CubeSmart (CUBE) Q3 2014 Earnings Report, Transcript and Summary

Good morning, and welcome to the CubeSmart Third Quarter 2014 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Charlie Place. Please go ahead.

Thank you, Kate. Hello, everyone. Good morning, and Happy Halloween. Welcome to CubeSmart's Third Quarter 2014 Earnings Call. Participants on today's call include Chris Marr, President and Chief Executive Officer; and Tim Martin, Chief Financial Officer. Our prepared remarks will be followed by a Q&A session. In addition to our earnings release, which was issued yesterday evening, supplemental operating and financial data is available under the Investor Relations section of the company's website at www.cubesmart.com. The company's remarks will include certain forward-looking statements regarding earnings and strategy that involve risks, uncertainties and other factors that may cause the actual results to differ materially from these forward-looking statements. The risks and factors that could cause our actual results to differ materially from forward-looking statements are provided in documents the company furnishes to or files with the Securities and Exchange Commission, specifically the Form 8-K we filed this morning together with our earnings release filed with the Form 8-K and the Risk Factors section of the company's annual report on Form 10-K. In addition, the company's remarks include reference to non-GAAP measures. A reconciliation between GAAP and non-GAAP measures can be found in the third quarter financial supplement posted on the company's website, again at www.cubesmart.com. I will now turn the call over to Chris.

Thank you, Charlie. It was a very satisfying third quarter as we smoothly transitioned to effective rents replacing occupancy gains as the primary contributor to our same-store revenue growth. Our results in the third quarter and year-to-date are very solid. And perhaps more importantly, we are extremely excited about our future. Our ongoing investment in people, training and systems will continue to enhance our platform as we focus on our goal of maximizing the value from each customer. Every submarket in our portfolio positively contributed to our sector-leading 7.7% same-store revenue growth. Our stores in the Denver, Atlanta, West Palm Beach and Philadelphia MSAs led the way with double-digit growth. We congratulate our team in El Paso, who produced a 360 basis point improvement in occupancy and 2.4% revenue growth over the third quarter of last year, despite a very difficult market environment for those stores. It was another productive and active quarter of investment activity. As noted in the release, we expect to end the year having acquired approximately $570 million. We have $165 million pipeline of Certificate of Occupancy and JV development deals, which will come into our platform in 2015. As Tim will expand upon in his remarks, our equity raises during and subsequent to the quarter end have provided the necessary equity capital to fund our 2014 acquisition activity and our current 2015 pipeline. I'm now pleased to turn the call over to Tim.

