Essex Property Trust Inc (ESS) 2011 Q1 法說會逐字稿

Greetings, and welcome to the Essex Property Trust, Incorporated first quarter 2011 earnings conference call.

(Operator Instructions).

As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Michael Schall, President and Chief Executive Officer of Essex Property Trust. Thank you, Mr. Schall, you may begin.

Thank you. And welcome, everyone, to our first quarter 2011 earnings call. As a reminder, we will be making comments during the call which are not historical fact, 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. Erik Alexander and Mike Dance will follow me with brief comments on operations and finance, respectively. John Eudy and John Lopez are here for Q&A. I'll cover the following topics on the call, Q1 results and market commentary is the first topic, then number two, the investment market, and finally, government budgets and jobs.

So on to the first topic, Q1 results, market commentary. Last evening, we reported FFO per share of $1.44 for the first quarter of 2011, which was $0.04 per share greater than the midpoint of the guidance range, and $0.03 above consensus. We experienced significant improvement in operations during the quarter, as we exited the typical seasonal slowdown after which momentum increased quickly. Each month from December has shown significant improvement, and we are now confident that the apartment supply and demand equation is tipping toward housing shortage, and thus both rents and occupancies are improving.

As before, northern California and Seattle remain a step ahead of southern California. Eric Alexander discusses these improvements in greater detail. We are seeing more evidence of a major difference between the current -- between current conditions, as compared to the recovery from the 2001 recession, that being the negligible level of for-sale housing development in the coastal markets. At this point, we don't anticipate a recovery in for-sale housing until at least 2013.

The last cycle taught us that high-density apartments can be constructed relatively quickly, and in significant numbers, and will tend to be located closer to the urban core. This may impact the relatively thin A-quality component within selected urban areas, without creating a supply imbalance in the overall region. As a result, tracking development deals will be a really important activity going forward, and one of our highest priorities.

We completed two acquisitions in the quarter, and we also have a $92 million acquisition in contract with contingencies removed. The first of the acquisitions is Santee Court, a 73-unit vacant condo deal next to Santee Village, which we acquired in 2010. With most of the vacant condos now on a new ownership path, we expect only a few of these deals in 2011. The second acquisition is Family Tree, which we expect to rehab. Strategically, we will avoid transactions that simply make the Company larger, opting instead for situations that we believe we can add value on a per share basis. We remain on track for $300 million to $500 million in acquisitions this year.

In development, we closed on a JV with a landowner in Seattle adjacent to Seattle Center, and less than a mile from the Space Needle. Closing of an approximate $45 million construction loan is expected in the next several weeks, with construction commencement to begin shortly there after. We've been working on this deal for over a year, and with rents increasing in Seattle the cap rate on today's rents is approximately 6.25%. Similar to our Seattle deal, we are working on several development deals that involve landowners with ready-to-build sites, but need credit support which we can provide.

In April, we acquired an 85% interest in a 12.6 acre land parcel in Santa Clara, pursuant to an approved bankruptcy plan. Again, this is a deal that we've been working on for over two years. The property is located at El Camino Real/Lawrence Expressway, and is currently a retail center with four years remaining on the primary lease. We are in the process of entitling 7.6 acres of the site for approximately 494 apartments. The seller and owner of the remaining 15% interest has the option of acquiring the remaining five acre parcel for retail development. Finally, we are beginning to ramp up our redevelopment activities, as once again we're seeing residents willing to pay more for up-scale units, a sharp contrast to the ultra-price sensitive consumer that we experienced beginning in 2008.

Next topic is the investment markets. Once again, we see evidence of cap rate compression in apartments along the West coast. There's simply too much money, chasing too few deals. Thus far in 2011, West coast apartment investment transactions are on pace to slightly exceed 2010 transaction volume. The 2010 apartment transactions were more than double the levels that we saw in 2008, but only about a third of the 2007 transaction volume. We conclude the transaction volumes, especially in the B-quality area have yet to normalize.

As a result, cap rates moved down during the quarter, ranging from 4.25% to 4.5% for A-property and A-locations, and from 4.75% to 5% for B-property and A-locations. Cap rates increased from there, for lesser locations and property quality. We have now worked through most of the pipeline of vacant and distressed condo and apartment property. However, there are several fractured condo deals, defined as those with a few sold units that remain in distress, along with buildings with more substantial physical or structural issues. With rents now increasing, we are pursuing development deals in several West coast markets underwritten based on today's rents. Development cap rates range from 5.5% to 6.25% or 6.75% to 7.5% upon stabilization.

Third topic, government budgets and jobs. With respect to California's fiscal situation, last quarter we reported that Jerry Brown submitted a plan to deal with California's approximate $26 billion budget deficit. This plan was comprised of spending reductions, and extensions of previously passed tax increases, both roughly half of the deficit amount. Jerry Brown is the first California Governor to deal with the state's structural budget issues, which essentially began following a massive increase in state tax revenue and spending from the internet boom.

Most of the cost reductions envisioned by the plan have been enacted, aggregating in excess of $12 billion. In the coastal markets, we assume the loss of approximately 50,000 state and local government jobs between mid 2010 and the end of 2011. The Governor's plan also involves submitting to voters the extension of tax increases enacted two years ago. The Governor has now missed the June window for that vote on the extension of tax increases, which leaves two alternatives. First, more substantial cuts to spending which will significantly impact education and essential services. And second, another temporary extension of prior tax increases set to expire on June 30, followed by a vote later this year. Accordingly, while good progress has been made, more actions are necessary. We will continue to follow this activity closely.

