filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the accompanying consolidated financial statements and notes thereto. These consolidated financial statements include all adjustments which are, in the opinion of management, necessary to reflect a fair statement of the results and all such adjustments are of a normal recurring nature.
On April 1, 2014, we completed the merger with BRE Properties, Inc. (“BRE”). For further details regarding the merger, see the discussion set forth under the caption “Current Business Activities - Merger with BRE Properties, Inc.” in Part I, Item 1 of this Annual Report on Form 10-K, which is incorporated herein by reference. The net assets and results of operations of BRE are included in our consolidated financial statements as of April 1, 2014. Certain statements below discuss the Company’s estimates of its 2015 regional Same-Property revenues; these estimates are for Essex on a standalone basis, excluding the impact of the merger with BRE.
OVERVIEW
ESS is a self-administered and self-managed REIT that acquires, develops, redevelops and manages apartment communities in selected residential areas located primarily in the West Coast of the United States. ESS owns all of its interests in its real estate investments, directly or indirectly, through the Operating Partnership. ESS is the sole general partner of the Operating Partnership and, as of December 31, 2014, had an approximately 96.7% general partner interest in the Operating Partnership.
The Company’s investment strategy has two components: constant monitoring of existing markets, and evaluation of new markets to identify areas with the characteristics that underlie rental growth. The Company’s strong financial condition supports its investment strategy by enhancing its ability to quickly shift acquisition, development, and disposition activities to markets that will optimize the performance of the portfolio.
As of December 31, 2014, the Company had ownership interests in 239 communities, comprising 57,455 apartment units.
The Company’s apartment communities are predominately located in the following major regions:
Southern California (Los Angeles, Orange, Riverside, San Diego, Santa Barbara, and Ventura counties)
Northern California (the San Francisco Bay Area)
Seattle Metro (Seattle metropolitan area)
As of December 31, 2014, the Company’s development pipeline was comprised of two consolidated projects under development, ten unconsolidated joint venture projects under development and various consolidated predevelopment projects aggregating 2,920 units, with total incurred costs of $1.1 billion, and estimated remaining project costs of approximately $0.4 billion for total estimated project costs of $1.5 billion.
As of December 31, 2014, the Company also had ownership interests in four commercial buildings (with approximately 325,200 square feet).
By region, the Company's operating results for 2014 and 2013 and projections for 2015 new housing supply, job growth, and rental income are as follows:
Southern California Region: As of December 31, 2014, this region represented 47% of the Company’s consolidated apartment units. During the year ended December 31, 2014, revenues for “2014/2013 Same-Properties” (as defined below), or “Same-Property revenues,” increased 5.5% in 2014 as compared to 2013. In 2015, the Company expects new residential supply of 17,950 multifamily and 14,300 single family homes, which represents a total new multifamily supply of 0.8% and 0.6% of total housing stock, respectively. The Company assumes an increase of 150,000 jobs or 2.1%, and an increase in same-property revenues between 4.50% to 5.50% in 2015.
Northern California Region: As of December 31, 2014, this region represented 31% of the Company’s consolidated apartment units. Same-Property revenues increased 9.6% in 2014 as compared to 2013. In 2015, the Company expects new residential supply of 11,400 multifamily and 7,000 single family homes, which represents a total new multifamily supply of 1.3% and 0.8%, respectively, of total housing stock. The Company assumes an increase of 90,200 jobs or 2.9%, and an increase in same-property revenues between 8.25% to 9.25% in 2015.
Seattle Metro Region: As of December 31, 2014, this region represented 21% of the Company’s consolidated apartment units. Same-Property revenues increased 7.5% in 2014 as compared to 2013. In 2015, the Company expects new residential supply of 9,000 multifamily and 7,500 single family homes, which represents a total new multifamily supply of 1.9% and 1.4%, respectively, of total housing stock. The Company assumes an increase of 43,300 jobs or 2.8%, and an increase in same-property revenues between 5.75% to 6.75% in 2015.
The Company expects 2015 Same-Property revenues to increase compared to 2014 results, as renewal and new leases are signed at higher rents in 2015 than 2014. Same-Property operating expenses are expected to increase in 2015 by 3% to 4%.
The Company’s consolidated communities are as follows:
| As of | As of | ||||||||||
| December 31, 2014 | December 31, 2013 | ||||||||||
| Apartment Units | % | Apartment Units | % | ||||||||
| Southern California | 22,168 | 47 | % | 13,855 | 46 | % | |||||
| Northern California | 14,789 | 31 | % | 9,431 | 32 | % | |||||
| Seattle Metro | 10,216 | 21 | % | 6,703 | 22 | % | |||||
| Other real estate assets(1) | 552 | 1 | % | — | — | % | |||||
| Total | 47,725 | 100 | % | 29,989 | 100 | % |
(1) Includes one property in Arizona. With the sale of Pinnacle South Mountain, executed in January 2015, the Company has exited the Arizona apartment market (see Note 17, "Subsequent Events" for details).
Co-investments communities, developments under construction and eight preferred equity interest co-investment communities are not included in the table presented above for both periods.
RESULTS OF OPERATIONS
Comparison of Year Ended December 31, 2014 to the Year Ended December 31, 2013
The Company’s average financial occupancies for the Company’s stabilized apartment communities or “2014/2013 Same-Properties” (stabilized properties consolidated by the Company for the years ended December 31, 2014 and 2013) increased 10 basis points to 96.2% in 2014 from 96.1% in 2013. Financial occupancy is defined as the percentage resulting from dividing actual rental revenue by total possible rental revenue. Actual rental revenue represents contractual rental revenue pursuant to leases without considering delinquency and concessions. Total possible rental revenue represents the value of all apartment units, with occupied units valued at contractual rental rates pursuant to leases and vacant units valued at estimated market rents.