Thanks, Chris, and thank you to everyone on the call for your continued interest and support. Our third quarter results, as Chris mentioned, are rewarding and indicative of the quality of our real estate, our systems, our brand and most importantly, our people. We reported FFO per share as adjusted of $0.28 for the quarter, $0.01 better than our guidance range. The beat on our numbers was again driven by solid growth and effective rates, occupancy and a little bit of good news across a number of expense line items. On the external growth front, as Chris mentioned, we now expect to close $570 million of acquisitions in 2014. To date this year, we've closed on the acquisition of 25 properties for $293.5 million. We expect to close on the first tranche of the Harrison Street portfolio acquisition early next week for $195.5 million. We also expect to close on 5 additional property acquisitions totaling $43.4 million by year end. And finally, to round out the $570 million total, we expect to close on 1 of our 5 properties under contract to buy at CO for $38 million during the fourth quarter. The details and expected timing of our CO deals are included on Page 25 of our supplemental package. Then looking forward to 2015, we have the balance of the Harrison Street portfolio slated to close in the first quarter for $27.5 million. We have the 4 remaining properties to be acquired at CO for $85.2 million. And then we have our 4 joint venture development properties, which are also detailed on Page 25 of our supplemental. And those, we expect to have a total investment of $79.9 million. So all of that activity totals $193 million. So certainly, a busy year for our investments team as all of that activity, the $570 million of closings in '14 plus the $193 million of 2015 commitments, comes to a grand total of $763 million. All of that investment activity has led to a busy year of capital raising as well. As we've discussed in the past, our objective is to fund our growth in a manner that's consistent with our goal of obtaining and maintaining a mid-BBB credit rating. So roughly speaking, we target funding our growth with 40% debt and 60% equity. Taking our total investment activity, both closed and committed, of $763 million, we look to support that growth with 60% of that total or around $458 million in the form of equity capital in order to achieve and maintain those targeted credit metrics. We look at equity funding coming through a combination of retained cash flow and raising equity capital through the sale of our common shares. As we outlined in our release, we were very active using our at-the-market or ATM program throughout the year, raising $273.4 million. Additionally, we sold equity in an overnight transaction earlier this month that totaled 7.5 million shares, including the shoe [ph] for proceeds of $143 million. Combining our ATM activity with the proceeds from our overnight offering, along with our free cash flow, we have raised the $458 million of equity capital necessary to fund all of our 2014 activity and all of our current commitments into 2015 in a manner that's consistent with our balance sheet targets. Additionally, on the balance sheet, during the quarter, we amended one of our $100 million bank term loans to extend the maturity into 2020 and improve pricing. We also achieved a significant milestone during the third quarter with the upgrade in our credit rating from Moody's from Baa3 to Baa2. And fresh off the presses, I'm excited to announce that just prior to the start of today's call, Standard & Poor's announced an upgrade to their rating on cue from BBB- to BBB. Certainly, a great affirmation from both agencies, recognizing the transformation of our company and the quality of our real estate, our balance sheet, our team. And on the more tangible side, the rating upgrades provide us with improved pricing on our bank term loans and also on borrowings under our revolving credit facility. Our solid operating results year-to-date and the impact of all of our investment and capital raising activity are reflected in our revised guidance included in yesterday's press release. We increased our guidance for full year FFO per share as adjusted by 2% at the midpoint to a range of $1.06 to $1.07. Underlying assumptions were also adjusted positively for same-store revenues, expenses and NOI. Our guidance included the impact of all of our announced investment activity as well as the impact of the increased share count resulting from our equity sales. Thanks again for taking the time to join us on this Halloween morning. And at this point, Kate, please open up the call for questions.

[Operator Instructions] And the first question comes from Todd Thomas from KeyBanc Capital Markets.

This is Grant Keeney on for Todd. Just hoping you guys could comment on the strategy into the off peak season in terms of pricing and what you guys are doing with concessions versus occupancy. And how does that compare to last year?

Sure. This is Chris. So the strategy is consistent. We are primarily focused on holding on to as much of our occupancy gains as possible. So the levers to pull to do that, obviously, continuing to provide our award-winning customer service is a piece of that and that's year round. In terms of pricing, it's a focus on both pieces. It's a focus on opening up the discount funnel a bit wider, providing some form of free rent across a wider variety of cube sizes than we would have done during the peak summer season and then actively managing street rates as well so that we are priced appropriately to maintain or hold on to as much of that occupancy as possible. As we've gone into October, we have been quite successful in holding on to the street rate gains that we have experienced over the course of the summer. And we have been successful in target-ly opening up the funnel on the discount side. So we continue to see good discount reduction versus October of last year. We continue to see street rates that are up, consistent with what we reported at 9/30. So we're pleased with where things have gone. As we go into November, December, January and February, our expectation is we'll need to get a little bit more aggressive in terms of opening up the discount funnel. We clearly will have to make some pricing adjustments with that primary goal of holding onto that occupancy going into the beginning of next busy season.

Okay. Can you comment on where occupancy stands today versus this time last year?

Sure. We are 160 basis points ahead of where we were as of this time last year.

And then just on the acquisitions. I know you guys had a lot of confidence on the pipeline and what you have in the hopper for CO deals and then the joint venture properties. But I was just wondering if you have any visibility into how the end of the year may shape up in terms of maybe some tax-driven sellers? I think in the recent past, there's been a year-end rush. And just wondering what the end of the year -- kind of activity-wise, what you expect.

Yes. Minimal. I think at this point in the game, what we have in the pipeline, we may see a few more deals come through here. But for the most part, as you've seen over the last few years, sellers generally get motivated in the springtime, heavy transaction volume, late summer, a lot of closings in September, October. So I don't expect a big rush.

