filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
53K characters. Original on sec.gov ·
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.
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, 2016, 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, redevelopment, and disposition activities to markets that will optimize the performance of the portfolio.
As of December 31, 2016, the Company had ownership interests in 245 communities, comprising 59,645 apartment homes, excluding the Company's ownership in preferred equity interest co-investments.
The Company’s apartment communities are predominately located in the following major regions:
Southern California (Los Angeles, Orange, San Diego, and Ventura counties)
Northern California (the San Francisco Bay Area)
Seattle Metro (Seattle metropolitan area)
As of December 31, 2016, the Company’s development pipeline was comprised of two consolidated projects under development, four unconsolidated joint venture projects under development and various consolidated predevelopment projects aggregating 2,223 apartment homes, with total incurred costs of $0.6 billion, and estimated remaining project costs of approximately $0.7 billion for total estimated project costs of $1.3 billion.
As of December 31, 2016, the Company also had ownership interests in two operating commercial buildings (with approximately 140,564 square feet).
By region, the Company's operating results for 2016 and 2015 and projections for 2017 new housing supply (defined as new multi-family apartment homes and single family homes, excluding developments with fewer than 50 apartment homes as well as student, senior and 100% affordable housing), job growth, and rental income are as follows:
Southern California Region: As of December 31, 2016, this region represented 49% of the Company’s consolidated apartment homes. Revenues for “2016/2015 Same-Properties” (as defined below), or “Same-Property revenues,” increased 6.2% in 2016 as compared to 2015. In 2017, the Company projects new residential supply of 36,425 apartment homes and single family homes, which represents 0.6% of the total housing stock. The Company projects an increase of 145,450 jobs or 2.0%, and an increase in Same-Property revenues of between 3.50% to 4.50% in 2017.
Northern California Region: As of December 31, 2016, this region represented 30% of the Company’s consolidated apartment homes. Same-Property revenues increased 6.8% in 2016 as compared to 2015. In 2017, the Company projects new residential supply of 19,150 apartment homes and single family homes, which represents 0.8% of the total housing stock. The Company projects an increase of 68,350 jobs or 2.2%, and an increase in Same-Property revenues of between 1.25% to 2.25% in 2017.
Seattle Metro Region: As of December 31, 2016, this region represented 21% of the Company’s consolidated apartment homes. Same-Property revenues increased 7.9% in 2016 as compared to 2015. In 2017, the Company projects new residential supply of 19,600 apartment homes and single family homes, which represents 1.6% of the total housing stock. The Company projects an increase of 44,600 jobs or 2.7%, and an increase in Same-Property revenues of between 3.75% to 4.75% in 2017.
The Company projects an increase in 2017 Same-Property revenues of between 2.75% to 3.75%, as renewal and new leases are signed at higher rents in 2017 than 2016. Same-Property operating expenses are projected to increase in 2017 by 2.50% to 3.50%.
The Company’s consolidated communities are as follows:
| As of | As of | ||||||||||
| December 31, 2016 | December 31, 2015 | ||||||||||
| Apartment Homes | % | Apartment Homes | % | ||||||||
| Southern California | 23,613 | 49 | % | 23,707 | 49 | % | |||||
| Northern California | 14,519 | 30 | % | 14,694 | 30 | % | |||||
| Seattle Metro | 10,239 | 21 | % | 10,239 | 21 | % | |||||
| Total | 48,371 | 100 | % | 48,640 | 100 | % |
Co-investments, including Wesco I, LLC ("Wesco I"), Wesco III, LLC ("Wesco III"), Wesco IV, LLC (“Wesco IV”), Canadian Pension Plan Investment Board ("CPPIB" or "CPP"), Palm Valley, BEXAEW, LLC (“BEXAEW”), BEX II, LLC ("BEX II"), communities, developments under construction and 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, 2016 to the Year Ended December 31, 2015
The Company’s average financial occupancies for the Company’s stabilized apartment communities or “2016/2015 Same-Properties” (stabilized properties consolidated by the Company for the years ended December 31, 2016 and 2015) increased 30 basis points to 96.3% in 2016 from 96.0% in 2015. Financial occupancy is defined as the percentage resulting from dividing actual rental revenue by total potential rental revenue (actual rental revenue for occupied apartment homes plus market rent for vacant apartment homes). Actual rental revenue represents contractual rental revenue pursuant to leases without considering delinquency and concessions. Total potential rental revenue represents the value of all apartment homes, with occupied apartment homes valued at contractual rental rates pursuant to leases and vacant apartment homes 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 apartment homes. 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 and the Company's calculation of financial occupancy may not be comparable to financial occupancy as disclosed by other REITs.