We believe that financial occupancy is a meaningful measure of occupancy because it considers the value of each vacant unit at its estimated market rate.
Market rates are determined using the recently signed effective rates on new leases at the property and are used as the starting point in the determination of the market rates of vacant units. The Company may increase or decrease these rates based on the supply and demand in the apartment community’s market. The Company will check the reasonableness of these rents based on its position within the market and compare the rents against the asking rents by comparable properties in the market. Financial occupancy may not completely reflect short-term trends in physical occupancy and financial occupancy rates, as disclosed by other REITs, may not be comparable to the Company’s calculation of financial occupancy.
The Company does not take into account delinquency and concessions to calculate actual rent for occupied units and market rents for vacant units. The calculation of financial occupancy compares contractual rates for occupied units to estimated market rents for unoccupied units, thus the calculation compares the gross value of all apartment units excluding delinquency and concessions. For apartment communities that are development properties in lease-up without stabilized occupancy figures, the Company believes the physical occupancy rate is the appropriate performance metric. While an apartment community is in the lease-up phase, the Company’s primary motivation is to stabilize the property which may entail the use of rent concessions and other incentives, and thus financial occupancy which is based on contractual revenue is not considered the best metric to quantify occupancy.
The regional breakdown of the Company’s 2014/2013 Same-Property portfolio for financial occupancy for the years ended December 31, 2014 and 2013 is as follows:
| Years ended December 31, | |||||
| 2014 | 2013 | ||||
| Southern California | 96.3 | % | 96.1 | % | |
| Northern California | 96.3 | % | 96.1 | % | |
| Seattle Metro | 96.0 | % | 96.1 | % |
The following table provides a breakdown of revenue amounts, including the revenues attributable to 2014/2013 Same-Properties.
| Number of | Years Ended December 31, | Dollar | Percentage | |||||||||||||||
| Property Revenues ($ in thousands) | Properties | 2014 | 2013 | Change | Change | |||||||||||||
| 2014/2013 Same-Properties: | ||||||||||||||||||
| Southern California | 58 | $ | 266,917 | $ | 253,007 | $ | 13,910 | 5.5 | % | |||||||||
| Northern California | 35 | 218,014 | 198,832 | $ | 19,182 | 9.6 | % | |||||||||||
| Seattle Metro | 29 | 114,962 | 106,982 | 7,980 | 7.5 | % | ||||||||||||
| Total 2014/2013 Same-Property revenues | 122 | 599,893 | 558,821 | 41,072 | 7.3 | % | ||||||||||||
| 2014/2013 Non-Same Property Revenues (1) | 79,978 | 43,182 | 36,796 | 85.2 | % | |||||||||||||
| 2014 BRE Legacy Property Revenues (2) | 280,087 | — | 280,087 | |||||||||||||||
| Total property revenues | $ | 959,958 | $ | 602,003 | $ | 357,955 | 59.5 | % |
(1) Includes eleven communities acquired after January 1, 2013, three sold communities and one redevelopment community.
(2) Includes 55 stabilized properties acquired in connection with the BRE merger on April 1, 2014, and two development communities in lease-up.
2014/2013 Same-Property Revenues increased by $41.1 million or 7.3% to $599.9 million for 2014 compared to $558.8 million in 2013. The increase was primarily attributable to an increase in scheduled rents of $39.1 million as reflected in an increase of 7.1% in average rental rates from $1,619 per unit for 2013 to $1,734 per unit for 2014. Scheduled rents increased in all regions by 5.2%, 9.5%, and 7.4% in Southern California, Northern California, and Seattle Metro, respectively. Income from utility billings and other income increased by $2.2 million and $1.1 million, respectively in 2014 compared to 2013. Financial occupancy increased 10 basis points in 2014 to 96.2% compared to 96.1% in 2013.
2014/2013 Non-Same Property Revenues increased by $36.8 million or 85.2% to $80.0 million in 2014 compared to $43.2 million to 2013. The increase was primarily due to revenue generated from twelve communities acquired or consolidated since January 1, 2013.
Management and other fees from affiliates increased $2.0 million or 28.7% to $9.3 million in 2014 compared to $7.3 million in 2013. The increase is primarily due to the asset and property management fees earned from the Wesco III, Wesco IV, and BEXAEW co-investments formed during 2014. The increase in management fees was offset by a reduction of $1.2 million in asset and property management fees from the sale of two Fund II communities in 2014.
Property operating expenses, excluding real estate taxes increased $64.3 million or 46.3% in 2014 compared to 2013, primarily due to properties acquired in connection with the BRE merger and six other communities in 2014. 2014/2013 Same-Property operating expenses excluding real estate taxes, increased by $3.8 million or 3.0% in 2014 compared to 2013, due mainly to a $1.6 million increase in repairs and maintenance and a $1.3 million increase in utilities expense.
Real estate taxes increased $50.6 million or 88.3% in 2014 compared to 2013, due primarily to properties acquired in connection with the BRE merger and six other communities in 2014. 2014/2013 Same-Property real estate taxes increased by $2.3 million or 4.5% for 2014 compared to 2013 due to a $1.6 million or 15.6% increase in property taxes for Seattle Metro due to higher assessed values for 2014.