The next question comes from Christy McElroy from Citigroup.

In terms of the C of O deals under contract, one of your peers has talked about limiting the dilution from newly developed assets to 2% to 3% of FFO. As you do these deals and you also have development projects in the JV, how are you thinking about the dilutive impact and capping that dilution at a certain level on a go-forward basis?

Yes. Thanks, Christy. That's always been the issue in our business, the tradeoff between FFO dilution and the value NAV creation from buying and leasing up, and it's a balance. We tend not to look so much at capping that dilution as looking at the risk profile relative to our balance sheet. And so for us, at our size, to have about 5% or so of gross assets in a slightly more risky -- either buy a CO and take a lease-up risk or JV development platform, it feels right. Again, we will -- we have a high degree of confidence in our platform in terms of being able to lease up the stores. And we've had recent success, including here at store #1 in Malvern, which opened in January, currently sits at just shy of 96% occupancy. So the confidence is there, but we want to do this on a very risk appropriate basis. And so to look at that kind of 5% to 7% of the balance sheet, in terms of these type of transactions, I think, makes sense for us.

And Christy, just to follow on to that. In thinking about it in the context of earnings dilution, that level of risk tolerance for us, where, as Chris mentioned, we look at it more from a balance sheet perspective. That gets you to a dilutive impact on FFO of kind of in that same range of $0.02 to $0.04. So we don't get there that way, but the result of where our comfort level is coincidentally gets you to a similar result on the dilutive impact.

Okay, got you. And then in terms of the $570 million of acquisitions that you've done and are doing, in aggregate, what has been the average occupancy and going-in yield of these assets initially?

Yes. The vast majority of these are stable. There are a few assets within that bigger number that have -- that are very low occupancy deals that we acquired early on in their life cycle. But if you look across the spectrum on all of those, including the bigger transaction with the Harrison Street portfolio, the blend is going to come in somewhere around 5.75% in terms of a cap rate and the occupancy on those, mid to high 80s.

Okay. And then just lastly, in terms of your New York Metro area portfolio, so including Connecticut, New Jersey, just looking at some of the numbers, same-store occupancy gains year-over-year and Q3, we're definitely below average for the portfolio, while it seems the revenue growth was on the low end of the spectrum. Can you talk a little bit about performance in that region and the competitive landscape? And of those properties, maybe you can provide an update on how the Storage Deluxe portfolio has been performing.

Yes. The Storage Deluxe portfolio continues to meet or exceed our budget and expectations, both occupancy, revenue and net operating income. When you look at those stores, not that dissimilar from our wonderful portfolio in Northern Virginia, Washington, D.C., not that dissimilar from Dallas in terms of a Texas market. The performance has just consistently been very strong. So if you look at New York, North Jersey, while it's only a modest increase in physical occupancy, those stores have always run above 90%. So from that perspective, looking by region, those New York, North Jersey stores, 6.8% revenue growth and an occupancy at 91.3%, up from 90.5%, while the absolute is modest and the 6.8%, again, below the 7.6% overall, it's just a market that's consistently strong and consistently very, very good. So we're very pleased with those stores and are very pleased with the market. I don't think there's really a better market in the country.

The next question is from Ki Bin Kim from SunTrust Robinson Humphrey.

Just a couple of questions regarding pricing and promotions. If I look at your scheduled rents, which have been outpacing realized rents for a while. Just curious, going forward, is there a chance that realized rents could be better than scheduled rents, just given the lagging nature of tenant turnover?

Interesting question, Ki Bin. I'm trying to process that. I guess, it's theoretically possible, given the impact on -- and the timing of changes in discounting and the pace at which you're able to push on street rates. So I guess, it's theoretically possible. I would think that in an environment of continued and steady growth, we'd probably rather see an environment where scheduled rents continue to outpace, which would lead to then higher levels of realized rent growth.

Okay. And in terms of just scheduled rents, and I know -- I'm sure it's not a perfect answer to this question, but is there -- have you at all kind of held back in pushing through rates [ph] higher than you could have, just maybe for the sake of having a little more ammunition going forward? Or are you generally just pushing it to the max level your system is allowing to?

