Good day, and welcome to the Essex Property Trust second quarter 2018 earnings call. As a reminder, today's call is being recorded. Statement made on this conference call regarding expected operating results and other future events are forward-looking statements that involve risks and uncertainties. Forward-looking statements are made based on current expectations, assumptions, and beliefs, as well as information available to the company at this time. A number of factors could cause actual results to differ materially from those anticipated. Further information about these risks can be found on the company's filings with the SEC. When we get to the question and answer portion, management asks that you be respectful of everyone's time and limit yourself to one question and one follow-up. It is now my pleasure to introduce your host, Mr. Michael Schall, President and Chief Executive Officer for Essex Property Trust. Thank you, Mr. Schall. You may begin.
Good morning, and thank you for joining us today for our second quarter earnings conference call. John Burkart and Angela Kleiman will follow me with comments, and John Eudy is here for Q&A. Today, I will discuss three topics, second quarter results and revisions to our 2018 market outlook, investment market conditions, and an update on regulatory matters. On to the first topic. We're pleased with our strong second quarter results, which reflect a mostly normal leasing season when compared to the early peak in market rents that we experienced in 2017. The deceleration in revenue growth in Q2 versus Q1 2018 is attributable to the occupancy gain difference in the two quarters, a 30 basis points increase in Q2 as compared to a 60 basis point benefit in Q1 2018.
While the market rent growth comps become easier in the second half of this year, it is our expectation that revenue growth will slow modestly as we push rents at slightly lower levels of occupancy, which will mostly benefit 2019. Overall, fundamentals for apartments remain favorable, and demand for rental housing continues to be strong. We are seeing strength in our Northern and Southern California portfolios, particularly in San Jose and San Diego, and supply-related weakness in Seattle. As expected, favorable macroeconomic trends support a positive outlook for the U.S. and West Coast economies, indicated by a re-acceleration in job growth across much of the country. During the quarter, hiring continued at a healthy pace in the Essex West Coast metros with 2.1% job growth for the trailing three months ending in June. This outperformed our initial forecast for the year of 1.6%.
The tech markets of Seattle and San Jose continued to lead the way with more than 3% job growth during the period driven by increases in the information sector. Given this strength, we are increasing our full-year job growth forecast on page S16 of the supplemental for San Jose and Seattle by 130 basis points and 70 basis points, respectively. This results in an increase in our full-year job growth forecast for the Essex markets by 40 basis points to 2%. Throughout the U.S., a stronger economy and tight labor market conditions are drawing more people back into the workforce. In the past year, the labor force is up 1.9 million people or 1.2%, which is double the average growth rate seen over the current cycle.
The higher labor participation rate can lead to incremental demand from people still living at home with parents or those currently doubling up. Strong jobs data has resulted in a weighted average unemployment rate in the Essex markets of 3.5%, well below the U.S. average. Shortages of skilled workers are pushing wages, which are growing faster than rents. Personal incomes are expected to grow 5.6% for the Essex portfolio in 2018 compared to market rent growth of 3%. As a result, we are seeing an improvement in rental affordability in all of our markets compared to one year ago. On S16.1 of the supplemental, we published a chart on cost to own a home versus rent in our West Coast markets.
Due to severe for-sale housing shortages and recent tax reform, the premium to own a home versus renting an apartment has risen to 77% as compared to the historical average of 49%. Large increases in median home prices, which are up 13% year-over-year, along with tax law changes, are driving the substantial increase. As a result, we expect this to favorably impact demand for rental housing and apartment fundamentals. Turning to supply. During the quarter, we completed a full scrub of our supply analysis, including on-the-ground surveys of under-construction projects to assess recent progress and expected delivery timing. Overall, supply remains relatively unchanged in our markets from our prior projections, with the exception of Los Angeles where delays push back deliveries to later in 2018 and into 2019, and Seattle, where supply is up slightly.
Our analysis indicates that Orange County, San Diego, San Francisco, and Seattle will be past their peak supply by the end of 2018. Overall, across our markets, we expect 2019 apartment deliveries to be relatively flat compared to 2018. Multifamily deliveries continue to be heavily concentrated in the downtown and CBD markets. As noted previously, when several nearby properties are delivered at the same time, lease-up concessions are often increased, temporarily disrupting pricing to stabilize communities. Specifically, in Seattle and downtown L.A., the concentration and timing of deliveries has resulted in four to six weeks of leasing concession at new communities, impacting price and resulting in periodic concessions at nearby stabilized communities. These concessions begin to abate once the pace of apartment deliveries subsides. Going forward, we believe construction starts will slowly decline in our markets given rising construction costs, shortages of skilled labor, and a more conservative lending environment.
As it relates to revisions to our 2018 market rent growth forecast on S16, there is no change to the Essex portfolio rent growth of 3%. However, there are changes within markets. Namely, we now expect San Jose rent growth to be 4%, which is 100 basis points stronger than our initial expectations due to better job growth. Conversely, Seattle is expected to be weaker than expected in the second half of 2018, given higher apartment deliveries in Q3 and Q4, and the greater seasonal drop-off in demand that usually occurs in Seattle in the back half of the year. My second topic, updates on investment markets. During the quarter, we closed on one disposition in San Diego at a low 4% cap rate and have one acquisition in a co-investment entity in contract for approximately $100 million.
