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Associated Estates Realty Corporation (NYSE:AEC)

Q1 2008 Earnings Call Transcript

April 29, 2008 2:00 pm ET

Executives

Michael Lawson – VP of IR and Corporate Communications

Jeff Friedman – Chairman, President and CEO

Lou Fatica – VP, CFO and Treasurer

John Shannon – SVP of Operations

Patrick Duffy – VP of Strategic Marketing

Analysts

Michael Salinsky – RBC Capital Markets

Andrew McCulloch – Green Street Advisors

Operator

Good afternoon and welcome to the Associated Estates Realty Corporation first quarter conference call. At this time, I would like to turn the call over to Mr. Michael Lawson, Vice President of Investor Relations for opening remarks and introduction. Please go ahead.

Michael Lawson

Thank you, Lynia. Good afternoon, welcome, everyone. I'd like to remind you that our call today is being webcast and will be archived on AEC's website through May 13. Joining me on the call are Jeff Friedman, President and CEO, John Shannon, Senior Vice President of Operations, Lou Fatica, Chief Financial Officer, and Patrick Duffy, Vice President of Strategic Marketing.

Before we begin, I would like to note that statements made during this call that are not based on historical facts are forward-looking statements. These forward-looking statements are based on current judgments and knowledge of management, which are subject to risks, trends, and uncertainties that could cause actual results to vary from those projected. The risk factors and cautionary statements identifying important factors that could cause actual results to differ materially from those in these forward-looking statements are detailed in the company's first quarter press release.

At this time, I'd like to turn the call over to Jeff Friedman.

Jeff Friedman

Thanks, Mike. Good afternoon, everyone, thank you for joining us. Before I turn the call over to Lou and John, let me take a few minutes to comment on the tremendous job our team has done so far in 2008 executing on the number of our strategic initiatives. We had another strong quarter with FFO per share, as adjusted, increasing 17.2% quarter-over-quarter.

We exited Toledo and sold our affordable portfolio. We increased the amount of our unsecured line of credit by 50% and extended the term for one year. We repaid 2008 maturities with proceeds from the property sales. We closed on the acquisition of two Class A assets in Richmond, Virginia, a new market for us that complements our Mid-Atlantic portfolio. We've reduced the average age of our portfolio to 14 years, one of the youngest of all of the apartment REITs. We are truly growing younger. We are off to a strong start and we are positioned to deliver for the remainder of the year. The depth and continuity of our management team, the quality of our portfolio, the strength of our unique submarkets combined with the demographics in the United States impacting household formation are all part of our success.

While John will discuss each of our markets in greater detail, I can generally say that we have not seen any significant moderation or deterioration in fundamentals. Concessions are down, occupancy is at 95%. We are still able to push rents in most of our markets and many residents seem to be staying longer as turnover is down 200 basis points quarter-over-quarter. As I said on our last call, we have taken a defensive posture in our property level budgets this year, given all of the economic uncertainty that exists nationwide. John and his team remain focused on improving the efficiency and effectiveness of our operating platform. Lou and his team continue to work towards strengthening the balance sheet, reducing interest costs, and doing all the things we need to do to get back to an investment-grade rating. Patrick and his team continue to strengthen and enhance the sales and marketing focus of property management as we look for additional opportunities to contribute to our growth. Our people, our processes, and our portfolio, our formula for success.

These are very exciting times at AEC. We have momentum, we have the best people, a younger, higher quality portfolio, we are in the right markets, and we are well-positioned to benefit from the strong apartment fundamentals.

Now, for more color on our financial performance during the quarter, I'd like to turn the call over to Lou.

Lou Fatica

Thank you, Jeff. For the first quarter, adjusted FFO, which excludes defeasance and other prepayment costs, was $0.34 per share or $0.05 per share greater than our internal forecast. This was an exceptional quarter for AEC, not only from a property performance standpoint but from a transactional standpoint. As Jeff mentioned, we successfully completed the sales of our Toledo portfolio and substantially all of our affordable properties at very attractive cap rates. Additionally, we increased the capacity of our unsecured line of credit from $100 million to $150 million, and extended the maturity to 2011.

