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Essex Property Trust Inc. (NYSE:ESS)

Q2 2008 Earnings Call

July 31, 2008 12:00 pm ET

Executives

Keith Guericke - President and CEO

John Eudy - EVP - Development

Mike Dance - EVP and CFO

Mike Schall - SEVP and COO

John Lopez - Economist

Analysts

Dustin Pizzo - Banc of America Securities

Alex Goldfarb - UBS

Jonathan Habermann - Goldman Sachs

Karin Ford - KeyBanc Capital Markets

David Toti - Citigroup

Anthony Paolone - JPMorgan

Steve Sakwa - Merrill Lynch

Michael Salinsky - RBC Capital Markets

Rich Anderson - BMO Capital Markets

Paula Poskon - Robert Baird

Good day, ladies and gentlemen, and welcome to the second quarter 2008 Essex Property Trust earnings conference call. (Operator Instructions)

I would now like to turn the call over to Mr. Keith Guericke, President and CEO. You may proceed, sir.

Keith Guericke

Thank you. Good morning, and welcome to our second quarter call. This morning, we'll be making some comments in the call which are not historical facts, such as our expectations regarding markets, financial results, and real estate projects. These statements are forward-looking statements which involve risks and uncertainties which could cause actual results to differ materially. Many of these risks are detailed in the company's filings with the SEC; we encourage you to review them.

Joining me today on the call will be Mike Schall, Mike Dance and John Eudy. Again, we are going to try and keep our comments short so that we are all going to speak. Included in the earnings release on our website, you'll find our market forecast for 2008. These forecasts are unchanged from the previous quarter.

Also included with the earnings release is a schedule entitled "New Residential Supply" which includes total residential permit activity for the larger US metros as well as information on median home prices and affordability, as compared to the markets that we operate in.

A note of interest, single-family permits for our combined markets, the Essex markets are down approximately 40% from the same quarter in 2007. This represents about 0.4% of existing stock. Multi-family is approximately the same. In order to get those details, you can visit our website under Investors and Media.

Last night, we reported another strong quarter with core FFO increasing 11.7% per share. For the quarter, the portfolio grew revenues 5.1% greater than the same quarter in '07 and 1.3% on a sequential basis. Again, I think the strong performance just demonstrates the fundamentals of our supply-constrained markets.

In the second quarter of 2008, we saw some signs of stabilization in our California existing home sales markets. Even though prices were down 21%, and transactions were down 20% from the previous year; however, we track movement from quarter-to-quarter, and the traditional seasonal increase Q2 over Q1 was much stronger this year, and Q2 '08 transactions in our markets were up sequentially 50% over Q1 '08. Last year, in the same period the seasonal increase was only 8%.

Lower prices are inducing transactions, albeit below historical levels. We think this is important because the increased transaction level indicates the confidence by the consumer that we are nearing the bottom of the price decline.

Going to each of the markets; in Seattle and Northern California, the economies are doing well with the exception of the Oakland MSA where the outlying areas are more heavily affected by the decrease in the housing jobs. The apartment markets in both Seattle and Northern California have performed at or above expectations through the first half of '08 with occupancy rates well above 95%. And rent growth at 10% for Northern California and 7.8% in Seattle for the second quarter. These two markets continue to be the two best rental markets in the country.

Southern California, as of June, year-over-year job growth across the region remains weak. We are seeing signs that the weakest sectors are beginning to stabilize. As we stated last quarter, the cuts in the housing sector occurred at a much more rapid pace than anticipated and we believe the worst of the cuts, the big cuts are behind us.

Now going to each of the markets and I've sort of lumped these by (inaudible) and Ventura and Orange are the markets where we've had the greatest issues. The Ventura and Orange County markets experienced disproportionately high growth in the home financing jobs, with the housing bubble that started in late 2001 and 2002. The job losses in the home finance sector began in early 2006 and accelerated in the second half of '07.

Again, we believe the worst losses have already occurred as of June jobs in the sector are back to the late 2001 levels. We expect these job markets will stabilize going forward and single-family supply will continue to decline to even lower levels. We don't expect to see significant job losses from a multiplier effect because the home finance sector does not have significant sub-industries that feed it.

Going to Los Angeles, home financing jobs were also cutback in LA, and are back to late 2002 levels. However, in LA, the bubble in the sector was much smaller relative to the market's economy. By comparison, over the last 12 months, home financing jobs are down 6.5% of the sector's total; however, this is only 0.1% of the total jobs in LA.

LA has also seen a large reduction in residential construction jobs; however, these have primarily been in North LA County which has little direct impact in downturn, West LA and Long Beach where our portfolio primarily is located. Manufacturing jobs have been the biggest drag on the economy, and we see signs of improving conditions in this sector in the first half of '08 relative to '07.

Finally, San Diego, this economy has outperformed the rest of the Southern California for the last 18 months. It had considerable job losses relative to construction, home construction, that's primarily behind us; however, San Diego is a much smaller exposure to the home financing jobs and heavy manufacturing.

Manufacturing jobs are flat year-over-year and this trend is continuing. They've had strength in the bioscience and other technology sectors and that's clearly helped the San Diego market. The market occupancy has remained above 95% and above levels from the same period last year.

Generally, we come in on cap rates. We continue to see softness there, although the number of transactions has been significantly smaller than typical. It is difficult to get a real fix on what cap rates are based on transactions.

