Essex Property Trust, Inc.
Q2 2018 Earnings Call Transcript

Published: 4 Aug 2018

[Operator:]

Good day, and welcome to the Essex Property Trust Second Quarter 2018 Earnings Call. As a reminder, today’s call 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 on the company’s filings with the SEC. [Operator Instructions] 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.

[Michael Schall:]

Good morning, and thank you for joining us today for our second quarter earnings conference call. John Burkart and Angela Kleiman will follow me with comments, and John Eudy is here for Q&A. Today, I will discuss three topics

[John Burkart:]

Thank you, Mike. Q2 was another solid quarter for Essex with year-over-year same-store revenue growth of 2.8% and NOI growth of 3%. Southern California led the portfolio in the second quarter with year-over-year revenue growth of 3.3% in part due to its 60 basis point gain in occupancy over the prior year’s period. This leasing season is playing out as anticipated. Our rents are following the historically normal rental rate curve, which peaks in July as opposed to last year when rental rates peaked early. The impact of the 2018 seasonal pattern is evident in our loss to lease numbers, which grew to 3.6% in July of 2018 compared to last year when loss to lease in July was 2%. In order to maximize revenue over the next 12 months, our operating strategy is favoring market rents instead of favoring occupancy. Therefore, we expect that our occupancy during the third quarter of 2018 will be about 30 basis points below the prior year’s period or approximately 96.4%, which will create a significant headwind in – for revenue this period. In July 2018, our same-store financial occupancy was 96.1%. Q3 2018 will be our low point for year-over-year revenue growth due to the occupancy headwind and timing of other income. Now we’ll provide an update on our markets. The Seattle market continues to be supported by strong job growth, posting year-over-year job gains of 3.1% in the second quarter of 2018, the second highest in the Essex portfolio. WeWork and Zillow continue to expand their downtown Seattle footprint by leasing the combined additional 200,000 square feet of office space. The city – the Seattle MD has roughly 5.2 million square feet of office space currently under construction, 45% of which is already preleased. Revenue in our East side and Seattle CBD submarkets grew 2.8% and 2.1%, respectively, for the second quarter of 2018 over the prior year’s period. After years of outperformance, market rents are relatively flat compared to last year. Moving on to Northern California. Job growth in the San Francisco Bay Area in Q2 averaged 2.5% year-over-year with over 76,000 jobs added. San Jose led the way with 3.3% job growth, while Oakland and San Francisco were up 1.8% and 1.7%, respectively. Facebook’s expansion was robust this quarter, signing the largest San Francisco office lease in the history for 756,000 square feet, taking all of Park Tower building as well as adding an additional 750,000 square feet across the bay in Fremont. Demand for prime office space continues to intensify as major tech companies compete for office space. An under-construction project in Mountain View changed hands from LinkedIn to WeWork and finally to Facebook, which ended up leasing both buildings totaling 450,000 square feet. Other office leasing activity remains healthy in the market. In San Francisco, a self-driving car maker and two biotech companies expanded their footprint by a combined 675,000 square feet. And in the South Bay, Amazon grew the Bay Area footprint by adding 385,000 square feet – by adding a 385,000 square foot lease in Sunnyvale. San Francisco quarterly office absorption was the highest amongst the Essex markets at 1.9% of total stock. Between San Francisco and Silicon Valley, there was about 7.5 million square feet of office space under construction, of which 68% is preleased. In July, we completed the lease-up of Station Park Green Phase 1 and estimate that pre-leasing for phases 2 and 3 will start sometime in mid-2019. Our year-over-year same-store revenue growth for the second quarter of 2018 continues to be led by Oakland and Fremont submarkets with 3% and 2.6% revenue growth. San Mateo and San Jose grew at 2.4% and 1.8%, respectively, for the same period, while San Francisco was last for the period. Heading down to Southern California. Job growth in Los Angeles in Q2 2018 averaged 1.4% year-over-year, 50 basis points above the pace of growth a year ago. Notable leases for the quarter includes Spotify’s 110,000 square foot expansion into the Arts District in downtown L.A. and WeWork’s 75,000 square foot lease, its 17th in the L.A. area. Revenue growth for the second quarter of 2018 was led by Woodland Hills with 5.1% and West L.A. with 3.9%, trailed by the Tri-Cities with 2% and Long Beach with 2%. Orange County jobs in the second quarter grew 1.3% year-over-year. While this pace was weaker than our other markets, it’s worth noting that reported growth was similarly soft at this time last year and then it was revised materially higher in the BLS’s annual benchmark revisions. Office activity continues to be healthy with 1 million square feet under construction, 40% of which is pre-leased. That is up from 20% pre-leased in Q1 of this year. Essex’s South and North submarkets grew year-over-year at 3.5% and 1.8%, respectively, for the period. Finally, in San Diego, year-over-year job growth remained at 1.9% in the second quarter of 2018. Revenue growth in the second quarter of 2018 was between 4% in the North side submarkets to 6.3% in Chula Vista over the prior year’s period. Currently, our portfolio is at 96.5% occupancy, and our availability 30 days out is at 5%. Our renewals are being sent out, consistent with the loss to lease. Thank you, and I will now turn the call over to our CFO, Angela Kleiman.