On the operations front, same community NOI contributed $0.03 per share in favorable FFO as compared to our forecast due to better than projected property revenues and favorable expenses for insurance. Other significant variances to our forecasted FFO for the quarter included successful tax appeals that resulted in a $0.02 reduction to tax expense for two of the four Toledo properties, which is were sold during the first quarter. As these properties were sold, the reduction in expense is reflected in discontinued operations rather than property NOI. And interest expense was lower by $0.01 due to the decrease in LIBOR rates. These favorable variances were partially offset by $0.01 as a result of our sales closing earlier in the year than projected.

With the disposition of our last wholly-owned affordable asset on April 25, year-to-date we've completed the sales of nearly $92 million of assets. Proceeds of nearly $70 million after debt repayments and buying out the land leases at certain of the affordable properties were substantially used to fund the $2 million defeasance costs associated with the prepayment of one of the Toledo property loans, the repayment of $25 million of debt scheduled to mature in 2008, and to fund our $30 million equity investment in the two Richmond acquisitions.

With the acquisition of Richmond, our total investment in Virginia over the last ten months is nearly $120 million, a total of 804 units, comprised of 268 units in Norfolk and 536 units in Richmond. With the sale of the Toledo portfolio and these acquisitions, the Mid-Atlantic and Southeast will contribute 45% of our NOI on a pro forma basis.

Before I update you on our full year expectations for 2008, I would I like to take a minute to discuss our balance sheet and liquidity. Our leverage at the end of the quarter, as measured by debt to unappreciated book value, stood at 58%. We have no remaining maturities in 2008 and $73 million of maturities in 2009. Our CMBS debt, with an average coupon of 7.7%, comprises less than a third of our total outstanding debt as compared to 55% just a year ago. Over 90% of our debt is fixed at an average interest rate of 6.6%, which is 60 basis points lower than a year ago. Given the current market conditions, we are pleased with our ability to increase our unsecured borrowing capacity while keeping pricing constant and achieving favorable covenant modifications. Our decreased leverage, improved coverage ratios, and additional liquidity resulted in S&P raising their outlook for AEC to positive from stable last week.

Moving on to our 2008 expectations, we are increasing our FFO guidance by $0.04 per share. Our FFO per share range, as adjusted for defeasance and other prepayment costs, is now $1.22 to $1.26. Our FFO guidance continues to reflect $100 million of acquisitions and $100 million of dispositions even though we have completed the majority of this activity year-to-date. We are currently evaluating additional dispositions in our Midwest markets, and we plan on providing updates on our quarterly calls.

In terms of acquisitions, we will continue to source and underwrite deals in our targeted markets and to the extent we find attractive opportunities we will pursue them in advance of any property sales and fund the acquisitions from our line of credit.

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

John Shannon

Thank you, Lou. I am going to provide an overview of our first quarter same community operating performance, specific market details, and some perspective on our expectations for the balance of the year.

For Q1 same community NOI increased by 3.6% quarter-over-quarter. This growth is due to a number of factors. Average physical occupancy remained unchanged on a quarter-over-quarter basis at 93.5% with occupancy of 95% at quarter end. Average net collected rents increased 3.1% portfolio wide with 4.1% from the Midwest and 1.1% from the Mid-Atlantic and Southeast. Concessions, as measured in dollars, declined 17%, or said another way, concessions are down by approximately one week. Key metrics on a quarter-over-quarter basis improved or remained relatively unchanged with traffic at similar levels and closing ratios in the 45% range. Also, annualized turnover declined 2% to 49% as our average length of tenancy is up two months over historical levels and fewer residents are moving out to buy homes, down from 22% in 2007 to 17% this year.

Controllable operating expenses, before taxes and insurance, increased just 2% with total expenses up 3.7%. And sequentially, total revenues increased 50 basis points over Q4 2007 and physical occupancy is up 60 basis points over the same period.

In review of our specific markets, Baltimore, Washington produced revenue growth of 5.9% quarter-over-quarter with quarter end physical occupancy of 96%. We increased rents and occupancy as no new supply was added to our large submarkets and the cost-to-own in our submarkets continues to reflect a significant premium to renting. In Atlanta, we achieved 4.1% quarter-over-quarter revenue growth with quarter end physical occupancy of 93.4%. Our properties, two in the Buckhead area and one in Duluth, are located in submarkets which have some of the better fundamentals in the metro Atlanta area. However, we are beginning to see some concessions creeping back into our Atlanta submarkets and we would anticipate some moderation to the growth we achieved in the first quarter. This softness was built into our budgets and the first quarter was stronger than we expected.

