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Associated Estates Realty Corporation (NYSE:AEC)

Q4 2013 Results Earnings Call

February 5, 2014 2:00 PM ET

Executives

Jeremy Goldberg - Vice President, Corporate Finance and IR

Jeff Friedman - President and CEO

Lou Fatica - Chief Financial Officer

John Shannon - Senior Vice President, Operations

Jason Friedman - Vice President, Acquisitions and Development

Patrick Duffy - Vice President, Strategic Marketing

Analysts

Gaurav Mehta - Cantor Fitzgerald

Ryan Meliker - MLV & Co.

Andrew Shapiro - Sandler O'Neill

Nick Joseph - Citigroup

Buck Horne - Raymond James

Operator

Good afternoon. And welcome to the Associated Estates’ Fourth Quarter 2013 Earnings Conference Call. My name is Holly, and I will be the operator for your call today. At this time, all participants are in listen-only mode. Following prepared remarks by the company, we will conduct a question-and-answer session. (Operator Instructions)

Thank you. Please note this event is being recorded. If we experience any difficulties with the connection of the conference call, please visit associatedestates.com for additional instruction.

Now, I would like to turn the call over to Jeremy Goldberg, Vice President of Corporate Finance and Investor Relations for opening remarks and introductions. Please go ahead.

Jeremy Goldberg

Thank you, Holly. Good afternoon, everyone. And thank you for joining the Associated Estates’ fourth quarter 2013 conference call. I’d like to remind everyone that our call today is being webcast and will be archived on the Associated Estates’ website for 90 days.

Prepared remarks will be presented by Jeff Friedman, our President and Chief Executive Officer; Lou Fatica, our Chief Financial Officer; and John Shannon, our Senior Vice President of Operations. Additionally, other members of our management team are available for the Q&A.

Before we begin our prepared comments, we would like to note that certain statements made during this call, including answers we give in response to your questions, will be forward-looking statements that are based on the current expectations and beliefs of management.

These forward-looking statements are subject to certain risks and trends that could cause actual results to differ materially from projections. Further information about these risks and trends can be found in our filings with the SEC and we encourage everyone to review them.

As a reminder, Associated Estates’ fourth quarter earnings release and supplemental financial information are available in the Investor section of our website and they include reconciliations to FFO and other non-GAAP financial measures, which will be discussed on this call.

At this time, I will turn the call over to Jeff.

Jeff Friedman

Thank you, Jeremy, and thanks to everyone for participating and listening to our call. A solid finish to the year and a strong start for 2014, fundamentals continue to improve, our highly competitive portfolio and our season operations team position as well to deliver our fifth consecutive year of NOI growth.

On the transactions front to date we’ve closed on three of seven properties we agreed to purchase in September. These completed acquisitions are stabilizing the cap rates that are approximately 40 basis points higher than originally underwritten. We expect to complete the acquisition of the remainder of the portfolio over the next 12 to 15 months, all of these acquisitions will be match funded by dispositions.

Turning to development, yesterday, we announced the formation of a 50/50 joint venture with AIG Global Real Estate on 358, a 410-unit development project in the SoMa, neighborhood of neighborhood of San Francisco. We are thrilled to have such a well-recognized and well-regarded real estate investor as our partner.

With the eking of this joint venture we are able to announce that we will internally fund all of our committed developments and acquisitions, while continuing to maintain our investment grade balance sheet.

With the property sales we have identified and the lease up of our current development projects, Associated Estates will have a best-in-class portfolio in all of our submarkets. This best-in-class portfolio will drive significant earnings growth and create considerable value for our shareholders for years to come. I wanted to just touch on fundamentals.

By now, most of you have heard from others that I have already reported about household formation, propensity to ramp and slowing permitted. All of these factors are positive for the apartment business. Not only do we expect a strong 2014 but as we look out to 2015 and 2016, for Associated Estates, we expect rent growth to be equal to or better than 2014. Our focus this year will be on core operations, announced transactions and current development. For Associated Estates, 2014 will be another year of continued execution.

Now I’d like to turn the call over to Lou.

Lou Fatica

Thank you, Jeff. Fourth quarter FFO per share was $0.33 for the year, a $1.27 per share both in line with our expectations. Q4 same community NOI was up 3.6%, also in line with expectations.

For the full year, same community NOI increased 5% as a result of the 3.3% increase in revenues and a 70 basis point increase in expenses. Average occupancy for the same community portfolio was 95.6% for the year.