[Angela Kleiman:]

Thank you, John. I’ll start with a review of our second quarter results, provide additional color on our full year guidance revisions and conclude with a balance sheet update. In the second quarter, core FFO grew 5.7%, exceeding the midpoint of guidance by $0.09 per share. As noted in our press release, $0.03 of the favorable variance relates to timing of operating expenses, which are now expected to occur in the second half of the year. The remaining $0.06 of outperformance is comprised of the following

[Operator:]

Thank you. [Operator Instructions] Our first question is from Nick Joseph with Citigroup. Please proceed with your question.

[Nick Joseph:]

Thanks. I just want to start on guidance. You mentioned that 3Q would be the low point for same-store revenue growth. So what are you assuming for 3Q and 4Q?

[Angela Kleiman:]

For the guidance range, we assume Q3 same-store revenue in the low 2s and Q4 in high 2s.

[Nick Joseph:]

Thanks. And then just on Prop 10. Hypothetically, if it does pass, some municipalities move to rent control, what do you think the timing would be in terms of how long it would take to actually implement?

[Michael Schall:]

Hey, Nick it’s Mike Schall. It’s a good question. There are many conversations that are going on at the local level with respect to rent control. And they are debating at the local level what exactly is going to happen if Prop. 10 passes. And – but at this point in time, either because they haven’t decided or because the deliberations are not open to the public, it’s pretty tough to tell exactly what they’re going to do or when they’re going to do it. There have been various cities that have tried to pursue new rent control proposals, including three that were defeated

[John Eudy:]

Yes. This is John Eudy. I’d like to add one comment. With the – all the cities that we deal with on the entitlement side, I can tell you the vast majority do recognize the fact that if rent control were to be initiated in a city, it would have a very large impact on their ability to produce housing. Most cities are behind on the housing element, and we believe that’s another governing factor. On – part of your question, you asked how long it would take. We don’t think most cities are waiting at the altar to initiate rent control, assuming Prop. 10 were to pass. We think they’re going to be thoughtful and methodical how they approach it. And it’s too speculative to say, like Mike said, exactly where it lands, but we believe that it will be done in a balanced way. In a few cities that do, it will probably be much less draconian as the 1970 version of rent control is our general belief.

[Nick Joseph:]

Thank you.

[Operator:]

Our next question is from Austin Wurschmidt with KeyBanc Capital Markets. Please proceed.

[Austin Wurschmidt:]

Hi. Thanks for taking the questions. I was just curious if the job growth outlook in your revised revenue guidance assume that the pace of job growth moderates in the back half of the year. It sounded like some of the 2Q data points on job growth were above some of the full year assumptions you provided.

[John Burkart:]

Sure. Job growth – this is John. Job growth, obviously, moves around quite a bit, and we follow it on a monthly basis. But in the end, we’re expecting the economy is doing – well, we see the economy doing very well right now. We raised our numbers a little bit to reflect that reality. We’re not expecting a big slowdown, but the numbers are somewhat volatile. So we just see a solid second half as it relates to job growth and just with some limited movement up and down.

[Austin Wurschmidt:]

Thanks. And then I thought your comments around households doubling up and an improving affordability was interesting, and I was just curious if you’ve seen this phenomenon in the past and if you have any sense of what the benefit this could provide from a demand or – perspective or an impact on market rents.