However, we would estimate that cap rates have probably slipped another 25 basis points moving across the board in each of our markets. So, for [AB] products, in the Bay area, we think that the spread is somewhere between 4.5 for the best and 5.75 for the B. Southern California, the spread is probably 100 basis points, 475 to 575 and Seattle 4.5 to 5.75.

With that information, I will turn the call over to John Eudy.

John Eudy

Thank you, Keith. Our active development pipeline, including Fund II transactions, is comprised of eight developments under construction are 658 units, $622 million. We are about halfway through the construction process, completion and delivery operations will occur fairly equally at the rate of about 200 million a year over the next three years, consistent with our strategic plan.

During the quarter, we have added to the active development pipeline, Joule Broadway 295 units in Seattle and Tasman Place, 284 units in Sunnyvale. On the remaining active development projects, I have the following to report: Eastlake 2851 in Seattle is now substantially complete and 94% leased as of yesterday, right on plan.

Belmont Station in Los Angeles, last quarter we expected to begin occupancy in July and disappointed to report that occupancy will slip into the first half of August and possibly as early as next week. We've previously reported that due to partnership capital defaults from the prior developer, we became the developer after construction started. In retrospect, we did not fully understand the extent, the plans were not coordinated properly and we underestimated the transition issues when we took over the developer role. Our people in the field have risen to the occasion and we are almost done.

To-date, I am extremely pleased with the pre-leasing team and the lease activity to date. For 79 days, since we opened, we have 98 leases or over one-third of the development leased and ready to occupy.

As an abundance of caution, we have moved our stabilization date to June 2009. If we continue to lease at the current rate, we will beat that date significantly. The balance of the other active development projects, including the Grand in Oakland, Fourth Street in Berkeley,, Studio 40-41 in Studio City, and Cielo in Chatsworth are on time and on budget to-date, consistent with prior quarters reporting.

On predevelopment activities, we have chosen to be defensive on our Essex-Hollywood transaction and we extended the lease with our tenant through July 2009, thereby delaying our anticipated start date. The Cadence transaction in San Jose and the Main Street in Walnut Creek developments are both on track and pending construction start in January 2010.

In our Supplemental S-9, we have noted two joint ventures. Both transactions include money partners having equal equity investments with us, unlike Belmont Station where the developer from the (inaudible) do not expect to have any kind of issues like we have experienced on Belmont Station since we are driving the transaction from day one. There are no other changes on the land held for development from last quarter.

One note on the recent spike in oil, we've seen additional pressure in metals and other oil-based materials such as asphalt and plastics. However the labor side of the equation has been very, very competitive, more than I've seen in the last 15 years. The offset to materials costs have netted out to annualized construction cost increases of less than 10% which we have already built into our modeling.

At this time, I would like to turn the call over to Mike Schall.

Mike Schall

Thanks, John. And thanks everyone for joining us today. Before discussing the quarter, I want to report that Essex sustained no damage from the earthquake that was centered in Chino Hills area of Southern California on Tuesday.

Now on to the quarter. Despite the housing gloom and doom stories out there that you heard, we had another strong quarter operationally. Long-term current conditions all seem to point to lower supply of both rental and for-sale housing which is good for Essex. In the short-term operating conditions remain good in southern California and very strong in Northern California in Seattle.

The summer is our peak leasing season and therefore is critically important to us and we remain well positioned for the remainder of 2008. During the second quarter, Northern California led the way with 10% Same-Property revenue growth well above our 2008 guidance of 5.5% to 7%.

Our Seattle revenue growth also exceeded the top end of the 2008 guidance range in this case by 0.8%. In Southern California, our revenue growth remained near the top of the guidance range which was 1.5% to 3% and we continue to have the same challenges that were discussed on prior calls, largely related to localized supply or job loss issues. Still it appears that recent shocks at Countrywide and Amgen for example are not getting worse and management is effectively working through those challenges.

Operating expenses grew at 3.6% for the quarter near the high-end of the guidance range of 2.5% to 4%. Year-over-year expenses were influenced by a couple of property specific issues and the impact of new initiatives including Level 1 and YieldStar. We recall that our guidance included large property tax reassessments at many of our Seattle properties which have contributed to their expense growth.

The 2.5% sequential increase in expenses reflects the cost that I just referred to plus the seasonal increase in turnover which ran at a 42% annualized rate in the first quarter and increased to 56% in the second quarter. We expect operating expenses to remain near the high-end of our guidance range for the remainder of 2008.

During the quarter, we completed our conversion of our property management and general ledger system to Yardi, in addition we now have 24-hour call center support for all of our properties. We note that typically 30% to 40% of our calls come in after hours or while the staff is otherwise unavailable, so the call center support is very effective.

We continue our implementation of the YieldStar's Price Optimizer software and it's running at 70 properties up from 24 reported on last quarters call. Loss to lease which estimates a difference between market and in-place rents without regard to concessions rebounded at the end of the second quarter to 2.4% of rental income versus 0.9% reported for the first quarter. Most of this change was attributable to firming rents in Southern California as compared to the discounting that was required to hold occupancy in the first quarter.

Overall in Southern California, we reported positive loss to lease of $1.8 million at June 30, 2008 versus negative loss to lease of $3.5 million at March 31, 2008. Our actions to maintain occupancy in the first quarter allowed us to be more aggressive in the second quarter, resulting in higher rent levels and a 50 basis point increase in sequential occupancy.