Depreciation and amortization expense increased by $168.2 million or 87.4% in 2014 compared to 2013, due to the acquisition of BRE and six other communities. The increase is due to the capitalization of approximately $313.1 million in additions to rental properties through 2014, including $152.8 million spent on acquisition of and additions to real estate under development, $81.4 million spent on redevelopment, and $78.9 million spent on capital expenditures on rental properties. Approximately $122.0 million in additions to rental properties were capitalized for 2013, including $17.8 million spent on acquisition of and additions to real estate under development, $47.3 million spent on redevelopment, and $56.9 million spent on capital expenditures on rental properties.
General and administrative expense increased $14.2 million or 53.2% in 2014 compared to 2013 primarily due to additional corporate employees from the BRE merger and $2.8 million in expenses related to the cyber-intrusion.
Merger and integration expenses include, but are not limited to, advisor fees, legal fees, and accounting fees related to the BRE merger. The Company completed the merger with BRE on April 1, 2014. Merger and integration expenses were $53.5 million for 2014 and $4.3 million for 2013.
Interest expense increased $48.0 million or 41.2% in 2014, primarily due to additional debt assumed as part of the BRE merger, offset by an increase in capitalized interest from development and redevelopment projects.
Equity income from co-investments decreased by $16.0 million to $39.9 million in 2014 compared to $55.9 million in 2013. The decrease was primarily due to the Company’s share of the gain on the sale of two Fund II communities of $6.6 million, promote income of $10.6 million, and income from early redemption of preferred equity investments of $5.3 million in 2014, compared to the Company's share of gain on the sale of five Fund II communities of $38.8 million, net of internal dispositions costs in 2013.
Comparison of Year Ended December 31, 2013 to the Year Ended December 31, 2012
The Company’s average financial occupancies for the Company’s stabilized apartment communities for “2013/2012 Same-Properties” (stabilized properties consolidated by the Company for the years ended December 31, 2013 and 2012) decreased 10 basis points to 96.2% in 2013 from 96.3% in 2012. The regional breakdown of the Company’s stabilized 2013/2012 Same-Property portfolio for financial occupancy for the years ended December 31, 2013 and 2012 is as follows:
| Years ended December 31, | |||||
| 2013 | 2012 | ||||
| Southern California | 96.1 | % | 96.1 | % | |
| Northern California | 96.3 | % | 96.7 | % | |
| Seattle Metro | 96.1 | % | 96.1 | % |
The following table provides a breakdown of revenue amounts, including the revenues attributable to 2013/2012 Same-Properties.
| Number of | Years Ended December 31, | Dollar | Percentage | |||||||||||||||
| Property Revenues ($ in thousands) | Properties | 2013 | 2012 | Change | Change | |||||||||||||
| 2013/2012 Same-Properties: | ||||||||||||||||||
| Southern California | 58 | $ | 235,306 | $ | 225,435 | $ | 9,871 | 4.4 | % | |||||||||
| Northern California | 35 | 184,508 | 170,578 | $ | 13,930 | 8.2 | % | |||||||||||
| Seattle Metro | 29 | 93,139 | 86,483 | $ | 6,656 | 7.7 | % | |||||||||||
| Total 2013/2012 Same-Property revenues | 122 | 512,953 | 482,496 | $ | 30,457 | 6.3 | % | |||||||||||
| 2013/2012 Non-Same Property Revenues (1) | 89,050 | 44,200 | $ | 44,850 | 101.5 | % | ||||||||||||
| Total property revenues | $ | 602,003 | $ | 526,696 | $ | 75,307 | 14.3 | % |
(1) Includes fifteen communities acquired after January 1, 2012, two redevelopment communities, and three commercial buildings.
2013/2012 Same-Property Revenues increased by $30.5 million or 6.3% to $513.0 million for 2013 compared to $482.5 million in 2012. The increase was primarily attributable to an increase in scheduled rents of $29.6 million as reflected in an increase of 6.3% in average rental rates from $1,502 per unit for 2012 to $1,597 per unit for 2013. Scheduled rents increased in all regions by 4.1%, 8.4%, and 7.7% in Southern California, Northern California, and Seattle Metro, respectively. Income from utility billings and other income increased by $1.0 million and $1.2 million, respectively in 2013 compared to 2012. Occupancy decreased 10 basis points in 2013 to 96.2% compared to 96.3% in 2012.
2013/2012 Non-Same Property Revenues increased by $44.9 million or 102% to $89.1 million in 2013 compared to $44.2 million to 2012. The increase was primarily due to revenue generated from fifteen communities acquired or consolidated since January 1, 2012 (Annaliese, Ascent, Bennett Lofts, Domain, Domaine, Essex Skyline at MacArthur Place, Fox Plaza, Montebello, Park Catalina, Park West, Reed Square, Slater 116, The Huntington, Vox and Willow Lake).
Management and other fees from affiliates decreased $1.2 million or 14.1% to $7.3 million in 2013 compared to $8.5 million in 2012. The decrease is primarily due to a reduction of $2.3 million in asset and property management fees from the sale of eight Fund II communities since the fourth quarter of 2012. An additional four communities owned by Fund II were sold in 2013.
Property operating expenses, excluding real estate taxes increased $14.9 million or 12.1% in 2013 compared to 2012, primarily due to the acquisition of fifteen communities. 2013/2012 Same-Property operating expenses excluding real estate taxes, increased by $3.6 million or 3.2% in 2013 compared to 2012, due mainly to a $1.4 million increase in repairs and maintenance, a $1.2 million increase in utilities expense, and a $0.9 million increase in administration costs.