The Company does not take into account delinquency and concessions to calculate actual rent for occupied apartment homes and market rents for vacant apartment homes. The calculation of financial occupancy compares contractual rates for occupied apartment homes to estimated market rents for unoccupied apartment homes, and thus the calculation compares the gross value of all apartment homes 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 2016/2015 Same-Property portfolio for financial occupancy for the years ended December 31, 2016 and 2015 is as follows:
| Years ended December 31, | |||||
| 2016 | 2015 | ||||
| Southern California | 96.4 | % | 95.9 | % | |
| Northern California | 96.3 | % | 96.1 | % | |
| Seattle Metro | 96.1 | % | 96.1 | % |
The following table provides a breakdown of revenue amounts, including the revenues attributable to 2016/2015 Same-Properties.
| Number of Apartment | Years Ended December 31, | Dollar | Percentage | |||||||||||||||
| Property Revenues ($ in thousands) | Homes | 2016 | 2015 | Change | Change | |||||||||||||
| 2016/2015 Same-Properties: (1) | ||||||||||||||||||
| Southern California | 20,698 | $ | 497,448 | $ | 468,614 | $ | 28,834 | 6.2 | % | |||||||||
| Northern California | 13,220 | 401,642 | 376,019 | 25,623 | 6.8 | % | ||||||||||||
| Seattle Metro | 10,239 | 217,259 | 201,417 | 15,842 | 7.9 | % | ||||||||||||
| Total 2016/2015 Same-Property revenues | 44,157 | 1,116,349 | 1,046,050 | 70,299 | 6.7 | % | ||||||||||||
| 2016/2015 Non-Same Property Revenues | 169,374 | 139,448 | 29,926 | 21.5 | % | |||||||||||||
| Total property revenues | $ | 1,285,723 | $ | 1,185,498 | $ | 100,225 | 8.5 | % |
| (1) | Same-property excludes properties held for sale. |
2016/2015 Same-Property Revenues increased by $70.3 million or 6.7% to $1.1 billion for 2016 compared to $1.0 billion in 2015. The increase was primarily attributable to an increase of 6.4% in average rental rates from $1,942 per apartment home for 2015 to $2,066 per apartment home for 2016.
2016/2015 Non-Same Property Revenues increased by $29.9 million or 21.5% to $169.4 million in 2016 compared to $139.4 million in 2015. The increase was primarily due to revenue generated by the acquisition, completed development, or consolidation of three communities, net of dispositions, since January 1, 2015.
Management and other fees from affiliates decreased by $0.6 million in 2016 compared to 2015. The decrease is primarily due to the loss of asset and management fees in 2016 as compared to 2015 associated with the Company's purchase of the joint venture partner's remaining membership interest in The Huxley, The Dylan, and Reveal communities during 2015 and the sale of certain communities.
Property operating expenses, excluding real estate taxes increased $14.8 million or 6.3% in 2016 compared to 2015, primarily due to the acquisition, completed development, or consolidation of three communities, net of dispositions, since January 1, 2015. 2016/2015 Same-Property operating expenses excluding real estate taxes, increased by $9.9 million or 4.7% in 2016 compared to 2015, due mainly to a $4.7 million increase in property management fees and a $2.3 million increase in maintenance and repairs.
Real estate taxes increased $10.6 million or 8.3% in 2016 compared to 2015, primarily due to the acquisition, completed development, or consolidation of three communities, net of dispositions, since January 1, 2015. 2016/2015 Same-Property real estate taxes increased by $2.2 million or 2.0% for 2016 compared to 2015 due to increases in tax rates and property valuations.