We reviewed recent institutional apartment transactions in the Essex markets and concluded that there has not been any significant change to cap rates. We continue to see A quality property and locations trading around a 4%-4.25% cap rate with B quality property and locations generally trading 25-50 basis points higher. As noted, the past two quarters, and even with healthy levels of multifamily permits, we continue to see a slowdown in the volume of preferred equity opportunities that meet our underwriting criteria. Development yields are compressing given that construction cost increase generally exceed property NOI growth rates, representing a significant headwind to new development. So far this year, we have closed one preferred equity investment for $26.5 million, bringing our total outstanding commitments to $398 million as of the second quarter. Angela will discuss revisions to our full-year investment guidance momentarily. Third topic, regulatory matters.
During the last few months, there has been a great deal of investor concern and reaction to Proposition 10 in California, seeking to repeal the Costa-Hawkins Rental Housing Act. As a reminder, Costa-Hawkins is a state law that seeks to promote housing production to meet demand by establishing guidelines for rent control policies that can be enacted by cities. In summary, Costa-Hawkins became state law in 1995 to counter the unintended negative effects of severe rent control laws adopted by certain cities, which resulted in a dramatic suppression of housing development and property improvement. Prior to Costa-Hawkins, there were 12 local rent control ordinances enacted. A few cities, including Berkeley, San Francisco, and Santa Monica, passed ordinances containing severe provisions such as rent control of vacant apartments, which had draconian impacts, including no meaningful production of rental housing for the following 20-year period.
These cities remain chronically undersupplied with respect to housing. The state legislature passed Costa-Hawkins in 1995 to increase housing production and quality, requiring vacancy decontrol in all California jurisdictions and exempting any new construction built after February 1st, 1995 for rent control. Following the enactment of Costa-Hawkins, new housing development experienced a significant rebound. Essex has been part of a broad coalition to oppose the repeal of Costa-Hawkins, joined by other apartment companies, trade organizations, unions, veterans, the NAACP, and a variety of pro-business groups. We believe that rent control is bad policy. Given California's severe housing shortage, vibrant economy, and an estimated 180,000 new jobs in coastal California in 2018, it remains unclear where many of the people filling the new jobs will live. We continue to vigorously oppose any expansion of rent control at both the state and local levels.
The outlook for changing rent control is now a critical consideration in all portfolio allocation decisions. Property in cities that tighten rent control will be less attractive, leading to greater housing shortages over time, while nearby cities without rent control become more attractive for investment. We operate in about 70 cities in California, and information about what cities might do if Costa-Hawkins is repealed is often incomplete or not available. Keep in mind, in the past two years, 10 cities pursued rent control for pre-1995 properties, with 80% of the proposals rejected. We will continue to periodically update you as needed. That concludes my comments, and I'll now turn the call over to John.
Thank you, Mike. Q2 was another solid quarter for Essex, with year-over-year same-store revenue growth of 2.8% and NOI growth of 3%. Southern California led the portfolio in the second quarter with year-over-year revenue growth of 3.3%, in part due to its 60-basis-point gain in occupancy over the prior year's period. This leasing season is playing out as anticipated. Our rents are following the historically normal rental rate curve, which peaks in July, as opposed to last year, when rental rates peaked early. The impact of the 2018 seasonal pattern is evident in our loss to lease numbers, which grew to 3.6% in July of 2018 compared to last year, when loss to lease in July was 2%. In order to maximize revenue over the next 12 months, our operating strategy is favoring market rents instead of favoring occupancy.
We expect that our occupancy during the third quarter of 2018 will be about 30 basis points below the prior year's period, or approximately 96.4%, which will create a significant headwind for revenue this period. In July 2018, our same-store financial occupancy was 96.1%. Q3 2018 will be our low point for year-over-year revenue growth due to the occupancy headwind and timing of other income. Now we'll provide an update on our markets. The Seattle market continues to be supported by strong job growth, posting year-over-year job gains of 3.1% for the second quarter of 2018, the second highest in the Essex portfolio. WeWork and Zillow continue to expand their downtown Seattle footprint by leasing a combined additional 200,000 sq ft of office space. The Seattle MD has roughly 5.2 million sq ft of office space currently under construction, 45% of which is already pre-leased.
Revenue in our Eastside and Seattle CBD submarkets grew 2.8% and 2.1% respectively for the second quarter of 2018 over the prior year's period. After years of outperformance, market rents are relatively flat compared to last year. Moving on to Northern California, job growth in the San Francisco Bay Area in Q2 averaged 2.5% year-over-year, with over 76,000 jobs added. San Jose led the way with 3.3% job growth, while Oakland and San Francisco were up 1.8% and 1.7% respectively. Facebook's expansion was robust this quarter, signing the largest San Francisco office lease in the history for 756,000 sq ft, taking all of Park Tower building, as well as adding an additional 750,000 sq ft across the Bay in Fremont. Demand for prime office space continues to intensify as major tech companies compete for office space.
