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Associated Estates Realty Corporation (NYSE:AEC)

Q2 2008 Earnings Call

July 29, 2008 2:00 pm ET

Executives

Jeff Friedman - Chairman, President and Chief Executive Officer

Lou Fatica - Vice President, Chief Financial Officer and Treasurer

John Shannon - Senior Vice President of Operations

Patrick Duffy - Vice President of Strategic Marketing

Kimberly Kanary - Vice President, Corporate Communications

Analysts

Andrew McCulloch - Green Street Advisors

Michael Salinsky - RBC Capital Markets

Paula Poskon - Rober W. Baird

Operator

Welcome to the Associated Estates Realty Corporation second quarter conference call. (Operator Instructions) At this time, I would like to turn the call over to Kimberly Kanary, Vice President of Corporate Communications for opening remarks and introductions.

Kimberly Kanary

I'd like to remind you that our call today is being webcast and will be archived on AEC's website through August 12. Joining me on the call are Jeff Friedman, President and CEO; Lou Fatica, Chief Financial Officer; John Shannon, Senior Vice President of Operations; 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 second quarter press release.

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

Jeff Friedman

Another great quarter for AEC; in fact this is the 12th consecutive quarter that we reported an increase in the same community NOI. Our second quarter and year-to-date results highlight two important points. First our properties are ideally positioned to benefit from all of the uncertainty in our economy and second our management team continues to execute on the strategic objectives we established in 2005, foremost of which was to invest in our properties and our people, to position the company to benefit from the improving apartment market conditions and improve what they have.

AECs properties are predominately Class B suburban properties located near major employers and high barrier to entry submarkets. With only a few exceptions there is no new competitive product being built and no competition from the shadow supply of unsold units. The high average home prices in our surroundings submarkets position our properties as a value alternative. We expect to benefit from these conditions for many years.

Our first half results are ahead of our full year forecast and as we said in our press release we have once again raised our full year guidance. We still continue to expect the second half of the year to moderate a bit, both sequentially and on a quarter-over-over basis. When we drill down into our markets we see in the Midwest for example, that the second half of 2007 was very strong and the comps become more difficult to be. Atlanta is a bit softer than we expected and Virginia and Florida are right where we thought they would be. Lou and John will both provide more specifics and color on today’s call.

Sure we’re the beneficiaries from the uncertainties in single-family housing and the high number of new house hold entering the rental markets, but AECs success is also driven by a team of highly skilled professionals with the discipline to stick to our strategic objectives and the proof is once again in our results. I’ll turn the call over to Lou.

Lou Fatica

For the second quarter FFO was $0.34 per share or $0.04 per share higher than our internal forecast. As Jeff said this was another greater for AEC. Our same community NOI increased by 8.3% as a result of solid 3.3% revenue growth and a 2.6% decline in expenses. The NOI growth is driven by higher net collected rents due to concessions burning off in most of our markets and an aggressive expense management of both controllable and non-controllable expenses.

Year-to-date same community NOI growth is 5.9% as a result of 3.5% revenue growth and relatively flat expenses. Based on the strengths of our performance during the first and second quarters and our expectations for the balance of the year we are increasing our FFO guidance by an additional $0.06.

Our full year FFO guidance per share has adjusted for defeasance and other prepayment costs, is now $1.30 at the midpoint. We expect our full year same community portfolio to deliver NOI growth in the range of 4.5% to 4.9% supported by forecasted revenue growth of 3% to 3.3% and projected expense growth of 1.1% to 1.6%. At the midpoint the forecasted NOI growth is 120 basis points higher than the previous guidance. Additional assumptions for our full year 2008 guidance can be found on Page 25 of our supplemental.

Before I turn the call over to John, who will discuss our specific market performance, I would like to take a minute to discuss our balance sheet, liquidity and FFO payout ratio. 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. We would expect to refinance the 2009 maturities with the GSCs allowance rates of sub 6% on a five or seven year basis or user our line of credit. Our remaining $156 million of CMBS debt with an average coupon of 7.7% comprises just 28% of our total outstanding debt. Over 90% of our debt is fixed at an average interest rate of 6.5% with a weighed average maturity of over eight years.

As a result of our refinancing and repayments the average interest rate on our fixed rate debt has decreased by 50 basis points over the past year. Our unsecured $150 million line of credit which currently has $13 million outstanding enables us to target acquisition opportunities in advance of property sales.