Depreciation and amortization expense decreased by $11.7 million or 2.6% in 2016 compared to 2015, primarily due to the amortization of a larger amount of in-place leases during 2015 compared to 2016, offset by the acquisition, completed development, or consolidation of three communities, net of dispositions, since January 1, 2015.
Merger and integration expenses include, but are not limited to, advisor fees, legal fees, and accounting fees related to the merger with BRE and related integration activity. There were no merger and integration expenses for 2016 and $3.8 million for 2015.
Interest expense increased $14.8 million or 7.2% in 2016, primarily due to the $500.0 senior unsecured notes due on April 1, 2025 issued in March 2015 and the $450.0 million senior unsecured notes due on April 15, 2026 issued in April 2016, which resulted in an increase of $14.9 million in interest expense for 2016 compared to 2015. Additionally, there was a $3.1 million decrease in capitalized interest in 2016 compared to 2015, which was due to a decrease in development costs as compared to the same period in 2015. These additions were offset by a reduction in interest expense due to the payoff of $150.0 million in private placement unsecured bonds in 2016.
Total return swap income of $11.7 million in 2016 consists of monthly settlements related to the Company's total return swap contracts that were entered into during 2015, in connection with $257.3 million of tax-exempt mortgage notes payable. The Company had total return swap income of $5.7 million in 2015.
Interest and other income increased $8.2 million or 42.6% in 2016, primarily due to an increase of $5.1 million in gains from the sale of marketable securities and $2.5 million in income from marketable securities and other interest income.
Equity income from co-investments increased by $26.8 million or 122.8% in 2016 compared to 2015, primarily due to $13.0 million in income on the gain on sale of two co-investment communities as well as income from five preferred equity investments originated during 2016.
Gains on sale of real estate and land increased by $107.2 million or 226.5% in 2016 compared to 2015, due primarily to a $126.6 million gain from the sale of minority membership interest in BEX II, LLC, $10.7 million gain on the sale of Harvest Park before a tax expense, a $7.3 million gain on the sale of Candlewood North and a $9.6 million gain on the sale of the Company's headquarters office building during 2016, as compared to approximately $7.1 million in gains on the sales of Pinnacle South Mountain and two commercial buildings as well as a $40.2 million gain on the sale of Sharon Green during 2015.
Deferred tax expense on gain on sale of real estate and land of $4.4 million for 2016 was recorded primarily due to the sale of Harvest Park, which was owned by our wholly owned taxable REIT subsidiary. There was no current tax expense on the sale of real estate and land for 2016 as the Harvest Park proceeds were used in a like-kind exchange transaction.
Gains on remeasurement of co-investment of $34.0 million in 2015 was due to the remeasurement of the Company's investments, caused by the Company's acquisition of a controlling interest in The Huxley and The Dylan properties, resulting in a gain of $21.3 million, and Reveal, resulting in a gain of $12.7 million. There were no gains on remeasurement of co-investments in 2016.
Comparison of Year Ended December 31, 2015 to the Year Ended December 31, 2014
The Company’s average financial occupancies for the Company’s stabilized apartment communities for “2015/2014 Same-Properties” (stabilized properties consolidated by the Company for the years ended December 31, 2015 and 2014) was unchanged at 96.2% in both 2015 and 2014. The regional breakdown of the Company’s stabilized 2015/2014 Same-Property portfolio for financial occupancy for the years ended December 31, 2015 and 2014 is as follows:
| Years ended December 31, | |||||
| 2015 | 2014 | ||||
| Southern California | 96.2 | % | 96.3 | % | |
| Northern California | 96.3 | % | 96.2 | % | |
| Seattle Metro | 96.2 | % | 96.0 | % |
The following table provides a breakdown of revenue amounts, including the revenues attributable to 2015/2014 Same-Properties.