Now, I would like to provide some additional facts on each major part of our portfolio starting in the Northwest. All markets surrounding and including Seattle are strong. We continue to carefully watch the supply picture particularly in Bellevue, although job growth has been sufficient to absorb new units. As of July 22nd our physical occupancy remains strong at 96.9% with net availability at 4.1%.

Home purchase activity represented 15.8% of move outs for quarter compared to 21.5% a year ago. In Northern California, as before, all sub-markets performing well, although the East Bay has greater supply issues and more fall out from the problems in for-sale housing.

Again, for Northern California as of July 22nd, physical occupancy was 97.2%, net availability of 3.7%. Home purchases declined substantially. They were only 8.3% of our turns for the quarter compared to 19.7% a year ago.

Southern California obviously is a huge area and there are considerable variations in results based on property location, the Inland Empire has by far the greatest difficulties with combination of more supply and too many more or less more transient jobs, like for example construction jobs. Fortunately, we have a very small presence there.

Our view is that San Diego, Los Angeles and Ventura counties improved marginally during the quarter and in Orange County conditions were effectively unchanged.

Overall, I believe that our operations group did a very good job of implementing an occupancy-based pricing strategy during the first quarter, which positioned us to firm rents in the second quarter.

Physical occupancy as of July 22nd, 2008, LA Ventura was 95.5%, net availability at 6.3% in Orange County 95.8% physical occupancy, net availability at 5.6% and San Diego physical occupancy is 96.1%, net availability of 5.8%. For all of Southern California combined move out activity attributable to home purchase was 7% for the quarter versus 14.5% a year ago and that pretty much follows similar patterns no matter how you break that down by county.

That concludes my comments. I'd like to turn the call over to Mike Dance. Thank you.

Mike Dance

Thanks, Mike. My comments today are intentionally brief to allow more time for the questions and answers that will follow. The strong June quarter results beat the First Call Consensus estimate for funds from operations by $0.02 a diluted share. The second quarter's results are very similar to the results we reported for the first quarter.

Given the uncertainties in the economy and the volatility in interest rates we believe the results achieved this quarter are an appropriately conservative run rate for the results that can be expected for the remainder of 2008. The favorable second quarter results benefited from a decrease in the interest expense of $20.2 million in the first quarter of 2008 to $19.8 million for the second quarter. While the total debt increased by $80 million.

The decrease of $400,000 in net interest expense reflects the additional interest expense of $900,000 from the mortgages originated in 2008, unless the increase in capitalized interest of $500,000 on the cost incurred for development communities.

And the reduction in the weighted average interest rate of 5.6% to 5.4% during the second quarter. This reduction in interest rates reduced our borrowing cost by $800,000 which is attributable to the $400 million of variable rate debt as of June 30th which paid a weighted average interest rate of about 3.5%.

We believe that the Fed will quickly increase short-term interest rates as soon as there are indications of a recovering economy to reduce inflationary pressures. If we continue to benefit from the current low interest rate environment with continued strong demand for housing in Northern California and Seattle, we are confident that we can beat the midpoint of our guidance. If there's a spike in short-term rates without the strong demand for rental housing, there's some risk we'll fall below the midpoint of our guidance.

Except for the change to project the 2008 interest expense, we have no other significant changes to our 2008 guidance. Before I close my remarks I want to highlight some of the accomplishments achieved during the quarter.

First, I want to recognize the finance team's success during the quarter as the company obtained approximately $70 million in secured 10-year debt financing by Freddie and Fannie. , They negotiated a five-year extension on the secured line and increased the line's borrowing capacity by $150 million, and arranged a $60 million construction loan from two of commercial banks that participate in our unsecured line.

Given the liquidity concerns caused by the turmoil in the credit markets, we feel fortunate to have the financing partners with the resources and commitment to meet our ongoing capital needs.

Next, I want to highlight the economic performance of our Value Fund II during the quarter. In our earnings supplement on S-11, the operating communities owned by the fund achieved year-over-year net operating income of 15%.

Based on our economic research, we refocus our capital allocations from Southern California to the Bay Area and Seattle and this has proven to be the correct strategy. The ability of our fund acquisition and development teams to source value-added opportunities in supply-constrained markets has to date exceeded our high expectations.

And lastly, I want to personally thank all of the employees in our information systems, accounting and property operations that this demonstrated outstanding team work and a willingness to work long hours to successfully complete the rollout of our new property management and accounting platform

This concludes my remarks and I will turn the call back to the operator for question.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Dustin Pizzo from Banc of America Securities. You may proceed.

Dustin Pizzo - Banc of America Securities

Hey. Good afternoon or good morning to you guys. Keith has there been any change to your underlying same-store revenue growth assumptions?

Keith Guericke

No. I mean we guided down inventory accounting for last quarter and I think we outperformed our worst expectations, but we have left everything else in place.

Dustin Pizzo - Banc of America Securities

Okay. So, how do you think about it then, I mean because the current range implies a pretty dramatic slowdown to about 2% in the second half. Is that just being overly cautious on your part or are you seeing anything and it sounds like you are not since you mentioned Southern California appears to have the worst behind us. Can you just help us think about that a bit?