Yes. Ki Bin, it's Chris. I think if anything, again, our levels of occupancy are a more recent phenomenon for Cube. And so I think when we look in the rearview mirror -- and this was my point about the future. We are extremely excited about the opportunity in front of us to continue to improve on all facets of our operation. I think when we look at the rearview mirror, if anything, we could have been more aggressive in cutting discounts and maybe more aggressive in pushing street rents sooner. I don't think the magnitude necessarily would have been any different. But we could have started a little bit earlier in the busy rental season than we did. And I think we'll take that knowledge into next year, and that's what gets us excited about, and can't wait for next year's busy rental season.

Okay. And if I could just squeeze in a last one, the same topic. You guys used to, once in a while, quantify the percentage of new customers getting promotions and what that level of discount has done year-over-year. I was wondering if you can provide that for the third quarter.

Yes. The exact numbers, we haven't been doing for a while. But in terms of the bigger picture, there was a decline, both in the percentage of new renters receiving the promotion Q3 '13 over Q3 '14. And then there was also a decline in the absolute value of the promotion as we pulled back on the levels, moving from first month free to something less than that. So both moving in a direction that positively impacted our overall levels of discounting in Q3.

So no comment here on the range maybe of the percent of customers?

No.

The next question comes from George Hoglund from Jefferies.

Just a couple of things. On the expense side, I mean, expense growth was relatively low. Just wondering what your outlook is going forward? Do you think you'll be able to maintain expense growth at these low levels?

Going forward for the balance of this year or on into the future, George?

Well, I guess, in 4Q and then sort of on -- I guess, going into kind of 1Q early next year.

Yes. So there are certain line items, marketing, most notably, that are -- that can shift relatively dramatically from quarter-to-quarter, just based on timing of spend. Marketing is a relatively volatile line item from quarter-to-quarter, as is repair and maintenance expenses. So those 2 saw relatively big swings. Over a longer continuum, we would expect that those would be at inflationary-type levels on a year-over-year basis. So our high occupancy levels, our great rental performance in the rental season allowed us to shift a bit of our marketing spend out of the peak leasing season and into the slower parts. So we think that evens out over time. And then from an R&M perspective, we had a lot of HVAC activity that just happened to fall in the third quarter. We'd expect that to even out, which would be implied in our full year expense guidance. And then looking forward into next year, we haven't, of course, provided guidance yet. But one would expect, not only for ourselves, but likely across the sector that you would anticipate relatively inflationary-type expense increases across the board, with some exceptions being the real estate tax line item and then, of course, anything that's weather-related that could impact utility costs or snow removal costs and the like.

Okay. And then -- so one more. On the C of O deals, I think historically, you guys have talked about lease-up pay searched in general on a property of -- taking about 3 years to reach stabilization. I mean, obviously, we've seen the pace of C of O deals or recent development deals get leased up a lot quicker. I was wondering if you have sort of an updated guidance what you guys are modeling in for lease-up on these?

Yes. When we underwrite, we're still modeling a 3 busy season lease-up at today's market rents, and we think that's appropriately conservative. We don't have enough data points yet. The data points, as you pointed out, that we have here in Malvern, our performance to date at Tremont, in the Bronx, are -- results of the Bruckner property in the Bronx, have been much more rapid in terms of the lease-up than that 3 busy season. But that's what we continue to underwrite and we'll adjust that, if needed, as we get more data points.

And the next question comes from Jana Galan from Bank of America Merrill Lynch.

This is Jane Wong on behalf of Jana. First, just a question on the JV and CO deals. You kind of mentioned before that you think of it as probably keeping it to about 5% on the balance sheet. I guess, just kind of -- as you look out in the next few years, how -- maybe if you could talk a little bit about -- would you want to ramp it up faster in the near term, just if you think that maybe supply could ramp up in a few years?