| Number of Apartment | Years Ended December 31, | Dollar | Percentage | |||||||||||||||
| Property Revenues ($ in thousands) | Homes | 2015 | 2014 | Change | Change | |||||||||||||
| 2015/2014 Same-Properties: (1) | ||||||||||||||||||
| Southern California | 12,875 | $ | 283,435 | $ | 267,413 | $ | 16,022 | 6.0 | % | |||||||||
| Northern California | 9,080 | 250,478 | 226,679 | 23,799 | 10.5 | % | ||||||||||||
| Seattle Metro | 6,558 | 124,143 | 115,219 | 8,924 | 7.7 | % | ||||||||||||
| Total 2015/2014 Same-Property revenues | 28,513 | 658,056 | 609,311 | 48,745 | 8.0 | % | ||||||||||||
| 2015/2014 Non-Same Property Revenues | 527,442 | 352,280 | 175,162 | 49.7 | % | |||||||||||||
| Total property revenues | $ | 1,185,498 | $ | 961,591 | $ | 223,907 | 23.3 | % |
| (1) | Same-property excludes BRE properties acquired April 1, 2014 and properties held for sale. |
2015/2014 Same-Property Revenues increased by $48.7 million or 8.0% to $658 million for 2015 compared to $609.3 million in 2014. The increase was primarily attributable to an increase of 8.1% in average rental rates from $1,741 per apartment home for 2014 to $1,882 per apartment home for 2015.
2015/2014 Non-Same Property Revenues increased by $175.2 million or 49.7% to $527.4 million in 2015 compared to $352.3 million in 2014. The increase was primarily due to the BRE merger and the acquisition or consolidation of ten communities, net of dispositions and properties held for sale, since January 1, 2014.
Property operating expenses, excluding real estate taxes increased $30.3 million or 14.8% in 2015 compared to 2014, primarily due to the BRE merger and the acquisition or consolidation of ten communities, net of dispositions and properties held for sale, since January 1, 2014. 2015/2014 Same-Property operating expenses excluding real estate taxes, increased by $2.3 million or 1.7% in 2015 compared to 2014, due mainly to a $1.7 million increase in repairs and maintenance.
Real estate taxes increased $20.7 million or 19.2% in 2015 compared to 2014, due primarily due to the BRE merger and the acquisition or consolidation of ten communities, net of dispositions and held for sale, since January 1, 2014. 2015/2014 Same-Property real estate taxes increased by $1.7 million or 3.2% for 2015 compared to 2014.
Depreciation and amortization expense increased by $92.8 million or 25.7% in 2015 compared to 2014, primarily due to the BRE merger and the acquisition or consolidation of ten communities, net of dispositions and properties held for sale, since January 1, 2014.
Merger and integration expenses include, but are not limited to, advisor fees, legal fees, and accounting fees related to the BRE merger and related integration activity. The Company completed the merger with BRE on April 1, 2014. Merger and integration expenses were $3.8 million for 2015 and $53.5 million for 2014.
Interest expense increased $40.3 million or 24.5% in 2015, due to an increase in average outstanding debt primarily due to assumed debt in connection with the BRE merger in addition to a $6.8 million decrease in capitalized interest in 2015 compared to 2014, which was due to a decrease in development costs as compared to the same period in 2014.
Total return swap income of $5.7 million in 2015 consists of monthly settlements related to the Company's total return swap contracts that were entered into during the year, in connection with $257.3 million of tax-exempt mortgage notes payable. The Company had no total return swap income in 2014.
Interest and other income increased $7.3 million or 62.1% in 2015, due to an increase in the investment of mortgage backed securities, an increase of $3.1 million in insurance proceeds and $0.6 million in income from the sale of an investment.
Equity income from co-investments decreased by $18.0 million to $21.9 million in 2015 compared to $39.9 million in 2014, primarily due to events in 2014 which did not recur in 2015, including the Company’s share of the gain on the sale of two co-investment communities of $6.6 million, promote income of $10.6 million, and income from the early redemption of preferred equity investments of $5.3 million in 2014, partially offset by $2.0 million in income from the early redemption of two preferred equity investments during 2015 and an increase of $7.4 million in equity income from co-investment operations. Additionally, income from preferred equity investments decreased by approximately $5.1 million from 2014 to 2015.