In addition given the current market conditions, we are extremely pleased with the pricing on this facility which is currently at a 160 basis point over LIBOR or 4.1% at quarter end.

Lastly, our expected FFO payout ratio 52% at the mid point of our guidance is the lowest of our multifamily peer group. This allows us to continue to invest in capital improvements at our properties in addition to providing an attractive dividend yield to our shareholders.

Now, let me turn the call over to John.

John Shannon

I will provide an overview of our second quarter same community operating performance, specific market details and some perspective on our expectations for the balance of the year. We had a terrific second quarter with same community NOI up 8.3% quarter-over-quarter. This growth is due to a number of factors.

Average physical occupancy remained unchanged on a quarter-over-quarter basis at 94.2% with occupancy of 96.7% at quarter end. Average net rents increased 3.1% portfolio wide with 4.6% in the Midwest and rents that were unchanged in the Mid-Atlantic and Southeast.

Quarter-over-quarter concessions will reflect the reduction of $550,000 or nearly 25%, all coming from the Midwest. Key metrics on a quarter-over-quarter basis improved or remained relatively unchanged with traffic and turnover at similar levels and closing ratios in the 50% range. Our average length of tenancy is up two months over historical levels and as you would expect fewer residents are moving out to buy homes, down from 22% in 2007 to 18% this year.

Household incomes on average at our communities are up 11% from $55,000 to $61,000; clearly an indication that we are seeing more traffic and move-in’s from renters by choice. Total operating expenses were down 2.6%.

While some of this is due to timing, the savings are primarily a result of strict adherence to budgeted expenses in a favorable property insurance renewal program and on a sequential quarterly basis, total revenues increased 2% and quarter ends physical occupancy is up almost 2% over Q1, 2008.

In review of our specific market Baltimore, Washington produced revenue growth of 3.7% quarter-over-quarter with quarter end physical occupancy of 96.4%. The Baltimore, Washington market continues to have positive household formation and job growth. We expect our Baltimore, Washington properties to continue to perform as expected with full-year NOI growth of 3.7%.

In Atlanta quarter-over-quarter revenue growth was down approximately 1% and quarter end physical occupancy was 93.8%. As we reported last quarter, concessions are back in the Atlanta submarkets, and we are offering on average six weeks of free rent.

With limited new supply as compared to historical levels and modest job and population growth, on the surface the metro area seems to be relatively healthy; however, we do anticipate continued softness and concessions for the balance over the year in our Buckhead and lower Gwinnett County submarkets due to recently delivered new apartment supply and the unsold condo shadow supply.

In Florida, with quarter end physical occupancy of 95.8% we had 2% negative revenue growth quarter-over-quarter which is consistent with our internal expectations. We are currently offering fewer concessions and we are forecasting positive revenue growth of approximately 1% in the second half of the year. On an annualized basis we expect full year NOI to be basically the same as the 2007 level.

The Midwest performed very well with revenue growth of 5% and NOI growth of 11.5%. The Midwest finished the quarter at a strong 97.2% physical occupancy level. The outlook for our properties and submarkets in the Midwest is much the same as we have previously discussed. There is virtually no new rental supply, residence are clearly staying longer and new household are opting to rent as a result of the turbulence in the single-family housing market.

Much has been written about the Midwest economy, but our result support that the problems have not had a negative impact on our business. The economy in Indianapolis and Columbus continues to improve with household formation and job growth up approximately 1.5%.

In Cleveland and Detroit household formations remains flat to slightly negative with job growth reflecting slight declines. These declines in jobs are misleading as they relate to our submarkets. As we have often noted our portfolio consists of high quality class B properties located in some of the most sought after suburban submarkets. Our locations are minimally impacted by the decline in manufacturing jobs and more specifically, the automotive industry that makes up much of the job losses.

In our Cleveland submarkets, where we have a total of 1,400 units only nine apartments or 1.5% are occupied by residents employed in the auto industry. In our Detroit submarkets, where we have 1800 units, only 44 or 2.5% are occupied by employees of the automobile industry.

Additionally, in many of our Midwest markets we are seeing steady job growth in the healthcare and the education sectors. We are very well positioned in the Midwest with our current portfolio and expect to continue to see solid revenue and NOI growth in the second half of the year.

In Southern Virginia, we have a property in Norfolk and two properties in Richmond. Although the three properties are not yet part of our same community portfolio, it is important to note that they are performing at 98% average occupancy and are achieving rents that continue to outperform our acquisition performance. The markets are benefiting from a 1% increase in both household formation and job growth along with the large presence of military and defense related businesses.