We are also beginning to track the number and location of federal jobs within the West coast markets, as federal budget issues are at least as significant as state issues, and there appears to be a growing bipartisan support for reducing federal spending. Non-military and non-farm federal jobs in the coastal sub-markets range from 0.8% to 1.9% of total jobs, thus we don't anticipate significant impacts from future federal job reductions. Thank you for joining us on the call today. I would now like to turn the call over to Erik Alexander.

Thank you, Mike. It's my pleasure to be here to report our first quarter operating results, and share some thoughts regarding the balance of 2011. As expected, the momentum that began to build at the end of last year, continued to gain steam throughout first quarter. Although quarterly results only modestly exceeded our expectations, we're very pleased with the sequential results. Rents are up for new leases as well as renewals, occupancies are strong and higher than the last quarter. Job growth has registered positively in all of our markets, and very low multi-family deliveries persist. At this point, there are no material changes to our economic forecast for 2011.

However, does it appear that we will reach market rent growth expectations earlier in the year. You can review these details on S-14. I think the encouraging news that came out of the first quarter was the acceleration of rent growth at the end of the period. Results in March were the strongest, and April was even better. With only a few days into May, it's probably too early to call the month, but if gains on renewals are an overall indication we should be in good shape.

As widely reported the news -- as widely reported in the news and by most of our peers, the San Francisco Bay area has been hot. Results in the Silicon Valley have led the charge for Essex, but we have seen impressive gains in rent growth in the Pacific Northwest during the past six weeks. Southern California performance isn't wowing anyone at this point, but better performance may be nearer than many predict.

Overall, the Essex portfolio saw market rents increase 9.2% since the first quarter of 2010, and 2.7% over the fourth quarter. This marks the fifth quarter in a row that we have seen market rent growth, and the rate of growth is also accelerating. As expected, this improvement in market rents has resulted in a growing loss-to-lease. At the end of the first quarter, this number stood at $18.5 million or 4.1% of scheduled rent, compared to $11.8 million or 2.6% at the end of last quarter. This obviously represents more opportunity to grow revenue.

Renewals continue to grow during the first quarter, and were at 4.5% higher than expiring leases. April results were comparative, with higher effective rents. Furthermore, with over 1,000 renewals booked so far in May, they are north of 5% compared to their expiring rate. June's offered renewals are even higher, averaging over 6%. Given that we only realized 40% turnover during the first quarter suggests that we have more upside with our renewal opportunities. So until we see a meaningful change in our renewal conversion ratio, I expect to achieve solid revenue growth from this component of our rent roll.

What did change noticeably during the first quarter was we saw greater gains in new move-in rents, compared to renewal rents as indicated in our press release. Although it's still early, May is starting off stronger than April. I expect to see continued improvement in our rent growth, as we roll through the best leasing months and address nearly 12,000 expiring leases during the second and third quarters.

Essex has always favored a higher occupancy strategy, but that doesn't mean that we will not go after higher rents. I think we cautiously increase renewals and new lease rates in the second half of 2010. As we gained sustained confidence, we were more aggressive throughout the first quarter, and we'll continue to push harder with all of the market fundamentals in our favor. Occupancies for our portfolio remain stable throughout the quarter and ended at 96.8%, and ticked up to 97.1% by the end of April with less than 5% availability. This result is consistent with our budgets. However, we should see lower occupancies during the summer months, as market rents continue to grow, more leases expire, and we push rent on renewals.

Our lease-up activities enjoyed the same positive results during the quarter, with all of them performing at or above our initial expectations. Skyline, Muse, and Allegro should all stabilize during the second quarter as previously reported. Next quarter, I will report on leasing activity for Santee Village and Via. Operating expenses were up slightly over the last year, but well within our budget for the first quarter. Nothing at this point, including utility costs, gives us any reason to think our total operating expenses won't be within guidance for 2011.

Now to our major areas of operation. Seattle is a rising star, with Essex rents up 4.9% sequentially, and 10.5% year-over-year in market rent growth. The end of April, this region was 97.5% occupied, and had 4% net availability. This result is very promising, following a fourth quarter that saw a drop in occupancy.

On the job front, Boeing expects to add jobs this year and for years to come, as they deliver the first dozen or so 787 Dreamliners, of the 850 that have been ordered. The future business climate also appears to be shaping up nicely, as Seattle office market continues to absorb vacant space reporting nearly 450,000 square-feet of leased space during the first quarter, which is about 0.5% of total stock.

Turning to northern California, again, the Bay area is the leader among markets for Essex. Essex market rents were up 3.7% sequentially, 11.7% year-over-year. And within that overall region, Silicon Valley posted the largest market rent growth at 5.1% sequentially, and 14.5% year-over-year. At the end of April, occupancy was 97.4% with a 4% net availability.

Job growth in this region continued to be modest but steady, with increased hiring in the lucrative tech and business service sectors, where over 12,000 of the 18,000 jobs added occurred year-over-year. This represents a 6.1% growth for these sectors, compared to 2.6% for the US overall. The office market continued to show strength especially in Silicon Valley, San Jose absorbed 1.2 million square-feet in the quarter or about 1.8% of stock. San Francisco added another 1.4 million square-feet of leased space or 1.3% of stock. Again, clear signs of a continuing recovery.

Finally, in southern California as expected, this market trailed the others, but Essex market rents were up 1.1% sequentially, and 6.8% year-over-year. Of note, Ventura and San Diego actually posted slightly better market rent results to Los Angeles, and compared to Los Angeles and Orange County. However, I do expect that based on recent performance in Los Angeles and Orange County, that these will -- these markets will still outperform San Diego and Ventura during 2011.