Real estate taxes increased $8.9 million or 18.5% in 2013 compared to 2012, due primarily to the acquisition of fifteen communities. 2013/2012 Same-Property real estate taxes increased by $2.6 million or 6.0% for the 2013 compared to 2012 due to $1.3 million or 17.5% increase in property taxes for Seattle Metro due to higher assessed values for 2013, and an increase of 3.7% in property taxes for the properties located in California.
Depreciation and amortization expense increased by $23.2 million or 13.7% in 2013 compared to 2012, due to the acquisition of fifteen communities. The increase is due to the capitalization of approximately $122.0 million in additions to rental properties through 2013, including $17.8 million spent on acquisition of and additions to real estate under development, $47.3 million spent on redevelopment, and $56.9 million spent on capital expenditures on rental properties. Approximately $121.2 million in additions to rental properties were capitalized for 2012, including $29.2 million spent on acquisitions of and additions to real estate under development, $46.6 million spent on redevelopment, and $45.4 million spent on capital expenditures on rental properties.
General and administrative expense increased $2.1 million or 8.6% in 2013 compared to 2012 offset by annual compensation increases for merit, investments in technology, and the addition of staff.
Merger and integration expenses include, but are not limited to, advisor fees, legal fees, and accounting fees related to the merger with BRE. The Company entered into a definitive agreement to combine with BRE in December 2013. Merger expenses were $4.3 million for 2013 and zero for 2012.
Interest expense increased $4.6 million or 4.1% in 2013, primarily due to an increase in average outstanding debt for the funding of 2012 and 2013 acquisitions and costs incurred on the development pipeline.
Interest and other income decreased by $2.2 million in 2013 primarily due to $2.3 million of promote income earned from achieving certain performance hurdles related to the Essex Skyline co-investment in 2012.
Equity income from co-investments increased by $14.2 million to $55.9 million in 2013 compared to $41.7 million in 2012. The increase was primarily due to the Company’s share of the gain on the sale of five Fund II communities of $38.8 million, net of internal disposition costs, and $1.4 million income earned from the early prepayment of a preferred equity investment in 2013. Additionally, equity income increased with income earned from four communities acquired by the Wesco joint ventures in the second half of 2012 and two communities in the second quarter of 2013. The increase in equity income in 2013 by the Wesco joint venture was offset by a decrease in income related to the sale of eight Fund II communities since the fourth quarter of 2012 including four communities sold in the third quarter of 2013.
Loss on early retirement of debt, net was $0.3 million for 2013 compared to $5.0 million in 2012. The $0.3 million loss in 2013 reflects a gain of $1.5 million earned from the redemption of bonds in the second quarter of 2013 offset by losses incurred from the write-off of deferred financing costs and prepayment penalties related to the prepayment of secured debt loans in 2013. The 2012 loss was due to the write-off of deferred financing costs and prepayment penalties related to the early termination of secured debt related to six communities. The loss for 2012 also included the Company’s pro-rata share of the write-off of deferred financing costs and prepayment penalties incurred for the prepayment of the secured debt for the Essex Skyline joint venture and seven Fund II communities sold in 2012.
Income from discontinued operations for 2013 was $31.2 million and included gains of $29.2 million from the sales of Linden Square, Brentwood and Cambridge. For 2012, income from discontinued operations was $11.9 million and included a gain of $9.8 million from the sale of Tierra del Sol/Norte and Alpine Country, net of internal disposition costs. Discontinued operations for 2013 and 2012 reflect the operating results of the three communities sold in 2013 and the two communities sold in 2012.
Liquidity and Capital Resources
The following table sets forth the Company’s cash flows for 2014, 2013 and 2012 ($ in thousands):
| For the year ended | ||||||||||||
| 12/31/2014 | 12/31/2013 | 12/31/2012 | ||||||||||
| Cash flow provided by (used in): | ||||||||||||
| Operating activities | $ | 492,983 | $ | 304,982 | $ | 267,499 | ||||||
| Investing activities | $ | (1,147,156 | ) | $ | (453,696 | ) | $ | (812,138 | ) | |||
| Financing activities | $ | 520,610 | $ | 148,599 | $ | 550,356 |
ESS’s business is operated primarily through the Operating Partnership. ESS issues public equity from time to time, but does not otherwise generate any capital itself or conduct any business itself, other than incurring certain expenses in operating as a public company which are fully reimbursed by the Operating Partnership. ESS itself does not hold any indebtedness, and its only material asset is its ownership of partnership interests of the Operating Partnership. ESS’s principal funding requirement is the payment of dividends on its common stock and preferred stock. ESS’s principal source of funding for its dividend payments is distributions it receives from the Operating Partnership.
As of December 31, 2014, ESS owned a 96.7% general partner interest and the limited partners owned the remaining 3.3% interest in the Operating Partnership.
The liquidity of ESS is dependent on the Operating Partnership’s ability to make sufficient distributions to ESS. The primary cash requirement of ESS is its payment of dividends to its stockholders. ESS also guarantees some of the Operating Partnership’s debt, as discussed further in Notes 7 and 8 of the notes to consolidated financial statements included elsewhere
herein. If the Operating Partnership fails to fulfill certain of its debt requirements, which trigger the ESS’s guarantee obligations, then ESS will be required to fulfill its cash payment commitments under such guarantees. However, ESS’s only significant asset is its investment in the Operating Partnership.
For ESS to maintain its qualification as a REIT, it must pay dividends to its stockholders aggregating annually at least 90% of its REIT taxable income, excluding net capital gains. While historically ESS has satisfied this distribution requirement by making cash distributions to its stockholders, it may choose to satisfy this requirement by making distributions of cash or other property, including, in limited circumstances, ESS’s own stock. As a result of this distribution requirement, the Operating Partnership cannot rely on retained earnings to fund its ongoing operations to the same extent that other companies whose parent companies are not REITs can. ESS may need to continue to raise capital in the equity markets to fund the Operating Partnership’s working capital needs, acquisitions and developments.
