Essex Property Trust, Inc. (ESS) Q2 2013 Earnings Report, Transcript and Summary

Greetings, and welcome to the Essex Property Trust, Inc. Second Quarter 2013 Earnings Conference Call. [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 2 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 midpoint 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 submarkets expected to grow at an average of between 4% to 6% in 2014 and 2015, absent significant change in the U.S. economy. Factors supporting this expectation include: Number one, loss to lease was approximately 6% of scheduled rent at June 30. Number two, personal income growth is well above the national average in the West Coast market. 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's a certain vibrancy and confidence in the West Coast market, especially Northern California and Seattle. As usual, we have summarized our 2013 forecast of residential supply, jobs and market growth on page S-16 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 S-16 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 investment 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 3 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 to approximately 5% for B quality property and B quality locations. Buyers are pushing back, citing higher financing costs, which are countered by sellers pointing to better economic conditions that will result in stronger rent growth going forward. And then third, in the case of Fannie Mae, increased interest rates have been accompanied by higher spreads. A 10-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 6 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 and 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 Coast of California. The combination of strong market price increases at higher mortgage rate makes the transition from renting to homeownership more difficult, which benefits apartments. That concludes my comments. 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 continue to post new highs for Essex, and on 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 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 21 and are off to a very impressive start. So in the 6 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 2 to 6 weeks, but 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 submarket for the 5 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 Epic. 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 forward 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 continue to be strong in all submarkets and the 12 active lease-up projects in downtown averaged 26 units per building per month for the second quarter. Strong rent growth is 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 year-over-year increase at 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 7 and 8 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 can 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 Zulily 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 transaction in the division has averaged over $2,000 for 3 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 products is a mere 1 month. June's year-over-year job growth was over 2.2%, led by San Jose submarket 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 0.5 million 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 2 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 the troop deployments have been delayed, keeping service men and women home longer. However, roughly 25,000 of the civilian workers of 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, Hyundai's headquarter project, the Ford 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 6 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 in 2012 due to the significant Prop. 8 adjustments, which were effective July 1, '12. 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 and 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 the '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, 3 properties remain, which are in the midst of being marketed and we anticipate selling them within the next 3 to 6 months. Depending on the timing of these dispositions, we expect to receive promote income of approximately $4 million after all 3 remaining properties sell. From 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 assets sales occur in '14, the '13 total FFO will be at the lower end of the guidance shown on S-14. Postponing the promote income from Fund II into '14 will have a favorable impact on our core FFO guidance, which assumes all 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 5 -- 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 was sold earlier than the September 30 disposition date assumed in our original '13 guidance. On the balance sheet, the notes and other receivables at June 30 stood at $110 million, an increase of nearly $100 million from the first quarter. This increase was the result of advancing our co-investment partnerships 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 Wesco III joint venture, which are secured by recent acquisitions of Regency and Gas Company Lofts will be repaid this month with the proceeds from the permanent secured financings. That ends my comments, and I'll now turn the call back over to the operator for questions.

[Operator Instructions] Our first question comes from the line of Nick Joseph with Citigroup.

This is Michael Bilerman here with Nick. Mike, 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?

It's a 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, lot of possible unintended outcomes. In this case, I'm going to make this 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 31 letter from Land and Buildings to BRE nor were we involved in the other reference -- the offer referenced in that 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 of 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.

So I won't ask about the $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.

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-priced 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 that we're building that 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 in time, we don't see a big premium. The one market that's 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.

Our next question comes from the line of David Toti with Cantor Fitzgerald. David Toti - Cantor Fitzgerald & Co., Research Division: I was wondering if you guys are potentially bidding on the Empire State building as well?

You're going to make me go back to my comment about counterproductive to discuss strategic items. I think I can deny that one outright as well. David Toti - Cantor Fitzgerald & Co., Research Division: Okay, okay. I 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 somewhere -- it would be all the deferred maintenance gets included in that number as well. So it's probably somewhere in the 8 to 8 plus or minus percent range, which is not dissimilar from our general approach to renovating apartments. David Toti - Cantor Fitzgerald & Co., Research Division: Okay. And then ...