The Los Angeles CBD showed some signs of softness in the first quarter, but there was net absorption and conditions appear to be improving as evidenced by our asset's performance. At the end of April, southern California was occupied at 95.7% and had a 5.5% net availability. Absorption among most new lease-ups in the region including ours, continues to be solid. So we expect any supply overhang to disappear by the second half of the year, paving the way for even stronger rent growth.

The southern California office markets experienced the first quarter of overall positive absorption in years, with about 1.4 million square-feet being leased or 0.4% of stock. Orange County was the strongest market within the region, followed by Tri Cities in the San Fernando valley. Overall, office vacancy fell in southern California to 17%. I think there are many reasons to be optimistic about the West coast in the coming years, but it is nice to finally see some cooperation in the results from our portfolio. With that, I will turn the call over to Mike Dance.

Thanks, Eric. Today I will highlight the capital markets and investment activity that occurred during the quarter, followed with some details on subsequent events. And I will conclude with a review of changes to our guidance, using information shown on S-13 included in the quarterly supplemental materials released yesterday. On March 31, we raised $150 million of debt from our first unsecured bond private placement with a coupon of 4.36%, and a five-year maturity.

This pricing is reflective of our strong financial position, and the all-in cost was less than a five year unsecured bank term loan and a five year GSE mortgage. As of May, the unpaid balance on our unsecured bank facilities was approximately $100 million. We continue to monitor the relative cost of alternative capital sources, as we plan to term out more of the variable rate interest rate debt over the next several months.

During the first quarter, the Company invested almost $10 million in preferred equity at a fixed 9% return for the next five years. Although the accounting and form is a preferred interest, in substance these investments are structured finance loans, secured by ownership interest in apartment communities with a loan-to-value, including our preferred interest of less than 65%. In March, we renegotiated the $19 million mortgage note purchased in December, and is now expected to yield approximately 11% over the next five years.

Changing to subsequent events, in April we issued approximately $74 million in preferred Series H shares at a 7.125% coupon. And the proceeds were used to retire the $80 million in 7.875% Series B preferred partnership units. The Company recently provided a Series F preferred shareholders a 30 day notice that the Company will be redeeming all of the $25 million of the Series F shares at par. The write-off of the issuance costs from these redemptions are offset by a gain from retiring the Series B units at a discount to par, so no gain or loss is expected in the second quarter's results. In May, we sold the Woodlawn Colonial Apartments for approximately $16 million at a gain, and the proceeds will be used to retire the Series F shares.

Now I will be discussing the changes in our revised assumptions, for the increase in the midpoint of the 2011 FFO guidance. I encourage those that have a copy of the Essex first quarter 2011 supplemental financial information to find S-13, as I will be referring to this schedule, and S-7 and S-9 for my remaining comments.

Starting at the top of S-13, the net operating income for the same-property portfolio is increased to 5.4% from the previous guidance of 4.3%, given the leasing activity described earlier by Erik. The $2.6 million increase over previous guidance is a $0.075 share increase in our 2011 guidance. The $300,000 increase in operating -- in the operating -- in the net operating income from development communities is the result of the sooner than planned completion of the Sunnyvale development known as Via, shown on S-9. This reduces capitalized interest, which I will discuss in a moment.

The Essex development team has worked closely with the general contractor to hire the best subcontractors, and coupled with value engineering is producing a higher quality product more efficiently. As a result, initial occupancy of phase one is expected to be six months early, and all phases should be available for rent before the end of the year. S-9 also shows a $5 million reduction in the total estimated cost of this development.

The 2010 acquisitions in northern California and Seattle are performing significantly better than our original underwriting, resulting in a $0.02 per share increase in our 2011 FFO guidance. The expected net operating income from the Family Tree acquisition, and the earnings from the structured finance investments, and the acquisition and contract that Mike mentioned earlier, less the cost of capital required to match fund these investments, and the dilution from the disposition of Woodlawn Colonial are estimated to achieve the $750,000 in net accretion from external growth activities consistent with our original guidance.

Also the original guidance estimated the cumulative impact from 2010 acquisitions in southern California due to the lease-up activities, reduced our midpoint of 2011 guidance by approximately $3 million or $0.10 per share. This dilution is clearly evidenced by the reporting we have on S-7. As shown on S-7, the southern California non-same-property net operating income was approximately $1.8 million, on an investment balance of nearly $270 million, or an annualized yield of 2.7%.

A component of this lower yield is the result of our cash method accounting for lease concessions. By the fourth quarter, we expect the yield on this same southern California non-same portfolio to be about 5%, or a $1.6 million per quarter higher run rate expected to be achieved in the fourth quarter, compared to the results reported in the first quarter. The accelerated delivery of the Via development, and the March acquisition of the 100% vacant Santee Village increases the estimated dilution from development lease-up activity in 2011 to approximately $4 million, for $0.03 -- or a $0.03 reduction to the original 2011 guidance.

In addition, to the reduction of capitalized interest on the Via development, S-9 also shows a change in the development status of our Walnut Creek development. The entitlements on the Walnut Creek development have a higher percentage of it's net operating income generated from ground-level retail, and a slower recovery in retail rents. In February, we decided to postpone further development activities on this site, and we reclassified the project to land held for future development. This action decreases capitalized interest by $1 million, and reduces our 2011 guidance by $0.03 a share.