An under-construction project in Mountain View changed hands from LinkedIn to WeWork and finally to Facebook, which ended up leasing both buildings totaling 450,000 sq ft. Other office leasing activity remains healthy in the market. In San Francisco, a self-driving car maker and two biotech companies expanded their footprints by a combined 675,000 sq ft. In the South Bay, Amazon grew the Bay Area footprint by adding a 385,000 sq ft lease in Sunnyvale. San Francisco quarterly office absorption was the highest amongst the Essex markets at 1.9% of total stock. Between San Francisco and Silicon Valley, there was about 7.5 million sq ft of office space under construction, of which 68% is pre-leased. In July, we completed lease-up of Station Park Green Phase One and estimate that pre-leasing for phases 2 and 3 will start sometime in mid-2019.
Our year-over-year same-store revenue growth for the second quarter of 2018 continues to be led by Oakland and Fremont submarkets with 3% and 2.6% revenue growth. San Mateo and San Jose grew at 2.4% and 1.8% respectively for the same period, while San Francisco was flat for the period. Heading down to Southern California, job growth in L.A. in Q2 2018 averaged 1.4% year-over-year, 50 basis points above the pace of growth a year ago. Notable leases for the quarter include Spotify's 110,000 sq ft expansion into the Arts District in downtown L.A. and WeWork's 75,000 sq ft lease, its 17th in the L.A. area. Revenue growth for the second quarter of 2018 was led by Woodland Hills with 5.1% and West L.A. with 3.9%, trailed by the Tri-Cities with 2% and Long Beach with 2%. Orange County jobs in the second quarter grew 1.3% year-over-year.
While this pace was weaker than our other markets, it's worth noting that reported growth was similarly soft at this time last year, then it was revised materially higher in the BLS's annual benchmark revisions. Office activity continues to be healthy with 1 million sq ft under construction, 40% of which is pre-leased. That is up from 20% pre-leased in Q1 of this year. Essex's South and North sub-markets grew year-over-year at 3.5% and 1.8%, respectively, for the period. Finally, in San Diego, year-over-year job growth remained at 1.9% for the second quarter of 2018. Revenue growth in the second quarter of 2018 was between 4% in the Northside submarkets to 6.3% in Chula Vista over the prior year's period. Currently, our portfolio is at 96.5% occupancy, and our availability 30 days out is at 5%. Our renewals are being sent out consistent with the loss to lease.
Thank you, I will now turn the call over to our CFO, Angela Kleiman.
Thank you, John. I'll start with a review of our second quarter results, provide additional color on our full-year guidance revisions, conclude with a balance sheet update. In the second quarter, Core FFO grew 5.7%, exceeding the midpoint of guidance by $0.09 per share. As noted in our press release, $0.03 of the favorable variance relates to timing of operating expenses, which are now expected to occur in the second half of the year. The remaining $0.06 of outperformance is comprised of the following: $0.02 from property revenues, $0.02 from property tax adjustments in the non-same store pool, and $0.02 from a combination of various miscellaneous items. As a result of our second quarter performance, we are increasing the midpoint of our full-year guidance for same property revenue and NOI growth by 15 basis points to 2.8% and 2.9%, respectively.
Year-to-date, we have raised the midpoint of our same property revenue and NOI growth guidance by 30 and 35 basis points, respectively. The strong second quarter results have also enabled us to raise our full-year Core FFO per share guidance by $0.07 at the midpoint to $12.53. This represents a 5.2% year-over-year growth, which is a 70 basis point higher than our original guidance of 4.5% Core FFO growth per share. Turning to our full-year investment guidance. Our initial guidance assumed between $4 million to $525 million of acquisitions, which would be funded with joint ventures or disposition proceeds. Therefore, our initial disposition guidance of $550 million to $750 million was dependent upon achieving our investment targets. Year-to-date, we have not acquired any properties as the assets in our markets remain highly desirable in the current competitive landscape, resulting in a continued tight cap rate environment, as Mike discussed earlier.
Given this dynamic, we have chosen to stay consistent to our disciplined underwriting and capital allocation strategy. Accordingly, we are modifying our 2018 investment guidance to assume $1 million to $300 million of acquisitions and $2 million to $300 million of dispositions for the full year. The revised guidance range includes transaction in the current pipeline. Note that our dispositions guidance excludes funding for our $250 million stock buyback program. Therefore, the amount of dispositions could increase from our guidance range, subject to the stock buyback volume, which we would execute on a leverage-neutral basis. Lastly, a brief update on capital markets and the balance sheet. As we look to the second half of the year, our capital needs remain de minimis.
The sale of Domain in the second quarter provided for all of our development funding needs, and we only have $120 million of secured debt maturing in the second half of the year, which was already contemplated in our $300 million unsecured bond issuance in the first quarter. With net debt to EBITDA 5.5 times and over $1.6 billion of liquidity, our balance sheet remains strong. That concludes my comments, and I will now turn the call back to the operator for questions and answers.
Thank you. At this time, we'll be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Our first question is from Nick Joseph with Citigroup. Please proceed with your question.
Thanks. I'll start on guidance. You mentioned that 3Q would be the low point for same-store revenue growth. What are you assuming for 3Q and 4Q?
For the guidance range, we assume Q3 same-store revenue in the low twos and Q4 in the high twos.
Thanks. Just on Prop Ten, hypothetically, if it does pass and some municipalities move to enact rent control, what do you think the timing would be in terms of how long it would take to actually implement?