In Florida, with quarter end physical occupancy of 94.3%, we had 1.3% negative revenue growth quarter-over-quarter, which is consistent with our internal expectations as we anticipated the weakness carrying over from 2007. We are beginning to see fewer concessions in these markets. However, as we forecasted, we do not anticipate positive revenue growth until the second half of the year. We continue to see an increase in traffic over previous periods and job growth and household formations continue in the region. Therefore, on an annualized basis, we still expect full year revenue to increase by 1% over 2007.

The Midwest, representing approximately 65% of our first quarter NOI, performed very well with revenue growth of 4.6% and NOI growth of 4.9%. Midwest finished the quarter at a healthy 95.2% physical occupancy. This strong performance is primarily driven by revenue growth as residents are clearly staying longer as a result of the turbulence in the single family housing market and there is virtually no new rental supply.

For the first quarter, we are averaging 4% on lease renewals. This coupled with our high quality assets located in some of the most sought after suburban submarkets has provided us with strong pricing power. Residents moving out for home purchases have significantly declined and we anticipate that renters will continue to stay longer.

In Southern Virginia, we have our property in Norfolk and two properties in Richmond. We acquired the Norfolk property in June 2007 and the property is exceeding its pro forma NOI by approximately 15%. We anticipate that the Norfolk market will continue to be strong. River Forest and Belvedere, the two Richmond properties that we just acquired, are operating at occupancy levels above 95% and have rents that are higher than our pro forma rents. We are confident that these properties will continue to operate at a high occupancy level because of their locations adjacent to growing employment centers. River Forest is located a few miles north of Fort Lee, where approximately 6,000 jobs will be added over the next five years as a result of the Defense Base Closure and Realignment Act. Belvedere is located just 15 minutes from the two largest employment centers in Richmond, downtown and Innsbrook.

Our success for the balance of the year will be driven by focusing on the basics of good property management, maintaining high occupancy, increasing rents, and providing superior customer service.

In summary, our core operations performed better than expected. Occupancy remained stable and we achieved rental increases on new leases and lease renewals. Although we raised our FFO guidance for the year and we exceeded our internal expectations in the first quarter, we are not revising our full year NOI growth guidance of 3.3% to 3.7%. We continue to take a defensive posture regarding the balance of the year due to the uncertainties of the economy.

At this time I'll turn the call back to over to Jeff.

Jeff Friedman

Thanks guys. Why don't we open up the call for questions now, Lynia?

Question-and-Answer Session

Operator

(Operator instructions) Our first question is from Michael Salinsky of RBC Capital Markets. Please go ahead.

Michael Salinsky – RBC Capital Markets

Good afternoon, guys. In terms of your guidance for the full year, you've kept $100 million of acquisitions and $100 million of dispositions. I think you mentioned that the Virginia properties were $30 million. Can you talk about your plans to meet that $100 million of additional acquisitions by the end of the year?

Lou Fatica

Sure, Mike. The Richmond properties of $30 million represented our equity investment. The total acquisition was $75 million. We assumed about $45 million of debt. So the balance of the year includes an additional $25 million or so of acquisitions.

Michael Salinsky – RBC Capital Markets

Okay, and then in terms of dispositions, there's an additional $12 million, assuming that $100 million. You said there is – you are looking at additional opportunities. I mean do you feel comfortable taking additional assets out into the market right now, given what you are seeing with asset pricing?

Lou Fatica

I think that's one of the things that we are evaluating right now. Today we only have two properties, two smaller properties that represent the balance of that $100 million of dispositions, and we are still evaluating other dispositions, so we haven't come to any conclusion regarding that.

Michael Salinsky – RBC Capital Markets

Okay. While we are on the topic of asset pricing right now, what are you seeing right now with regard to cap rates across your markets?

Lou Fatica

I'm going to let Patrick answer that, Mike.

Patrick Duffy

Generally, in the Midwest we are seeing cap rates in the 6.5% to 7% range for well-located class A and B properties. In the Mid-Atlantic and Southeast we are seeing cap rates in the 5.5% to 6% range, once again for Class A properties.