Savings from the new issuance of Series H preferred and the Series F redemption, coupled with both DownREIT and [EPLP] redemptions that have occurred, decreases are preferred, and non-controlling interest costs by $2 million from the original guidance, and increases our 2011 FFO guidance by $0.06 a share.

With all these moving pieces, I will close with a recap of the $0.10 per share increase in the midpoint of the 2011 FFO guidance. First, the improved same-property results increases our 2011guidance by $0.075 per year. Second, better than expected results on the ten acquisitions in northern California and Seattle increases guidance by $0.02 a share. Third, the acquisition of Santee Village, and the early delivery of the Via development, and the postponement of the Walnut Creek development reduces the original 2011 guidance by $0.06 a share. And lastly, the second quarter changes in our preferred equity, and the redemption of the non-controlling interest increases the 2011 guidance by $0.06 a share. That nets to $0.10 a share, and that concludes my remarks. And I will return the call back to the operator for questions.

Thank you.

(Operator Instructions).

Our first question is from [Swara Biono] with Morgan Stanley Smith Barney. Please go ahead.

Hi, good morning.

Good morning.

I was just wondering if you can give us some guidance on how same-store revenues will trend for the remainder of the year on a year-on-year basis?

We're looking at about a 1.4% to just under 2% increases on a sequential basis, a little bit less in Q2, ramping up in Q3, and the fourth quarter. Q3 and Q4 are roughly estimated to be the same, just under 2%.

Sure. That's helpful. So I was just wondering if Erik can comment around the financial occupancies ticking up in the stronger market like Bay area and Seattle? I was just wondering your approach on that strategy, and if you're not leaving some rent growth on the table with that strategy, especially given the new leases are actually performing very well.

Yes, I mean, there's -- we're probably always leaving a little bit on the table, if we're not forecasting higher rents in the future, and then giving out increases above current market rents. I think what we are doing is to try to capture as much of that as possible, and bring people to markets that are expiring. And we have a strategy of also offering a slightly higher rate on a longer term lease to, again, try to pick up some of that. So as we gain confidence through the first quarter -- and as I said, we didn't see any meaningful turnover. We're trying to push the envelope where we can there.

Great. That's all I have. Thank you.

The next question is from Rob Stevenson with Macquarie. Please go ahead with your question.

Hi. Good afternoon, guys. Mike, I can appreciate the first year as CEO and wanting to be conservative, but if I look at the revenue guidance still at 4.2 for the year, is there a massive decline in occupancy that you guys are expecting at some point during the summer, with where your renewals are trending and where your new leases are trending, on rental rate standpoint, that wouldn't have you blowing that number away?

Wow, that's an interesting way to phrase a question, Rob. (Laughter). I don't think that we're trying to be overly conservative. I mean, we, I think, the have a reputation maybe of leaning a little bit toward that. You are trying to pick sort of a transitioning market, and we're doing our best to try to pick that carefully. But remember, when we were in a pretty tough time in Q4 of last year, where we had roughly 4% on renewals, and only 1.6% on new leases. So isn't it a little -- it seems to me to be a little early to be calling victory on the entire year. So I guess to answer your question, there could be a little element of conservatism here.

However, just remember, I mean, it takes time to book the revenue. We have to turn the unit, and get enough of them into the current year in order to make these numbers work. I think that that is -- you saw it in the quarter, where I think there was expectations were perhaps above reality, even though the actual lease transactions were very strong in the quarter. It just takes time to turn those units, and get into it the books and records. So I don't know how else to answer it. Again, it's a transitionary time, and we're not going to go all-in with respect to, gee, is there going to be a few bumps in the road from here on out? I hope not, but I'm not sure that will be the case.

But you're not expecting occupancy to drop down to 92%, 93% during the summer.

No, I mean, Mike said it. If you get -- we had 1.4% sequential growth in the quarter. If the stays between that and 2%, you get the numbers that we have. So I think those are pretty strong numbers. I think that 1.4% was number two in the peer group. So if we're between 1.4 and 2 sequentially for the next few quarters, that's the number we have. I think that sounds pretty strong to me. Doesn't it to you?

Yes, I just think it's going to end up being a little higher. On another question for you, construction costs, you guys are continuing to ramp up, and sort of backfilling the pipeline. What are you guys seeing, in terms of hard costs and labor costs these days, and the sort of trend there, especially with gas prices continuing to increase?

John Eudy is here, and I will let him comment. But again, this is one of those markets that's rapidly potentially changing. And so we're again, going to try to predict an inherently transitioning market where contractors are willing to do things at very thin margins in order to keep their people employed, to a marker to where people are more -- contractors busier, and therefore not willing to do that. And son, there is a little bit of an element here of trying to predict what's going to happen. And with that said, that's probably what John was going to tell you, but John do you want to add something to that?

Yes, but not much more, Mike. The two pieces, labor side, there's still a lot of capacity in the market. Yes, things are ramping up. There are a few deals now starting to occur, and there will be more as the year goes on. But relative to the overall availability of labor in the markets that we're developing in, it's not anywhere near how busy people were in 2006 and 2007. So I think there's still plenty of pricing available.

We're currently in the process of buying out a few jobs, so we have a lot of competition amongst the subs which tells me that they are -- there's still room to negotiate pretty hard on the cost side, obviously with gas going up and other commodities going up. We do have that factored into our numbers, that we expect that there will be increases on the -- in the hard cost side for materials. We are projecting in our numbers approximately a 4% growth number over what we current believe we are buying out our jobs at currently, going into the second half of the year. Next year, I do think that number will go up, but we'll wait until we get there, because right now we're pricing on what we know.