[Michael Schall:]

Yes, this is Mike. yes, we, for a long time, have believed that as long as we’re in the band of 90% to 110% of long-term average rent-to-median income ratio, that, that tends to be a good spot in terms of rental pricing. If it’s below 90%, it probably indicates that there’s something wrong with the market. And if it’s above 110%, then you get into these affordability issues. And that ratio improved in each market, as noted in my script. And interestingly, in Northern California, we are under the 110% threshold in all three major metros. So that’s good news. And we’re pretty close to 110% in most of Southern California. So we’ve actually really come a long way with respect to affordability in the last several quarters.

[Austin Wurschmidt:]

And where has that ratio been historically?

[Michael Schall:]

Again, it’s – we’re comparing the – this is the band of 90% to 110% of the long-term, 25-year, 1990 to 2017 average. So it depends by market. Typically, Southern California is in the 22% range typically, and Northern California is in the 22% range except San Francisco is more like 27%. And Seattle is about 19%. That’s the long-term historical average.

[Austin Wurschmidt:]

Great. Thank you.

[Operator:]

Our next question is from Jeff Spector with Bank of America Merrill Lynch. Please proceed.

[Jeff Spector:]

Great. Thank you. Hi, everyone. I just want to go back to, Mike, your opening comments and clarify your comments on occupancy for 2019. It sounds like we’re saying second half will decline a bit well. And are you [indiscernible] on rent – on trying to push rent? Are you saying that you feel in 2019 that based on demand, occupancy should pick back up again?

[Michael Schall:]

Yes, let me actually kick that to John because I think you’re referring to his outlook for the rest of this year. So John, you want to handle that?

[John Burkart:]

Yes, absolutely. So what I’m seeing is in Q1, we had a benefit of 60 basis points occupancy year-over-year. Q2, that shifted to 30 basis points. And in Q3, it’ll actually be a headwind of 30 basis points, and that clearly impacts the year-over-year numbers that Angela was referencing, the reason being as we’ve shifted to the strategy that the market has improved and the seasonality of the curve is consistent with the past, with last year or with historical standards. Last year, it fell off early. So we shifted strategies to favor achieving market rent as opposed to maximizing occupancy. So it’s that adjustment, which is also in line with increased turnover, increased units turning. Each unit that turns, there’s a certain occupancy related to it. So as we turn more units in the summer and as we focus on achieving market rent instead of occupancy, there’s a natural adjustment. It’s not because the market’s weak, it’s because actually the market’s stronger, and we’ve adjusted our management strategy to maximize revenue over the next 12 months. So Q3 is the one that’s most impacted negatively, as I mentioned. And then Q4 will bring our occupancy back up as we enter the weaker part of the rental season. Does that answer your question?

[Jeff Spector:]

Yes. Thanks. And I thought Mike in his opening talked about the expected benefit in 2019. But that’s helpful.

[John Burkart:]

Sure, yes. I’ll...

[Michael Schall:]

Let me...

[John Burkart:]

Sure, sure.

[Michael Schall:]

Answer that. So yes, exactly. So if we’re going to create a occupancy headwind in Q3, then by pushing rents – obviously, the rent growth – we only have four months left of 2018, and so the benefit from the higher rent growth is going to mainly start us out on a positive foot into 2019. Keep in mind that loss to lease at the end of July was 3.5% this year versus 2% last year. So that increment, you could expect to help us in 2019.

[Jeff Spector:]

Okay. Thanks. Then just one follow-up on the rent control conversation. I mean, is it too early to talk about – if a town does implement rent control, what would Essex do with their – in that town or a municipality?

[Michael Schall:]

Yes, this is Mike. Yes, we’ve given a lot of thought to this, and we’ve done a lot of research on what the discussions are in these various cities. And it’s pretty difficult to glean any conclusions, obvious conclusions from those discussions because so many things are in flux right now. Because all rent control is not the same. There are, as we’ve said, relatively few cities that have extreme forms of rent control, and then there are other cities that have moderate forms of rent control. As we think of the world given – and John said this a few minutes ago, but I’ll just reiterate part of it from my perspective – there seems to be a real split in how to deal with California’s incredible housing shortage. A lot of the politicians and legislature have chosen to do things that are going to promote more housing development, consistent with California’s Global Warming Solutions Act, which effectively seeks to put housing and office next to one another and get people out of their cars. There were 15 bills signed by Governor Brown last year, for example, that had the objective of increasing housing development, raising money for affordable housing, penalizing cities that didn’t produce their housing element, et cetera. So you have that on the one hand, and then you have this whole other political movement to try to use rent control as a solution to a problem. Well, rent control obviously doesn’t produce more units. In fact, it produces less units because cities with extreme forms of rent control are going to produce less housing like they did last time around. So we know that. They also – there’s also a fiscal impact in that the estimated cost to the state and local governments is in the hundreds of millions of dollar range, which is, I would think, problematic as far as that goes. And then finally, the third problem with rent control is there’s conversions, for example, condos from rental housing into other forms of housing. So it actually depletes the housing stock. So what we’re talking about here is, there are people in the short term that will benefit from rent control, i.e., those that get a rent control unit. And then further down the road, there’s going to be greater shortages, and the people that will be most vulnerable in that scenario will again be the people of limited means because there’s going to be fewer houses – fewer housing units available in that scenario, and they’re likely to be more expensive and more difficult to obtain.

