Essex Property Trust Inc (ESS) 2013 Q2 法說會逐字稿

Greetings, and welcome to the Essex Property Trust Inc. second quarter 2013 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.

Statements made on this conference call regarding expected operating results and other future events are forward-looking statements that involve risks and uncertainties. Forward-looking statements are made based on current expectations, assumptions, and beliefs, as well as information available to the Company at this time. A number of factors could cause actual results to differ materially from those anticipated. Further information about these risks can be found in the Company's filings with the SEC.

It is now my pleasure to introduce your host Mr. Michael Schall, President and Chief Executive Officer for Essex Property Trust. Thank you Mr. Schall, you may begin.

Thank you Christian.

Welcome to our second quarter earnings call. As usual, Erik Alexander and Mike Dance will follow me with comments on operations and finance respectively, John Eudy and John Burkart are available for Q&A. I'll cover two topics on the call. First, second quarter results and commentary. And second, cap rates and investment markets.

So on to the first topic. Yesterday, we reported another strong quarter, with core FFO per share of $1.88, an increase of nearly 13% over the prior year and above the high end of the guidance range that was presented on our last earnings call. Operations were better than expected in the second quarter, which includes the results of our peak leasing season, leading us to increase the mid point of the core FFO guidance range by $0.03 per share. Mike Dance will discuss the guidance range further in a few minutes.

Rents in the Essex portfolio are now approximately 10% higher than in the third quarter of 2008, which approximates the prior peak in rents, and 29% above the trough in rents experienced amid the great recession in Q4 2009. Our review of economic data suggests a continuation of the strong housing markets on the West Coast, with rents in the Essex sub-markets expected to grow at an average of between 4% to 6% in 2014 and 2015, absent significant change in the US economy.

Factors supporting this expectation include number one, loss to lease was approximately 6% of scheduled rent at June 30th. Number two, personal income growth is well above the national average in the West Coast markets. The national average personal income growth is 2.3%, compared to Seattle at 3.8%, Northern California at 4%, and Southern California at approximately 3%.

Number three, given strong personal income growth, rent to median income, a proxy for rental affordability remains at sustainable levels. And number four, with the exception of Seattle, production of for sale housing continues at a muted level, and for sale housing is becoming less affordable given rapid increases in housing values, and increasing interest rates. Limited for sale construction mutes the impact of higher levels of apartment development. Overall, we continue to believe that household formation will be significantly greater than the total of for sale and rental housing deliveries.

Economic data remained strong during the second quarter, supporting our expectation for a continued favorable apartment environment. Beyond the data, there is a certain vibrancy and confidence in the West Coast markets, especially Northern California and Seattle. As usual, we have summarized our 2013 forecast of residential supply, jobs, and market growth on page F16 of the supplement. We lowered the job growth projections for Los Angeles, because June was weaker than expected, mostly due to the loss of 24,000 jobs in the entertainment industry.

Although jobs in the entertainment industry are often volatile, this decline is unusually large. Several firms, including Walt Disney and Dreamworks Animation, have reduced staff ahead of the normal industry seasonality. As a result, our estimated market rent growth for Los Angeles on page F16, was reduced from 6.5% to 6%. However, this does not change our conclusion that Southern California will continue its gradual recovery.

On to my second topic, which is cap rates and investment markets. The investments markets are adjusting to higher interest rates, and better than expected apartment fundamentals. Although apartment transactions are only down about 10% from last year, there are fewer properties on the market that meet our criteria. We guided to $400 million in acquisitions in 2013, and have closed $290 million thus far this year. We remain on track to hit or possibly exceed the guidance with respect to acquisitions. We've also been an active seller, given the previously announced liquidation of Fund II, and the potential sale of three portfolio properties.

From our recent transaction experience, we draw the following conclusions. Number one, cap rates for institutional quality property in A quality locations have not changed significantly, and remain in the low 4% range. The combination of scarce availability of these properties and significant institutional apartment demand have held pricing constant. Second, for smaller properties and lesser locations, which often involve an individual or group of smaller buyers, cap rates have increased about 10 to 25 basis points through approximately 5% for B quality property and B quality locations. Buyers are pushing back citing higher financing costs, which are countered by sellers pointed to better economic conditions that will results in stronger rent growth going forward.

And then third, in the case of Fannie Mae, increased interest rates had been accompanied by higher spreads. A ten year Fannie Mae loan at 65% loan-to-value, is now priced at around 4.75%, which is about 75 basis points lower than in 2007, but up from about 3.3% earlier this year. Shorter terms, Freddie Mac and swap bank loans are generally more competitive financing options. And number four, our overall expectation for the next six months is for transaction volumes to remain at essentially muted levels.

On the development side, we believe that the supply of apartments will peak in 2014 to 2015, an approximate 10% increase in construction costs over the past year, higher interest rates, and overall conservative underwriting by construction lenders will continue to slow the number of apartments that are started. We're beginning to see a few lower density condo developments in San Francisco for the first time since the great recession. We expect more condo activity if the median priced home continues to increase rapidly. The median home price increased year-over-year by 13% in Seattle, and from 20% to 35% in Coastal California. The combination of strong market price increases and higher mortgage rates makes the transition from renting to home ownership more difficult, which benefits apartments.

And that concludes my comments, and thank you for joining the call. I'll now turn the call over to Erik.

Okay. Thank you Mike.

Property operations turned in another solid quarter highlighted by continued strength in Seattle and Northern California. And while Southern California has yet to accelerate the way that we had hoped for, the region does continue to deliver improving results, and we remain optimistic about future growth. Leasing activity during the period continued to strengthen following a good first quarter.