Fitch Ratings ("Fitch"), Moody’s Investor Service, and Standard and Poor's (“S&P”) credit agencies rate Essex Property Trust, Inc. and Essex Portfolio, L.P. BBB+/Stable, Baa2/Stable, and BBB/Stable, respectively.
At December 31, 2014, the Company had $25.3 million of unrestricted cash and cash equivalents and $117.2 million in marketable securities, of which $44.2 million were held available for sale. The Company believes that cash flows generated by its operations, existing cash and cash equivalents, marketable securities balances, availability under existing lines of credit, access to capital markets and the ability to generate cash from the disposition of real estate are sufficient to meet all of the Company’s reasonably anticipated cash needs during 2015. The timing, source and amounts of cash flows provided by financing activities and used in investing activities are sensitive to changes in interest rates and other fluctuations in the capital markets environment, which can affect the Company’s plans for acquisitions, dispositions, development and redevelopment activities.
The Company has two lines of credit aggregating $1.03 billion as of December 31, 2014 including a $1.0 billion unsecured line of credit. As of December 31, 2014, there was a $229.8 million balance on this unsecured line of credit with an underlying interest rate of LIBOR plus 0.95%. In January 2015, the facility maturity date was extended to December 31, 2018 with one 18-month extension, exercisable by the Company. The Company also has a $25.0 million working capital unsecured line of credit agreement. As of December 31, 2014, there was a $16.6 million balance on this unsecured line with an underlying interest rate of LIBOR plus 0.95%. This facility matures in January 2016.
In April 2014, the Company, assumed $900.0 million aggregate principal amount of BRE’s 5.500% senior notes due 2017; 5.200% senior notes due 2021; and 3.375% senior notes due 2023 (together “BRE Notes”). The carrying value of the BRE Notes, plus premium, was $934.7 million as of December 31, 2014.
In April 2014, the Company issued $400.0 million of senior unsecured notes due on May 1, 2024 with a coupon rate of 3.875% per annum. The interest is payable semi-annually in arrears on May 1 and November 1 of each year, commencing November 1, 2014 until the maturity date of May 1, 2024. The Company used the net proceeds of this offering to repay indebtedness under the Company's $1.0 billion unsecured line of credit facility and for other general corporate purposes.
As of December 31, 2014, the Company had $465.0 million of private placement unsecured bonds outstanding at an average interest rate of 4.5% with maturity dates ranging from March 2016 through August 2021.
In April 2013, the Company issued $300.0 million of senior unsecured bonds due May 1, 2023 with a coupon rate of 3.25% per annum. The interest is payable semi-annually in arrears on May 1 and November 1 of each year, commencing November 1, 2013, until maturity. The Company used the net proceeds of this offering to repay indebtedness under the Company’s $600.0 million unsecured line of credit facility and for other general corporate and working capital purposes.
During the third quarter of 2012, the Company issued $300 million of senior unsecured bonds due August 2022 with a coupon rate of 3.625% per annum and payable on February 15th and August 15th of each year, beginning February 15, 2013.
As of December 31, 2014, the Company had a $225.0 million unsecured term loan outstanding at a weighted average effective interest rate of 2.4%. The term loan has a variable interest rate of LIBOR plus 1.05%. The Company has entered into interest rate swap contracts for a term of five years with a notional amount totaling $225.0 million, which effectively converted the interest rate on $225.0 million of the term loan to a fixed rate of 2.4%.
As of December 31, 2014, the Company’s mortgage notes payable totaled $2.2 billion which consisted of $2.1 billion in fixed rate debt with interest rates varying from 4.3% to 6.4% and maturity dates ranging from 2015 to 2021 and $179.2 million of
tax-exempt variable rate demand notes with a weighted average interest rate of 1.8%. The tax-exempt variable rate demand notes have maturity dates ranging from 2025 to 2040, and $153.2 million are subject to interest rate caps.
The Company’s unsecured line of credit and unsecured debt agreements contain debt covenants related to limitations on indebtedness and liabilities and maintenance of minimum levels of consolidated earnings before depreciation, interest and amortization. The Company was in compliance with the debt covenants as of December 31, 2014 and 2013.
The Company pays quarterly dividends from cash available for distribution. Until it is distributed, cash available for distribution is invested by the Company primarily in investment grade securities held available for sale or is used by the Company to reduce balances outstanding under its line of credit.
The Company has benefited from borrowing from Fannie Mae and Freddie Mac, and there are no assurances that these entities will lend to the Company in the future. To the extent that the Company’s access to capital and credit is at a higher cost than the Company has experienced in recent years (reflected in higher interest rates for debt financing or a lower stock price for equity financing) the Company’s ability to make acquisitions, develop communities, obtain new financing, and refinance existing borrowing at competitive rates could be adversely impacted. For the past two years the Company has primarily issued unsecured debt and repaid secured debt when it has matured to place less reliance on mortgage debt financing, and to unencumber more of the Company's communities.
Derivative Activity
The Company uses interest rate swaps and interest rate cap contracts to manage certain interest rate risks. The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves. The fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts). The variable cash payments (or receipts) are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves. The Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements.
The Company has entered into interest rate swap contracts with an aggregate notional amount of $225.0 million that effectively fixed the interest rate on the $225.0 million unsecured term loan at 2.4%. These derivatives qualify for hedge accounting.