[Jeff Spector:]

Okay. Thank you. That helps.

[Michael Schall:]

Thanks.

[Operator:]

Our next question is from Alexander Goldfarb with Sandler O’Neill.

[Alexander Goldfarb:]

Hey, good morning out there. Mike, just appreciate your comments on the nuance of the conversations over rent control with the different cities. But I guess from – on the point of vacancy decontrol because that seems to be one of the most key elements of Costa-Hawkins and whether or not cities did draconian or not, is there any sense, as you guys speak to the different municipalities, that they understand the impact that removing vacancy decontrol would have? Or is it all part of a nebulous thing and they’re not even bringing that element up?

[John Eudy:]

This is John Eudy, Alex. There’s no question that cities understand that. And if we were to lose vacancy decontrol by virtue of a city passing that, it also brings in the element of a fair rider return. And it’s pretty clear that if you don’t have the ability to turn units at market, you wouldn’t be able to achieve that. So there’s a legal argument there that also keeps the cities in line to understand that metric. So we believe the vast majority of cities get it. There will be a few exceptions that we’ll have to work with if it comes to that.

[Alexander Goldfarb:]

Okay. And then the second question is, you guys – Mike, you spoke earlier in the year about the – obviously the impact of pricing versus last year’s early peak and then with the wild fires, and you spoke 30 basis points – or Angela, you spoke about 30 basis points lower occupancy hitting third quarter. But still, you guys definitely crushed on the quarter. Classic Essex. So how much do we take your comments with a bit of grain of salt when you’re saying that hey, third quarter is going to be the low point of the year versus things are going better? And I guess the point is, has the economy improved a lot more than you guys thought when you had your outlook and discussions at NAREIT earlier this year? Or is it the standard Essex conservatism?

[John Burkart:]

Hey, Alex thank you for the compliment, I guess, and this is John. And where we’re at as it relates to the numbers, I – in my script, I mentioned that July, we were at 96.1% occupancy very specifically to show that occupancy really has drifted down pretty significantly. And I, of course, ended the script with the fact that we’re at 96.5% current fiscal. So we’ve pushed it back up some. But that 30 basis point changed from last year for the third quarter, which the third quarter last year we were at 96.7%, and so we’re expecting to average in on the third quarter this year at 96.4%, still a good number, it’s real. There’s a real headwind, and it really is a difference from Q2 when we had a 30 basis point benefit. That’s a 60 basis point swing. So the real numbers, it relates to the strategy change, and then that actually tied back to yes, the market is performing as expected and it’s performing well. And the curve has – market peaked, as expected, in July as opposed to early, and so we were adjusting to that. So no, we’re not seeing – baking it in a big way, but thank you for the compliments.

[Alexander Goldfarb:]

Okay. But were you saying, John, that the market hasn’t improved more than you thought it? The market has been consistent with the way you guys originally thought earlier this year?

[Michael Schall:]

Yes, it’s Mike. Think of this as a big lagging machine. And what happens today, it doesn’t show up in the numbers until some future day because again, we have to turn leases in the new reality. So what we’ve done last year is we were given a choice between how much rent can we get in the third quarter. I’m talking about 2017. How much rent can we get? Or are we better off trying to push occupancy? We made an occupancy-based decision to push occupancy given that scenario. Now we’re looking at this year, 2018, and we come to a different conclusion. And the way it shows up in the numbers, it looks like it’s getting weaker, but - it’s not getting weaker, it’s getting better. It’s just going to take several months or couple quarters for you to really see the benefit of that. 2018, because of, again, the shape of the market rent curve, 2018, for the first half of the year, we have really tough comps because we gave up so much rent growth in the second half of 2017. That won’t happen this year. Again, I go back to this loss to lease being the critical piece of it, At the end of – July 2017, it was 2% and going down. And in 2018, it’s 3.5%, much more normal and much stronger. So again, it’s going to take a few months and some quarters for this to become apparent, but we’re looking down the road in terms of our pricing decisions and trying to maximize revenue down the road somewhere.