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 properties performed better than expected. Occupancy remained stable and we achieved rental increases on new leases and lease renewals.

On our Q1 conference call, we said that we would continue to take a defensive pasture regarding the balance of the year, due to the uncertainties of the economy. Given that we are well into Q3, we have a higher level of certainty as to our full-year performance and as Lou mentioned, we are raising our same community 2008 NOI guidance range to 4.5% to 4.9%. Our portfolio is well positioned for solid performance for the balance of the year and into 2009.

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

Jeff Friedman

Let’s open the call up for questions.

Question and Answer Session

Operator

(Operator Instructions) Our first question comes from Andrew McCulloch, of Green Street Advisors; please go ahead.

Andrew McCulloch - Green Street Advisors

Just looking at some of your turnover metrics for this quarter compared to Q2 2007, their net down, but it changed a lot in between markets, some are up quite a bit, some are down. Can you walk through some of those markets and maybe some of the reasons why those turnover ratios have changed so much?

Jeff Friedman

Sure, the turnover for example in the Indiana market has always been one of our highest markets due to some of the student base with Butler there. The Michigan market’s been fairly flat. Central Ohio I think we saw this in some of our markets before Andy, in the Florida and Maryland when we were really pushing rents. We’ve seen a slight increase in turnover in Central Ohio because we’re pushing rents, so we view that as a fairly good thing. Northeast Ohio, we’re staying flat, Pennsylvania flat and then the other meaningful one is in Georgia where we have seen a higher increase of turnover and that’s principally due to job losses from the residence that reside at our Gwinnett County apartments.

Andrew McCulloch - Green Street Advisors

Okay, on the remaining acquisition can you give us a little more color on what you see there as far as pricing and how maybe cap rates have changed over the last few months?

Lou Fatica

We do continue to look at acquisition opportunities. Year-to-date we’ve closed on two acquisitions; what we’re seeing in the markets, we’re seeing cap rates for the well located properties going up maybe 10 to 50 basis points.

Andrew McCulloch - Green Street Advisors

You guys seeing any substantial widening out of cap rates between A, B and C products in your markets?

Lou Fatica

No, not in the markets that we’re looking in. We’re primarily focused on the Mid-Atlantic and Florida markets.

Jeffrey Friedman

Andy, this is Jeff. Let me add that, we’re not really looking at the sea property, so right Patrick, I don’t know that we would be the best ones to tell you about what’s happening there. We’re clearly seeing less properties that are being put on the market. That velocity as people will refer to it is definitely down. I don’t know if the sellers don’t want to sell at these prices. In some cases we’re seeing properties that are not in a condition to be sold, they haven’t been maintained to a level that the sellers wouldn’t have to take big hits, so we’re just not seeing as much products.

Andrew McCulloch - Green Street Advisors

Can you guys track home ownership rates for your particular markets because I think the census data showed that home ownership rates for the U.S. as a whole actually went up this last quarter, which is kind of counter intuitive when you look at employment growth and home sales figures.

Jeff Friedman

Do we track home ownership rates in our submarkets, it’s something we do not Andy and all of the bigger broader data that I’ve seen; I think we talked about in New York that may read in June it seems like a long time ago, there was discussion about the increase in household formations. They weren’t surprised by numbers if all of those new households in effect became renters even though actually all of them won’t in 2008. So, what you said Andy it is counter intuitive and a little bit different than some of the number that we’ve seen, but I believe you if you tell us.

Operator

Thank you. Our next question comes from Michael Salinsky of RBC Capital Markets; please go ahead.

Michael Salinsky – RBC Capital Markets

First question, looking at a turnover going back to Andy’s question there and also looking at the revisions to guidance this year; you look back to the third quarter of last year, you had an 8% increase in same-store expense; is it possible we could see expenses down again in the third quarter or basically what are you seeing right now in term of expenses?

Jeff Friedman

Well, if we keep trending the way we are with our turnover we’ll be down approximately 3% on our turnover from the last year if you annualize the first half from the 61% down to a 58%, which is about a 3% pick up and if translated into that; that would be about a $200,000 savings on an annualized basis, so yes we could see pick up from there. We also think that we are going to see some pick up from our service providers where we are renegotiating contracts both for landscape and terrace, those type of things and we’ve been getting some positive results from that with pricing down those contracts.