Average new lease rates continued to post new highs for Essex, and on a portfolio-wide basis, reached $1,756 in July. Renewal activity was also strong and slightly ahead of expectations. For the quarter, renewal rates grew 5.2% over expiring rates, and were 5.7% higher in July. This compares favorably with last July when renewals were 5.2%. We expect August and September renewals to be in the mid-5% range, given the offers extended to residents, which include our voluntary 10% cap on rent increases for existing residents.

Even at these higher rental rates, turnover remains in line with our plan for the year. Portfolio occupancy ended lower for the quarter compared to last year, as we took advantage of economic of rent growth and increased our profitable redevelopment activity. For context, our portfolio occupancy was actually 10 basis points higher this quarter compared to the second quarter of 2012 when you net out the renovation activity for both periods.

Even in Southern California where rent growth isn't as strong as the rest of the portfolio, we saw increases in scheduled rent, and took advantage of renovation opportunities at several properties in the region. We believe the modest reduction in occupancy is a worthwhile trade-off for higher scheduled rent in the second half of the year, and will continue to reward us in 2014.

Following our pre-leasing efforts, we opened Phase I of the Epic development on June 21st and are off to a very impressive start. During the six weeks since opening, we have leased 145 apartment homes, and already have 83 of those units occupied. We expect to stabilize Phase I in October, and deliver the second phase by November. Rent levels are near pro forma, with concessions ranging from two to six weeks. We are well ahead of our absorption schedule.

Beyond our own success, we are very pleased that competitors are also enjoying strong absorption. In fact, our research provider reported that average absorption in the sub-market for the five active lease-up projects was a whopping 60 units per property per month during the second quarter. So while this pace is not likely to continue, demand is more than sufficient to absorb the 30 to 35 units we need each month to execute our plan at Essex. Therefore, we believe this robust leasing activity supports the strong fundamentals in San Jose, and gives us reason to continue to be bullish on the region.

We also began pre-leasing efforts at Connolly Station in Dublin at the end of the quarter, and are looking for to receiving our certificate of occupancy later this month. We've leased a dozen apartment homes sight unseen, and we'll begin conducting our first model tours this week. With an interest list of more than 500 people, we hope to achieve absorption ahead of plan at this project, as well.

Now I'll share some highlights for each region beginning with Seattle. Seattle continues to perform above our expectations. Rent growth continued to be strong in all sub-markets, and the 12 active lease-up projects in downtown averaged 26 units per building per month for the second quarter. Strong rent growth has also extended to the south end of the region, with actual achieved rents growing by 7% since the beginning of the year. Employment growth remained strong in the region, with a year-over-year increase of 2.4%, and year-to-date commercial office absorption totaled 1.9 million square feet, and overall vacancy is hovering around 13%.

Of note, Vulcan announced last month that it will begin construction on Phases VII and VIII of Amazon's headquarters, adding over 600,000 square feet to their South Lake Union location. Once all the projects under construction are completed, Amazon could occupy more than 7 million square feet in downtown Seattle. While Amazon is clearly one of the most important employers in the Metro, Disney, Expedia, and Zulilly all announced expansions during the quarter, as well.

Moving to Northern California, as expected Northern California continues to lead the way for Essex, with the highest growth in rental rates and revenue for the portfolio. In fact, new lease transactions in the division have averaged over $2,000 for three months in a row. Consistent with rising rents, the median price of a home in San Francisco has now topped $1 million, with condominiums not far behind at $850,000. Equally impressive is the fact that inventory for sale product is a mere one month. June's year-over-year job growth was over 2.2%, lead by San Jose sub market at 2.7% growth.

Office absorption in the region was modest during the quarter leasing just over 400,000 square feet. However, Facebook and Samsung have both broken ground on more than 1 million square feet of development for their Companies, and Netflix received approval for their 500,000 square-foot project in Los Gatos.

Turning to Southern California, rent growth continues to be steady in the region. Average new rents have increased every month since January, and renewals reached 4.4% in July, the highest rate of increase in two years. Additionally, renovated apartments like our project Highridge in Palos Verdes, are achieving average rent gains of $400 yielding 15% returns on our costs. We will continue to take advantage of these opportunities, and still see Los Angeles and Orange County as our top markets in Southern California this year. Overall job growth in June slowed in Los Angeles, but Orange County, San Diego, and Ventura met our growth expectations.

In San Diego, we are keeping an eye on the potential impact of sequestration. The positive impact is that troop deployments have been delayed, keeping servicemen and women home longer. However, roughly 25,000 of the civilian workers at the Defense Department were furloughed in July. This budget reduction measure is scheduled through September, but could be extended.

Office absorption in Southern California was positive in all counties for the quarter, and totaled 1.1 million square feet. But results in Los Angeles are still negative from a year-to-date perspective. However, the most significant commercial news coming out of the region for the quarter is the fact that Mercedes-Benz signed a 1.1 million square foot industrial lease in Long Beach. Combined with Boeing's transfer of 300 to 400 engineering jobs in the second half of this year to the Long Beach facility, Boondocks' headquarters project, a port expansion and other large projects in the region, we still believe Southern California is poised for more meaningful growth in the coming quarters.

The majority of the economic indicators and leasing metrics are positive, and signify continued revenue growth for us. Therefore, we remain confident in all of our markets and our ability to deliver results consistent with our increased guidance for 2013.

I thank you for your time. I'll now turn the call over to Mike Dance.

Thanks Erik.

Today, I'll provide commentary on our second-quarter results, and changes to the full year guidance, as well as an update on a select balance sheet item. This quarter's operating results for revenues and expenses outperformed our guidance. These results are consistent with the first quarter, in which results surpassed expectations. As such, we are raising our same property revenue forecast 20 basis points at the midpoint to 6%, and same property NOI growth of 20 basis points to 7.2%.

Our expense growth remains unchanged at 3% to 4%. Expense growth in the first six months of the year was 4.8%, slightly better than our expectation. Expense growth in the second half of the year should be below the full-year guidance range, since the comparative period in 2012 is more reflective of our operating expense run rate for our portfolio.