During the quarter, we sold two properties for $46.3 million, bringing total proceeds for the year to $139 million, consistent with our full year guidance. We ended the year with net debt to gross real estate assets of 45.9% and secured debt to gross real estate assets of just under 16%, both in line with targeted metrics.

Unencumbered NOI represented just under 73% of total NOI and the fixed charge coverage ratio for the full year was 2.90 times. Near term debt maturities are quite manageable with $45 million maturing in 2014 and $20 million maturing in 2015.

Before I provide you with details on our 2014 guidance, I just wanted to take a minute to discuss some changes to our supplemental disclosures as it relates to our same community portfolio. With the continued focus on all-in property revenue versus net rent and net collected rents, we have moved to reporting average property revenue per occupied unit in average period occupancy.

We believe that this makes it easier to assess our property level performance. These changes reflect some important discussions we’ve had with our analysts and shareholders as we continue to improve the quality and clarity of how we report results. We always welcome your feedback.

Turning to our full year guidance for 2014, we expect FFO to be in the range of $1.27 to $1.31 per share. At the midpoint of our FFO guidance range, we are projecting same community revenue growth of 3.25%, expense growth of 2.25%, resulting in same community NOI growth of 3.9%.

As Jeff mentioned, 2014 will mark the fifth consecutive year of same community NOI growth with cumulative growth over the five-year period projected to be better than 22%. This cumulative growth should stack favorably against the multifamily peer group.

Our acquisition guidance includes the closing of Alpha Mill Phases I and II in Charlotte during Q2 and closing on 1160 Hammond in Atlanta during Q4. We expect the closing of Varela in Tampa to occur in early 2015.

Our models always assumed that year end 2014 closing for Varela and thus this does not have an impact on 2014 earnings. Our disposition guidance encompasses the sale of fixed assets, one of which is under contract and scheduled to close at end of February and three of which are currently being marketed and scheduled to close during Q2.

The remaining two other projected sales are in Southeast Florida and marketing is expected to commence in mid 2014 with closings by the end of 2014 or early 2015. Cap rate spreads between what we’re selling and what we’re buying are expected to be in the range of 50 to 60 basis points or about 20 basis points better than originally projected.

When we mark-to-market real estate taxes on our dispositions and added 3% management fee. The comparable market cap rate spreads on our acquisitions and dispositions are just 0 to 10 basis points.

Our development guidance includes our pro rata share of the projected spend on five committed developments, one in Bethesda, one in Dallas, one in San Francisco and two in Los Angeles. Our share of the all-in-cost for these five developments is $371 million with remaining spend of $244 million.

We expect to be 66% funded at the end of 2014. Funding for this five development deals through completion will come from free cash flow, disposition proceeds and construction loans. Property management fees associated with the lease up of the committed portfolio acquisition were at $200,000 to $300,000 of revenue and FFO for 2014.

Additionally, construction management fees, net of associated expenses related to our joint venture developments in downtown L.A. and San Francisco are expected to add an additional $500,000 of earnings and FFO through projected 2014 results.

Property management and construction management fees are expected to contribute one to two pennies of FFO in 2015 and 2016. General and administrative expenses are projected to be in the range of $18.6 million to $19.1 million and includes $500,000 to a $1 million in legal costs associated with the ongoing litigation related to our master lease tenant in our Wilshire Boulevard commercial building.

At the midpoint of our guidance, our projected 2014 FAD payout ratio on the $0.76 per share dividend is approximately 65%. Additional details regarding the full year guidance for 2014 can be found on Page 24 of the supplemental.

At this time, I will turn the call over to John.

John Shannon

Thank you, Lou. Turning to core operations, our same community NOI was up 3.6% over Q4 2012. Our average occupancy for the quarter was 95.4%, and our current physical occupancy is better than 96%.

For Q4 2013, same community revenue per occupied unit was up 4.1% in the Midwest, 1.8% in the Mid-Atlantic, 3.7% in the Southeast and 5.1% in the Southwest. Same community new lease rents were down 2% and renewal lease rents were up 3.6% across the portfolio. This is consistent with seasonal trends.

Same community expenses for the quarter were up 1.9% over Q4 2012 and for the full year, up a modest 70 basis points. It is important to note that continued improvement in our operating margins has been one of our key strategic objectives over the past several years. With growing rent, expense management and budget compliance, our operating margin has improved better than 500 basis points over the past three years, going from 57.2% in 2010 to 62.4% in 2013.

Regarding our stabilized acquisitions that are not part of our same community results throughout Westin, Miami, the Blakeney in Charlotte and Rienzi in Dallas, all performed well and collectively finished the quarter at 96% physical occupancy with NOI better than 9% higher than our acquisition underwrites.