Yes. Again, it's really -- it's a multipronged answer that all comes back to the risk-adjusted return. So when we look at the size of our balance sheet, when we look at the opportunities on the acquisition side, when we look at the spreads that we can get between an acquisition and a CO dealer development deal, the market performance, et cetera, so we will be very nimble. And I think we were on the forefront of looking at these deals. We certainly started to do a few CO deals before anybody else. The joint venture development concept, we certainly -- we're leading the way with that as well. And so we'll be nimble. But it's just -- fundamentally, I know it's a broad answer but it comes down to risk-adjusted returns relative to other opportunities.

And I'm sorry if you touched on this, but did you provide kind of an update on the overall supply across the U.S.?

No, we didn't. Again, supply, when you think about it from a big picture perspective, remains muted by historical standards. Having listened to the other calls, I would agree that where you're seeing at least conversations or a desire for activity or in the markets you would expect, the boroughs of New York and the major Texas markets, I think when we start to see some supply, I would expect that it will be in those markets first. I think the good thing is, particularly in the boroughs, there's certainly an imbalance between supply and demand. So I think that new supply will get absorbed fairly quickly. Again, with the caveat that if it's a smart development, we're all for it, meaning built in the right location, built with the right quality enhances the overall market. I think that helps the submarket. It helps everybody over time. But I don't see anything that should be alarming through the end of 2015 at this point.

And just a last question. Could you provide any color regarding street rates and increases on in place from the third quarter?

Yes. As I think I mentioned before, street rates continue to be roughly at the level that we reported at September 30 in terms of the increase over last year. So we've been able to hold on to most of that gain. And the new -- or the existing tenant rate increase process has not changed materially for the last few quarters.

The next question comes from Dave Bragg from Green Street Advisors.

Chris, the point that you made on value creation, your focus there as it relates to development was helpful. Can you talk about the price per square foot that you're getting into the development deals on relative to stabilized acquisitions in the same markets?

Yes. I think the price per square foot tends to move around, just given obviously the cost of land in the markets in which we're looking at. We tend to look at what's the stabilized cap rate expectation relative to where an acquisition -- if one was available of similar quality in that submarket might [ph] chained. And when we look at the CO deals in our pipeline, that continues to be a 225 to 275 basis point range in terms of the spread there. And on development, it's about 25 basis points wider than that for the risk. And so we look at it that way to say that's a good opportunity. I think on the CO deals, if you'll look at -- had we built it ourselves relative to -- and even the JV development to some extent. But on the CO deals, had we built it ourselves versus acquiring it at CO, we are paying something above cost. But we -- again, we think that premium relative to the risk makes sense for our company and our size.

Okay. And just on that point, given all the private equity capital that seems to be getting more interested in self-storage development, to help us understand how compelling that proposition might be, what type of fee do you pay relative to their cost?

Yes. Again, it's -- I guess, our developers tend not to look at it from a fee perspective. It's really a -- from us, it's what's an acceptable yield at stabilization relative to our other options. And then we use that to derive a price that we're comfortable at. Again, these deals, the risk obviously to us is the lease-up, but it's also cost-to-capital risk because we're making a commitment somewhere out in the future. And so we have a keen focus. As you can see by the timing on these, most of these are at the outer date. We have a few in the 1Q '16 opening. We're not going out longer than 16, 18 months in terms of that commitment for that reason. And so it's not really a fee-based, so I can't really answer what the percentage is. Really, we're looking at those yields and backing into a price that we think makes sense, given the time risk and the lease-up risk.

All right. Just want to try to this one more way. So when you talk to private developers who are building on their own account, what do they tell you the spread that they're achieving is between acquisition, cap rates and their development yields? Is it 300 basis points?

Yes. That -- I mean, that's feels about right.

Okay. All right, great. And another question for Tim. With the ratings upgrades, could you talk about that impact on your cost of capital and where you think you can price unsecured today relative to secured?

Yes. We're really not all that focused on the secured component of it as our secured debt to gross assets is down, falling below 7% at this point. I think the upgrade, both from Moody's and then today's upgrade from S&P, certainly have a positive impact on expected pricing, although I do think a lot of that was priced in, given the positive outlooks that each of the agencies has had on the prior ratings for a period of time. So certainly, it's helpful on the margin. Perhaps 5 basis points would be my guess. And then on the bank debt side, we priced off of a ratings grid. So we move up, depending on the instrument, the term -- individual term loans and the credit facility, that is a 20 to 25 basis point spread savings on bank borrowings.