Of note is that the State of California is on a June 30 fiscal year and we received Proposition 8 reassessments that are effective as of July 1 late in the third quarter. For the year-to-date expense results Northern California taxes are up almost 5% over the prior period of 2012, due to the significant Prop 8 adjustments which were effective July 1, 2012. The expense guidance for '13 assumes another $500,000 increase in property taxes in California from property assessments returning to their higher proposition '13 assessed values.

I'd also like to point out that the lowering of the high end of the range for revenue on NOI guidance is due in part to the success we are achieving with our interior renovations. This year, we are planning on renovating between 1,200 and 1,400 apartment homes which are achieving impressive returns. However, these renovations take approximately 30 days, during which time these apartments are not available for rent. Accordingly, any renovations begun after July will not be able to generate enough incremental revenues in '13 to offset the additional vacancy.

Our second half of the year guidance assumes we continue these interior renovations through the fourth quarter, which is expected to increase in '13 rehab vacancy by about 20 basis points for the second half of the year compared to the same period in '12.

As previously reported, last year we began liquidating Fund II which terminates in September '14. To date, three properties remain which are in the midst of being marketed, and we anticipate selling them within the next three to six months. Depending on the timing of these dispositions, we expect to receive promote income of approximately $4 million after all three remaining properties sell.

From an accounting perspective, the Fund II promote income is not recognizable until the last asset in the Fund is sold. Accordingly, if any of the Fund II asset sales occur in '14, the '13 total FFO will be at the lower end of the guidance shown on S14. Postponing the promote income from Fund II into '14 will have a favorable impact on our core FFO guidance, which assumes all of the co-investment income from the Fund II assets will cease on September '13.

We are raising the midpoint of our core FFO per diluted share by $0.03 to $7.58. The increase is related to higher same property net operating income of $0.06 per share, which is partially offset by $0.02 of lower interest income from the preferred equity investment that was repaid and not part of the guidance, and $0.01 of dilution from the disposition of Fund II assets we sold earlier than the September 30th disposition date assumed in our original '13 guidance.

On the balance sheet, the notes and other receivables at June 30th stood at $110 million, an increase of nearly $100 million from the first quarter. This increase was the result of advancing our co-investment partnership's funds which were secured by real property at terms comparable to secured bank loans. In July, Fund II repaid $45 million with proceeds from dispositions, and loans totaling $57 million to the West Coast three joint venture, which are secured by recent acquisitions of Regency and Gas Company Lofts, won't be repaid this month with the proceeds from the permanent secured financings.

That ends my comments, and I will now turn the call back over to the operator for questions.

Thank you. We will now be conducting our question-and-answer session.

(Operator Instructions)

Nick Joseph with Citigroup.

Great, thanks. This is Michael Billerman here with Nick. Mike, I just had a question for you and it's hypothetical. If an investor was agitating for change at another Company, and they had capital sources backing them and you were such a capital source, would you want to stay silent in that or would you be public?

Michael, I love you.

It's not even Valentine's Day.

It's very good question, and I think I understand the context. However it's hypothetical, and every situation is different. So let me just start by making a broader comment, which is as a general statement, I believe it is counterproductive to discuss strategic activities on the call. It leads to, I think, a lot of possible unintended outcomes. In this case, I'm going to make just one brief statement, and then decline further questions.

And so that statement is as follows. We are not involved in any way, including any related discussions with the July 31st letter from Lanham Buildings to BRE, nor will be involved in the offer referenced in the letter. So, hopefully that will take care of it. Again Michael, I think every situation is different, and there are pros and cons in terms of how these things are viewed strategically and how they play out. And there's great uncertainty as well with respect to what happens because we can't see more than a couple steps ahead. So, I think I'll just leave it at that and not comment on this any further. As you may have noticed, we had a great quarter, and hopefully we can get some questions about the Company and recent activity.

All right. So I won't ask about $8 million increase in marketable securities and whether that was BRE. We'll leave that aside. I'll let Nick ask a really good question about the Company.

Thanks. No pressure, I guess. You were able to buy condos that were trading at pretty large discounts to replacement costs and then convert them to rentals. So now that you've seen a larger cover in the asset prices, what are your thoughts for those assets longer-term?

Nick, it remains the same as it was before. We thought that there was a great opportunity to buy condos at apartment prices, something that I've not seen in my career. And I've been here I think it's 28 years or something like that. And so it was a very unusual opportunity. And so now we're starting to see the median price home increase relatively dramatically, and we are tracking the differential between condo values and apartment values. As a general statement right now, they're close to parity, and that includes not only the condos that we bought in the 2009 to 2011 period, but almost everything we're building now has a condo map as well. So we've got virtually our entire development pipeline that has condo maps as well. So we're tracking it, at this point time we don't see a big premium. The one market they're starting to be very close is San Francisco. But with apartments trading at very attractive cap rates, we don't see a large arbitrage even in that market at this point in time.

Great, thanks.

Thank you.

David Toti with Cantor Fitzgerald.

Hello guys. I was wondering if you guys are potentially bidding on the Empire State building as well?

Wow, you're going to make me go back to my comment about counterproductive to discuss strategic items. Well I think I can deny that one out right as well.

Okay, okay. I just have a couple of detailed questions. On the CapEx spending for the Gas Company and Regency, what kind of return do you underwrite on that sort of $20 million-ish?

Well in this case, there's a number of different things and I don't remember specifically what it is. In general, revenue generating CapEx is underwriting to somewhere around in the 13% to 15% range, but that's if you exclude deferred maintenance, which inevitably is part of the CapEx spend. And in this case, I think it's similar. All the deferred maintenance gets included in that number as well. So it's probably somewhere in the 8% to 8% plus or minus range, which is not dissimilar from our general approach to renovating apartments.