It's in the cap rate, too. We underwrite it as part of the cap rate. In the case of Gas Company Lofts, there are some other opportunities like potentially a rooftop deck and some other things that we think it's 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 rent -- redevelopment, which is in that 8% to 10% on everything, which includes some deferred maintenance fees. David Toti - Cantor Fitzgerald & Co., Research Division: 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, 10 years ago where the affordability gap has 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 up because of pricing? How do you sort of -- do you think about the 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 that it's at the same level that you saw in that period of time, the dotcom boom and over that period. Now rents went up 40% in 2 to 3 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 income, 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. 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 submarkets, it's not going to push that rent-to-median income ratio that quickly. And therefore, I see more sustainability there as well.

Our next question comes from the line of David Harris with Imperial Capital.

Let me ask a question of you Mike that I asked David Simon on his call a little earlier in the week. Let's assume over the next 3 to 5 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 time frame. 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 and in effect lock in some 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 deal was a 10-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.

Would you be more cautious today about underwriting a development than you would have been 3 months ago, say, or 2 months ago before we saw the move in long-term rates?

Yes, I think I 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 of years down the road. And so we want to make sure that we have plenty of room for markets that change in that case as well. We had -- we'd announced in the quarter the Downtown San Jose 1 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 a 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 kind of continues down the same path, which is a market performed in a scenario where it transitions to something more like a 24-hour city, certainly as L.A. has, it becomes much more exciting than that. And so that was the thought process behind 1 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 discussed this numerous times before. You're kind of hovering around where my NAV is. It may be below yours or whatever. But I mean, generally speaking, you would be -- I mean, unless you've got specific use of proceeds or were trading at or above your estimate of NAV, you wouldn't be using the ATM?

We'll see. We had only used it to match fund investments that are accretive to NAV per share, improve the growth rate of the portfolio and improve the cash flows of the company. So we are not going to be issuing equities 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.

Our next question comes from the line of Rob Stevenson with Macquarie.

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 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 mean, 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 is here, so he's dealing with this on a daily basis. 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 deals, development deals, are struggling to become financed. And so even though there's a lot of planned deals out there, we still see a drop-off, not dramatic, in 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 5 development deals in North San Jose, they were all approved by the city at the same time, we think that North San Jose submarket, essentially those transactions, I think, is about 3,000 units, John?

3,500.

3,500 units get delivered and then it drops off significantly in that submarket. But I think that the move will be toward about a 20% reduction in '14, '15 in Northern California. And then Southern California, we see -- we just don't see supply 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 what -- Woodland Hills comes to mind. The Warner Center area has a couple of lease-ups that are essentially changing. And 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 that I just had about condos and the relationship between apartment values and condo values and the absence of a premium on that condo value side is, I think, what is the limiting factor when it comes to the for-sale development. Again, if you -- I mentioned there was somewhere in the 20% to 35% median household or median priced home growth. Obviously, if that happens again, then I think we'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 some lower density types of transactions in San Francisco there to be able to build those condos. We are not seeing that strong competition yield 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 of years.

And how much has material and labor sort of changed between the Emeryville and the San Mateo development starts about 1 year ago and 1 South Market this year?

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

Yes, it's just a feel for an 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 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 measured on stabilization somewhere in the 6.5% range, again depending upon market rent growths. And underwritten today based on rents in place today is somewhere in the mid-5s.

Our next question comes from the line of Alexander Goldfarb with Sandler O'Neill. Alexander David Goldfarb - Sandler O'Neill + Partners, L.P., Research Division: It didn't take long for the county questions to come up, just -- but listen at least, you guys talked 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 up and what's going on in Seattle?

Seattle, they tend to do this every 2 or 3 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 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 of our fair share of property taxes in King County. Alexander David Goldfarb - Sandler O'Neill + Partners, L.P., Research Division: Okay. So basically you guys are the 1%-ers up there?

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 that they increased 1 milligrade in Seattle and, yes, 20-something percent increase in property tax is a tough hit. Alexander David Goldfarb - Sandler O'Neill + Partners, L.P., Research Division: Okay. Next is if we look at your rent growth this year, San Mateo has been outpacing -- 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 rental growth versus San Mateo? Is that rent control policy? Or is there's some other dynamic going on there?