Hey, Nick. It's Mike Schall. It's a good question. There are many conversations that are going on at the local level with respect to rent control, they are debating
At the local level, what exactly is going to happen if Proposition 10 passes. At this point in time, either because they haven't decided or because the deliberations are not open to the public, it's pretty tough to tell exactly what they're going to do or when they're going to do it. There have been various cities that have tried to pursue new rent control proposals, including three that were defeated, Long Beach, Pasadena, and Inglewood. There are some that are on the local ballot. Santa Cruz and Santa Ana are examples of that. Of course, there was the failed attempt to repeal the Washington State law that bans rent control currently. There's a lot of activity in this area, and none of it is complete. For example, it's difficult to distinguish what types of rent control these different cities are going to have.
Some forms, as noted in my comments, are extreme, those that involve controlling vacant units, for example. Many of them are not nearly that extreme, and therefore, there's a lot to be learned, and we still need a lot more information before we can make a good decision about what the impacts are going to be.
Yeah. This is John Eudy. I'd like to add one comment. With all the cities that we deal with on the entitlement side, I can tell you the vast majority do recognize the fact that if rent control were to be initiated in their city, it would have a very large impact on their ability to produce housing. Most cities are behind on their housing element, and we believe that's another governing factor. On part of your question, you asked how long it would take. We don't think most cities are waiting at the altar to initiate rent control, assuming Proposition 10 were to pass. We think they're going to be thoughtful and methodical how they approach it, and it's too speculative to say, like Mike says, exactly where it lands.
We believe that it will be done in a balanced way, and the few cities that do will probably be much less draconian as the 1970 version of the rent control, is our general belief.
Thank you.
Our next question is from Austin Wurschmidt with KeyBanc Capital Markets. Please proceed.
Hi. Thanks for taking the questions. I was just curious if the job growth outlook in your revised revenue guidance assumed that the pace of job growth moderates in the back half of the year. It sounded like some of the 2Q data points on job growth were above some of the full-year assumptions you provided.
Sure. This is John. Job growth obviously moves around quite a bit, and we follow it on a monthly basis. In the end, we see the economy doing very well right now. We raised our numbers a little bit to reflect that reality. We're not expecting a big slowdown, the numbers are somewhat volatile. We just see a solid second half as it relates to job growth and just with some limited movement up and down.
Thanks. I thought your comments around households doubling up and improving affordability was interesting, and was just curious if you've seen this phenomenon in the past, and if you have any sense of what the benefit this could provide from a demand perspective or an impact on market rents.
Yeah. This is Mike. Yeah, we, for a long time, have believed that as long as we're in the band of 90%-110% of long-term average rent to median income ratio, that tends to be a good spot in terms of rental pricing. If it's below 90%, it probably indicates that there's something wrong with the market. If it's above 110%, then you get into these affordability issues. That ratio improved in each market, as noted in my script. Interestingly, in Northern California, we are under the 110% threshold in all three major metros. That's good news, and we're pretty close to 110% in most of Southern California. We've actually really come a long way with respect to affordability in the last several quarters.
Where has that ratio been historically?
Again, we're comparing. This is the band of 90%-110% of the long-term 1990 to 2017 average. It depends by market. Typically, Southern California is in the 22% range, typically, and Northern California is in the 22% range, except San Francisco is more like 27%, and Seattle's about 19%. That's the long-term historical average.
Great. Thank you.
Our next question is from Jeffrey Spector with Bank of America Merrill Lynch. Please proceed.
Great. Thank you. Hi, everyone. I just want to go back to, Mike, your opening comments and clarify your comments on occupancy for 2019. It sounds like we're saying second half will decline a bit. On trying to push rent, are you saying that you feel in '19 that based on demand, occupancy should pick back up again?
Yeah, let me actually kick that to John because I think you're referring to is the
His outlook for the rest of this year. John, you want to handle that?
Yeah, absolutely. What I'm saying is in Q1, we had a benefit of 60 basis points occupancy year-over-year. Q2, that shifted to 30 basis points, in Q3, it'll actually be a headwind of 30 basis points, that clearly impacts the year-over-year numbers that Angela Kleiman was referencing. The reason being is we've shifted strategies as the market has improved and the seasonality of the curve is consistent with the past, with last year or with historical standards. Last year, it fell off early. We shifted strategies to favor achieving market rent as opposed to maximizing occupancy. It's that adjustment, which is also in line with increased turnover, increased units turning. Each unit that turns has a certain occupancy related to it. As we turn more units in the summer, and as we focus on achieving market rent instead of occupancy, there's a natural adjustment.
It's not because the market's weak, it's because actually the market's stronger, we've adjusted our management strategy to maximize revenue over the next 12 months. Q3 is the one that's most impacted negatively, as I mentioned, Q4 will bring our occupancy back up as we enter the weaker part of the rental season. Does that answer your question?
Yes, thanks. I thought Mike in his opening, talked about the expected benefit in 2019, that's helpful.
Exactly.
Yeah.
Let me-
Sure
answer that. Yes, exactly. If we're going to create a occupancy headwind in Q3, then by pushing rents, obviously the rent growth, we only have four months left of 2018, and so the benefit from the higher rent growth is going to mainly start us out on a positive foot into 2019. Keep in mind that loss to lease at the end of July was 3.5% this year versus 2% last year. That increment you could expect to help us in 2019.