Okay. And then, finally you guys have been fairly active on the acquisition markets. Has there been any demand really by the sellers for OP/down units in any of these transactions? Or is it they just want cash?

We are working on a couple of transactions that involve OP or DownREIT units. They, by their nature, tend to be longer negotiations than straight acquisitions where we're just writing a check, because it involves obviously whose stock do you want to own, essentially. And we're hopeful that we will be seeing more of those transactions. But you're quite right, we haven't seen that thus far. Again, as I think I said in the call, the sort of missing piece in the typical transaction world is the well-located B-type product, which is probably those same transactions are going to be most applicable to OP trade and/or down rate transactions, and we're not seeing them on either side.

So if you are not seeing them on the sell for cash side, that's probably indicative of trading for stock, although obviously trading for stock mitigates to a great extent some of the tax impacts of a sale. So we're hopeful. We think that we will see them. A number of syndicators and other major owners that own significant amounts of property and OP trade and DownREIT transactions give them liquidity and a variety of other advantages, so we remain hopeful that we will be able to conclude on a couple of those transactions.

Does any of these tax changes or tax increases would impact the sale of assets, to where for the next year that might wind -- while these things still in place, would wind up benefiting that?

I don't think that the essential contribution of a property to a partnership is something that the taxation is changing on. You do have Prop 13, where essentially the buyer's cap rate is different from the seller's cap rate. So if you have properties with very low bases on an OP trade transaction, that can be an issue. On a DownREIT transaction, you can generally preserve that -- the Prop 13 or the old tax base, and thus becomes less an issue. So again, sort of the missing piece in the transaction world, if you consider that the West coast is, what, predominantly 30-year-old, plus or minus property, given that we produce less than 1% of our stock a year, that's a pretty significant missing piece in the overall equation.

Okay. Thanks, guys.

The next question is from Eric Wolfe with Citigroup. Please go ahead with your question.

Hi, thanks. Mike, one of your comments stood out to me. I'm not sure I'm going paraphrase it correctly, but you made it seem like you expect development to come back fairly quickly like it did the last cycle, and that you were tracking new development projects as a result. Is that right?

That's exactly right. I mean one of the -- I thought there was a commentary, what or a question from one of the other calls that talked about, what are you doing differently going forward. And I think that we learned something from the last cycle. You take Bellevue, for example, which produced -- there was so much development activity within a very concentrated space, and a very concentrated period of time, all of us would agree that that is one of absolute best sub-markets on the West coast.

So I think what we take away from that situation is, that development transactions will tend to be more urban, they will tend to be more concentrated. And I'll give you another example. So within southern California, there's plenty of development activity in downtown, the CBD LA, and in the Marina, but Long Beach really didn't have, which is also within the LA metro area and County, Long Beach did not have that over-building phenomenon.

So we have learned, and I think that what we will do differently this time is -- and we've talked about it internally, how we're going to do this, we will track the development pipeline very carefully. There are a lot of deals being discussed in the marketplace, many of them as John Eudy reminds me of often, many of them, they don't really know what their costs are. They expect rents that are not achievable in the marketplace, at least not yet. And their operating expenses are too low, so they think they're six plus caps, but they're really somewhere in the fives.

But there are a lot of transactions out there, that are like that so we're trying to sift through them. And, in fact, John is calling a meeting, because he's so busy looking at development deals right now. And most of them don't work because of one of those issues, but I think a lot of them will be done. And it's going to become important that we monitor that supply and we manage our portfolio accordingly. Having said that, I think we're talking about -- we're not talking about next year, we're talking about 2013, before they really start coming into play. So we have plenty of time, in terms of -- because the whole construction process has to happen first. And that is just beginning to start at this point in time.

Yes, so the development engines are going, but still two or three years until we see that impacting the results?

Exactly. Consider that market rents, Erik threw out the numbers. If you've got year-over-year market rates growing 9%, and you've got sequential market rent growth at 2.7%, development pro formas that didn't work six months ago, are now starting to make some sense. So it's only a matter of getting the rents and -- rents to a certain level, and it enables a number of development deals. I mean it's kind of good for us, because the point I was trying to make with respect to the deals we have been working on, is we've been working on them for a year or two, both the Santa Clara deal and the Seattle deal. And therefore, we underwrote them at about a six cap a year or two ago, and those deals are looking very good now.

Got you. And I guess, along the same lines, thinking about where cap rates are in your markets right now, low 4%, I guess maybe 5%, I'm just curious as you think a little bit longer out to more normalized environment where supply is meeting demand, and maybe homeownership rates have finally stabilized. What would you see as a normalized cap rate in your markets?

Oh, boy, that's the best of all questions. Cap rates over the 25 years I've been here, have ranged from low 4's to maybe 7.5, for pretty good quality product, and 8s during a couple periods of time, I guess. But -- and I think interest rates are a key part of that overall equation. I would think that it seems like in a relatively low interest rate environment that we've been in for the last 15 years, cap rates would be some where in the 5.5 type range, maybe a little bit less or a little bit more. But I think that would be -- and I'm assuming certainly higher interest rates than we have now. And again, there's a relationship between the two. I think if interest rates stay where they are today, that cap rates will remain maybe a little bit higher than they are, but around 5% range. And is that how you underwrite deals right now, thinking maybe on a five to seven-year basis you get the strong growth for the next three years, then eventually that normalizes, and you get to call it a mid five cap rate on sort of an inflationary type rent growth? Actually, we have more rent growth assumed, than what you just said. We -- John Lopez is here, and he takes our 30 some odd sub-markets along the West coast. And he breaks them down and tracks supply and demand, and gives us five-year rent growth projection. Again, it assumes no major hiccups in the economy, and no dark clouds out there. But, so just knowing what we know now, we see supply demand imbalance pretty significantly.