I think it's part rent control policy and then on the total rent side are capitalized into that on the non-rent-control building. Alexander David Goldfarb - Sandler O'Neill + Partners, L.P., Research Division: Okay. 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 rentals -- to rental apartments is really condos, not for-sale homes, do you guys foresee that there's 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?

We see any housing development as a threat. I mean, 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 are 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. In San Francisco, I think the median priced home is somewhere -- median priced condo is about $850,000. And therefore, that transition from a 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.

Our next question comes from the line of Nick Yulico with UBS.

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 kind of renter profile and you talked about some of the new development and the absorption there, I'm curious if you could -- do you have any stats or commentary on how much of the demand over the past year or so has been from kind of people within the area moving there or whether they got 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.

This is Erik. I don't have the breakdown for people coming in and out. I would tell you that, anecdotally -- I can get back to you with that, but anecdotally, both Seattle and the Bay Area definitely include 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 mean, I don't think it's had a 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 if 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 there are more have than have-nots 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 2 groups are going to act -- react much differently. One of the group, the first group, is going to be the renters in the South of Market Street in San Francisco, the very expensive areas, the areas that are -- that everyone would desire, let's say. It would be their first choice in housing and where the greatest demand rests. However, people that can afford that have to make another choice and if we've given them now 3 10% rent bumps, that -- if we give them 3 10% rent bumps to someone that's gotten 2% to 3% compensation 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 to fall into that latter category and are going to be forced into other locations and other housing decisions. I go back to -- we're 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 that led the job growth and demand for housing outstripped 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.

Our next question comes from the line of David Bragg with Green Street Advisors.

I think you're flagging a modest increase for Class B cap rates, but can you provide a little 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've got a fair -- 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 to follow up on Los Angeles, a comment made earlier. Do you believe that the significant job losses in the entertainment industry are they're 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.

Our next question comes from the line of Rich Anderson with BMO Capital Markets.

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. I mean, they're both California propositions affecting property taxes. And what happens is everyone is subject to Prop. 13, which locks in...

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 of add-ons and gross of 2%. If the value of the property goes down in value, you will get a onetime only adjustment under Prop. 8, give you some relief in 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. I just wanted to make sure I understood those nuances. When you talked about you're 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 like a change in the portfolio function that's creating that 10% increase over the prior peak?

No, really not. That's what we're trying to do, is give you some idea of where we've come from and so we're doing that on essentially the same property-type of basis. So yes, there's quite a bit variation within that, yes, 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. The buyer always considers Prop. 13. If this is going back to a merger context, then you have the Avalon and Bay situation where they merged into Bay to avoid the Prop. 13 adjustments on the Bay portfolio.

So it 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 [indiscernible]. You can apply whatever cap rate you want to it, but it's roughly $30 million.

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.

Our next question comes from the line of Michael Salinsky with RBC Capital Markets.

First question, I think, Mike, in your prepared comments, I think you mentioned 3 wholly owned dispositions. What's the size we're kind of talking there? And as you wrap up Fund II, actively in 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.

Do you have the unlevered IRR, per chance?

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

I 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 in the preferred equity front? I know that had been kind of reserved for the last couple of 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 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. I mean, 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 suburban markets. As you look across the portfolio today, given your track record for asset location, where do you see the better growth opportunities? I mean, urban is typically outperformed, but it's also facing a decent amount of supply pressure.

I think I have 2 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 it's going to, I think, urbanize or continue to urbanize the West Coast. Throughout of, 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 will intimately 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. 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 getting priced out of the better markets and they're going to find other good, still good, apartment or homes in other locations that are not considered quite as attractive.

Our next question comes from the line of Steve Sakwa with ISI Group.

Mike, as you look out over the next kind of 10 years and you kind of assess the growth in your portfolio, how do you see that NOI growth compares to kind of what you've put up the last 15 years, which has been just shy of about 4.5% then. 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 2 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, that notable exception, of the 2006, 2008 period, where we were producing lots of housing.