Okay. And then I just wanted --

It's in the cap rate too. We underwrite it as part of the cap rate. And in the case of Gas Company Lofts, there are some other opportunities like the potentially rooftop deck and some other things that we think. It's under an under-amenitized building, and so we think there's some real value in a couple of things, but I don't have the details exactly which pieces account for what. But as a general statement it follows our overall approach to redevelopment, which is in that 8% to 10% on everything which includes some deferred maintenance fees.

Okay. That's helpful. And then, I just want to go back to the topic of housing affordability. Because it feels to me like we're sort of replaying the scenario that we saw let's say I don't know ten years ago where the affordability gaps really sort of widened out pretty quickly. Except at that time we had a lot of -- you saw a lot of people moving out to purchase homes. This is a little bit different. So would you say that you have significantly more pricing power today because of the inability of your tenants to purchase homes? And, is there a flip side risk to really sparking churn just for people moving out because of pricing? How do you sort of do you think about that dynamic?

Well, maybe I'll start with some comments on rent to median income. In San Francisco, in that period of time you're referring to, the late '90s and 2000, 2001, our rent to median income was above 30% in San Francisco, it's about 25% currently, and that's the highest in the Essex portfolio. And so, we don't think it's at the same level that you saw in that period of time, the dot com boom and over that period. Now rents went up 40% in two to three years during that period of time, so we really haven't seen that kind of rent growth, and then of course it came right back down.

So, I don't think it's the same as that period of time. And I think that as I said on the call that the rent to median incomes in general look like they're in the band of plus or minus 10% from the long-term historical averages, so we don't see that as much of a problem at this point in time. And then finally, the relationship between what's happening with personal income growth, which hopefully will become household incomes, when you're growing those numbers in the 3% to 4% range which we are, and a little bit more in some of the sub-markets, it's not going to push that rent to median income ratio that quickly. And therefore, I see more sustainability there as well.

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

Thanks.

David Harris, Imperial Capital.

Okay, hi everybody. Let me ask the question of you Mike that I asked David Simon on his call a little earlier in the week. Let's assume over the next three to five years we are in a rising rate environment. Today you're allocating capital with the hope that some of that capital will produce nice returns over that timeframe. You're making decisions actually today in that context. What do you think you might be doing differently if we suppose that perhaps we go to a more normalized longer-term rate environment?

David, yes. Good question. It's a question that is being debated by our Board. But I think we've taken several steps toward answering that, and the primary step is to extend maturities, in effect lock in very favorable rates for as long as we can. And the significance of that is that, that allows us time to transition from the market that we're in into markets that may be not as favorable as the current one.

I would also say or suggest that if that happens, if interest rates go up, we would certainly hope that we would have a more positive economic backdrop in terms of higher GDP growth rates, higher job growth, and less unemployment. And so I'm not sure that even increasing interest rates at some not too extreme level would be beneficial net-net for the Company. But I think in terms of our planning, it really leads to longer maturities and less debt ultimately. And I think you've started to see over the last couple of years us move in that direction. Our last bond was a ten year deal, and we're going to try to focus on that going forward, which again provides plenty of opportunity to transition into a different type of market.

But would you be more cautious today about underwriting a development than you would've been three months ago, say or two months ago before we saw the move in long-term rates?

Yes, I think I've made comments on the prior calls that in general, we're going to try to hit the bottom end of the cycle very aggressively on the development side and then tail off as we get into mid-cycle. And clearly, I think that we've done that as well. And so development is something that we're essentially committing to a cap rate today, and matching it with funds that we're going to generate or raise a couple years down the road. And so, we want to make sure that we have plenty of room for markets to change in that case as well.

We announced in the quarter the downtown San Jose One South market development deal, which we're very excited about. And it's interesting that some people look at downtown San Jose and say that's the less desirable area. From our perspective, we see this movement toward urbanization really and throughout the United States but certainly here on the West Coast as being something that's important to us. And we think that the right urban hubs are going to generate higher rents ultimately. And so we look at it much like we did Los Angeles, downtown Los Angeles where in the worst-case scenario it kind of continues down the same path, which is the market performed in a scenario where it transitions to something more like a 24-hour city certainly as LA has. It becomes much more exciting than that. And so that was the thought process behind One South Market.

Okay. And then finally a question on the ATM, there was no issuance in the second quarter.

That's correct.

Okay. And just remind me; I know we've discussed this numerous times before is you're kind of hovering around where my NAV is. It may be below yours or whatever, but generally speaking, you would be -- unless you've got specific use of proceeds or we're trading at or above your estimate of NAV you wouldn't be using the ATM?

We had only used it to match fund investments that are accretive to NAV per share to improve the gross rate of the portfolio and improve the cash flows of the Company. So we are not going to be issuing equities there on cash.

And you'd be very sensitive to the stock price relative to your own estimate of NAV?

Yes. In the situation you described, when NAV drops below or the share price drops below NAV, we're much more likely to want to do our external growth with joint venture partners. And we have a platform that is very successful at changing to that platform at times so that we're issuing less equity and typically using more leverage and a joint venture partner's equity as well.

And no share buyback program in place at the moment?

That is correct.

Okay, great. Thank you.

Rob Stevenson with Macquarie.

Thanks. Good afternoon guys. Can you talk a little bit about the San Jose and Seattle markets in terms of supply and what you're seeing there, and what's sort of broken ground over the last couple of quarters and what you guys think is likely to break ground over the remainder of '13?