The next question is from Paula Poskon from D.A. Davidson. Paula J. Poskon - D.A. Davidson & Co., Research Division: I just wanted to follow up on the new supply questions or discussion. I'm assuming -- I don't know why, but I'm assuming that most of that refers to ground-up development, greenfield development. Are you seeing much adaptive reuse of existing structures in infill [ph] locations?

Not any more than you would've thought about historically. Again, it tends to be in the urban locations where you're seeing a conversion of an older warehouse building to storage. That's somewhat typical in the boroughs, Washington, D.C. to some extent. In terms of inbound, interestingly, we do see more because historically, we saw little suburban office owners who are looking for another use for a product that's in rough shape. So we have seen some folks looking to potentially convert some suburban office into storage, which is -- which has its challenges. But no, I would say that's not really changed overall from historical levels.

And next, we have a follow-up from George Hoglund from Jefferies.

Yes. A couple of more things. One on the equity issuance. So for the ATM program, you guys have said that you have raised enough equity now to cover all your plan to -- or your sort of under contract '15 acquisitions. So is that fair to assume that unless you guys essentially go into contract in more properties, there's not going to be any more ATM issuance?

Ever or in the near term?

Well, I'm just -- I mean, in the near term. Or I guess, what I'm getting at is, are you guys basically not going to do any more ATM issuance unless you do more deals? Or could we see you, given where the stock has gone lately, given the favorable price, you guys might raise more equity just in anticipation that you're probably going to do more deals in '15?

Yes. We have been pretty disciplined about being proactive in raising the equity capital to support the growth that we view as probable. And so the ATM activity, the overnight offering that we had done earlier this month, we felt that it was appropriate to seize the opportunity to fund the commitments that we have made today. I think it is highly likely that we will be out of the market for the balance of 2014 from an equity raising standpoint. And we would look at starting 2015 with, first, an expectation that we have free cash flow. We will generate free cash flow that will fund a portion of our growth that is speculative and above and beyond what we have committed today. And then to the extent that we see momentum or opportunities that become likely or probable, we will start to think about raising additional equity capital to support that growth, as we have done over the past several years. So I think we'll pause here for a bit because we have taken some chips off the table and funded our existing pipeline. And then as we rebuild the pipeline, we'll revisit.

Okay. And then on the third-party management platform, what are you hearing or what are you seeing out there from some smaller operators in terms of -- any sort of increased interest from their ends in terms of you guys growing that platform?

Yes. So it's Chris. The growth this year has been consistent with our plan. We had targeted adding basically 25 new properties. We're at 23 with a nice pipeline behind that. The pipeline has shifted a bit. It is now much more of the inbound. Our folks who are interested in some form of a development asset with CubeSmart being involved at the beginning as third-party manager, those -- the market is good for the existing operator. We obviously added a big portfolio to our platform in the third quarter of existing assets. So there are still folks out there. But clearly, there's been a little bit of a shift in the winds and we're seeing much more of our deal flow coming in now with stores that we would manage if and when they're built.

Okay. And then just the last one. Are you also seeing any increased interest from institutional partners who want to invest or -- in another fund or in -- from your existing capital partners?

Well, I think, again, when you have an industry that is doing as well as storage is, it's on everybody's radar screens. So there hasn't -- historically, there isn't now any shortage of folks who would love to find a way to be involved in the business. And that's a great thing about self-storage, and we always look at the varying opportunities. I think where our cost of capital is today and where we're moving as a company, our preference is to do as much on balance sheet as makes sense for us.

There are no additional questions at this time. This concludes our question-and-answer session. I would now like to turn the conference back over to Chris Marr for any closing remarks.

Thank you, everybody, for listening. I know it's an extremely busy day today in terms of calls. We appreciate your participation. We look forward to seeing many of you next week in Atlanta at NAREIT. And we look forward to reporting our fourth quarter earnings and revisiting back with you in early 2015. Thanks. Have a great day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.