Gains on sale of real estate and land increased by $1.3 million or 2.8% in 2015 compared to 2014, due primarily to $7.1 million in gains on the sales of Pinnacle South Mountain and two commercial buildings as well as a $40.2 million gain on the sale of Sharon Green during 2015 as compared to approximately $16.8 million in gains on the sales of Vista Capri North, Coldwater Canyon, Pinnacle Town Center, and a land parcel adjacent to the Company's Park Viridian property, as well as a $29.2 million gain on the sale of Mt. Sutro during 2014.
Gains on remeasurement of co-investment increased by $34.0 million in 2015 compared to 2014, due to the remeasurement of the Company's investments, as a result of the Company's acquisition of a controlling interest in The Huxley and The Dylan properties, resulting in a gain of $21.3 million, and Reveal, resulting in a gain of $12.7 million.
Liquidity and Capital Resources
The following table sets forth the Company’s cash flows for 2016, 2015 and 2014 ($ in thousands):
| For the year ended December 31, | ||||||||||||
| 2016 | 2015 | 2014 | ||||||||||
| Cash flow provided by (used in): | ||||||||||||
| Operating activities | $ | 712,523 | $ | 617,410 | $ | 493,312 | ||||||
| Investing activities | $ | (421,412 | ) | $ | (725,556 | ) | $ | (1,147,156 | ) | |||
| Financing activities | $ | (255,873 | ) | $ | 108,214 | $ | 520,610 |
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 sole source of funding for its dividend payments is distributions it receives from the Operating Partnership.
As of December 31, 2016, 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 6 and 7 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.
At December 31, 2016, the Company had $64.9 million of unrestricted cash and cash equivalents and $139.2 million in marketable securities, of which $44.8 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 2017. 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.
As of December 31, 2016, the Company had $315.0 million of private placement unsecured bonds outstanding at an average interest rate of 4.5% with maturity dates ranging from September 2017 through August 2021.
As of December 31, 2016, the Company had $2.9 billion of fixed rate public bonds outstanding, with interest rates varying from 3.25% to 5.50% and maturity dates ranging from 2017 to 2026.
As of December 31, 2016, the Company had $100.0 million outstanding on its $350.0 million unsecured term loan. The $350.0 million unsecured term loan has a delayed draw feature and bears a variable interest rate of LIBOR plus 0.95%. The Company has entered into four forward starting interest rate swap contracts for a term of five years with an aggregate notional balance of $150.0 million, with settlements starting in March 2017, which effectively will convert the interest rate on $150.0 million of the term loan to a fixed rate of 2.2%. At December 31, 2016, the Company had an active $25.0 million notional interest rate swap, with a maturity date in July 2017, which effectively converts $25.0 million of the term loan to a fixed rate of 2.4%
As of December 31, 2016, the Company’s mortgage notes payable totaled $2.2 billion, net of unamortized premiums and debt issuance costs, which consisted of $1.9 billion in fixed rate debt with interest rates varying from 3.0% to 6.4% and maturity dates ranging from 2017 to 2027 and $281.7 million of tax-exempt variable rate demand notes with a weighted average interest rate of 1.2%. The tax-exempt variable rate demand notes have maturity dates ranging from 2025 to 2046, and $20.7 million is subject to interest rate caps and $257.3 million is subject to total return swaps.
The Company has two lines of credit aggregating $1.03 billion as of December 31, 2016 including a $1.0 billion unsecured line of credit. As of December 31, 2016, there was a $125.0 million balance on this unsecured line of credit with an underlying interest rate of LIBOR plus 0.90%. In January 2017, the facility maturity date was extended to December 31, 2020 with one 18-month extension, exercisable at the Company's option. The Company also has a $25.0 million working capital unsecured line of credit agreement. As of December 31, 2016, there were no amounts outstanding on this unsecured line with an underlying interest rate of LIBOR plus 0.90%.
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, 2016 and 2015.
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.
Derivative Activity
The Company uses interest rate swaps, interest rate caps, and total return swap 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 and total return 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 counterparties nonperformance risk in the fair value measurements.
The Company has entered into interest rate swap contracts with an aggregate notional amount of $175.0 million, $25 million of which effectively fixed the interest rate on $25.0 million of the $100.0 million drawn on its $350.0 million unsecured term loan at 2.4%. The remaining $150.0 million in swaps are forward starting swaps, with settlement payments commencing in March 2017. These derivatives qualify for hedge accounting.