Okay, thanks. Just one follow-up on the rent control conversation. Is it too early to talk about if a town does implement rent control, what would Essex do in that town or in municipality?
This is Mike. We've given a lot of thought to this, and we've done a lot of research on what the discussions are in these various cities. It's pretty difficult to glean any conclusions, obvious conclusions from those discussions, because so many things are in flux right now, because all rent control is not the same. There are, as we've said, relatively few cities that have extreme forms of rent control, and then there are other cities that have moderate forms of rent control. As we think of the world, given, and John said this a few minutes ago, but I'll reiterate part of it from my perspective, there seems to be a real split in how to deal with California's incredible housing shortage.
A lot of the politicians and legislature have chosen to do things that are going to promote more housing development, consistent with California's Global Warming Solutions Act, which effectively seeks to put housing and office next to one another and get people out of their cars. There were 15 bills signed by Governor Brown last year, for example, that had the objective of increasing housing development, raising money for affordable housing, penalizing cities that didn't produce their housing element, et cetera. You have that on the one hand, and then you have this whole other political movement to try to use rent control as a solution to a problem. Rent control obviously doesn't produce more units. In fact, it produces less units because cities with extreme forms of rent control are going to produce less housing like they did last time around. We know that.
There's also a fiscal impact in that the estimated cost of the state and local governments is in the hundreds of millions of dollar range, which is, I would think, problematic as far as that goes. Finally, the third problem with rent control is there's conversions. For example, condos from rental housing into other forms of housing, so it actually depletes the housing stock. What we're talking about here is there are people in the short term that will benefit from rent control, i.e., those that get a rent control unit. Further down the road, there's going to be greater shortages, and the people that will be most vulnerable in that scenario will again be the people of limited means because there's going to be fewer housing units available in that scenario, and they're likely to be more expensive and more difficult to obtain.
Okay, thank you.
Did that help?
Yeah, thanks.
Our next question is from Alexander Goldfarb with Sandler O'Neill. Please proceed.
Hey, good morning out there. Mike, I just appreciate your comments on the nuance of the conversations over rent control with the different cities. I guess on the point of vacancy decontrol, because that seems to be one of the most key elements of Costa-Hawkins and whether or not cities do draconian or not. Is there any sense, as you guys speak to the different municipalities, that they understand the impact that removing vacancy decontrol would have, or is it all part of a nebulous thing and they're not even bringing that element up?
This is John Eudy, Alex. There's no question that cities understand that
If we were to lose vacancy decontrol by virtue of the city passing that, it also brings in the element of a fair rate of return, and it's pretty clear that if you don't have the ability to turn units at market, you wouldn't be able to achieve that. There's a legal argument there that also keeps the cities in line to understand that metric. We believe the vast majority of cities get it. There will be a few exceptions that we'll have to work with, if it comes to that.
Okay. The second question is, Mike, you spoke earlier in the year about obviously the impact of pricing versus last year's early peak, and then with the wildfires, you spoke about 30 basis points, or Angela, you spoke about 30 basis points, lower occupancy, hitting third quarter. Still, you guys definitely crushed on the quarter, classic Essex. How much do we take your comments with a bit of grain of salt when you're saying that, hey, third quarter is going to be the low point of the year versus things are going better. I guess the point is, has the economy improved a lot more than you guys thought when you had your outlook and discussions at NAREIT and earlier this year? Or is it the standard Essex conservatism?
Hey, Alex, thank you for the compliment, I guess. This is John, where we're at as it relates to the numbers, in my script, I mentioned that July we were at 96.1% occupancy, very specifically to show that occupancy really has drifted down pretty significantly. I, of course, ended the script with the fact that we're at 96.5 current physical. We've pushed it back up some. That 30 basis point change from last year for the third quarter, which the third quarter last year, we were at 96.7, we're expecting to average in on the third quarter of this year at 96.4, still a good number. It's real. It is a real headwind, and it really is a difference from Q2 when we had a 30 basis point benefit. That's a 60 basis point swing. They're real numbers.
It relates to the strategy change, that's actually tied back to, yes, the market is performing as expected, it's performing well. The curve has The market peaked as expected in July as opposed to early, we're adjusting to that. No, we're not sandbagging in a big way, but thank you for the compliments.
Okay. What you're saying, John, is that the market hasn't improved more than you thought it. The market has been consistent with the way you guys originally thought earlier this year.
Yeah. Hey, Alex, it's Mike. Think of this as a big lagging machine, that what happens today, it doesn't show up in the numbers until some future day, because again, we have to turn leases in the new reality. What we've done last year is we were given a choice between how much rent can we get in the third quarter, I'm talking about of 2017. How much rent can we get? Are we better off trying to push occupancy? We made an occupancy-based decision to push occupancy given that scenario. We're looking at this year, 2018, we come to a different conclusion. The way it shows up in the numbers, it looks like it's getting weaker, it's not getting weaker. It's getting better. It's just going to take several months or couple quarters for you to really see the benefit of that.
2018, because of, again, the shape of the market rent curve, 2018, for the first half of the year, we had really tough comps because we gave up so much rent growth in the second half of 2017. That won't happen this year. I go back to this loss to lease being the critical piece of it. At July 2017, it was 2% and going down, in 2018, it's 3.5%, much more normal and much stronger. Again, it's going to take a few months and some quarters for this to become apparent, we're looking down the road in terms of our pricing decisions and trying to maximize revenue down the road somewhere.