[Alexander Goldfarb:]

Okay. Thank you.

[Operator:]

Our next question is from Dennis McGill with Zelman & Associates. Please proceed.

[Dennis McGill:]

Hi. Thank you. Actually, following that last question. So when you look at the decision of a year ago and push occupancy versus today to be more focused on the rent side, when you think about the change in the market, how much of that better outlook that you have today is due to stronger demand versus less supply? Or what’s the right way to think about the balance of those two things shifting over the last year?

[John Burkart:]

I’ll – this is John. I’ll start and Mike want to – Mike might want to follow on. But really – certainly, we have strong demand out in the marketplace, and it’s showing in the curve. As well as, supply was a little bit light in the first half of the year, which we benefited from. So it’s really a combination, and that’s probably what brought the curve back to what you might say is the normalized seasonal pattern. And the result of that is better year-over-year comps as it relates to market rents and then, therefore, the shift in operations strategy.

[Dennis McGill:]

Okay, just to clarify. When you say less supply in the front half of this year, was that a push out of supply into the second half of 2019?

[John Burkart:]

So you know what? It seems like that’s just the ongoing theme for the last two years, is supply keeps getting pushed out. And certainly, in some markets like in L.A, we saw supply getting pushed out, and it continues to be pushed out. So yes, it’s not the supply somehow kind of evaporated, it’s just more of a – it continues to be delayed, and we’re benefiting from that. It’s – when the supply all comes at the same time in a concentrated area, that’s problematic. In context, the amount of supply that’s in the marketplaces, in MSAs, versus the demand, we’re clearly upside down there. We obviously have a housing crisis. We do not have enough supply. But it impacts pricing when it all gets delivered at the same time, same place. And so at this point in time, it’s – this last half of he year has been a little slower.

[Michael Schall:]

Dennis I would add maybe one thing to that. And that is, it’s very difficult to determine when the supply is going to actually be completed because of these labor shortages and other things that tend to delay. So the way we have it now, for example, is we had much more supply in L.A. in the first half. But now, according to our projections, it looks like it’s mostly second half focused. However, we don’t know how much of that is actually going to get pushed into 2019. It’s just impossible for us to get down to that level of detail and to understand the labor markets in enough detail that we can make that comment. And Seattle is the other piece of it, which is, again, second – heavy second half supply in 2018. Some of that very easily could get pushed into 2019. So – but again, when we look at price and look at pricing and expectations, we use the best information we have, recognizing that some of these things are very difficult, if not impossible, to predict.

[Dennis McGill:]

Yes. In understanding that volatility, I guess what I was trying to get at to make sure I understand your comments correctly is if you’ll be more offensive today on a go-forward basis than you were at this time a year ago, that more offensive strategies sounds like it’s being driven from the demand side, and it sounds like the supply side has a relatively similar outlook. Is that fair?

[Michael Schall:]

That’s a – yes, okay, I get more of what you’re saying. Yes, the – we think supply and demand, critical housing shortage, we think there’s no way that demand catches up – or supply catches up with demand under any scenario. The issue is that when you get into some of these markets, the apartment deliveries are much more concentrated in the Downtown L.A. or Downtown Seattle, for example, South Lake Union in Seattle even more specifically than the downtown. And the more you get that concentration, the greater chance you have that several buildings are going to compete with one another and are going to start getting to six to eight weeks of concession, which effectively stops rental growth in your stabilized communities. So that phenomena is what I’m talking about. And this is periodic disruption. This has nothing to do with overall supply and demand. It just has to do with how aggressive owners become on lease-ups of multiple properties competing with one another in order to each absorb somewhere around 30 units a month. How far do they have to push rents or concessions in order to make that happen. I think that’s the key issue, and it’s very difficult for us to estimate what that would be. As noted in the comments on the call, Seattle tends to also be more seasonal with respect to job growth and demand. And so that’s why we have pushed back on Seattle or pushed those estimates down in terms of market rent growth for the year.

[Dennis McGill:]

Okay. One other question of Costa-Hawkins. If – have you done any work – when we look at your mix of assets pre and post-1995, any sense on where the market would be as to whether that change would be a relative benefit to you or headwind to you versus the broader market?