The Company has entered into four total return swap contracts, with an aggregate notional amount of $257.3 million, that effectively converts $257.3 million of mortgage notes payable to a floating interest rate based on SIFMA plus a spread. Additionally, the total return swaps provide fair market value protection on the mortgage notes payable to our counterparties during the initial period of the total return swap until the Company's option to call the mortgage notes at par can be exercised. The Company can currently call one of the total return swaps with $114.4 million of the outstanding debt at par, while the call option on the other three total return swaps relating to $142.9 million of the outstanding debt can be exercised starting on January 1, 2017. These derivatives do not qualify for hedge accounting.
As of December 31, 2016 the Company also had three interest rate caps with an aggregate notional amount of $20.7 million that effectively limit the Company’s exposure to interest rate risk by providing a ceiling on the underlying variable interest rate for $20.7 million of the Company’s tax exempt variable rate debt.
As of December 31, 2016 and 2015, the aggregate carrying value of the interest rate swap contracts was an asset of $4.4 million and zero, respectively and is included in prepaid expenses and other assets on the consolidated balance sheets and a liability of $33.1 thousand and $1.0 million, respectively. The aggregate carrying value of the interest rate caps was zero on the balance sheets as of both December 31, 2016 and 2015. The aggregate carrying value of the total return swaps was zero and $4.0 thousand as of December 31, 2016 and 2015, respectively.
Hedge ineffectiveness related to cash flow hedges, which is reported in current year income as interest expense, net was income of $0.3 million for the year ended December 31, 2016. Hedge ineffectiveness was not significant for the years ended 2015 and 2014.
Issuance of Common Stock
In 2016, 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., Capital One Securities, Inc., Citigroup Global Markets Inc, Jefferies LLC, J.P. Morgan Securities LLC, Mitsubishi UFJ Securities (USA), Inc, and UBS Securities LLC. The Company did not issue any shares of common stock pursuant to its equity distribution program in 2016. In 2015, ESS issued 1,481,737 shares of common stock for proceeds of $332.3 million, net of fees and commissions. During the first quarter of 2017 through February 21, 2017, ESS has not issued any shares of common stock pursuant to this program. 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, fund redevelopment and development pipelines, fund acquisitions, and for general corporate purposes. As of February 21, 2017, ESS may sell an additional 5,000,000 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, 2016, non-revenue generating capital expenditures totaled approximately $1,219 per apartment home. The Company projects to incur approximately $1,250 per apartment home in non-revenue generating capital expenditures for the year ending December 31, 2017. These expenditures do not include the improvements required in connection with the origination of mortgage loans, expenditures for deferred maintenance on acquisition properties, expenditures for property renovations and improvements which are expected to generate additional revenue, and do not include expenditures incurred, due to changes in government regulations, that the Company would not have incurred otherwise. 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 2017 and/or the funding thereof will not be significantly different than the Company’s current expectations.
Development and Predevelopment Pipeline
The Company defines development projects as new communities that are being constructed or are newly constructed and are in a phase of lease-up and have not yet reached stabilized operations. As of December 31, 2016, the Company had two consolidated development projects comprised of 796 apartment homes with an estimated cost of $0.5 billion of which $0.4 billion remains to be expended, and four unconsolidated joint venture active development projects comprised of 1,427 apartment homes with an estimated cost of $0.8 billion, of which approximately $0.4 billion remains to be expended. The Company's share of these estimated remaining project costs is approximately $0.2 billion.
The Company defines predevelopment projects as proposed communities in negotiation or in the entitlement process with an expected 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 homes may not be available for rent and, as a result, may have less than stabilized operations. As of December 31, 2016, the Company had ownership interests in six major redevelopment communities aggregating 1,869 apartment homes with estimated redevelopment costs of $170.2 million, of which approximately $65.5 million remains to be expended.