Okay. Thank you.
Thanks.
Our next question is from Dennis McGill with Zelman & Associates. Please proceed.
Hi. Thank you. Actually, following that last question, when you look at the decision of a year ago to push occupancy versus today to be more focused on the rent side, when you think about the change in the market, how much of that better outlook that you have today is due to stronger demand versus less supply? What's the right way to think about the balance of those two things shifting over the last year?
This is John. I'll start. Mike might want to follow on, certainly, we have strong demand out in the marketplace. It's shown in the curve, as well as supply was a little bit light in the first half of the year, which we benefited from. It's really a combination. That's probably what brought the curve back to what you might say is a normalized seasonal pattern. The result of that is better year-over-year comps as it relates to market rents, then therefore, the shift in operation strategy.
Sorry, just to clarify, when you say less supply in the front half of this year, was that a push-out of supply into the second half into 2019?
Sure. You know what? It seems like that's just the ongoing theme for the last two years is supply keeps getting pushed out, and certainly in some markets, like in L.A., we saw supply getting pushed out, and it continues to be pushed out. Yes, it's not the supply somehow kind of evaporated. It continues to be delayed, and we're benefiting from that. When the supply all comes at the same time in a concentrated area, that's problematic. In context, the amount of supply that's in the marketplaces, in the MSAs versus the demand, we're clearly upside down there. We obviously have a housing crisis. We do not have enough supply. It impacts pricing when it all gets delivered at the same time, same place. At this point in time, this last half of the year has been a little slower.
Dennis, I would add maybe one thing to that, and that is, it's pretty difficult to determine when the supply is going to actually be completed because of these labor shortages and other things that tend to delay. The way we have it now, for example, is we had much more supply in L.A. in the first half. It now, according to our projections, looks like it's mostly second half focused. However, we don't know how much of that is actually going to get pushed into 2019. It's just impossible for us to get down to that level of detail and to understand the labor markets in enough detail that we can make that comment. Seattle is the other piece of it, which is again, heavy second half supply in 2018. Some of that very easily could get pushed into 2019.
Again, when we look at price and look at pricing and expectations, we use the best information we have, recognizing that some of these things are very difficult, if not impossible to predict.
Yeah, understanding that volatility, I guess what I was trying to get at and make sure I'm understanding your comments correctly, is if you're being more offensive today on a go-forward basis than you were at this time a year ago, that more offensive strategy sounds like it's being driven from the demand side, and it sounds like the supply side is a relatively similar outlook. Is that fair?
Yeah. Okay. I get more of what you're saying. Yeah, we think supply and demand, critical housing shortage, we think there's no way that demand catches up or supply catches up with demand under any scenario. The issue is that when you get into some of these markets, the apartment deliveries are much more concentrated into Downtown L.A. or Downtown Seattle, for example, South Lake Union in Seattle, even more specifically than the downtown. The more you get that concentration, the greater chance you have that several buildings are going to compete with one another and are going to start getting to six to eight weeks of concession, which effectively stops rental growth in your stabilized community. That phenomenon is what I'm talking about, and this is periodic disruption. This has nothing to do with overall supply and demand.
It just has to do with how aggressive owners become on lease-ups of multiple properties competing with one another in order to each absorb somewhere around 30 units a month. How far do they have to push rents or concessions in order to make that happen? I think that's the key issue, and it's very difficult for us to estimate what that would be. As noted in the comments on the call, Seattle tends to also be more seasonal with respect to job growth and demand, that's why we have pushed back on Seattle or pushed those estimates down in terms of market rent growth for the year.
Okay. One other question on Costa-Hawkins. Have you done any work, when we look at your mix of assets pre and post-1995, any sense on where the market would be as to whether that change would be a relative benefit to you or headwind to you versus the broader market?
It's Mike. I'm not sure I understand exactly where you're coming from. Let me just try and make a couple of broad comments, Dennis, you can chime in here and if I'm off base. We're operating in 70 cities, as I noted on the call in California. Four of them, we have more than 2,000 units in. The rest of them are, again, properties scattered throughout many cities in California, and there's no great concentration. What we have done, and it's not a perfect science, what we've done is try to evaluate our portfolio in those four areas that we have the greatest concentration. Two of them have a less onerous, long-standing rent control ordinance, that's L.A. and San Jose, and two of them do not have rent control at all.
We're, again, trying to monitor, make good portfolio allocation decisions, recognizing that we're very diversified, and as John Eudy said, this conundrum of more of rent control movement throughout California while you have an enormous housing shortage and a bunch of law, again, including the Global Warming Solutions Act, the 15 bills signed by Governor Brown last year. The conundrum embedded, or the contradiction embedded in that discussion leads us to believe that there has to be a compromise somewhere in the middle, which will be to the benefit of less severe forms of rent control. We don't know, and it's impossible to know at this point in time.
Okay. That's helpful. I can follow up more offline. Thank you, guys.
Thank you.
Thank you.
Our next question is from Richard Hill with Morgan Stanley. Please proceed.