Michael Salinsky – RBC Capital Markets

Okay. And how does that compare to say six to 12 months ago?

Patrick Duffy

Six to 12 months ago, we were probably seeing in the Mid-Atlantic and Southeast, cap rates in the 5% to 5.5% range, so cap rates are about 50 basis points higher.

Michael Salinsky – RBC Capital Markets

Okay. And that holds true in the Midwest as well?

Patrick Duffy

Yes.

Michael Salinsky – RBC Capital Markets

Okay. And with the sale of the affordable portfolio now as well as the older Toledo portfolio, what are your assumptions in terms of CapEx for the year?

Lou Fatica

Well, I think we'll hold to our original guidance with our CapEx of about $600 per unit in recurring CapEx. And then another $200 per unit for what we call investment capital with the roof replacements, exterior painting, and we are also looking at doing a kitchen and bath renovation at our 184-unit property in Columbia, Maryland.

Michael Salinsky – RBC Capital Markets

Okay. In terms of your guidance, the big change I saw was the change in interest expense. What was the driver behind the reduction in interest expense forecast for the full year?

Lou Fatica

Primarily that was just the impact of transactional activity. Our original forecast had assumed acquisitions to happen during the first quarter and they didn't happen until the second quarter. And then lastly, although it's a very small component, our variable rate debt, we've reduced down our expectations in terms of LIBOR and are looking more in the range of 2.75 to 3.25 for the balance of the year for LIBOR rates on our variable rate debt.

Michael Salinsky – RBC Capital Markets

Okay. That's very helpful. Thanks, guys.

Lou Fatica

Thanks, Mike.

Operator

(Operator instructions) Our next question is from Andy McCulloch of Green Street Advisors. Please go ahead.

Andrew McCulloch – Green Street Advisors

Hey, good afternoon. What was the cap rate on the Richmond acquisitions? What were the two cap rates? And also what is the rate on the debt you are assuming?

Lou Fatica

I'll answer the rate on the debt. The blended rate is 5.63%. It's a 30 year FHA debt that we assume. And Patrick can address the cap rates.

Patrick Duffy

The blended cap rate was the 5.6% with Belvedere having a 5.1% cap rate and River Forest having a 5.9% cap rate.

Andrew McCulloch – Green Street Advisors

Great, thanks. And then just on your guidance, Lou, can you just walk us through this again? It looks like your interest expense is down by $1.4 million, and your G&A is up about $300,000. That's $1.1 million delta, which is about $0.07 a share. Could you just walk us through that how that translates into your FFO guidance?

Lou Fatica

Sure, I mean, that's really just the function of the transactional activities and really the expectation of when property sales happen and the dilution from any NOI. So when we take a look at that, and I don't have the specifics in terms of the actual components of that NOI breakout, but the $300,000 G&A increase is really a function of what happened to our share price during the first quarter. We have projected an impact of about $150,000 related to share price appreciation, it was double that, and we just kind of annualized that for the year. And in terms of the interest expense, as I mentioned, it was really a function of transactional activity and the expectations of when property acquisitions would occur. So Richmond happened later than what we had projected and our remaining acquisition has been pushed back later into the year as well.

Andrew McCulloch – Green Street Advisors

Okay, thanks.

Jeff Friedman

Let's make sure, Andy, this is Jeff.

Andy McCulloch – Green Street Advisors

I can follow-up offline with you guys.

Jeff Friedman

What's that?

Lou Fatica

I'll follow-up with you, Andy, and go through that.

Andy McCulloch – Green Street Advisors

Okay, great.

Lou Fatica

Okay.

Jeff Friedman

I think the other part was the loss of NOI from the sale if properties. So if that was $0.07 then the other $0.03 or $0.04 making up the difference between the $0.04 of additional guidance was in the loss of NOI from the properties we sold.

Andy McCulloch – Green Street Advisors

Okay. That makes sense. Great, that's it from me. Thanks, guys.

Jeff Friedman

Thank you, Andy.

Operator

(Operator instructions)

Jeff Friedman

Okay, Lynia, it looks like we answered everybody's questions. I want to thank everyone for participating today. And that will conclude our call. Thanks very much.

Operator

Thank you for participating in today's conference. You may now disconnect your line.

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