Again, a lot of the -- with the last recovery period was very muted on the multi-family side, because you had single family being delivered in pretty significant numbers, and because of the mortgage situation. So we have sort of the flip of that scenario this time around, where single -- we don't see any single family headwinds at all, which means that it's going to -- more and more people are going to be focused on apartments, and should lead to a much better cycle.

In the last cycle, we barely reached our -- the relationship between rents and median incomes is something we track carefully. We barely hit the long-term historical average of rents meeting income, meaning half the time it should be above the average, and half the time below the average. We just barely got back to the average line.

So we think that was muted cycle. And if I just paraphrase, just so everyone knows what the pieces are, John, sort of average rent growth potential over five years he thinks is somewhere around 30%. So rent growth potential, again, absent dark clouds on the horizon. He gets there by taking the current discount to the rent to median income relationship, which can produce somewhere in the 8% to 10% range rent growth. And then we should be able to get above that line.

In other words, that's -- just to get back to the average line, we should get another 8% to 10% to go back to a normal cycle, what you achieve at the top of the cycle. And then finally, we think that the median household income growth rate will be about 3% over five years, which is about 15%. You had add all those up, and you get somewhere around 30%. That's what we think the potential is.

That's very helpful. Thank you.

Thank you. Ladies and gentlemen, in the interest of time, please limit your questions to two. Our next question is from Jay Haberman with Goldman Sachs.

good morning. Mike, you talked about cap rate compression. I know in the last call you mentioned cap rates bounced up a little bit, I think it was 25, 30 basis points when treasury yields rose late last year. Just a question, I know you also talked about too much capital chasing too few deals. Can you just comment about, are you seeing really the A's compress at this point? You mentioned B's yet to normalize. But are you expecting them to follow as well?

Yes, sure, Jay. Appreciate the question. It's a good one. Yes, last quarter I thought cap rates were up 25 basis points. We did the Family Tree transaction and that -- amid that scenario, and then we found that we were being outbid pretty significantly in a lot of different places. Again, we just didn't see very many B-quality apartments. So it wasn't like we were bidding on stuff and getting beat on the B's. There just weren't any really to speak of.

Family tree, by the way, was a fully marketed deal. And we think it's a low, mid five type cap rate, but involves some renovation to get there. So here's a little bit of value added component in that. But just more recently, just looking at some of the transactions, we walked away from a transaction, for example, in CBD LA, amid this increased 100 basis points, the increase in cap rate, or 100 basis points increase in interest rates, ten-year interest rate environment. And that transaction was done at a pretty big number, more recently. So I think that as I -- we look at the world now, it appears to be a very competitive world. And the -- both the REITs are there, there's some private money there, and you're starting to see the pension fund world engage as well. And as we all know the pension funds have a tremendous appetite, once they decide to join in.

Okay. Can you just remind us, second question, what your hurdles are today, whether it's for acquisitions or new starts on development?

On development, it's -- we want on today's rents around a 6% cap rate. Cap rates vary a little bit, so we're assuming -- we're looking at a cap rate the way the market looks at it. From an accounting perspective, you essentially allocate interest expense for a 100% interest scenario. So we're doing it like a developer, which is essentially a normal construction loan, maybe 60% construction loan. So we'll have 60% capitalized costs, then we'll be running our IRR models, and IRR models that will achieve in the high teen type rate.

And on acquisitions, sorry?

Acquisitions, we use a little bit different model, because we're more concerned about adding -- it's a matter of growth, initial yield and value add, and so a little bit more difficult. But if the implied -- if you take a 60% blend of equity, our FFO yield, and 40% our average debt rate, that blends it around -- and I know I'm ignoring growth on purpose -- but that blends in at around 4.25% to 4.3%. But that's not what -- that's now what we're trying to do, obviously. We are trying to earn -- we're trying to identify acquisitions that are accretive to that number, day one, let's say, at least 25 basis points, but in most cases, higher than that. And get paid for the value added component, and try to make sure that what we're buying is in the top tier of our markets from a projected growth standpoint.

Okay. Thank you.

The next question is from David Harris with Gleacher & Company. Please go ahead.

Yes. Hi, guys. If I look at the amount of money you've got out on the development program, the redevelopment program, and look at that compared to your equity base, I'm sort of coming up short 10%. Is that -- how big do you envision development, redevelopment getting, Mike? Or is --are we kind of pretty much at the max as to where you feel -- you want to put the Company at risk?

Hi, Dave, it's Mike. I think with the transitions going on internally, John Burkart is now looking at several opportunities to -- where we can add significant value through redevelopment. So I think some of that is just the change going on internally. And I think you can expect a lot bigger spending than even historical standards over the next several quarters, as we look at the opportunities where we can get significant return on invested capital in those areas. So I think it's just a short-term phenomenon that you're seeing.

On the redevelopment side, for sure, John and I, John Burkart and I are working through the plan which will involve significantly more unit dinners, for example, which we've pretty much stopped, given the conditions that we had before. And it will take time to ramp that up. And -- but we think that throughout the rest of this year, and really first quarter 2012 we think we will be fully ramped up, as to more unit turns. Interestingly, we've done a fair amount of exterior siding work and those types of things. And now we can come back with unit turns and get a pretty decent premium. So that is an porn part of the plan -- an important part of the plan for later this year and next year.