Sure. I made the general comment that we expect deliveries to peak in '14 and '15, and it's interesting. I think someone has the planned units in one of our vendor data, which appears to be pretty substantial. But, and John Eudy's here, and so he's dealing with this on a daily basis. And so even though there's a lot of planned units out there and this is part of my comments, a lot of those are having trouble. A lot of those development deals are struggling to become financed, and so even though there's a lot of planned deals out there and we still see a drop-off, not dramatic, into the '14, '15 period. In Seattle, I think we have about the same amount of multi-family supply in '14 as in '13. So, and then it drops off in '15, I don't have that number right in front of me. In San Jose, because of the five development deals in North San Jose that were all approved by the city at the same time, we think that North San Jose sub-market essentially those transactions, which I think was about 3,000 units, John?

Yes, 3,500.

Get delivered, 3,500 units get delivered and then it drops off very significantly in that sub-market. And -- but I think that the move will be toward about a 20% reduction in '14 and '15 in Northern California, and then Southern California we just don't see supplies being a huge issue there. And again, we see Southern California essentially staying at a very muted level for the next several years. Although there are some pockets where supply can be an issue, so I'm making a broader statement even though within a local pocket there could be some issue and Woodland Hills comes to mind. The Warner Center area has a couple of lease ups that are essentially changing, and then San Diego has something similar. But, so that's the multi-family side.

On the single-family side, again Seattle continuing to produce pretty significant amounts of single-family for-sale housing, but muted throughout the rest of the West Coast. And the discussion I just had about condos and the relationship between apartment values and condo values and the absence of a premium on that condo values side is I think what is the limiting factor when it comes to the for-sale development. Again, I mentioned it was somewhere in the 20% to 35% median household or median priced home growth. Obviously if that happens again, then I think you're going to start seeing condo development, because that will create that premium that we're referring to that is necessary for condo development.

And John, I just asked John this question yesterday. And again, he can comment if he wants to. To what extent are you seeing condos compete with our apartment sites? And, his answer was just on a very limited basis, but we're really not seeing any -- some lower density types of transactions. In San Francisco, they're being built as condos. But we're not seeing that strong competition for our apartment sites by the condo developers. We view that as a good thing. So, I think that there's a number of factors that are causing this limitation in supply, and we don't see it changing or we don't see it certainly going against us over the next couple years.

And how much has material and labor changed between the Emeryville and the San Mateo development starts about a year ago and One South Market this year?

This is John Eudy. On a percentage basis is that the --

Yes. Just a feel for in addition to interest rates moving up and land costs moving up what's the change in construction costs?

To reference what Mike indicated, around 10%. Both of those starts were last August I believe, and then obviously we just announced the San Jose deal, and if you were to mark it to market, in that 10% range plus or minus.

Okay. And then just lastly, what are you guys currently expecting from a stabilized yield on the current development pipeline?

We have not really changed our underwriting standards, so we're -- on measured -- on stabilization somewhere in the 6.5% range, again dependent upon market rent growths, and underwritten today based on rents in place today, some more in the mid 5%s.

Okay. Thanks guys.

Thanks.

Alexander Goldfarb with Sandler O'Neill.

Good morning, good morning out there.

Hello Alex.

Hello. It didn't take long for the accounting questions to come up. Just --

Expected.

Yes. But listen, at least you guys talk about it which is good. Just a few questions for Mr. Dance. Mike, you went over the California property tax. In the same-store, Seattle looked to be up strong year-to-date on property tax, like 23%. Can you just provide a little more color on what's going on in Seattle?

Well Seattle, they tend to do this every two or three years, so some of this is a catch-up from prior years. And we're appealing them, but until we're successful on the appeal, we pay the property taxes and accrue them accordingly. I think one thing to note, our accounting policy may differ from some of our peers, in that when we do have an appeal that relates to prior years we run that through a non same-store so we don't get the lumpiness in our NOI results. So basically, Seattle has a cap on what they can raise in the revenue in any one year. So what that means is apartments have recovered before the other real estate sectors, so we're taking the brunt of it this year. We would expect over time, Seattle would see recovery in the industrial and office space and we would just be paying our fair share rather than more than our fair share of property taxes in King County.

Okay. So basically you guys are the one percenters up there?

It seems like it. Alex we were surprised as well, because we had assumed that -- we knew we had big valuation increases, but we were surprised at the increase in the millage rate in Seattle. And yes, 20%-something increase in property tax is a tough hit.

Okay. Next is, if we look at your rent growth this year, San Mateo has been the strongest and it's been outpacing San Francisco. Yet, when you go out to San Francisco you see a lot of the surge of people who want to live in San Francisco. They bus down to the Peninsula, so sort of curious why San Francisco is lagging rent growth versus San Mateo. Is that rent control policy? Or is there some other dynamic going on there?

Yes, I think it's part rent control policy. And then on the total rent side, our cap plays into that on the non rent control building.

Okay. And then -- I'm sorry? And then just finally, on the condo side you mentioned that condos are sort of coming back in San Francisco. Given that the biggest threat to rental apartments is really condos, not for-sale homes, do you guys foresee that there is potentially an issue where rents have gone up meaningfully where people say I can still live in the same infill urban neighborhood, but instead of renting I can now own and try and keep money rather than throwing money away every month? Do you see that as a potential threat in San Francisco?

Well we see any housing development as a threat. We believe that -- we take on the one hand household formation, on the other hand, total number of units that are being built, whether they're condos or single-family or apartments. And we try to look for where the greatest imbalance is. And the other piece of it is that we are located in areas with very expensive for-sale housing, and in San Francisco I think the median price home is somewhere -- the median price condo is about $850,000. And therefore, that transition from an apartment renter to a homeowner is just not an easy one. Especially on the condo side, you certainly have monthly dues that are pretty significant which take away some of that perceived benefit that you're talking about given low interest rates.

Okay, thank you.

Nick [Walicka] with UBS.