[Michael Schall:]

It’s Mike. I’m not sure I understand exactly where you’re coming from. Let me just try and make a couple of broad comments. And Dennis, you can chime in here and – if I’m off base. We have – we’re operating in seven cities, as I noted in – on the call, in California. Four of them, we have more than 2,000 units in. And so the rest of them were, again, properties scattered throughout many cities in California, and there’s no greater concentration. So what we have done, and this is not a perfect science, what we’ve done is try to evaluate our portfolio in those four areas that we have the greatest concentration. Two of them have a less onerous but longstanding rent control ordinance. That’s L.A. and San Jose. And two of them do not have rent control at all. And so we’re, again, trying to monitor, make good portfolio allocation decisions, recognizing that our – we’re very diversified. And as John Eudy said, this conundrum of more – of rent control movement throughout California, while you have an enormous housing shortage and a bunch of law, again including the Global Warming Solutions Act, the 15 bills signed by Governor Brown last year, the conundrum embedded or the contradiction embedded in that discussion leads us to believe that there has to be a compromise somewhere in the middle, which will be to the benefit of less severe forms of rent control. But we don’t know, and it’s impossible to know at this point in time.

[Dennis McGill:]

Okay. That’s helpful. Thank you, guys.

[Michael Schall:]

Thank you.

[Operator:]

Our next question is from Rich Hill with Morgan Stanley.

[Rich Hill:]

Hey, guys thanks for your time. Why don’t we just come back to the supply question a little bit? Is there anything – I know supply can be somewhat volatile and somewhat hard to completely forecast. But is there anything that would give you upside to expect that maybe supply would be lower than what you’re projecting? I know you mentioned development yields, and that makes a lot of sense to me. But we’re could upside be where this sort of supply crest happen sooner than we’re expecting?

[Michael Schall:]

Yes, this is Mike, and maybe some others want to chime in here. There’s a lot of things happening that affect development. It’s one of the most sensitive parts of our business. I’ve made the comments with respect to our preferred equity program where we’re seeing less opportunities. We started the year with a very robust pipeline, and little by little, it’s been pared down. And our belief is we were somewhere around $100 million this year, but we thought we were going to be well in excess of that. And when you look at the factors that are constraining that production, it goes back to those things that I said. But you have some new things. We have tariffs, which include Canadian lumber, for example, and steel. And you have direct – the rent control discussions are not pro-development or pro-business for that matters. And so you have a number of issues that you didn’t have before. And even though the state is trying to produce more housing, the environment seems to be pushing against that, leading to that contradiction that I was talking about earlier.

[Rich Hill:]

Got it. And so is there any – are there any specific markets where you think supply might surprise to the downside versus the upside? Or is that getting a little bit too detailed?

[Michael Schall:]

Well, we think Northern California mostly has peaked. And I mentioned the markets that we’re very confident that had peaked. The areas that we remain concerned about are L.A. and, I guess, Seattle would be the two because I – we don’t think that they have peaked at this point in time or there’s very significant permitting. I would guess that when you get down to the starts, that’s where you’re going to start seeing problems on those deals because – and John Eudy – John has two jobs. He’s the co-chair of our coalition, which is a full-time job – actually more than a full-time job; and he’s also Head of Development. And he looks at a lot of deals. John, why don’t you chime in and talk about what you’re seeing out there?

[John Eudy:]

Well, I can say that in our dealings with cities on a couple of entitlements that were in the process, most cities’ impact on their stack is far less than it was a year and two years ago. There are far fewer deals being processed now than there were in the peak, if you will, of the development pipeline buildup between 2014 and 2015. So I think that the outlook two years from now is going to be very much aligned lower than it is in the worst-case exception that it’s growing because it’s not. And then the headwinds between construction costs and the concern right now in the short run with the Costa-Hawkins repeal is muting it even further. So supply is going down.

[Rich Hill:]

Got it. And then just maybe one more question on Costa-Hawkins and Prop. 10. Your comments are very well taken on the market not having enough supply of affordable housing. But given all the noise associated with it, if Prop. 10 was to occur, would it lead you to think about maybe entering into some markets that you’re not currently participating in? Or are you just very confident with your markets over the medium to long term?