Keith Guericke

You have been very kind; you haven't used the sandbagger word. Those who know us know that we've been generally pretty conservative, we never want to disappoint.

And I think as Mike accurately described it is that we are being conservative this quarter and we probably could have tightened the range a little bit, but felt that even though we think that the worst of the job cuts are behind us and we don't see any storms in the horizon, I think that we feel good about where our guidance is and we certainly don't ever want to have to guide down half or re-guide up after we have guided down.

So, we have been conservative and again it is just uncertainty in the future with respect to what the heck is going to go on.

Dustin Pizzo - Banc of America Securities

Fair enough. Then as you think about the potential for interest rate spikes as you mentioned, when do you expect the Fed to first increase rates?

John Lopez

Well, that will be based mainly on recovery and what we are seeing in GDP growth, it was strong in the second quarter but disappointed in expectations, so until the housing drag is over which probably won't be for another couple quarters, it probably won't be a spike in the interest rates.

Keith Guericke

Those are the words of John Lopez, our Economist.

Dustin Pizzo - Banc of America Securities

Okay. So you think that is more of an '09 event than 08.

Keith Guericke

Probably.

Dustin Pizzo - Banc of America Securities

Okay. And then just lastly, should we expect any onetime charges associated with the new line of credit in the fourth quarter?

Keith Guericke

No, the old line of credit is at the end of term. It expires in January. So we expect roll that out in the next couple of quarters here, so it won't be significant.

Dustin Pizzo - Banc of America Securities

All right. Perfect. Okay.

Keith Guericke

Thank you.

Operator

Your next question comes from the line of Alex Goldfarb from UBS. You may proceed.

Alex Goldfarb - UBS

Good morning.

Keith Guericke

Good morning, Alex.

Alex Goldfarb - UBS

Just going to the [E-Con] forecast, I am just comparing the jobs forecast that you have in your first quarter to the second quarter and essentially it looks the same although looking at the data the job situation seems to be getting worse. Can you just give us an update on what your thoughts are for leaving the forecast the same?

Mike Schall

Yes, Alex. Southern California, the year-over-year numbers look depressing and mainly because the losses were big in the second half of last year. So, we are expecting that those comparisons will get better as we go in line and that is why we are holding our forecast there.

In San Jose, the industry jobs are down a bit, but if you look at the household survey the numbers are quite strong and so we think that given the possibility of correcting those numbers that were well within the guidance growth range in that area. So we consider it would be Oakland right now, the outlying areas is Oakland.

Alex Goldfarb - UBS

Okay. Then moving to the new line, can you give us a comparison what the new pricing is relative to the existing pricing?

Keith Guericke

We're not going to disclose that until we have it finalized and we file our 8-K.

Alex Goldfarb - UBS

Okay. The Hollywood office lease extension on that development site there, your decision to renew or extend the lease, what is the driver of that? Is that capital preservation? Are there other projects that would have come on line at that point? Is it entitlement issue? What is the driver?

Mike Schall

We have a tenant that has wanted to extend every year. They've been in the building for ten years. And the lease that we did with them and the extension is an accretive transaction, it gives us a bit of breathing room to wait out the market in Los Angeles area and we think the pricing on the buyout will get better over the next 12 months to 18 months. So we have made the selective decision to push it out.

Alex Goldfarb - UBS

Okay. Then my final question is a two part development question. One if you can just let us know the yield impact of the cost increase on Belmont Station and the second part is as you guys continue to look at busted condo development sites, are you seeing any increased pressure or incentive for the existing developers who want to make a deal now versus earlier this year?

Mike Schall

On the impact of the construction increases for Belmont, it is about a 35% to 40%, a 40 point basis decrease in our expected yield on it. We are going to end up on that, and remember that is a bond deal, Alex. So there is a lot of accretion associated with bond financing. We are going to end up at about the 560 to 590 range on the stabilized yield. As far as the broken condo question, Keith you want to handle that.

Keith Guericke

Yes. We've had our acquisition guys are looking for those kinds of things and there are a number of transactions that we have looked at. Frankly, we've been looking at not the raw land as much as sort of deals that are truly either half constructed or completely done and unable to sale and frankly the developers generally don't have any equity and so you are really having to go back and negotiate with either the mez or the construction lenders.

We have not been able to cut any deals yet. We have been very close on a couple of transactions, but I am seeing the pressure on the developers increase and as frankly every deal seems to get a little bit closer. So I have confidence here we're going to see some of those transactions come to fruition.

Alex Goldfarb - UBS

Thank you.

Operator

Your next question comes from the line of Jonathan Habermann. You may proceed.

Jonathan Habermann - Goldman Sachs

Hey , guys. Jay Habermann here. Just a question starting off in second half, I know you are being a bit more cautious. I am just curious. You mentioned in Southern California focusing a bit more on occupancy to stabilized rates, do you see that trend picking up a bit more back half of the year in terms of not being able to push rent growth as much?

Keith Guericke

I think that that has been the management philosophy or strategy in Southern California all year to hold occupancy and if your traffic patterns remain, typical as in prior years and we will benefit from that because we will not be starting off in a whole. So, I think Southern California still has some headwinds and as a result of that, I think we'll continue to be a defensive management approach. So it will be hold occupancy, I think we continue that for the rest of the year and likely into probably into early 2009.