Also in November, we acquired two properties in Raleigh that were in lease up. At the time of acquisition, the Lofts at Weston was 76% occupied and St. Mary Square was 87% occupied. Leasing continues to be strong. The Lofts is currently 85% occupied and St. Mary’s is 99%.

Our portfolio acquisitions includes 795 units that have been constructed by the current owner that we will acquire upon completion, a 100-unit Phase II in Charlotte, a 345-unit deal in the Perimeter submarket of Atlanta and a 350-unit development in the Westshore submarket of Tampa.

We took over management of the Charlotte properties out from Mill Phase I and II on January, 6th and we expect to close on both phases in the second quarter. In regards to the property in Atlanta of 1160 Hammond, we will be taking on management lease-up responsibilities next month with an anticipated closing in Q4.

Regarding the property in Tampa, Varela, we are projecting we will assume management lease up this summer with an anticipated closing in early 2015. During the fourth quarter, we sold Courtney Chase in Orlando at a sale price of $38.1 million, which equates to a market cap rate of 5.6%. Also, we sold an older non-core 102-unit property in Columbus, Ohio for $8.2 million or 6.4% market cap rate.

We are under construction at 7001 Arlington Road in Bethesda, Canterbury in Dallas, and The Desmond on Wilshire in LA. Additionally, in 2014, we will start construction on 953rd in LA and 358th in San Francisco. I want to emphasize how excited we are about our development pipeline. The location, amenities and occupational features of these five fields are truly best-in-class by any measure and they will create significantly value.

As just stated, apartment fundamentals continue to improve. We are well-positioned to have another good year in 2014. Our 2014 guidance at the midpoint reflects same community revenue growth of 3.25% and NOI increasing by 3.9%. To get to the 3.25% midpoint of revenue guidance for 2014, we anticipate 3.8% revenue growth in the Midwest, 2.3% in the Mid-Atlantic, 3.6% in the Southeast and 3.9% in the Southwest. For the full year, average occupancy for the same community portfolio is projected to be 95.6%.

I will now turn the call back over to Jeff.

Jeff Friedman

Thanks, John. Strong finish to a good year. Holly, why don’t we open up the call for questions?

Question-and-Answer Session

Operator

(Operator Instructions) And your first question is from the line of Gaurav Mehta from Cantor Fitzgerald.

Gaurav Mehta - Cantor Fitzgerald

Thank you. Good afternoon. Jeff, in your prepared remarks you talked about the property that filled in for Q and I think you mentioned that the cap rate was 40 basis points higher than what originally underwritten. Is that the trend that you are seeing in your markets or was that a situation specific to those three assets?

Jeff Friedman

Gaurav, I believe I talked about the returns on the acquisitions been better than we performed. And John talked about the sale. Is the question about the properties we acquired or the properties we sold?

Gaurav Mehta - Cantor Fitzgerald

Well, I think I heard you saying that the cap rate was 40 basis points higher for the properties that you acquired?

Jeff Friedman

As a result of the better than expected NOI that we are generating from the properties, that’s correct.

Gaurav Mehta - Cantor Fitzgerald

Okay. And then, are you able to talk about details on the development joint venture in terms of your return expectations and what kind of fees are you looking at?

Jason Friedman

Sure, Gaurav, this is Jason. The joint venture in San Francisco with AIG, first let me just say AIG is an experienced multifamily investor and we are excited to be their partner. It’s a straight 50/50 joint venture. Associated Estates will be the property manager and we will also receive a construction management fee. The expected returns on the deal, the untrended return on cost is 5.5% to 6%.

Gaurav Mehta - Cantor Fitzgerald

Okay. And is this situation particular to one specific development site or there is a provision to expand that to future development?

Jason Friedman

Our deal is just on San Francisco on our 358th project.

Gaurav Mehta - Cantor Fitzgerald

Okay, thank you. That’s all I have.

Jeff Friedman

Thanks, Gaurav.

Operator

And your next question comes from the line of Ryan Meliker with MLV & Co.

Ryan Meliker - MLV & Co.

Good afternoon, guys. Just a couple of quick things here. First of all, I recall last quarter you talked about the plan to sell Germantown and the idea that given the quality of that asset and the investor appetite for that market that you should get a pretty attractive cap rate and just complement pretty quickly. Is there any update on how that process is going?

Patrick Duffy

Hi, Ryan. This is Patrick Duffy. We do have bid for Germantown, our 242-unit property in Nashville listed. We've had a high level of interest in the property and we are conducting tours and have a call for offers later this month.

Ryan Meliker - MLV & Co.