Okay. And how have you -- I guess I'm trying to understand kind of your unlevered IRR hurdles when you're looking at new investments today. One, what is that figure? And two, how was 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, and specifically levered IRR, 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 IRRs because we're really trying to benchmark, improving the company on a per-share basis, so it's very tied to how we view the stock. So 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 levered 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, we're using the stock we're using our co-investment partnerships.

And then I guess I'm just trying to tie this, so if class A assets are trading in the low 4s on presumably sort of 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 that transaction at a 4% cap 10 years from now. Is that what you'd need to assume or...

Exactly. I agree with you. But I think we haven't bought -- we're building those A properties in A locations. We can't buy them. I agree with you. We would struggle with buying A properties in A locations. Again, we try to find -- I think the average cap rate of what we bought over the last couple of years as somewhere, and I don't think cap rates have changed all that much, but it's somewhere in the plus or minus 4.75% range. And then the reversionary cap rate, we have not -- I mean, I understand from an IRR standpoint you have to use that. But again, if you're using your own stock, you're going to have the same reversionary issue whether or not you buy a building because it's going to ultimately affect the value of the company. So hopefully -- does that help? Does that answer the question? We haven't bought -- we don't buy at full cap. Deals can't make them work.

Our next question comes from the line of Paula Poskon with Robert W. Baird. Paula J. Poskon - Robert W. Baird & Co. Incorporated, Research Division: I just have a local question. You mentioned the BART system earlier, Mike. Was there -- 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 can't -- I don't know. I don't have the sense that we were significantly affected by the BART strike here, primarily because Palo Alto is on the Peninsula and the Peninsula is not -- BART says it goes as far as 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 on, 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. I think as a broader statement, it has a big impact.

[Operator Instructions] Our next question comes from the line of David Harris with Imperial capital.

I got a question about the size of your development program. If I'm doing the math right, it looks like you’re the -- 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 sort of pushing the outer limits of where this program you feel comfortable about this size of this program relative to size of the company or do you think there's still room to -- for that number to go up?

A couple of things. I think the risk associated with the redevelopment program is entirely different. So we do not look at that as being significantly -- we don't view it 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 G-Max type of contract, I mean, 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, it may be 1 point less, sorry?

Redevelopment, in my view, since it's so short term in nature in terms of most of the impacts, I just -- I don't view it as -- we can fund 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 and 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 just take the redevelopment out of the equation. I mean, 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. The board is comfortable with 10% as the enterprise value, which is again, that's their part of the decision.

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

Yes, max.

Our next question comes from the line of Haendel St. Juste with Morgan Stanley.

So a couple of more questions on development. First, we're triangulating to a mid-5 current yield for your new 1 South Market project. Does that sound right? And what's the IRR you're underwriting for that project?

Say that again?

I said I guess we're triangulating to a current mid-5 yield for your new San Jose project, 1 South Market. Does that sound right? And what's the IRR you're underwriting for that project?

This is John Eudy. The 5.5% math is correct. The IRR is in the range of 9% unlevered; in the 12%, 13% levered.

Okay. Can you also discuss development opportunities that you're seeing today in your core markets? [indiscernible] the challenge is on sourcing new deals at pencil, just kind of get a sense as to what you're seeing out there, how are you able to source this particular deal given the context of -- the challenge of these deals being more difficult to source and underwrite?

It is more difficult, we've said that for the last for several quarters. And if you look at our current pipeline, all but one -- the 1 South Market deal were announced basically 1 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 deliveries. So we're not at the early -- 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 deals that we like that make sense in pencil and we think the volume is going to go down over the next several quarters. I don't know if that answers your question, but timing-wise, we were early in, it's harder and harder to make deals at the current prices.

One more. I think you guys mentioned earlier in 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 as a source of capital for these developers? And if so, what type of returns or type of structures would you seek?

Haendel, 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 look at a couple of other options, including JVs and even JVs that involve 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.

Our next question comes from the line of Tayo Okusanya with Jefferies.

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 the early '90s were we've got a portfolio of homes as part of RTC days. And we think it's difficult to execute in a REIT-type of format, but there's certainly money to be made as house prices go up fairly dramatically. So in our view, the real question is, the disciplined question of if there's 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 challenges. 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 laws is inventory or not and if you sell too many, the IRS may deem it as inventory or not, real estate held for investment.

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 or remarks 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.