As of December 31, 2014 the Company also had nine interest rate cap contracts totaling a notional amount of $153.2 million that effectively limit the Company’s exposure to interest rate risk by providing a ceiling on the underlying variable interest rate for $153.2 million of the Company’s tax exempt variable rate debt.
As of December 31, 2014 and 2013, the aggregate carrying value of the interest rate swap contracts was a liability of $1.8 million and $2.7 million, respectively. The aggregate carrying value of the interest rate cap contracts was zero on the balance sheets as of December 31, 2014 and 2013.
Hedge ineffectiveness related to cash flow hedges, which is reported in current year income as interest expense was not significant for the years ended December 31, 2014, 2013 and 2012.
Issuance of Common Stock
In 2014, the Company filed a new shelf registration statement with the SEC, allowing the Company to sell an undetermined number or amount of certain equity (only ESS) and debt securities as defined in the prospectus.
ESS has entered into equity distribution agreements with Cantor Fitzgerald & Co., Barclays Capital Inc., BMO Capital Markets Corp., BNP Paribas Securities Corp., Citigroup Global Markets Inc, Jefferies LLC ("Jefferies"), J.P. Morgan Securities LLC ("JP Morgan"), Liquidnet, Inc., Mitsubishi UFJ Securities(USA), Inc, and UBS Securities LLC ("UBS"). Pursuant to its equity distribution program, in 2014, ESS issued 2,964,315 shares of common stock for $534.0 million, net of fees and commissions, and in 2013, ESS issued 913,344 shares of common stock for proceeds of $138.4 million, net of fees and commissions. During the first quarter of 2015 through February 24, 2015, ESS has issued 636,021 shares of common stock at an average price of $224.76 for proceeds of $142.0 million, net of fees and commissions. Under this program, ESS may from time to time sell shares of common stock into the existing trading market at current market prices, and the Company anticipates using the net proceeds, which are contributed to the Operating Partnership, to pay down debt, acquire apartment communities and fund the
development pipeline. As of February 24, 2015, ESS may sell an additional 413,979,566 shares under the current equity distribution program.
Capital Expenditures
Non-revenue generating capital expenditures are improvements and upgrades that extend the useful life of the property. For the year ended December 31, 2014, non-revenue generating capital expenditures totaled approximately $1,198 per unit. The Company expects to incur approximately $1,200 per unit in non-revenue generating capital expenditures for the year ending December 31, 2015. These expenditures do not include the improvements required in connection with the origination of mortgage loans, expenditures for deferred maintenance on acquisition properties, and expenditures for property renovations and improvements which are expected to generate additional revenue. The Company expects that cash from operations and/or its lines of credit will fund such expenditures. However, there can be no assurance that the actual expenditures incurred during 2015 and/or the funding thereof will not be significantly different than the Company’s current expectations.
Development and Predevelopment Pipeline
The Company defines development activities as new communities that are in various stages of active development, or the community is in lease-up and phases of the project are not completed. As of December 31, 2014, the Company had two consolidated development projects comprised of 624 units with an estimated cost of $447.0 million of which $58.0 million remains to be expended, and ten unconsolidated joint venture active development projects comprised of 2,296 units with an estimated cost of $1.0 billion, of which $362.0 million remains to be expended. The Company's share of these estimated remaining project costs is approximately $192.0 million.
The Company defines the predevelopment pipeline as proposed communities in negotiation or in the entitlement process with a high likelihood of becoming entitled development projects. The Company may also acquire land for future development purposes or sale.
The Company expects to fund the development and predevelopment pipeline by using a combination of some or all of the following sources: its working capital, amounts available on its lines of credit, construction loans, net proceeds from public and private equity and debt issuances, and proceeds from the disposition of properties, if any.
Redevelopment Pipeline
The Company defines redevelopment communities as existing properties owned or recently acquired, which have been targeted for additional investment by the Company with the expectation of increased financial returns through property improvement. During redevelopment, apartment units may not be available for rent and, as a result, may have less than stabilized operations. As of December 31, 2014, the Company had ownership interests in three major redevelopment communities aggregating 963 apartment units with estimated redevelopment costs of $122.0 million, of which approximately $96.4 million remains to be expended.
Alternative Capital Sources
Wesco, I LLC (“Wesco I”) is a 50/50 programmatic joint venture with an institutional partner for a total equity commitment of $300.0 million. Each partner’s equity commitment is $150.0 million. Wesco I will utilize debt targeted at approximately 50% of the cost to acquire and improve real estate. The Company has contributed $150.0 million to Wesco I, and as of December 31, 2014, Wesco I owned nine apartment communities with 2,713 units with an aggregate carrying value of approximately $682.4 million.
During 2012, the Company entered into a 50/50 programmatic joint venture, Wesco III LLC (“Wesco III”), with an institutional partner for a total equity commitment from the parties of $120.0 million. Each partner’s equity commitment is $60.0 million, and Wesco III will utilize debt targeted at approximately 50% of the cost to acquire and improve real estate. During the first quarter of 2014, BRE contributed three assets to Wesco III. The Company has contributed $39.7 million to Wesco III and, as of December 31, 2014, Wesco III owned six apartment communities with 993 units for an aggregate carrying value of approximately $230.7 million.
Investments with Wesco I or Wesco III must meet certain criteria to qualify for inclusion in the joint ventures and both partners must approve any new acquisitions and material dispositions. The joint ventures have an investment period of up to two years. The Company records revenue for its asset management, property management, development, and redevelopment services when earned, and promote income when realized, if Wesco I or Wesco III exceeds certain financial return benchmarks.