Alternative Capital Sources
The Company utilizes co-investments as an alternative source of capital for acquisitions of both operating and development communities. As of December 31, 2016, the Company had an interest in 1,427 apartment homes of communities actively under development with joint ventures for a total estimated cost of $0.8 billion. Total estimated remaining costs total approximately $0.4 billion, of which the Company estimates that its remaining investment in these development joint ventures will be approximately $0.2 billion. In addition, the Company had an interest in 11,274 apartment homes of operating communities with joint ventures for a total book value of $0.8 billion.
Contractual Obligations and Commercial Commitments
The following table summarizes the maturity or due dates of the Company’s contractual obligations and other commitments at December 31, 2016, and the effect such obligations could have on the Company’s liquidity and cash flow in future periods ($ in thousands):
| 2017 | 2018 and 2019 | 2020 and 2021 | Thereafter | Total | ||||||||||||||||
| Mortgage notes payable | $ | 82,796 | $ | 878,529 | $ | 745,452 | $ | 441,313 | $ | 2,148,090 | ||||||||||
| Unsecured debt | 340,000 | 75,000 | 500,000 | 2,350,000 | 3,265,000 | |||||||||||||||
| Lines of credit | — | 125,000 | — | — | 125,000 | |||||||||||||||
| Interest on indebtedness (1) | 217,709 | 379,762 | 243,695 | 262,494 | 1,103,660 | |||||||||||||||
| Ground leases | 2,897 | 5,794 | 5,794 | 106,111 | 120,596 | |||||||||||||||
| Operating leases | 1,750 | 3,673 | 3,915 | 10,361 | 19,699 | |||||||||||||||
| Development commitments (including co-investments) (2) | 287,827 | 308,219 | 107,954 | — | 704,000 | |||||||||||||||
| $ | 932,979 | $ | 1,775,977 | $ | 1,606,810 | $ | 3,170,279 | $ | 7,486,045 |
| (1) | Interest on indebtedness for variable debt was calculated using interest rates as of December 31, 2016. |
| (2) | Estimated project cost for development of the Company's 500 Folsom project is net of a projected value for low-income housing tax credit proceeds and savings from tax exempt bonds. |
Variable Interest Entities
In accordance with accounting standards for consolidation of variable interest entities ("VIEs"), the Company consolidates the Operating Partnership, 19 DownREIT limited partnerships (comprising eleven communities), and 9 co-investments. The Company consolidates these entities because it is deemed the primary beneficiary. The consolidated total assets and liabilities related to the 9 consolidated co-investments and 19 DownREIT limited partnerships, net of intercompany eliminations, were approximately $989.3 million and $288.1 million, respectively, as of December 31, 2016, and $893.1 million and $231.8 million respectively, as of December 31, 2015. Noncontrolling interests in these entities was $52.9 million and $54.6 million as of December 31, 2016 and 2015, respectively. As of December 31, 2016, the Company did not have any other VIEs of which it was not deemed to be the primary beneficiary and did not have any VIEs 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 amortized over the average remaining term of all acquired leases.
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
Same-Property net operating income (“Same-Property NOI”) is considered by management to be an important supplemental performance measure to earnings from operations included in the Company’s consolidated statements of income. 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. Same-Property NOI, which is based on net operating income ("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:
| 2016 | 2015 | 2014 | |||||||||
| Earnings from operations | $ | 420,800 | $ | 331,174 | $ | 201,514 | |||||
| Adjustments: | |||||||||||
| Depreciation and amortization | 441,682 | 453,423 | 360,592 | ||||||||
| Management and other fees from affiliates | (8,278 | ) | (8,909 | ) | (9,347 | ) | |||||
| General and administrative | 40,751 | 40,090 | 40,878 | ||||||||
| Merger and integration expenses | — | 3,798 | 53,530 | ||||||||
| Acquisition and investment related costs | 1,841 | 2,414 | 1,878 | ||||||||
| Net operating income | 896,796 | 821,990 | 649,045 | ||||||||
| Less: Non Same-Property NOI | (115,934 | ) | (99,320 | ) | (60,464 | ) | |||||
| Same-Property NOI | $ | 780,862 | $ | 722,670 | $ | 588,581 |
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 anticipated cash needs, 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, anticipated property and growth trends in various geographic regions, statements regarding the Company’s expected 2017 Same-Property revenue generally and in various areas, and 2017 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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