But no changes to your outlook on pricing?

Patrick Duffy

Yeah.

Ryan Meliker - MLV & Co.

Okay. Great. And then second question, can you just give us a little color on why you decided to go with AIG for the joint venture for the development out in San Francisco, was this something that you thought they really brought to the table or was it just economics that you negotiated with them or were the best?

Jeff Friedman

Well, this is Jeff. We, a 50/50 joint venture is not your typical joint venture. And particularly in this high-profile location we found that many of the names that you would typically recognize this joint venture partners were accustomed to own including some of the deals AIG has done with other folks. They own 90% or 95% and the development partner is a 5% partner.

So as far as we were concerned, we wanted to own 50% of the deal and that narrowed down some of the names that from a development perspective wanted more of the ownership.

The second part was this is a core and long-term investment for us. And so when we spoke to the potential joint venture partners, there are a number of investors and development deals that don't necessarily look upon returns from a development deal from a long-term hold standpoint, they have a shorter term perspective. That narrowed the group down a little further.

And so we had a number of a very high quality opportunities and it was really the relationship that Jason developed with the AIG team, I think that together we both came to the conclusion that we thought this investment for both of us really fit the bill the best.

Ryan Meliker - MLV & Co.

Okay. That makes sense. I was just hoping to get some color on that. That's helpful. And then lastly, I'm wondering, did you guys talk to KKR about that, especially given that the company has taken a stack in your stock, I would have thought that maybe that would have been a partner to move forward with regards to that development as well?

Jeff Friedman

Well, two parts to that question, we have spoken with KKR, they're a great name smart investors, we're proud to have them as a shareholder. With regard to their interest in a development deal joint venture, it doesn’t fit their investment profile. We have spoken with them and other private equity shops about JVs and this kind of deal just doesn't really fit their return criteria.

Ryan Meliker - MLV & Co.

Okay. And then last question and then I'll jump out of the queue. But, obviously, your stock trades at a material discount to something what we believe that is in the private market value of the portfolio. With a company like KKR coming in the mix, you've had discussions about maybe strategic opportunities for them to come in and help grow the platform or try to monetize some of that discount going forward?

Jeff Friedman

Well, I think you're going to get all the questions, especially the tough ones, supposing tough ones out of the way, look…

Ryan Meliker - MLV & Co.

Sorry, Jeff.

Jeff Friedman

Our discussions with KKR they see value, they see an experienced management team and they see the opportunity to possibly do some other things together. And so, we'll continue talking with them as we talk with other folks. In terms of taking a platform to another level, obviously for us, particularly with regard to 2014, the fact that we can self-fund all of our acquisitions, all of our developments, we don't need any money. Our problem is today not necessarily the people who want to invest with us. Our problem is finding the returns that would really justify the cost of the money we would need to grow.

Ryan Meliker - MLV & Co.

That makes a lot of sense. I'll jump out. Thanks a lot Jeff. I appreciate your honesty and candor.

Operator

Your next question comes from the line of Andrew Shapiro from Sandler O'Neill.

Andrew Shapiro - Sandler O'Neill

Thanks. I wonder, if you are considering a similar partnership with the AIG in the Desmond on Wilshire or you guys committed to finish that project 100% ownership?

Jeff Friedman

No. The Desmond deal, we’re going to own a 100%. We are not considering the joint venture on that deal.

Andrew Shapiro - Sandler O'Neill

Thanks. Secondly, can you guys consider 2014 the high water mark in regard to expenses. I mean going forward, do you think they should moderate kind of flatten out or how you kind of view ‘14 in grand scheme of things in relation to expenses?

John Shannon

Hey Andrew, John Shannon. Our expense guidance had two and quarter at the midpoint. We don’t think its necessarily a high water mark or a low water mark. We think that’s where will trend for the next several years anyway of that 2% to 3% expense growth. When we look at our expenses over 10-year period, they average approximately 2.9% per year and over a five year period, it’s less than 2%. So the 2% to 3% would be a fair average on a going forward basis.

Andrew Shapiro - Sandler O'Neill

All right. Thanks. And then finally can you just comment on the guided 200,000 transaction expense, given your kind of $250 million of potential transaction that seems kind of low?

Lou Fatica

Hi Andrew, this is Lou. That acquisition guidance expense is associated with the completion of the two deals that we talked about, Alpha Mill Phase I and II and the 1160 Hammond at Atlanta. So typically if you look back historically, we spend anywhere between 50,000 to 100,000 per deal on acquisitions and that would track to that.

Andrew Shapiro - Sandler O'Neill

Okay. Thank you. That’s it for me.