Jonathan Habermann - Goldman Sachs

Even holding occupancy you still have fairly big embedded gains to lease in certain markets particularly Northern California and Seattle?

Keith Guericke

Gains to lease?

Jonathan Habermann - Goldman Sachs

Loss to lease, sorry.

Keith Guericke

Yes, we do. Are you asking what does that mean for renewal pricing?

Jonathan Habermann - Goldman Sachs

No. Just getting to your assumptions for the back half of the year you are being more cautious but it sounds that you still have some up sight embedded there?

Keith Guericke

Exactly. I think the rebound in loss to lease really paints a pretty strong picture because Southern California loss to lease at the end of Q1 where we were pretty much discounting to maintain occupancy. We had a gain to lease, a negative loss to lease at $3.5 million. That flipped around completely by the end of Q2 to where we had a real loss to lease of $1.8 million.

So, clearly pricing firmed during the second quarter. Again, part of this is because we had relatively high occupancies. We made sure that we had relatively high occupancies coming out of the first quarter which positioned us for the second quarter. You all heard that we went through the physical occupancy numbers.

So, after the end of the quarter, we are now two thirds of the way through our summer peak leasing season and occupancies have continued to be firm through the end of July. So all that seems to indicate that we are well positioned for the rest of the year and we will be able to push a little bit harder on rents and don't see real soft conditions where we're going to have to be very aggressive, as we were at the end of the first quarter.

Jonathan Habermann - Goldman Sachs

Right And just going back to the other comment, Fed increasing interest rates. What are your expectations for cap rates over the next say six to nine months? Are you waiting on the sidelines for more opportunistic activities and does that in any way influence your timing of a new fund?

Keith Guericke

The answer is yes. Our acquisition goal for the year was $100 million which is very minimal. We haven't closed anything as of yet. We have got one very small transaction here in Northern California that is closing today, at a pretty significant cap rate better than we've seen in the past. We do think as pressure is put on the sellers then cap rates will improve.

Unfortunately, this is a matching game as we all know and to the extent that our, interest rates go up or our stock price were to back up, have to match the FFO yield and the debt cost against the yields in the marketplace. So sometimes, cap rates going up significantly. Unless it goes up significantly, it is hard to make these transactions work. So, we're being very selective in trying to conserve our capital and use it wisely.

Jonathan Habermann - Goldman Sachs

In terms of uses of capital, just from weighing the benefits of development now versus acquisitions, given that we're seeing cap rates, in some cases move up closer to development yields. How does that then bias your decision?

Keith Guericke

Frankly, one of the things that we recognize here is that you can't get in and out of the business of development. We can be conservative as John said in Studio City. We leased that site for another year because we think costs are going to come down and that might help yields a little bit.

So we can lighten up on the development, but we can't get out completely, but I would tell you that if cap rates move another 25 basis points, acquisition is going to be a very compelling investment alternative and we will push on the pedal for that. We will consider a Fund III.

Jonathan Habermann - Goldman Sachs

Great, thank you.

Operator

Your next question comes from the line of Karin Ford from KeyBanc Capital Markets. You may proceed.

Karin Ford - KeyBanc Capital Markets

Hi, good morning.

Keith Guericke

Good morning, Karin.

Karin Ford - KeyBanc Capital Markets

One of your competitors talked about seeing some credit quality issues in Southern California, a couple of markets there. Have you guys seen similar type issues there?

Keith Guericke

I listened to one other call that was referring to that. No, we really don't see it. Those would typically be more the outlying areas, and our credit or delinquencies are running as low as they have for the last several years. So, we have seen no change in that.

Where you would expect those changes would be once again in the Inland Empire where you are pushing up against affordability issues and a lot of job losses and those types of issues which tend to precede significant delinquency issues, but not an important factor in our portfolio.

Karin Ford - KeyBanc Capital Markets

Okay. Next question relates to dispositions. I think you guys had talked on the last call that you had some teed-up in Southern California and I think you targeted $100 million to $200 million for year. Can you just give us an update on that?

Keith Guericke

Sure. We have got three properties on the market, one in Seattle and two in Southern California. As we speak, there is some activity on all of them. We do not have contracts with contingencies removed and our policy has been not to report the stuff until it is done. So, there is activity. We would expect that at least a couple of those will get done before year-end which will probably be close to our target for the year.

Karin Ford - KeyBanc Capital Markets

That is helpful. Final question, it sounds like you guys economically are expecting an inflection point in the California economy in the home market late '08, early '09. Does that inflection point make you reconsider your current asset allocation that you guys did between Southern Cal and Northern Cal a few years ago?

Keith Guericke

I think we always are looking at that and part of our process is to approximately semiannually, John Lopez is here so he runs this process. He ranks our 30 something sub-markets by three-year rent growth potential.

So, we are very focused on that, continue to run that. I don't think that we are ready to make a change at this point. However, some of the dynamics are beginning to change and we continue to evaluate that on an ongoing basis. So, I think for now we're happy with the prospects in Northern California and Seattle.

Karin Ford - KeyBanc Capital Markets

Great. Thanks very much.

Operator

Your next caller comes from the line of Michael Bilerman from Citigroup. You may proceed.

David Toti - Citigroup

Hi. This is David Toti here with Michael Bilerman.

Keith Guericke

Did we hire, Michael?

David Toti - Citigroup

I don't know. I think we are still in New York.

Keith Guericke

We really like Michael to come work for us. He is great.