Hey, guys. Thanks for your time. Wanted to just come back to the supply question a little bit. Is there anything, I know supply can be somewhat volatile and somewhat hard to completely forecast, but is there anything that would give you upside to expect that maybe supply would be lower than what you're projecting? I know you mentioned development yields, and that makes a lot of sense to me, but where could upside be where this sort of supply crest happen sooner than we're expecting?
Yeah. This is Mike, and maybe some others want to chime in here. There's a lot of things happening that affect development. It's one of the most sensitive parts of our business. I've made the comments with respect to our preferred equity program, where we're seeing less opportunities. We started the year with a very robust pipeline, and little by little, it's been pared down and our belief is we sit somewhere around $100 million this year, but we thought we were going to be well in excess of that. When you look at the factors that are constraining that production, it goes back to those things that I said. You have some new things. We have tariffs, which include Canadian lumber, for example, and steel. The rent control discussions are not pro-development or pro-business for that matter.
You have a number of issues that you didn't have before, even though the state is trying to produce more housing, the environment seems to be pushing against that, leading to the contradiction that I was talking about earlier.
Got it. Are there any specific markets where you think supply might surprise to the downside versus the upside, or is that getting a little bit too detailed?
Well, we think Northern California mostly has peaked, I mentioned the markets that we're very confident that have peaked. The areas that we remain concerned about are L.A. and I guess Seattle would be the two, because we don't think that they have peaked at this point in time, or there's very significant permitting. I would guess that when you get down to the starts is where you're going to start seeing problems on those deals. Because, John Eudy, John has two jobs. He's the co-chair of our coalition, which is a full-time job, actually more than a full-time job, he's also head of development, and he looks at a lot of deals. John, why don't you chime in and talk about what you're seeing out there?
Well, I can say that in our dealings with cities on a couple of entitlements that were in the process, most cities' impact on their staff is far less than it was one year and two years ago. There are far fewer deals being processed now than there were in the peak, if you will, of the development pipeline buildup between 2014 and 2015. I think the outlook two years from now is going to be very much aligned lower than it is in the worst case exception that it's growing, because it's not. The headwinds, between construction costs and the concern right now in the short run with the Costa-Hawkins repeal is muting it even further. Supply is going down.
Got it. Just maybe one more question on Costa-Hawkins and Proposition 10. Your comments are very well taken on the market not having enough supply of affordable housing. Given all the noise associated with it, if Proposition 10 was to occur, would it lead you to think about maybe entering into some markets that you're not currently participating in, or are you just very confident with your markets over the medium to long term?
Yeah, this is Mike. It's interesting, again, back to the scenario. There's a few cities, let's go back to the pre-Costa-Hawkins world, which we did just fine, by the way. In that world, as John and I have talked about, there were a few cities that had very extreme forms of rent control, basically you built no housing in those cities. Obviously, the demand is the demand for housing, therefore, it has to go somewhere else. If you have cities with extreme forms of rent control, you would be more likely to invest in the cities that are nearby those cities, the places where the people that are working, in San Francisco, for example, or Berkeley, for example, might live.
We got to have a pretty good idea of how that will work, because presumably, if you're going to lock down housing in some cities, the cities that are the likely beneficiaries will be the cities nearby. Rents will, because again, you're talking about a net reduction of rental housing in that scenario, rents will probably go higher, not less high. They will benefit from the greater demand or the lack of supply, let's say, that is caused by the rent-controlled cities.
Understood. Thank you, everyone. I appreciate the call.
Thank you.
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Karin Ford.
Karin Ford. Karin, are you there? I don't know if we can unmute your line. We can't do it from here. Let's try for a minute. Sorry, we apologize for this technical problem. Well, what should we do? Bob, can you get a list and we can call, we can make some calls afterwards and try to get to the rest of the questions?
Wait a couple minutes.
Okay. Yeah, we're going to take maybe a minute break here and see if we can figure out the technical problem. Again, we apologize.
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Can you guys hear?
We're going to join Karin Ford in for her question.
All right.
Great. Thank you.
Thank you. Sorry about that. Glad to hear we're back. Wanted to just ask one more about Proposition 10. I know you said the cap rates haven't moved in your markets, are you seeing more products starting to come to market from landlords ahead of potential repeal?
Karin, it's Mike. Thank you for sticking with us. Anecdotally, we've heard that there are some more listings out there, as I said in my comments, we really scrubbed all the deals that had been completed year to date just to make sure that we weren't missing something. We went through them one by one, the deals that were in the markets that we care about. There was no indication that cap rates have changed in those transactions. Again, there's some anecdotes that maybe there'll be a little bit more transaction activity as we get in the back half of the year. Although that's not unusual because all the sellers know that rents peak in June and July, and therefore they typically wait until June or July to get the best underwriting of their deal. I wouldn't say that's at all unusual.
Great, thanks. My second question is, I was interested in your comments about single-family affordability in your markets and the lack thereof given the current tax regime. We started to see some weakness in the housing markets here in the Northeast, and we obviously don't have the same job growth that you guys have out there. Do you think that a single-family headwinds could be a real demand driver for you guys in 2019 as people start to recognize the tax impact of the tax law change?