Thanks. I just had a question on the Peninsula, San Jose. If you look at that mark and you look at your rent stats for your renter profile, and you talk about some of the new development and the absorption there. I'm curious if you could -- if you had any stats or commentary on how much of the demand over the past year or so has been from people within the area moving there, or whether they got a job transfer within the Bay Area to that market versus say new entrants to the entire area who got a job from out-of-state perhaps?

Yes, this is Erik. I don't have the breakdown of people coming in and out. I would tell you that anecdotally, I can get back to you that. But anecdotally, both Seattle and the Bay Area definitely includes people that are relocating out of the area whether they're going to work for Google or Amazon, what have you. But that's definitely a piece of the demand. But more of it is related to the folks that already live in the region.

Okay. And then I guess just a follow-up on that would be if you look at that then, how does that affect an area like the East Bay, which presumably I don't think has had as strong job growth? Maybe some people have moved from the East Bay to the Peninsula for jobs. Longer-term, how do you guys think about the East Bay in relation to San Francisco or the Peninsula?

Yes, this is Mike. I think that it's -- the rental pool is very dynamic, and depending upon who you are within the rental pool, you're going to have a set of decisions about where you're going to invest in housing. And so those relationships change every single day. And let's take the world as it is today which is a there's more haves than have-not's in the -- I'd say in the economy that we've had before. Therefore, there's a growing disparity. There are some tech workers that are getting very high increases in compensation, and then there is a group of people that are getting 2% to 4% if they're lucky. And obviously, those two groups are going to react much differently. One of the group, the first group is going to be the renters in the South of Market Street and San Francisco, the very expensive areas, the areas that everyone would desire let's say and would be their first choice in housing and where the greatest demand rests.

However, people that can't afford that have to make another choice. And if we've given them now three 10% rent bumps, that is -- if we give them three, 10% rent bumps to someone that's gotten 2% to 3% composition increases, which I guarantee has happened out there at some level, they're really forced to make another housing decision which is exactly what we would expect to happen. And the East Bay will be a logical place to go, because it's -- there are still very good markets within the East Bay and they're not as expensive as some of the better locations. And so again, I think you have sort of a bifurcation between the people that can afford the best locations and the best properties, and those that cannot. And as rents go higher, there are going to be more and more people that fall into that latter category, and are going to be forced into other locations and other housing decisions.

And I go back to we were talking earlier about the 1999 to 2001 period. Essentially the entire Bay Area, the interesting part was the entire Bay Area was 98% occupied. So with that and with the job growth and demand for housing outstrip the supply by such a large amount, that essentially the whole Bay Area filled up. So, we're not at that point, but we're certainly going down that road.

Okay, thank you.

Dave Bragg with Green Street Advisors.

Thank you. Good morning. Mike Schall, thank you for the color cap rates earlier. I think you're flagging a modest increase for Class B cap rates. But can you provide a little more color on this, including whether or not you think it's broad-based across your footprint or more isolated in one of the regions?

Good question, Dave. I think it's pretty broad-based. And again I think it's driven more by who your buyer is than the category, which I think the institutional quality property is going to be generally focused on the better areas. So no, I think it's actually pretty broad-based. This is within our footprint. And again, we're -- we've got a fair -- a pretty significant amount of property that we've marketed in the last 90 to 180 days. And therefore, it's essentially drawing conclusions from that experience.

Okay, that's helpful. And just a follow up on Los Angeles. A comment made earlier. Do you believe that the significant job losses in the entertainment industry that it's just a seasonal issue, nothing structural?

Again, we think mostly it's seasonal. But again it was bigger than is normally part of that seasonal adjustment. So we're concerned that some part of it is structural, and we're concerned that some part of the entertainment industry goes to another state or another area. We just don't know.

Okay. Thank you.

Richard Anderson with BMO Capital Markets.

Thanks, good morning everybody out there.

Hello Rich.

Apologize if I don't quite understand this, but is it accurate to say that a part of your portfolio qualifies for Prop 8 and part qualifies for Prop 13?

No, it's not accurate. They're both California propositions affecting property taxes. And what happens is, everyone is subject to Prop 13 which locks in -- (multiple speakers)

Yes, that much I know.

Okay, and then, so what happens is, you will create a line for property tax that starts with 1% of assessed value plus a couple add-ons and gross of 2%. If the value of the property goes down in value, you will get a one-time adjustment under Prop 8 --

Okay, got you.

That will give you some relief really from property taxes. And when that recovers, which is what's happening now, you'll go back to the Prop 13 trend line.

I got you. Okay, thank you. Just wanted to make sure I understood those nuances. When you talked about your being 10% above the prior peak rent, which I think you said was the third quarter of '08, is that really -- is that an apples to apples type of comparison? Or, is there more to it than that? Is there a change in the portfolio function that's creating that 10% increase over the prior peak?

No, we're really not. That's what we're trying to do is give you some idea of where we've come from, and so were doing that on essentially a same property type of basis. So there's quite a bit of variation within that, because certain areas are up more than others. But no, it's intended to be same property.

Okay. And then my last question is on the cap rates that you were quoting. Do you factor in the Prop 13 issue and change of control issue when you come up with those numbers, or is that sort of before that?

Always.

Okay.

The buyer always considers Prop 13. If this is going back to a merger context --

Right.

Then you have the Avalon and Bay situation where they merge into Bay to avoid the Prop 13 adjustment on the Bay portfolio. So --

So that really leads to the bigger question for you. And that is do you have an estimate of what Prop 13 does to your net asset value?

We have it on an annual basis to have to follow, and you can follow whatever cap rate you want to it. But it's roughly $30 million.

$30 million? Okay, thank you very --

And Rich, just so you know, for our internal NAV calculation, we make the adjustment.

Okay. And what is that internal NAV analysis?

That is something that we aren't sharing.

Okay, thank you.

Thanks.

Michael Zielinski with RBC Capital Markets.