Michael Salinsky – RBC Capital Markets

Okay with regard to real estate taxes some of those that have come in the second quarter, have those been pretty much inline with your expectations?

Lou Fatica

Yes Michael, this is Lou. Real estate taxes are trending fairly consistent to our budget with the exception of Indiana. It continues to have upward pressure on real estate taxes they we are currently appealing at this time. Year-to-date real estate taxes are up 4% from a year ago.

Michael Salinsky – RBC Capital Markets

Secondly John in your comments you touched upon the auto industry. Two banks in the Cleveland and the Columbus area there that have had some write-downs as of late; do you know what your exposure is to the financial industry?

John Shannon

Yes, NCB is a large in flow for some of our properties, but really outpacing that are the Cleveland Clinic University Hospital progressive, so we have some strong employers behind the NCB so we’re not concerned about some of the banking firms having difficulties or perhaps laying off some folks.

Michael Salinsky – RBC Capital Markets

Okay, with regard to traffic levels, you mentioned that traffic levels were up on a year-over-year basis; do you have a break out of that for the Midwest versus the non-Midwest portfolio?

John Shannon

Yes, I do. What I did say on the call with Mike was that the traffic was basically unchanged year-over-year. We have seen a pick up to a certain degree in the Florida market with traffic down there and we just think that its again people not buying homes are out shopping and looking at our apartments for their housing choice.

Michael Salinsky – RBC Capital Markets

Okay. With regards to the acquisition guidance, you’ve completed about $75 million year-to-date, your guidance still calls for $100 million; have you identified any properties at this point and if so when do you anticipate closing on those?

Jeff Friedman

We’re continuing to look at acquisition opportunities; we have not placed any under contract at this point.

Michael Salinsky – RBC Capital Markets

Okay; is there any updates on the disposition front either?

Jeff Friedman

Currently, we have two properties listed both properties are small properties. We hope to sell both properties by year-end.

Michael Salinsky – RBC Capital Markets

Okay and switching over to the GSEs, can you just provide some additional color on what you’re hearing with regards to terms, LTVs, things of that nature, as well as you’re wiliness to do business in the future?

Jeff Friedman

Well, we’re hearing much the same of as everybody else has been talking about; the doors are opened for business. We’re looking at spreads somewhere in the 210 to 230 range depending on the term of the deal or the length of the deal, but what you’re finding out is that everything is really deal specific, so it’s really hard to paint a broad brush on where a certain deal would close at, but we’ve had conversations about our 2009 maturities with both Freddie and Fannie and our confident that we can place that somewhere in the 6% range, in the five and three quarter to six and a quarter range.

Michael Salinsky – RBC Capital Markets

Okay and the LTVs on that?

Jeff Friedman

Those deals would be around 60% LTV. I mean they’re doing higher leverage, but typically our leverage is around the 60% level.

Michael Salinsky – RBC Capital Markets

Okay and then finally just if you can provide an update on the ongoing redevelopment at reflections and now that’s progressing?

John Shannon

Things are going well. We’ve got in the first five weeks, we’ve delivered 84 apartments; they look terrific. We’re getting in the neighborhood of what our underwriting had with an $85 premium for those apartments, plus 3% to 4% increase in the base rents. So, so far the things are very successful; the constructions moving along beautifully.

Operator

Thank you our next question comes from the line Paula Poskon of Robert W. Baird. Please go ahead.

Paula Poskon – Rober W. Baird

Just a one quick question; can you talk a little bit about the traffic that you’re seeing in the mid Atlantic region and your ability to push rents there?

Patrick Duffy

Paula this is Patrick Duffy. Our traffic for the first six months of 2008 is inline with the same period of last year. Our conversion ratio is approximately 42% in the mid Atlantic region which is approximately the same level as last year. We’re continuing to push rents in the mid Atlantic. In the Baltimore, Washington market we were able to increase rents by 4.8% during the first six months of 2008, so the mid Atlantic market is very strong.

Paula Poskon – Rober W. Baird

Are you seeing any push backs from tenants anywhere that you’re pushing rents?

Patrick Duffy

We’re not. In the mid Atlantic it still continues to be a very strong market for us.

Operator

We have no questions in the queue at this time.

Jeff Friedman

Thanks everyone for joining us. I would also like to thank the AEC team for another great quarter; keep up the hard work and thanks everyone for joining us.

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Source: Associated Estates Realty Corporation Q2 2008 Earnings Call Transcript

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