During the second quarter of 2013, the Company provided two short-term bridge loans to Wesco III totaling $56.8 million to assist with the purchase of the Regency at Mountain View and Gas Company Lofts and both loans were at a rate of LIBOR + 2.50%. Wesco III repaid these two loans on Regency at Mountain View and Gas Company Lofts in January 2014 and April 2014, respectively.
On April 1, 2014, in connection with the merger, the Company acquired a 50% interest in Wesco IV LLC (“Wesco IV”) and a
50% interest in BEXAEW LLC (“BEXAEW”). Wesco IV and BEXAEW’s remaining 50% interest is owned by institutional partners. Wesco IV and BEXAEW expect to utilize debt targeted at approximately 50% and 60%, respectively, of the cost to acquire and improve real estate. Under the terms of Wesco IV’s and BEXAEW’s operating agreements, Essex is entitled to asset management, property management, development and redevelopment service fees. In addition, Essex is entitled to its 50% pro rata share of the income or loss generated by these entities and, upon the achievement of certain performance measures, is entitled to promote income. As of December 31, 2014, Wesco IV owned five apartment communities with 1,116 units with an aggregate carrying value of approximately $297.9 million. As of December 31, 2014, BEXAEW owned nine apartment communities with 2,723 units with an aggregate carrying value of approximately $519.2 million.
Contractual Obligations and Commercial Commitments
The following table summarizes the maturity or due dates of the Company’s contractual obligations and other commitments at December 31, 2014, and the effect such obligations could have on the Company’s liquidity and cash flow in future periods ($ in thousands):
| 2015 | 2016 and 2017 | 2018 and 2019 | Thereafter | Total | ||||||||||||||||
| Mortgage notes payable | $ | 94,580 | $ | 240,164 | $ | 885,881 | $ | 941,526 | $ | 2,162,151 | ||||||||||
| Unsecured debt | — | 715,000 | 75,000 | 1,800,000 | 2,590,000 | |||||||||||||||
| Lines of credit | — | 16,577 | — | 229,814 | 246,391 | |||||||||||||||
| Interest on indebtedness (1) | 188,481 | 353,889 | 286,471 | 326,666 | 1,155,507 | |||||||||||||||
| Development commitments (including co-investments) | 185,651 | 63,319 | 578 | — | 249,548 | |||||||||||||||
| $ | 468,712 | $ | 1,388,949 | $ | 1,247,930 | $ | 3,298,006 | $ | 6,403,597 |
| (1) | Interest on indebtedness for variable debt was calculated using interest rates as of December 31, 2014. |
Variable Interest Entities
In accordance with accounting standards for consolidation of variable interest entities (VIEs), the Company consolidates 17 DownREIT limited partnerships (comprising ten communities). The Company consolidates these entities because it is deemed the primary beneficiary. The consolidated total assets and liabilities related to these VIEs, net of intercompany eliminations, were approximately $200.0 million and $196.6 million, respectively, as of December 31, 2014, and $194.9 million and $178.3 million respectively, as of December 31, 2013. Interest holders in VIEs consolidated by the Company are allocated net income equal to the cash payments made to those interest holders for services rendered or distributions from cash flow. The remaining results of operations are generally allocated to the Company. As of December 31, 2014, the Company did not have any VIE’s of which it was not deemed to be the primary beneficiary.
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements, in accordance with U.S. generally accepted accounting principles, requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. The Company defines critical accounting policies as those accounting policies that require the Company's management to exercise their most difficult, subjective and complex judgments. The Company’s critical accounting policies relate principally to the following key areas: (i) accounting for business combinations; (ii) consolidation under applicable accounting standards of various entities; (iii) assessing the carrying values of the Company's real estate and investments in and advances to joint ventures and affiliates; and (iv) internal cost capitalization. The Company bases its estimates on historical experience, current market conditions, and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from those estimates made by management.
The Company accounts for its business combinations, including the merger and other acquisitions of investments in real estate, in accordance with ASC 805-10, Business Combinations, which requires the acquired tangible and intangible assets and liabilities to be recorded at fair value, with excess purchase price, if any, recorded to goodwill. The Company must make significant assumptions in determining the fair value of the tangible and intangible assets and liabilities acquired and consideration transferred. The use of different assumptions in estimating the fair value could affect the measurement and timing of recognition of acquired assets and liabilities and related expenses.
The consideration transferred in a business combination is generally measured at fair value. For debt assumed by the Company, the fair value is determined using estimated market interest rates for debt with comparable terms in place at the time of the acquisition. For equity issued by the Company, the fair value is generally based on the fair value of the Company’s equity interests at the date of issuance.
The fair value of the tangible assets, which principally includes land and building, is determined first by valuing the property as a whole as if it were vacant, using stabilized net operating income and market specific capitalization rates. The fair value of the land and building is then recorded based on its estimated fair value.
In calculating the fair value of identified intangible assets of an acquired property, the in-place leases are valued based on in-place rent rates and estimated time and cost to lease a unit.
The initial purchase accounting is based on the Company’s preliminary assessment, which may differ when additional information becomes available. Subsequent adjustments made to the initial purchase accounting, if any, are made within the measurement period, which will be finalized within one year of the acquisition date.
The Company assesses each entity in which it has an investment or contractual relationship to determine if it may be deemed to be a VIE. If such an entity is a VIE, then the Company performs an analysis to determine who is the primary beneficiary. If the Company is the primary beneficiary, then the entity is consolidated. The analysis required to identify VIEs and primary beneficiaries is complex and judgmental, and the analysis must be applied to various types of entities and legal structures.