Good afternoon guys. First question, I think Mike, in your prepared comments I think you mentioned three wholly-owned dispositions. What's the size we're talking there? And as you wrap up Fund II, actively marketing, you're getting a sense of price. What's the IRR you expect on Fund II at this point?

On the dispositions, it's roughly $50 million to $55 million. The IRR really on the dispositions for Fund II ranges from 10% to 15%, that's levered.

And do you have the unlevered IRR by chance?

I do not. We can look up and get back to you on it.

I'd appreciate that. Second of all, just given the move we've seen in interest rates over the last 90 days, are you seeing more opportunities on the preferred equity front? I know that had been kind of reserved for the last couple quarters as rates were very low.

Mike I think it's too early to tell exactly what's going to happen. There's this -- whenever the conditions change in the marketplace, there's this period of time where things just need to settle out. So, I'm not sure that cap rates have settled out, nor am I sure that other opportunities have necessarily presented themselves. We're continuing to look for preferred equity type of transactions, and I think we'll have some success. It's hard to tell whether that's attributable to the rate environment or just other things.

Okay. And finally, Mike a bigger picture question for you. If you look at the supply numbers, they tend to be a bit more urban. One of your peers in terms of adding new development starts talked about focusing a little bit more on the suburban markets. As you look across the portfolio today, given your track record for asset allocation, where do you see the better growth opportunities? Urban has typically out-performed, but it's also facing a decent amount of supply pressure.

I think -- I have two answers. One is long-term, and the other one is short-term. And for the long-term, I would pick the more urban locations. Again, you're having cities that are incentivizing the more urban locations relative to planned transit improvements and other infrastructure, and so there's a whole part of how the West Coast is developing that is going to I think urbanize or continue to urbanize the West Coast. I'll throw out an example. BART is now expanding into San Jose, and well BART has gone as far south as on the east side as Fremont.

And so, that represents really a major accomplishment. And we'll ultimately connect to the Caltrain, which goes back up to San Francisco. So trying to understand where the opportunities are going to be, and where the best growth is, and I think it's going to be urban. Having said that, in the short term because of the phenomena that I was mentioning earlier where people are getting priced out of the best locations, you may see the secondary areas actually outperform the core areas. And we're starting to see that to some extent with respect to the East Bay relative to San Francisco and other areas. Because again, some people are going to get priced out of the better markets, and they're going to find other good still good apartment or homes and other locations that are not considered quite as attractive.

Appreciate the color. Thank you.

Steve Sakwa with ISI Group.

Thanks. Good afternoon or good morning gentlemen.

Hello Steve.

Hello. Mike, if you look out over the next 10 years and you assess the growth in your portfolio, how do think that NOI growth compares to what you've put up the last 15 years, which has been just shy of about 4.5%? Do you think your portfolio grows slower, faster, or kind of about the same?

Wow, that's a great big picture question. I would say about the same. I think you had a period of hyper growth in the '90s, and then you had a decade of fairly tough conditions from 2001 to '11 let's say. So I think if you were going to handicap it, it would be somewhere in that same result, which means that because you have affordability is probably the key consideration, and other housing choices. Those would be the two key considerations. I think that that means that we expect personal income and household incomes to grow at about the same rate, because you can't push it too far. And we expect also that housing scarcity or we're going to continue to essentially not produce enough housing in these markets, pretty consistent with the last 15 years. With the exception of that, the notable exception, of the 2006 to 2008 period where we were producing lots of housing.

Okay. And how have you -- I guess I'm trying to understand you're unlevered IRR hurdles when you're looking at new investments today. One, what is that figure? And two, how has that changed over the last maybe 60, 90, 120 days?

Well, it's interesting because as a fund investor, we are pretty focused on IRR's, and specifically levered IRR's. So we're -- I think most of our acquisitions are in the 8% to 9% unlevered. And if we can find a value add piece that will push us a little higher, all the better, which takes us to about somewhere in the 12% to 13% levered IRR range. On balance sheet, we really don't pay that much attention to IRR's, because it's really -- we're really trying to benchmark improving the Company on a per-share basis. And it's very tied to how we view the stock. And if I go back to Q2, we didn't issue stock, and we used the JV because A, we think we can generate a little bit higher level of return, but B, we just didn't want to issue the stock at that price. So we're really trying to look at whether we can -- how we add value on a per-share basis using the stock or using our co-investment Partnership's.

And then, I guess I'm just trying to tie this. So if class A assets are trading in the low 4%s on presumably Prop 13 adjusted figure, and you can maybe grow cash flow at 4.5% per annum, I guess I'm trying to figure out how you get to an 8% to 9% unlevered. Unless you assume that you exit the transaction at a 4% cap ten years from now. Is that what you'd need to assume? Or --

Well that's -- exactly. I agree with you. But I think ¶ So, hopefully does that help? Does that answer the question? We don't buy 4% cap. The deal is, we can't make them work.

Right. No it does. I appreciate it, thanks.

Thanks.

Paula [Pokson] with Robert W Baird.

Thanks. I just have a local question. You mentioned the BART system earlier Mike, did your employees or your tenants have any significant disruption on the short-lived BART strike earlier in July? And, what's the risk of significant disruption if they strike again?

Good question Paula, I don't know. I don't have the sense that we were significantly effected by the BART strike here, primarily because Palo Alto is on the Peninsula and the Peninsula is not a BART city. It goes as far south as SFO. So the significance is really on the other side of the Bay for Fremont going into downtown San Jose and connecting with the Caltrain that would make it possible to get to Palo Alto from Fremont. But at this point in time, it's not possible. So I think that the impact was muted, and as it relates to the Essex personnel. And I think as a general statement given the congestion on the roads out here, that as a general statement the BART strike makes things a lot more difficult to get to places. So I think as a broader statement, it has a big impact.

Thanks Mike.

Thanks.