And just to be clear on (inaudible) go down, I look at the development, the amount of money you've got out on development and redevelopment, and express that as a percentage of your equity base, it's plus or minus 10%, $400 million relative to the size of the Company, is there a sort of top limit by which you guys talk around, in terms of where you might be -- feel that you've gone far enough? Is it 15%, 20%? I mean, could you see the program getting 50% bigger?

Okay, got you. On the redevelopment side, its a function of spending those dollars, take a lot of effort and time so they don't add up very easily. But I would think that we will get to the $30 million plus or minus spend per year on redevelopment side. On the development side, we talked about our overall plan is to be $100 million to $150 million in deliveries every year, so you need a pipeline that's roughly two to three times that, in order to have that delivery. I think John and I, John Eudy and I are in the discussion of expanding that, given where we are in this particular cycle and the opportunities that we're seeing before us. So you could see that as much as double, given again the -- what we perceive as bottom of the cycle -- bottom of the cycle, attractive deals. Deals where we don't have to wait very long, where we can essentially enter a transaction that's fully entitled, we can lock up the general contractor, and so we know what the costs are. And so given the advantages and the yield spread on those transactions, we are more excited about development that we have been for some time.

Okay. So you so, just to be clear -- you're talking about potentially doubling the size of the program from here?

Yes, double. So we said -- previously we said $100 million to $150 million in deliveries a year, that could go to $200 million to $300 million a year for the next few years.

You've managed the risk by taking it to a venture partners? Obviously, you've done that with some of the projects anyway.

That's one of the possibilities. We've had a painful lesson with [Forester & Schwab], so we're not likely to go down that road. We are talking about using some of our unencumbered pool to essentially place financing on an unencumbered asset., as opposed to -- it's obviously the development deal will enter that unencumbered pool at some point in time in the future, so we may -- so we're pursuing a number of different ways to mitigate some of the finance risk on the development deals.

Okay. And then just one simple question. Is how much of the portfolio rolls in the second and third quarters?

Let's see, what did I say, 12,000 expirations in the second and third quarter, so 55. That's on all --

That's a different pool, yes.

It's probably about 55% to 60%.

Yes, exactly.

55 to 60. Okay. Great, thanks, guys.

Thank you, David.

The next question is from Karin Ford with KeyBanc Capital Markets. Please go ahead with your question.

Mike, I wanted to follow up on your comment on your decision to increase redevelopment, because you were seeing some preferences by your residents for higher price point, and more -- higher level of finish on apartments. Is that causing you to think that maybe incrementally A's are going to do slightly better than B's in this recovery, as a result of the changing preference.

Karin, that's a good question. I think that typically, given price sensitivity, A's and B's compressed, as price sensitivity increased which we certainly saw to the extent I've never seen before in my career in 2008, that compression occur. And so as things uncompress, I think you can expect A's to outperform B's for that period of time. I don't think that changes the long-term growth rate of an A versus a B. I want to be clear on that point. I think sub-markets are more important than product quality as it relates to long-term growth rate, but I think you could see some uncoupling of A and B rents, given a better economic scenario.

Over the short term, got it.

Over short term.

Okay. And then second question is, can you just tell us where rent is as a percentage of income today? And have you ever historically, when rents have started to push significant higher quickly like they are today, have you ever seen any time in the past when California or any of your municipalities have put into place any type of regulatory restrictions on raising rents?

I'll let John Lopez handle your first question, but I'll go to the second one. We do see, to the extent you have a housing shortage, and to the extent that the landlords are not vigilant with respect to renewal rate increases, I think that you will see some political backlash from that. And so I know in prior cycles, in the 1997 to 2000 period rents, market rents up about 40%. And we were limiting our renewal rent increases to about 10%. At that level, I don't think that's a problem. To the extent that you have more extreme rent bumps, I think, yes, will you start getting some political backlash, which could include rent control. California as a state, has a statewide vacancy decontrol ordinance, which is really important in the broader scheme of things. But we also have local rent control in a variety of our areas, including San Francisco and Los Angeles. So, John with that, can I ask you to comment on the rent to median income relationship?

Looking at it regionally, up in the northwest, Seattle, it's around 16.5% right now, and it runs about 18%. So we still have a significant gap there. In northern California, it varies quite a bit between maybe 17% or 18% up to 20%, 21%. Oakland, San Francisco, and San Jose somewhere in between. We still have the biggest gap, we have is in Silicon Valley. We're getting close to that measure in San Francisco, the long run average, but we typically run about 18, 19 in Silicon Valley. We're 17 now, so we still after pretty good gap there. In southern California the overall average is 20% historically, and we're at about 18 to 19 across the market. So we still got a little bit of ways to run. So the biggest gaps would be in LA, Silicon Valley, and Seattle.

That's very helpful, thank you.

Thank you.

The next question is from Paula Poskon with Robert W. Baird. Please go ahead with your question.

Thanks very much. Mike, I know your guidance for dispositions a few months ago was $0 million to $150 million. Any further thoughts as you're -- we're heading further into the year, and are you actively marketing anything right now?

Paula, we are about to market a couple of transactions. And -- but we're also mindful of trying to make sure that we minimize dilution from those sales. And so we're going to look for a pretty big price on some of these transactions that we are going to market. And if we don't sell them, it's not going to bother us. We're going wait, and we're going to pick our -- pick the timing right, make sure that we minimize that dilution. So, yes, we're working on it. And I don't know if we do sell property, additional property this year, it's going to be more back half of the year weighted, so probably isn't going to have a huge impact on the numbers.

