness of the overhang in your markets.

Yes, this is John. When we started the year, our forecast now is that we're a little bit higher than when we started the year to put it in relative terms. What the revision downward was, because mainly we had expectations of about 2% cuts in the education jobs and we got about 5%. And remember, those cuts don't happen January through August. They all happen in two months in the summer. So it's kind of a case where going into the summer, if we had gotten the cuts in education, we thought we would be closer to our expectations that we had.

And that big drop, particularly in Oakland and LA, was a big effect. But if you look at sort of the underlying other categories of business services and health services and stabilization in our, the financial sector and construction sectors, you know, those are above where we would expect it to he be. So, we're thinking we thought until it's going to be 2012 before this is an economy that's growing above average.

Okay, and you're talking about California, West Coast versus the nation, is that what you mean?

Yes.

Okay, and then last question, a lot is made of the competition to buy core multifamily assets. In your case where you're buying busted condos, can you describe for me what the foreclosure process is from a competition standpoint for some of the assets that you've done?

Well, what's been going on is generally we've approached -- the only note we actually bought was the Santee note, where we could have foreclosed on it. Generally the other transactions we've gone to the lender, where they have actually foreclosed and it was an REO property, or the property was in default, and we worked with the lender and the current borrower in order to cut a deal. So we actually haven't had to do a foreclosure. But in California, frankly in the early 1990s, we bought a lot of RTC properties and John Eudy was very involved in running that process.

Basically, you file a notice of default, there is a time from, usually 90 days, and at that point in time, depending on how far upside down they are, they generally file bankruptcy and then you have to go through a process. And it's anywhere from 3 to 18 months to actually control the property through that process, depending on how much equity they have or how big a war chest they have to fight you in court.

Right, but you're not -- you're not necessarily the only person, only game in town looking for opportunities like that, correct?

No, of course not. I mean, we're coming up against -- we haven't seen a lot of the public -- well, that's not true. We have some of our, some of our peers have done the exact same thing, but, yes, there's a couple of funds out there doing this. So there is competition for this product, for this type of product.

All right, thanks. Congratulations, again, Keith.

Our next question is from Michael Salinsky with RBC Capital Markets. Please proceed with your question.

Good afternoon. Based upon your comments, sounds like the plan is to fill the open COO role internally, correct?

Yes, that will be the plan and we don't have any imminent changes in that regard. As I said before, we restructured the company earlier this year and brought two guys, Eric Alexander and John Burkhart, one is a Senior Vice President and the other is Executive Vice President and they are running -- we split the ops role into two and they are running it. So I think that's going -- that will remain in place for the foreseeable future.

Okay. There isn't any charges or anything that you're expecting in the fourth quarter, first quarter related to the transition, correct?

I don't, I don't think that we've decided exactly what that's going to look like. So it was not going to be a -- it won't be a large charge if there will be one, I'm not ready to comment on that at this point.

Okay, fair enough. Third, Keith, I think you mentioned you were looking at a few more of the development projects, potentially penciling. Just curious, as you look down the predevelopment pipeline, which ones appear most feasible and are shovel-ready at this point?

This is John Eudy. We've got a little under 1,400 units in our legacy-owned, fully entitled category. We're looking at all of them. I don't want to identify specifically, but it's likely that we'll be starting a few of them next year.

Okay. Fourth, with redevelopment, the pipeline's has slowed down over the last couple years obviously as you haven't been able to get the rent growth to justify the investment. Just given where rents are trending right now, is there a thought of the next 6 to 12 months to start ramping that back up?

Mike, we do want to ramp that back up and I guess from my perspective, we've reassigned some of the redevelopment guys to be active in our acquisition program. For example, last quarter we talked about the Commons project, which is very well located, two-story garden-style building in Campbell here in Northern California, requires a reside, requires some other work. So I think with virtually everything that we're buying, there is some activity associated with it, and so rather than focusing on the portfolio, redevelopment is one of those things you can do really at any time, but I think the higher and best use for those guys at this point in time is trying to facilitate the acquisition program and so we have retasked them into that area.

Okay. Then finally, a question for Mike Dance, not to leave him out. Just given the line balance at this point, as well as the investment activity subsequent to quarter end, you talk about going through the forward starting swaps there. Assuming there's a plan to start terming out some of that off the line there in the fourth quarter and first quarter of next year?