Operator

(Operator Instructions) And your next question is from the line of Nick Joseph with Citigroup.

Nick Joseph - Citigroup

Great. Thanks. Thanks for the detail on the revenue expectations by market. What market you are expecting the most supply pressure in 2014 and 2015?

Patrick Duffy

Hi Nick, this is Patrick. The market that we expect to have the most supply pressure would be Metro DC and in that market, we operate five properties that present about 1800 units and four of the five properties will be impacted by new supply, two in the Eastern Loudoun County, one in Vienna, Virginia, one in Woodbridge. The property in Vienna, Virginia and the property in Woodbridge are both are in submarket where they are approximately 800 units in lease up.

So our 2014 revenue assumption for those two properties is flat rent. And then in Eastern Loudoun County, there is only one property in lease up. And so the two properties we have in eastern Loudoun County, we have a forecasted revenue growth of about 2.6%. In Raleigh where there is a lot of new supply, we believe that our five properties are relatively insulated from the new supply because of their locations and some of their attributes. So we actually see a pretty strong revenue growth of approximately 4.5% coming from Raleigh portfolio.

Nick Joseph - Citigroup

Okay. Have you seen any supply come back in the Midwest at all?

Patrick Duffy

No we are not. We operate 25 properties in the Midwest and none of those properties are impacted by new supply in a meaningful way.

Nick Joseph - Citigroup

Okay. And then in terms of G&A guidance, assuming pretty much flat growth from last year. Could you talk about what you are doing to keep G&A at that level and will give you confidence in that guidance?

Lou Fatica

Nick, this is Lou. As you may recall, we talked about some of the noise in our 2013 G&A numbers as it relates to ongoing litigation at our commercial property at Desmond. And so we incurred about just under a million dollars of expenses. So of that $19.5 million of G&A, $1 million of that was associated with that litigation.

We’re also projecting between $500 and a $1 million of G&A relative to 2014 and that's included in our guidance as well. So I mean, I think, we’ve said for a long time, they operate as a public company, there’s a base number and we look at our G&A as an all-in-number relative to a total low standpoint with our allocation to the property at 2.4% being less than the peer average of 3.5%.

So today, we have about a 4.5% gap between our G&A and our peers in terms of that average. And our focuses continue to drive that down, not so mucSh by reductions to that G&A number, but growing the topline revenue as we see the impact of these acquisitions and the developments coming on line.

Jeff Friedman

Nick, this is Jeff. Let me add one thing to that. In addition in 2013, we had a disproportionate charge relating to a multi-year compensation plan that was put in place in 2013, a three-year plan. And the impact in ’13 was disproportionate than to what it will be in ‘14 and ’15. So part of that pickup going forward is as a result of that as well, right Lou?

Lou Fatica

Correct, right. That’s about $800,000.

Jeff Friedman

That’s about $800,000. So that’s a positive adjustment that is not intended to going forward run rate on the G&A.

Nick Joseph - Citigroup

Great. Thanks guys.

Jeff Friedman

Thank you.

Operator

And your next question comes from the line of Buck Horne from Raymond James.

Buck Horne - Raymond James

Hey, good afternoon. Thank you for taking the question out. I had one on the Mid-Atlantic, which was answered in terms of the supply outlook and how your revenue assumptions grow out. I just wondered if could do the same exercise for Dallas and what kind of supply pressures you see in Dallas, how those may affect your properties and in that particular market?

Jeff Friedman

In the Dallas market, we're currently operating four properties. Two properties are located in North Dallas. Both properties are approximately 13-years old. And while there's new supply in North Dallas because of the age and rental rate of those two properties were really not been impacted by new supply in the downtown and Uptown area of Dallas.

We operate two properties, the Rienzi which is in Uptown and 21-Forty, which is in the Medical District. Both of those properties are competing against several properties that are in leased up. However, we’re maintaining the rents, we’re growing the rents. And I believe, we are forecasting rent growth for those two properties of approximately 3%.

Buck Horne - Raymond James

Okay. Did I hear right, the overall market you are forecasting 3.9%?

Jeff Friedman

Correct, because the two properties in North Dallas are projected to have higher rent growth than the two properties in the Uptown Medical District.

Buck Horne - Raymond James

Okay. All right. Thanks very much.

Jeff Friedman

Thanks Buck.

Operator

And there are no further questions at this time.

Jeff Friedman

Well, thanks very much everyone for joining our call today and we’re available if you need us. That will conclude the call, Holly. Thank you.

Operator

Thank you. This concludes today’s telephone conference. You may now disconnect.

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