[Michael Schall:]

Yes, this is Mike. It’s interesting, again back to the scenario. So if there’s a few cities – let’s go back to the pre-Costa-Hawkins world, which we did just fine, by the way. In that world, as John and I have talked about, there were a few cities that had very extreme forms of rent control and basically we built no housing in those cities. So obviously, the demand is the demand for housing. And therefore, it has to go somewhere else. So if you have cities with extreme forms of rent control, you would be more likely to invest in the cities that are nearby those cities, the places where those – the people that are working in San Francisco, for example, or Berkeley, for example, might live. And we got – have a pretty good idea of how that will work. Because presumably, if you’re going to lock down housing in some cities, the cities that are the likely beneficiaries will be the cities nearby. And rents will – because again, you’re talking about a net reduction of rental housing in that scenario, rents will probably go higher, not less high. So they will benefit from the greater demand or the lack of supply, let’s say, that is caused by the rent control cities.

[Rich Hill:]

Understood. Thank you, everyone. I appreciate the color.

[Michael Schall:]

Thank you.

[Operator:]

Hello, are you able to hear me now?

[Michael Schall:]

Yes, we hear you.

[Operator:]

Okay, you can hear. We’re going to join Karin Ford for her question.

[Michael Schall:]

Great. Thank you.

[Karin Ford:]

Sorry about that. Glad to hear we’re back. I wanted to just ask one more about Prop. 10. I know you said that cap rates haven’t moved in your markets, but are you seeing more product starting to come to market from landlords ahead of potential repeal?

[Michael Schall:]

Karen, it’s Mike and thank you for sticking with us. Anecdotally, we’ve heard that there are some more listings out there. But as I said in my comments, we really scrubbed all the deals that have been completed year-to-date just to make sure that we weren’t missing something. So we went through them one by one, the deals that were in our – in the markets that we care hear about. And so there was no indication that cap rates have changed in those transactions. But again, so there are some anecdotes that maybe there’ll be a little bit more transaction activity as we get to the back half of the year, although that’s not unusual because all the sellers now that rents peak in June and July, and, therefore, they typically wait until June or July to get the best underwriting of their deals. So I wouldn’t say that’s at all unusual.

[Karin Ford:]

Great. Thanks. And my second question is I was interested in your comments about single-family affordability in your markets and the lack thereof in – given the current tax regime. We started to see some weakness in the housing markets here in the Northeast, and we obviously don’t have the same job growth that you guys have out there. Do you think that single-family headwinds could be a real demand driver for you guys in 2019 as people start to recognize the tax impact of the tax law change?

[Michael Schall:]

Karin, it’s Mike again. We’ve seen – when you look at production of housing in California, we’ve seen very, very low levels of production for single-family homes largely because of California’s Global Warming Solutions Act, which seeks to put housing – high-density housing near the jobs, lower carbon pollution, fix the traffic problems that we have, increase in spending for public transit, et cetera. So that agenda is sort of operating in the background, and that is not a pro-single-family home type of agenda. So we see more densification of housing in the urban markets. And so I don’t think that’s going to happen. I think that if anything, there’ll be more condos being developed, and I think that’s a big possibility. And more on that discussion as well as it relates to a number of our properties. So I think it’s more likely to be in the high-density area than it is in the single-family home.

[Karin Ford:]

Great. Thank you.

[Operator:]

Our next question is from John Guinee with Stifel. Please proceed.

[John Guinee:]

Oh, great. Thank you. John Guinee here. Quick question for you. If you’re looking at land at today’s prices, and the current hard costs and, as you know, land prices are sticky and really haven’t come down, on an untrended basis, what does your underwriting show is the return on cost for development if you have to pay today’s prices?

[John Eudy:]

This is John Eudy, John. It depends on the specifics, obviously, but far less than it would motivate you to do a deal. If you take it on today’s numbers, probably average somewhere in the high – and that’s buying land at today’s number and entitlements out a year. So the high 3%, low 4%, 4.25% at the high.

[John Guinee:]

Do you see institutional money essentially willing to continue at that kind of – those kind of returns? Or are they finally backing off?

[John Eudy:]

From my perspective, it appears like they’re backing off. And we see it through the pref equity program as well the pipeline going down. Mike, what do you think?

[Michael Schall:]

Yes, I totally agree with John. And I would say maybe one caveat because there are deals that have a significant amount of money that are already invested in them, and those are the ones that tend to move forward. When you get beyond those transactions because, let’s say, a 4% yield is better than having $10 million invested in a deal that’s not going forward. So you end up with that conundrum. But aside from that, I totally agree with John.