That's right.

Okay, thank you.

We did expand the line, so there's not quite the pressure of having too much usage on it. The line was expanded from $200 million to $275 million, and we added an accordion facility that can take it to $350 million. So the pressure to term it out isn't quite what it used to be, so we have the ability to keep it on the line a little bit longer now.

Okay. So you have $275 million of forward starting swaps I think currently. Does the hedge charge you are potentially expecting, does that relate to this, or does it relate to the hedge that was put in place during the quarter?

It relates to the fact that when we took out debt during the quarter, we didn't settle enough swaps. So as long as the next settlement we have will be enough to eliminate any effectiveness going forward.

Okay, thank you.

Our next question comes from Paula Poskon with Robert W. Baird. Please proceed with your question.

Thanks. Just one quick question for Mike Dance. Any update on the redemption of the remaining exchangeable notes, and particularly on the exchange option that expired yesterday?

We tendered, or we called all of them. So the natural response to our calling them is we expect all the bond holders to redeem and they will get a few bucks extra per bond for the value of the common being in excess of the exchange price. But it's -- that would all run through equity.

Thank you very much.

Our next question comes from Jim Wilson with JMP Securities. Please proceed with your question.

Thanks. Good morning, guys. I was just wondering, I know you gave a lot of good color on the competitive market for leasing related to condos and all the markets. Could you maybe discuss a little more of the condition of the buildings in terms are they those that are still out there on the market, are they heavily being converted and rented? Are they still sitting vacant, and in turn, what you think, or where you think the most intriguing acquisition opportunities of these kinds of deals still sit. Is it in a place like Seattle, where there's just more of a relative supply of them, or is it elsewhere? Thanks.

Let me try and -- that's a broad question and we have a number of markets. I think Seattle, we generally have run through the potential supply up there. There was a large broken condo. It's actually being leased up. And we've taken a run at it and several others have taken a run at it, and no transaction has resulted. There's not a lot of additional product in that marketplace.

The Bay Area, there's not a lot of product. There's a couple of deals here, but on a relative basis, not much. It seems that the most -- the greatest opportunity is in the LA market, and San Diego to a certain extent. So I would guess that, that those, those products are being -- are currently generally being leased. Where they are not being leased it's because the developer has gone broke and they haven't finished it and so the lender is sitting there with something that's 80%, 90%, 95% complete and they can't start leasing it until somebody could actually step in and finish it, which has been an opportunity that we've taken advantage of.

I can't tell you exactly how much of that stuff's still out there. I would guess a few thousand units in the L.A. market and maybe, maybe 1,000, 1,500 units in the San Diego market, and then the Orange County, there's a couple of deals. They are fairly significant. However, the developer/owner is a very large developer and I suspect that they are going to try and -- what they have said to the public is they are going to try and ultimately hold onto it and lease it and sell it when the condo market comes back. Up and down the West Coast, that sort of equates to maybe 2,000 to 3,000 units of that kind of stuff left.

Okay, great. That's great color, thanks.

Our next question comes from Tayo Okusanya with Jefferies & Company. Please proceed with your question.

Yes, good afternoon. Just a question on external growth. You guys seem to be doing very well with lease-up of your developments. And I was just wondering how you plan to balance the mix between expanding out on the development side versus making more acquisitions at lower and lower cap rates.

This is Mike. We are interested in both actually. If we can find development deals in the markets that have the best growth potential, we'll do development and as we've said before, we're going to continue to pursue acquisitions. We, having said that, and John Eudy is here. He can comment.

The development deals, there's still a lot of land that's priced based on couple years ago and land sellers kind of get a number in their head and they don't like to lower it. And so you end up with transactions that have a reason to happen and therefore it's difficult to find development deals. So I expect the acquisition market to remain pretty good. Again, they've got these distressed deals at this point in time. Hopefully the traditional well-located property will come back to the market at some point in time in the future and we've seen a little bit of that, but just not that much. I think a the lot of the activity has been heavily weighted toward the newer, more distress situation. So, we look at both as being attractive and with the growth expectations over the next couple years, I think we need to pursue both.

Obviously on the acquisition side, cap -- we're very sensitive to cap rates. And if we can continue to be around, around the 5 cap rate range, I think that those deals make a lot of sense. If we have to push further into the 4s, then they are going to make less sense and we're going to look to do more development. John, any comments, anything to add to that?