Okay, that's helpful. Thank you. And then just two small questions for Mike Dance. Among the 2011 debt maturities that have extension options, is it your intention to exercise those?

The only one that we're really looking at would be, [Freddy] has the ability to reprice in December of this year, their facility to us, the secured facility, and depending on that pricing, we will have the ability to repay that. So that's probably the only major one that will occur this year that we have in our plans.

And the construction ones on the JV's?

We already paid off the [Jewel] construction loan. The other ones are in the funds, so that's a separate decision, and we're in the process of evaluating alternatives there.

Great, and just lastly, on the forward starting swaps, I think you had spoken previously about expecting to settle $20 million in the first quarter. The description in the press release, is that the same, or was that something different?

That's the same, so we're done. They're all gone.

Thank you very much.

The next question is from Michael Salinsky with RBC Capital Markets. Please go ahead with your question.

Hi, good afternoon, guys. Mike, I think you touched upon a $90 million to $100 million acquisition, that's under contract. Can you just give us a little bit more color on that one, as well as just curious to get your thoughts on Fund three at this point, if that's still something that's on the table.

Yes, I don't want to go into too much detail with respect to the acquisition. It's in southern California. It's supposed to close today, so I don't want to jinx myself in terms of that. So in contract continues to move just a little bit higher cap rate, but the market is not dead center where we would otherwise like to be. So we're constant working through the trade offs between cap rate and growth rate and location and those types of things. So I think that's, perhaps enough said on that topic. And I'm sorry, what was the other part of the question?

And if Fund three is still on the radar screen for 2011?

we've entered into an agreement with a state pension fund to essential acquire some assets in a joint venture type of mode. And just to be clear, when we use joint venture, we're not forming joint ventures with the purpose of leveraging up. We are trying to essentially get paid for what we do on the real-estate side, and then participate together or a little bit better than our partner on the potential returns from the property. So that's what we're trying to accomplish there. It's likely that the assets that we're acquiring today will go into that venture, and that venture could lead to Fund three at some point in time.

That's helpful. Second question relates to the difference between acquisitions and development. In terms of underwriting, I know you touched on the cap rate, but in terms of an unlevered IRR, what spread do you need for a development, and just given your supply -- given your supply -- your comments on supply at this point? What risk premium do you need on that?

We're underwriting levered IRRs on acquisitions in the 14 to 15 range. And the IRRs on developments are, again levered, are in the 18% to 20% high teen, 20% range.

Okay. And those are seven-year or ten-year?

Those are seven-year.

And are you factoring in recession into that seven-year?

No.

Thank you.

And the next question is from Andrew McCulloch with Green Street Advisors. Please go ahead with your question.

And Michael, when you talk about 30% potential rent growth over the next five years, how do you think about it? And how would you model what the growth in operating expenses may look like over that time period?

We assume that we're going get some ramp-up in operating expenses. We think it will average somewhere around 3%. And remember, a big component of our operating expenses are property taxes, and Prop 13 locks them in at a plus -- maximum of plus 2%. So wages can grow a little bit faster, and wages are a very unique thing, because we still have a relatively high unemployment rate, although construction workers generally don't make good leasing agents. So you have a little bit of a mismatch between where they are.

Still, I think you will see normal conditions, or at least that's what appears --what we see at this point in time with respect to labor, which could mean 3% to 4% type of increases there. The only category of expense that I think we're very concerned about is utilities, which I believe we budgeted around, Erik, 6% this year? And we're within that range, but the utility number is the one that we're most concerned about. Otherwise, I think operating expenses in the 3% range, we think are pretty achievable for the next several years.

Great. And then just on acquisitions, I think Keith had mentioned in the past there were small portfolio -- portfolios floating around in your market, call it 2,000 to 4,000 units that could be potential acquisition targets. Can you talk to that at all?

There are several of those portfolios out there. And we are talking to some people about a few of them. Still, expectations of what they're worth, and given -- versus what we have a portfolio, obviously, and we're concerned about this relativity between our portfolio expressed on a per share basis, than what we might give up in terms OP units or DownREIT units to acquire a portfolio. That is a very critical and important relationship for us. And so we've struggled to cut a deal on those transactions. We continue to try.

The nice thing is, the syndicators and a lot of the owners of property from the 1980s which were doctors, lawyers, syndicators, et cetera, are now at a point in their lives where they really don't want to deal with the headaches of multi-family, which I assure you are fairly substantial, and only get worse every year. So for which is -- lucky for me is Erik's job now. (Laughter). So those transactions, and as people get into the point in their life where they don't want to operate properties, or deal with some of the challenges of this business, legal issues, that type of thing, we think that there will be -- we're a natural home for some of them. And again, we're working on it. That is part of Keith's role. Keith is again, roughly three days a week, and using his gray hair to get in front of some of the larger owners on the West coast is something that we think is a good use of his time, and will be productive at some point.

Great. Thanks a lot.

Thank you.

There are no further questions in queue. I would like to turn the call back over to management for closing remarks.

Thank you. And just in closing, just comment that we're pleased with the progress during the quarter, and believe that the outlook remains very strong. We're also very confident that the long-term rental growth rates for the West coast markets will be among the best in the country. Thank you for joining us on the call today. We appreciate your interest in the Company, and we look forward to hearing from you on next quarter's call. Thanks again.

This concludes the teleconference. You may disconnect your lines. Thank you for your participation.