The Company assesses the carrying value of its real estate investments by monitoring investment market conditions and performance compared to budget for operating properties and joint ventures, and by monitoring estimated costs for properties under development. Local market knowledge and data is used to assess carrying values of properties and the market value of acquisition opportunities. Whenever events or changes in circumstances indicate that the carrying amount of a property held for investment may not be fully recoverable, the carrying amount is evaluated. If the sum of the property’s expected future cash flows (undiscounted and without interest charges) is less than the carrying amount of the property, then the Company will recognize an impairment loss equal to the excess of the carrying amount over the fair value of the property. Adverse changes in market conditions or poor operating results of real estate investments could result in impairment charges. When the Company determines that a property is held for sale, it discontinues the periodic depreciation of that property. The criteria for determining when a property is held for sale requires judgment and has potential financial statement impact as depreciation would cease and an impairment loss could occur upon determination of held for sale status. Assets held for sale are reported at the lower of the carrying amount or estimated fair value less costs to sell.
Further, the Company evaluates whether its co-investments are other than temporarily impaired and, if so, records an impairment loss equal to the excess of the co-investments' carrying value over its estimated fair value.
The Company capitalizes all direct and certain indirect costs, including interest and real estate taxes, incurred during development and redevelopment activities. Interest is capitalized on real estate assets that require a period of time to get them ready for their intended use. The amount of interest capitalized is based upon the average amount of accumulated development expenditures during the reporting period. Included in capitalized costs are management’s accounting estimates of the direct and incremental personnel costs and indirect project costs associated with the Company's development and redevelopment activities. Indirect project costs consist primarily of personnel costs associated with construction administration and development, including accounting, legal fees, and various corporate and community onsite costs that clearly relate to projects under development.
The Company bases its accounting estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may vary from those estimates and those estimates could be different under different assumptions or conditions.
Net Operating Income (“NOI”)
Same-Property net operating income (“NOI”) is considered by management to be an important supplemental performance measure to earnings from operations included in the Company’s consolidated statements of operations. The presentation of Same-Property NOI assists with the presentation of the Company’s operations prior to the allocation of depreciation and any corporate-level or financing-related costs. NOI reflects the operating performance of a community and allows for an easy comparison of the operating performance of individual communities or groups of communities. Prospective buyers of real estate have different financing and overhead structures, with varying marginal impacts to overhead by acquiring real estate, and NOI is considered by many in the real estate industry to be a useful measure for determining the value of a real estate asset or group of assets. The Company defines Same-Property NOI as Same-Property revenue less Same-Property operating expenses.
The reconciliation of earnings from operations to Same-Property NOI for the periods presented:
| 2014 | 2013 | 2012 | |||||||||
| Earnings from operations | $ | 201,514 | $ | 188,705 | $ | 167,025 | |||||
| Adjustments: | |||||||||||
| General and administrative | 40,878 | 26,684 | 24,573 | ||||||||
| Management and other fees from affiliates | (9,347 | ) | (7,263 | ) | (8,457 | ) | |||||
| Depreciation and amortization | 360,592 | 192,420 | 169,173 | ||||||||
| Merger and integration expenses | 53,530 | 4,284 | — | ||||||||
| Acquisition and disposition costs | 1,878 | 1,161 | 2,215 | ||||||||
| Net operating income | 649,045 | 405,991 | 354,529 | ||||||||
| Less: Non Same-Property NOI | (234,147 | ) | (26,073 | ) | (16,698 | ) | |||||
| Same-Property NOI | $ | 414,898 | $ | 379,918 | $ | 337,831 |
Forward Looking Statements
Certain statements in this "Management's Discussion and Analysis of Financial Condition and Results of Operations," and elsewhere in this Annual Report on Form 10-K which are not historical facts may be considered forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended, including statements regarding the Company's expectations, hopes, intentions, beliefs and strategies regarding the future. Forward looking statements include statements regarding the Company's expectations as to the timing of completion of current development and redevelopment projects and the stabilization dates of such projects, expectation as to the total projected costs of development and redevelopment projects, beliefs as to the adequacy of future cash flows to meet operating requirements, anticipated cash needs to provide for dividend payments in accordance with REIT requirements, expectations as to the amount of non-revenue generating capital expenditures, future acquisitions, the Company's development and redevelopment pipeline and the sources of funding for it, the anticipated performance of existing properties, the effect of property sales on future results, anticipated property and growth trends in various geographic regions, statements regarding the Company’s expected 2015 Same-Property revenue, and 2015 Same-Property operating expenses, statements regarding the Company's financing activities, and the use of proceeds from such activities.
Such forward-looking statements involve known and unknown risks, uncertainties and other factors including, but not limited to, that the Company will fail to achieve its business objectives, that the actual completion of development and redevelopment projects will be subject to delays, that the stabilization dates of such projects will be delayed, that the total projected costs of current development and redevelopment projects will exceed expectations, that such development and redevelopment projects will not be completed, that development and redevelopment projects and acquisitions will fail to meet expectations, that estimates of future income from an acquired property may prove to be inaccurate, that future cash flows will be inadequate to meet operating requirements and/or will be insufficient to provide for dividend payments in accordance with REIT requirements, that the actual non-revenue generating capital expenditures will exceed the Company's current expectations, that there may be a downturn in the markets in which the Company's communities are located, that the terms of any refinancing may not be as favorable as the terms of existing indebtedness, as well as those risks, special considerations, and other factors discussed in Item 1A, Risk Factors, of this Form 10-K, and those risk factors and special considerations set forth in the Company’s other filings with the SEC which may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. All forward-looking statements are made as of today, and the Company assumes no obligation to update this information.
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