David Toti - Citigroup

Just a couple of questions, you guys have answered quite a few details today. As ground-up development becomes more challenging in the context of increasing supply and sort of [pin] uncertainty, do you see more of a focus on redevelopment and repositioning?

Keith Guericke

We have a separate group within the organization that does that, and we think it is an important part of what we do. Just taking a step back the macro picture is we believe in locations first and if you are going to be very, very selective as to locations which we are and you all know we are, then you have to have more flexibility with respect to what to do with product that is well located.

So, we believe that redevelopment and acquisitions are all things that we have to do well, given our restrictive nature of where we buy or where we invest. So, I think that same dynamic applies. We look at all of the different options, we try to allocate capital very actively within the company and we try to find where the best yields of growth. Everything is benchmarked effectively against what did they do for FFO per share today, what is the impact on NAV per share, what is the impact on the growth rate of the portfolio?

So, basically all transactions are sort of benchmarked against that backdrop. We will do any of those three execution options. . Clearly, redevelopment is in many cases the best. Sorry, that is maybe a little bit too general, but that is the way we approach it.

David Toti - Citigroup

That's helpful. Then just another big picture question, when you are thinking about the second half of the year and you are hedging your expected performance somewhat, are you growing increasingly concerned about unemployment or are you more concerned about supply issues?

Keith Guericke

I think it’s the macro economy that we are more concerned about. The nice thing about supply is you can pretty much plot them on a map and we have done that. So we know where the supply spreads are. You don't get surprised on that front or if you do, it is shame on you.

The real uncertainty here is in the general economy and what is going to happen there. So that is much more difficult to project. As you know John Lopez is here. He can talk about that a bit more, but he is very focused on the jobs data. We have a weekly Monday morning meeting that he reports out any new activity in that area and we are very sensitive to that data.

David Toti - Citigroup

Great. Then just one last question, if you could potentially quantify any changes in the underwriting to the developments that you are looking at in your shadow pipeline today versus developments that are currently underway?

Keith Guericke

Well, as you know, we target the mid six cap rate on our deals with the current environment. It is challenging to get there in the short run, except for unique deals. So I would say while we are keeping our powder dry, we are look at every transaction. The level of volume on our shadow pipeline is declining a bit over the last six to 12 months, especially in light of the cap rates have moved up a little bit. That alternative is more attractive.

David Toti - Citigroup

Great. Thank you very much.

Operator

Your next question comes from the line of Anthony Paolone from JPMorgan. You may proceed.

Anthony Paolone - JPMorgan

Thank you. On the deal flow, you talked about not having done anything year-to-date and the bid/ask spreads still being pretty wide. Are you seeing a lot of the deals that you bid on year-to-date or looked at actually clearing or is it that these projects or properties are still lingering in the market trying to get a sense is to whether its the market bid/ask spreads that's remained pretty wide or is it just that it not yet at a place where you want to participate?

Keith Guericke

Well, if you just look at the two primary markets we are trying do, where we are trying to expand our portfolio and that'd the Bay Area and Seattle. In the Bay Area, there has only been for the first half of the year I think three or four transactions. One was in San Francisco at a very low cap rate, and the other two were: one in San Jose; and I think one in the East Bay.

Modest cap rates and most of the stuff that we have looked at generally has not cleared in either market. In Seattle so to the same thing applies there has only been a few transactions, again one on Mercer Island at a very low cap rate.

It's a brand new property and a couple of in the East side at sort of low five to mid five cap rates. So it's as I said earlier we are trying to be judicious with our capital and make sure that where we've got allocated to development and whatever we use on the acquisition side is accretive to what we are trying to do and make us a better company.

So, generally I would say that the volume of transactions is down. Nobody is really aggressively buying out there. We haven't been able to get to transactions that make sense for us. We've been into several that we have gotten pretty far down the road and just couldn't make it work at the end of the day. So, we've kept our discipline and walked from them.

Anthony Paolone - JPMorgan

Okay. Then, looking at Northern California and Seattle it has been several quarters now that you've been growing revenues at a pretty rapid clip. How much do you think you have left in that market?

Keith Guericke

We benchmarked that against the relationship between rents and meeting income levels and you will recall that these markets are the markets that, Northern California and Seattle I mean are the markets that got beat up the most, coming out of the last cycle, and so rent and meeting income relationships were pushed down quite a bit when we started this cycle.

So I think that John Lopez knows his numbers better than I do, but I think in San Francisco we are at the long-term historical relationship between rent and meeting income, which means that going forward there will be a bias toward growing at about meeting income growth rate, but in Silicon Valley, East Bay, Seattle certainly we are still at a 5% to 10% lower relationship, so that means that you should be able to continue to push rents. So, we think that there still is upside potential there.

The other sort of barometer is that typically when economic conditions deteriorate you have more of a propensity of people doubling up and we really haven't seen that to any great extent at this point in time. So that, is obviously the reason why we continue to look at Seattle and Northern California from an acquisition standpoint. So, all these things tie together at some levels. We think that there is still room to grow here.

Mike Dance

Let me just throw another piece of information in there. The other thing we look at is single-family affordability. Even though we've seen home prices drop, anywhere from 8% to 20% depending on those sub-market in Northern California and Seattle, even at the top end of 20% in Northern California that takes the median home price down to $600,000, which given the median household income in this marketplace keeps the affordability at about 60% which is very similar to Seattle. So, again, single-family affordability still is an issue in these markets.