[John Guinee:]

Great. Thank you very much.

[Operator:]

Our next question is from John Pawlowski with Green Street Advisors.

[John Pawlowski:]

Thanks. Mike, I’d like to get your thoughts just on the broader political risk in California. I mean, Costa-Hawkins is one aspect, and you have some other legislation about initiatives moving against commercial landlords like Prop. 13, Prop. C. So the odds of legislators or voters reaching for the economics of landlords seem to be increasing. It’s becoming increasingly less leaning to date. I guess my question is, how do you approach political risk in comparing any type of risk-adjusted return framework to California markets versus non-California markets? And have you started factoring that into investment decisions outside of this Costa-Hawkins, very city level-specific considerations?

[Michael Schall:]

Yes, John, this is Mike. It’s – that’s a – it’s a good question. And we – you – pretty much everything through the lens of supply and demand for housing. And so if the regulatory environment gets so extreme that you start seeing job growth slow, which drives the demand side, then that would cause us to make a different decision potentially. But we are always going to be the same. We’re going to look through the lens of supply and demand for housing, and we’re going to seek areas that have the best dynamic – the best supply-demand dynamic. And right now we believe that’s in California, in the various markets that we’re in. If that dynamic changes because of the political risk, then we would come to a different conclusion. So it’s – and I think it’s far from certain what California is going to do because we have seen, certainly on the office side and in a variety of ways, the local governments very willing to accommodate the growth of California, wanting to accommodate the Apples and Googles, et cetera, of the world. And you’re right, more recently, you’ve seen these head tax proposals and a variety of things that seem very focused on those entities. Notably, in Washington, Amazon, the head tax was repealed after being passed. But I think to give you some idea, there is some give-and-take here, and where the politicians come out on this is going to be really critical. I think, again, there’s a dichotomy here. You have Gavin Newsom that is supportive of our position with respect to Prop. 10. He’s not favor of the repeal, but the democrat party is in favor of repeal. You have a variety of issues going back and forth. I think we just need to let it play out. I mean, our hope is that reason prevails at the end of the day. And the – there’s a study by UC Berkeley’s Terner Center that starts a conversation about what should happen that I think is notable, and it’s available online. And so I think it’s too early to tell. And we will see – we will know in the next year or two which way this is going to go.

[John Pawlowski:]

Okay, that’s super helpful. Today – back to the rent control risk. Today’s prepare – portfolio allocation decisions, are you redlining any cities right now from an investment standpoint?

[Michael Schall:]

I wouldn’t say redline because, again, an investment decision – rent control is only one factor within the investment decision. And in fact, you would say that if, for example, Santa Cruz decides to establish a pretty extreme form of rent control, would there be a cap rate that would also bend? It’s not the current cap rate environment, obviously, but, again, there’s a number of considerations that really prevent you from absolutely redlining things. Again, assuming that the cap rates and yields are not – don’t change very significantly to compensate you for that risk and for the lower return.

[John Pawlowski:]

Okay, great. Thank you.

[Operator:]

Our next question is from Tayo Okusanya from Jefferies.

[Peter Abramowitz:]

Hi. This is Peter Abramowitz on from Tayo. I just wanted to touch on the tax expense growth in the same-store pool in the first half just given that it has particularly kind of climbed down in the second quarter but also below the peers’ in the first half. So I was just wondering what sort of trends you’re seeing that’s keeping that pretty low. And how sustainable is that going forward? Or what are you seeing for the back half?

[Angela Kleiman:]

On the tax front, first half was lower, but it’s primarily because we had essentially property tax adjustments. And so we had expected – in the non-same-store pool. So as far as the same-store pool, it’s coming in pretty much as expected. Seattle is always a little bit of a wildcard, and it’d be coming a little bit higher. And so we do expect second half property tax to be even higher than in the first half. Does that answer your question?

[Peter Abramowitz:]

Yes, sure. Thank you.

[Angela Kleiman:]

Great. Thanks.

[Operator:]

There are no more questions at this time. We will return the conference back over to Mike for closing comments.

[Michael Schall:]

Thank you. Hey, we’re so sorry for our technical problems during the call. Apologize for that. And I want to thank you for your participation today. Hope to see many of you at the BofA Merrill Lynch conference next month. Good day.

[Operator:]

Thank you. This concludes today’s conference. You may disconnect your lines at this time, and thank you for your participation.