(Operator Instructions)

David Harris with Imperial capital.

Hello again. I've got a question about the size of your development program. If I'm doing the math right, it looks like your -- if I add your contribution to the development program and the redevelopment program, it looks like you're about 8% of total enterprise value, and about 12% of equity. Is that just sort of pushing the outer limits of where this program you won't fear you feel comfortable about the size of this program relative to the size of the Company? Or do you think there's still room too for that number to go up?

A couple things, I think the risk associated with the redevelopment program is entirely different. So we do not look at them as being significantly -- we don't view them as being the same. So, we've talked about development in the up to 10% of capital, our share, most of the development is in a co-investment type of vehicle. And, but even with respect to development once we're in the ground with a good contractor and a GMAX type of contract, our risk goes way down at that point in time. We have the capital risk, which is probably our principal risk that we're concerned about, because again development is committing to a cap rate today but not having the certainty of your cost of capital locked down unless you want to pre-fund it, which is expensive. So if that's the key risk that we're focused on, and the closer we get to delivery of existing deals and other things happening, the more willing we are to look at new transactions. So, it's not just simply how much, it's really where are things looking at the transactions individually and trying to make good risk reward decisions as it relates to development.

Okay. So if I knock out the redevelopment, maybe a point less? Sorry?

Redevelopment in my view, since it's so short-term in nature in terms of most of the impact, I don't view it as a we can find it easily off of our line. We only spend $30 million to $40 million a year in total in the redevelopment process. The returns are the highest as it relates to -- again as I said earlier, cash on cash returns on invested dollars is somewhere in the 8% to 10% range net-net. So, we just don't see the risk associated with the redevelopment as being significant, and therefore, we're going to do as much as we can as long as the demand for upgraded units and better amenities and that type of thing are there.

All right. Well let's take the redevelopment out of the equation. Does your Board talk to you about sort of having a limit of as to where they would feel comfortable about the size of the program not in dollar terms but relative to total enterprise value or equity value whichever metric you want to look at?

Yes. No the Board is comfortable with 10% of the enterprise value, which is again that's part -- they're part of the decision.

Okay. And that's their max, is it?

Yes, max.

That's the max. Okay. All right. Thank you.

Thank you.

Hendel St. Just with Morgan Stanley.

Hello there.

Hello Hendel.

So a couple more questions on development. First, we're triangulating to a mid 5% current yield for your new One South Market project, does that sound right? And what's the IRR you're underwriting for that project?

I didn't hear the first part.

Yes, say that again?

I said, I guess we're triangulating to a current midsize yield for your new San Jose project One South Market?

Right, right, right.

Does that sound right, and what's the IRR your underwriting for that project?

Hello, this is John Eudy. The 5.5% is correct. The IRR in the range of 9% unlevered, and the 12%, 13% levered.

Okay, and thanks. And can you also discuss the development opportunities you're seeing today in your core markets, heard from others the challenges on sourcing new deals at [pencil]. Just trying to get a sense as to what you're seeing out there? How you're able to source this particular deal, given the context of the other challenge of these deals be more difficult to source and underwrite.

It is more difficult, and we've said that for the last several quarter. And if you look at our current pipeline, all but one, the One South Market deal were announced basically a year or more ago in 2011 early '12. So you can see the amount of volume has gone down significantly. And the timing of it, we're in the somewhere between second and third base on delivery. So we're not at the late stage of jumping in, we're kind of at the late stage of completing the pipeline. And what we see in general is it's harder and harder to find yields that we like that make sense at pencil, and we think the volume is going to go down over the next several quarters. I don't know that answers your question. But timing wise we were early in, and it's harder and harder to make deals at the current land prices.

One more. I think you guys mentioned earlier on the call that you noticed that certain developers are having trouble lining up financing for some of their deals. Wondering to what degree you'd be interested in stepping in as the source of capital for these developers? And if so, what type of return to type of structures would you seek?

Handel, we actually have considered that and we are looking at a couple of different programs. One is a preferred equity type of program focused on development, and that would be priced in the around 10% type of range. And we've looked at a couple other options, including JVs and even JVs that involved a preferred equity piece. So, we have a number of different approaches to it. But I think the point John was making is that even with those things we're further along in the cycle, and so we are cautious with respect to the development commitments. And I think that that is going to be the way it is for the next couple of years.

All right, gentlemen. Thank you.

Thank you.

Tayo [Okusanya] with Jefferies.

Yes, good afternoon. My question is actually a little bit more broad-based. You've heard some of your peers make kind of very public comments about their views on the single-family for rent business, I'm just kind of curious what you think about that business?

Yes we've made comments on that business as well. We looked at it pretty hard, we've actually and Mr. Eudy led this charge in early '90s where we bought a portfolio of homes as part of the RTC days, and we think it's difficult to execute in a REIT type of format. But there's certainly many be made as house prices go up fairy dramatically. So, in our view, the real question is the discipline question of if there's a opportunity to take a significant gain, will these entities take that gain or will they try to perpetuate something that might be more challenging to execute?

And your viewpoint on it being difficult to have it in a REIT format is based on what challenges you see in the business?

The challenges are having assets scattered in lots of different places, and just the asset management challenge of -- it's really a CapEx and a maintenance and repair type of issue I think from our perspective.

There's also complicated REIT laws about whether real estate is inventory or not. And if you sell too many, the IRS may deem it as inventory and not real estate held for investment.

Got it. Thank you.

Thank you.

Thank you. There are no further questions at this time. I'd like to turn the floor back over to you all for any closing comments and remarks that you may have.

Great, thank you. In closing, we just want to thank you once again for joining the call. We appreciate your interest in the Company, and we look forward to speaking to you next quarter. Thanks again.

Ladies and gentlemen, this does conclude today's conference. You may disconnect your lines at this time, and we thank you all for your participation. Good day.