Keith Guericke

And just one last thing to add is obviously future growth is obviously dependent on future job growth. So, we are in good condition. If we get good job growth, we can maintain above average growth in those markets.

Anthony Paolone - JPMorgan

Okay. Then also on the expense side, you've had margin expansion in those markets because the revenue side has been so robust, but expenses on a standalone basis have grown at an above average clip in those areas too. If those markets were to slow, you think those expenses would come down commensurately?

Keith Guericke

I think you have to break that apart. Really, the percentage of expenses above what you would consider normal. If the normal expense growth is 2.5% to 3%, some significant amount of that can be explained with these new initiatives, the property tax situation in Seattle and the other stuff that I commented on the call. So, I think that those things are beyond the normalized expense growth and really are the reason why our expenses are above the long-term expected increase in expenses.

So, I think it is more timing of different things. Again Seattle property tax we have got some big reassessments up there based on valuation, significant valuation increases. That is not going to happen ever year, that is a phenomenon that is a one-time only event, and is affecting us again, similarly Level 1 call center support, YieldStar, some of the other initiatives that we are working on have a one-time increase in expense. So I think it will go back to a more normalized level from this point on. Mike do you have anything to add to that?

Mike Dance

We also changed our philosophy on how we allocate property management fees back to the properties. So this year some properties that were not paying any property management fees without starting to charge them a fee and that again increase the allocation away from G&A to property absolute impacted the NOI and no impact on FFO, its just a reallocation. We were much lower than our peers in what we were allocating so we are closer to the middle of the group now.

Anthony Paolone - JPMorgan

Okay. Thank you.

Keith Guericke

Again accounting rules world. I am just kidding.

Operator

Your next question comes from the line of Steve Sakwa from Merrill Lynch. You may proceed.

Steve Sakwa - Merrill Lynch

Thank you. A couple questions, can you just talk about the development yields that you expect on that $600 million? How that's maybe changed and what kind of returns are you targeting on the redevelopments and what kind of dollars do you think that you will spend annually on the redevelopment program?

Keith Guericke

On developments, the range is 6.25 to 6.5 on the stabilized number and redevelopment.

Mike Dance

Yeah, redevelopment we will spend $30 million to $40 million and the average there will be about 8% return on that $30 million to $40 million.

Steve Sakwa - Merrill Lynch

Okay. Mike, do you have any update or have a quantification on the convert with regard to APB 14 or is that not applicable to your convert deal?

Michael Dance

The APB 14, I have to refresh my memory, it has been a while, but if you look at the new rule that's coming out effective January 1…

Steve Sakwa - Merrill Lynch

Yes, you're talking about the non-cash interest expense.

Michael Dance

Yes, basically, it will take what we are paying at 3.625 and probably bring it up closer to 6% on $225 million, so at least a 100 basis points, that will be a couple of million dollars.

Steve Sakwa - Merrill Lynch

Okay. Will you put that in your Q or do you know exactly what it will be or you are still finding out?

Michael Dance

We probably should put that in our Q. I don't know that we have done that yet. So, I will check it. It's probably closer to $4 million a year. It is probably about 200 basis points on $200 million, but we restate our prior periods, so it doesn't have a year-over-year impact.

Steve Sakwa - Merrill Lynch

I understand. I didn't know if and when you were going to disclose that if that has been out there or whether you were still working through it?

Michael Dance

Several analysts have done a pretty good job of estimating it. I think it's already out there, but it is a good idea for us to collaborate that and put it in the in the Q. So, I don't think we have yet, but it is not too late, we haven't filed it yet. So thank you.

Steve Sakwa - Merrill Lynch

Okay. Thanks a lot.

Operator

Your next question comes from the line of Michael Salinsky. You may proceed, sir.

Michael Salinsky - RBC Capital Markets

Good morning. Looking a little bit more granular at Southern California performance, do you have a breakout of that for Class A versus Class B within your portfolio?

Keith Guericke

What are you looking at specifically? What do you want broken out?

Michael Salinsky - RBC Capital Markets

I am just looking at performance relative to what you had previously indicated for the quarter was more focused in the Class B segment or how the A and B segments were performing on a relative basis.

Keith Guericke

I mean that is sort of anecdote, I have the property by property operations in front of me. Don't see a lot of change between Class A and Class B. It is much more affected by location. So Southern California being a huge area 20 million, 25 million people, it is local sub-markets specific to a much greater extent than it is Class A versus Class B. So, I don't think there is a much significant difference in how one class of property acted relative to another within a local marketplace.

Michael Salinsky - RBC Capital Markets

Okay. So, it is safe to say you are not seeing anybody trading down from As to Bs yet in the cycle?

Keith Guericke

It is hard to tell but no. I mean again some of the Class A to Class B activity, there is some lease ups in a variety of different areas. I think the dynamics of those lease ups for example affect all, they don't affect one versus the other, and it is hard to generalize in terms of are people moving up or they moving down.

It is dependent upon the local supply in the marketplace and rent levels and they all relate to one another. So, it is pretty difficult to generalize on that statement. The overall trends we don't see a big difference between A and B.