No, your point was right. On the key land urban infill locations that we go after, land sellers tend to own their property without leverage and they are not -- they don't have a gun at their head like some of these condo guys that we have been fortunate enough to purchase from that have gone broke. And there are a couple of deals that we have in the Q that may translate into actual starts next year if we go all the way with them, but it's -- we're very sensitive to the numbers and we're competing our development yield and risks associated with acquisitions where we can buy below replacement cost and that line hasn't crossed yet, but it's in the process.

Okay, great. And then recent acquisitions, when you look at Bella Bellagio, Santee Court, lie at descriptions of all these things, granite counter tops, marble cabinetry, fitness center, is there a general push towards acquiring more Class A properties at this point? Is that something you're strategically doing? Or is it really more on a case by case basis?

We've always been focused on markets first, and, and we really do believe that our success has been because of our focus on the market. Then next is the product, and given that we're so focused on these markets, we're going to go after what's available. As I said, my comments, this cycle has been really very unique in that we've been able to buy A quality condos with granite and with beautiful amenity packages for cap rates that really equate to apartment products. So it's an opportunity in the marketplace right now and we are going to take that advantage, take that opportunity because clearly we're getting A product, in some cases A-plus product for apartment values. That will change.

As I said in my previous comment, there's not that much of it left in the marketplace that we can go after, and then I suspect that as this market continues to mature, or the -- this recovery matures, the people -- there's going to be more B product for sale. And if it's in our A market, you know, that's really been our driver of our successes, B product in an A market. The fact that we can get A stuff right now well below replacement, it's sort of a frosting on the cake, if you will.

Great, thank you. Keith, I just wanted to say congratulations as well. I haven't known you that long, but in the one year I've worked with you, you've been nothing short of a class act, so thanks for all of your help.

Thank you.

Our next question comes from Andrew Fenton with Credit Suisse. Please proceed with your question.

Good morning. Do you have any submarkets or specific properties where you've pushed rents and had to back off after higher than expected move-outs?

Yes. I mean it's a constant balancing act. And we have definitely had that. I would say it happens less than, I don't know, 20% of the time, and I can't -- it's not like I can say, well, it's always in Seattle or it's always in Southern California.

The reality is we're trying to push rents and when we push too far, then you either -- you don't get absorption or you push people out of your building. So it's nothing, nothing unusual I guess at this point. But yes, we do see that.

Okay, and just in terms of general trends, how have you seen the pushback across your portfolio versus, say, other periods in time when you've pushed rents? Is it relatively similar, or any pockets where there's an extreme one way or another?

I'm trying to figure out how I could put that in a more general sense. I don't think it's really all that different. I guess maybe the point you just made, which is, there are pockets of strength and some of the comments that I made before, the better markets and our ability to get the highest rents are really tied back to these areas of, you know, greater economic activity. So it's not pervasive. It's not everywhere, all submarkets are going up together, which has certainly happened in prior recoveries. It's more like there are certain areas that are benefiting immediately, and then other areas that are lagging.

And it's interesting. In Seattle, for example, we bought a property in Bellevue. Bellevue is -- it had done very well. Rents had recovered very aggressively, and then we acquired a property that's 4, about 4 miles away in a very good city in Kirkland that really hasn't moved all that much. So it tends to be very pocketed and over time obviously all the normal relationships will likely reestablish themselves. I don't -- it's not like if you get 10% in Bellevue there's another 10% before a market that's 5 miles away recovers. The reality is it's all going -- it takes time for the market to adjust and over time it will.

Okay, thanks.

You're next question is from Dustin Pizzo with UBS. Please proceed with your question.

Hi, guys. Sorry if you've touched on this already, but given you have a pretty attractive currency today, how are you thinking about the Series B preferreds, just with the dividend rate up just under 8%?

We are evaluating that. No decisions have been made. We could probably issue a new preferred and save, maybe 50 basis points, so is that worth the friction caused by that, or use another currency to pay that down, so we are evaluating it. No decision's been made.

Okay, thank you.

There are no further questions in queue at this time. I would now like to turn the floor back over to management for closing comments.

Thank you all, and I will see many of you in New York at NAREIT. And next quarter, Mr. Schall will be in charge. Thank you all for being on the call.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.