Karin, it's Mike again. When you look at production of housing in California, we've seen very low levels of production for single-family homes, largely because of California's Global Warming Solutions Act, which seeks to put high-density housing near the jobs, lower carbon pollution, fix the traffic problems that we have, increase in spending for public transit, et cetera. That agenda is sort of operating in the background, and that is not a pro single-family home type of agenda. We see more densification of housing in the urban markets, I don't think that's going to happen. I think that, if anything, there will be more condos being developed, and I think that's a big possibility.
More on that discussion as well as it relates to a number of our properties. I think it's more likely to be in the high-density area than it is in the single-family home.
Great. Thank you.
Our next question is from John Guinee with Stifel. Please proceed.
Great. Thank you. John Guinee here. Quick question for you. If you're looking at land at today's prices and the current hard costs, as you know, land prices are sticky and really haven't come down. On an untrended basis, what does your underwriting show you is the return on cost for development if you have to pay today's prices?
This is John Eudy, John. It depends on the specifics, obviously, far less than it would motivate you to do a deal if you take it on today's numbers. Probably average somewhere in the high, that's buying land at today's number, and entitlements out a year or so. High three, low four and a quarter at the high.
Do you see institutional money essentially willing to continue at those kind of returns, or are they finally backing off?
From my perspective, it appears like they're backing off. We see it through the pref equity program as well, the pipeline going down. Mike, what do you think?
Yeah, I totally agree with John. I would say maybe one caveat, because there are deals that have a significant amount of money that are already invested in them, and those are the ones that tend to move forward.
When you get beyond those transactions, because, let's say, a four yield's better than having $10 million invested in a deal that's not going forward. You end up with that conundrum. Aside from that, I totally agree with John.
Great. All right. Thank you very much.
Our next question is from John Pawlowski with Green Street Advisors. Please proceed.
Thanks. Mike, I'd like to get your thoughts just on the broader political risk of California. Costa-Hawkins is one aspect. You have some other legislative or ballot initiatives moving against commercial landlords like Proposition 13, Proposition C. The odds of legislators or voters reaching for the economics of landlords seems to be increasing. It's becoming an increasingly left-leaning state. I guess my question is, how do you approach political risk in comparing any type of risk-adjusted return framework to your California markets versus non-California markets? Have you started factoring that into investment decisions, outside of just Costa-Hawkins, very city-level specific considerations?
Yeah, John, this is Mike. It's a good question. We view pretty much everything through the lens of supply and demand for housing. If the regulatory environment gets so extreme that you start seeing job growth slow, which drives the demand side, then that would cause us to make a different decision, potentially. We are always going to be the same. We're going to look through the lens of supply and demand for housing. We're going to seek areas that have the best dynamic, the best supply-demand dynamic. Right now, we believe that's in California in the various markets that we're in. If that dynamic changes because of the political risk, then we would come to a different conclusion.
I think it's far from certain what California's going to do, because we have seen, certainly on the office side and in a variety of ways, the local governments very willing to accommodate the growth of California, wanting to accommodate the Apples and Googles, et cetera, of the world. You're right. More recently, you see these head tax proposals and a variety of things that seem very focused on those entities. Notably in Washington, Amazon, the head tax was repealed after being passed. I think it gives you some idea. There's some give and take here, and where the politicians come out on this is going to be really critical. I think, again, there's a dichotomy here. You have Gavin Newsom, that is supportive of our position with respect to Proposition 10.
He's not in favor of the repeal, but the Democratic Party is in favor of repeal. You have a variety of issues going back and forth. I think we just need to let it play out. Our hope is that reason prevails at the end of the day. There's a study by UC Berkeley's Terner Center that starts a conversation about what should happen that I think is notable, and it's available online. I think it's too early to tell, and we will know in the next year or two which way this is going to go.
Okay. That's super helpful. Back to the rent control risk. Today, as you prepare portfolio allocation decisions, are you redlining any cities right now from an investment standpoint?
I wouldn't say red line because again, an investment decision, rent control is only one factor within the investment decision. In fact, you would say that if, for example, Santa Cruz decides to establish a pretty extreme form of rent control, would there be a cap rate that would offset that? It's not the current cap rate environment, obviously. Again, there's a number of considerations that really prevent you from absolutely redlining things. Again, assuming that the cap rates and yields don't change very significantly to compensate you for that risk and for the lower return.
Okay, great. Thank you.
Our next question is from Tayo Okusanya from Jefferies. Please proceed.
Hi, this is Peter Abramowitz on for Tayo. I just wanted to touch on the tax expense growth in the same-store pool in the first half. Just given that it was particularly kind of clamped down in the second quarter, but also below the peers in the first half. I was just wondering what sort of trends you're seeing that's keeping that pretty low, how sustainable is that going forward? What are you seeing for the back half?
On the tax front, first half was lower, it's primarily because we had essentially property tax adjustments, we had expected in a non-same-store pool. As far as the same-store pool, it's coming in pretty much as expected. Seattle is always a little bit of a wild card, they did come in a little bit higher. We do expect second half property tax to be higher than the first half. Does that answer your question?
Yeah, sure. Thank you.
Great. Thanks.
There are no more questions at this time. We will turn the conference back over to Mike for closing comments.
Thank you. Hey, we're so sorry for our technical problems during the call. Apologize for that. Want to thank you for your participation today. Hope to see many of you at the Bank of America Merrill Lynch conference next month. Good day.
Thank you. This concludes today's conference. You may disconnect your lines at this time, and thank you for your participation.