Michael Salinsky - RBC Capital Markets

Okay. Mike in your comments you were talking about the performance of Fund II, when do you expect to begin harvesting value from that fund, just given the strength we've seen in Seattle and Northern California over the past couple of years?

Michael Dance

I think that selectively we'll start harvesting those that are in more outlier locations, but those that are close to the jobs we believe there is a lot of runway left and we will hold on them for another several years.

Michael Salinsky - RBC Capital Markets

Okay. Third, just looking at the opportunities within your portfolio, looking at also some of the pressure we are seeing in some other markets around the country, a couple of years back you partnered with a consortium there to look at a portfolio in DC area. Is there any chance Fund III if and when it does materialize would be outside of your target geography at this point?

Keith Guericke

Probably not. We have built our skill set around investing in the West Coast and I would guess that those partners who want to come in and invest with us would look to that skill set and expect us to stay true to that.

If we were to do something like go after another market at DC or Boston or New York or whatever, we would probably team up with one specific partner who had an interest in it as opposed to trying to do it through Fund III.

Michael Salinsky - RBC Capital Markets

Okay, that's helpful and then finally just looking at you had the TRS income there in the first quarter, is there any additional income we should be looking for in the second half of the year, are there any opportunities on the horizon at this point?

Keith Guericke

There are, but not enough certainty at this point in time to disclose any of them.

Michael Salinsky - RBC Capital Markets

Thank you.

Operator

Your next question comes from the line of Rich Anderson from BMO Capital Markets. You may proceed.

Rich Anderson - BMO Capital Markets

Thanks. Most of my questions have been answered, just one or two on the busted condo strategy. How big of an opportunity would you say that is? And how many assets are out there in dollar value?

Keith Guericke

Wow, that is tough. I mean if you go through, the San Diego market started it and we went down there and looked. I think most of that's past now. We had a couple of deals that were in contract and ultimately couldn't get there and the developers I think in both cases found additional equity to bring in and save themselves so those deals went off the market. There is a couple of deals in LA we are looking at. I would guess that…

Rich Anderson - BMO Capital Markets

Is it a $100 million or is it a $1 billion?

Keith Guericke

I would guess it is closer to a $1 billion than a $100 million. I can think of one or two deals right off the top of my head that are $100 million. It is probably in the $1 billion range.

Rich Anderson - BMO Capital Markets

Okay. When you talk to those folks and sometimes as you mentioned you are speaking to the lenders, is it different conversation sense that you are not really talking about cap rates necessarily, its busted condominium. I mean are they a little bit out of touch with that conversation or are they pretty skilled at the process?

Keith Guericke

It depends. I mean we had one transaction we spent a fair amount of time on recently, that the developer knew he was [toast] and he was just looking to save a little bit of his own equity and the mez was gone and really what we were doing is we are dealing with the construction lender and we were looking at it from an apartment deal trying to make it work as because the condo market is not working for them, it is not going to work for us.

So we were looking at it on a cap rate basis and trying to buy new product at mid-to-high 5s, and we had dialogue. But frankly, at the end of the day, I think the construction lender found people with a better set of rose-colored glasses than we had on. Again, there are people out there who have raised funds, who are looking for that stuff. So those transactions are happening and I think they will clear probably at cap rates that we are not willing to pay.

Rich Anderson - BMO Capital Markets

Okay. Just a quick one, maybe for Mike Schall. Is there any seasonality to speak up in Southern California relatively speaking to go Northern California and Seattle?

Mike Schall

Yes. Actually there is. I think it is less. Seattle has the most seasonality because things pretty much shutdown from Thanksgiving to mid-January. The holidays are phenomena for everyone and so we do try to scale back our lease expirations beginning in mid-November through mid-January. So, it has effectively taken those lease expirations and lump them into the summer months. So, it is less dramatic, but yes, it is still seasonal.

Rich Anderson - BMO Capital Markets

Okay, thank you.

Operator

Your last question comes from the line of Paula Poskon from Robert Baird. You may proceed.

Paula Poskon - Robert Baird

Thank you. How worried are you, if at all, about the impact of a potential SAG strike in Southern California?

Keith Guericke

I don't know that we went through the (inaudible) strike, and I have heard some comments on other call that was a horrible thing. I talked to our operations people and Mike Schall is here who runs ops. I think we had five people, let's say GM having a little tough time.

I don't think our properties are necessarily located in generally different locations than our competitors. So we haven't seen it. We are not particularly concerned about it, but apparently that is a concern in the marketplace.

Paula Poskon - Robert Baird

I have had some questions about it. Thank you. Then lastly, what are you seeing in insurance trends?

Keith Guericke

Insurance?

Paula Poskon - Robert Baird

Yes, your insurance costs.

Keith Guericke

They have declined in last year. I mean there was a huge run-up in insurance costs for the last five years, up to about the last year, and then costs have moderated. I think the expectation of the insurance industry is that property casualty insurance is going softening market. We have seen that in our most recent renewal and I think that will probably continue for a while.

Paula Poskon - Robert Baird

Thanks very much.

Operator

We have no further questions. I would now like to turn the call back to Mr. Keith Guericke, President and CEO. You may proceed.

Keith Guericke

Thanks a lot for joining us. Again if there are any questions we didn't answer, please call anyone of us We are here and we will talk to you next quarter. Thank a lot. Bye.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect.

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Source: Essex Property Trust Inc. Q2 2008 Earnings Call Transcript
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