filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
54K 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
Essex 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. Essex owns all of its interests in its real estate investments, directly or indirectly, through the Operating Partnership. Essex is the sole general partner of the Operating Partnership and, as of December 31, 2017, 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 Company's portfolio.
As of December 31, 2017, the Company had owned or held an interest in 247 operating apartment communities, comprising 60,239 apartment homes, excluding the Company's ownership in preferred equity 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, 2017, the Company’s development pipeline was comprised of five consolidated projects under development, two unconsolidated joint venture projects under development and various consolidated predevelopment projects aggregating 1,982 apartment homes, with total incurred costs of $557.0 million, and estimated remaining project costs of approximately $752.0 million, $572.0 million of which represents the Company's estimated remaining costs, for total estimated project costs of $1.3 billion.
As of December 31, 2017, the Company also had an ownership interest in one operating commercial building (totaling approximately 106,564 square feet).
By region, the Company's operating results for 2017 and 2016 and projections for 2018 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, 2017, this region represented 47% of the Company’s consolidated operating apartment homes. Revenues for “2017 Same-Properties” (as defined below), or “Same-Property revenues,” increased 3.8% in 2017 as compared to 2016. In 2018, the Company projects new residential supply of 35,150 apartment homes and single family homes, which represents 0.6% of the total housing stock. The Company projects an increase of 111,000 jobs or 1.5%, and an increase in 2018 Same-Property revenues of between 1.9% to 2.9% in 2018.
Northern California Region: As of December 31, 2017, this region represented 32% of the Company’s consolidated operating apartment homes. Same-Property revenues increased 2.6% in 2017 as compared to 2016. In 2018, the Company projects new residential supply of 14,250 apartment homes and single family homes, which represents 0.6% of the total housing stock. The Company projects an increase of 54,900 jobs or 1.6%, and an increase in 2018 Same-Property revenues of between 2.0% to 3.0% in 2018.
Seattle Metro Region: As of December 31, 2017, this region represented 21% of the Company’s consolidated operating apartment homes. Same-Property revenues increased 5.8% in 2017 as compared to 2016. In 2018, the Company projects new residential supply of 17,450 apartment homes and single family homes, which represents 1.4% of the total housing stock. The Company projects an increase of 35,450 jobs or 2.1%, and an increase in 2018 Same-Property revenues of between 2.4% to 3.4% in 2018.
In total, the Company projects an increase in 2018 Same-Property revenues of between 2.0% to 3.0%, as renewal and new leases are signed at higher rents in 2018 than 2017. Same-Property operating expenses are projected to increase in 2018 by 2.1% to 3.1%.
The Company’s consolidated operating communities are as follows:
| As of | As of | ||||||||||
| December 31, 2017 | December 31, 2016 | ||||||||||
| Apartment Homes | % | Apartment Homes | % | ||||||||
| Southern California | 23,343 | 47 | % | 23,613 | 49 | % | |||||
| Northern California | 15,848 | 32 | % | 14,519 | 30 | % | |||||
| Seattle Metro | 10,238 | 21 | % | 10,239 | 21 | % | |||||
| Total | 49,429 | 100 | % | 48,371 | 100 | % |
Co-investments, including Wesco I, Wesco III, Wesco IV, Wesco V, LLC, CPPIB, BEXAEW, BEX II, and BEX III 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, 2017 to the Year Ended December 31, 2016
The Company’s average financial occupancies for the Company’s stabilized apartment communities or “2017 Same-Property” (stabilized properties consolidated by the Company for the years ended December 31, 2017 and 2016) increased 30 basis points to 96.6% in 2017 from 96.3% in 2016. Financial occupancy is defined as the percentage resulting from dividing actual rental revenue by total potential rental revenue. 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 apartment home 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 a variety of factors, including overall supply and demand for housing, concentration of new apartment deliveries within the same submarket which can cause periodic disruption due to greater rental concessions to increase leasing velocity, and rental affordability. 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 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 2017 Same-Property portfolio for financial occupancy for the years ended December 31, 2017 and 2016 is as follows:
| Years ended December 31, | |||||
| 2017 | 2016 | ||||
| Southern California | 96.6 | % | 96.3 | % | |
| Northern California | 96.8 | % | 96.3 | % | |
| Seattle Metro | 96.4 | % | 96.1 | % |
The following table provides a breakdown of revenue amounts, including the revenues attributable to 2017 Same-Properties.
| Number of Apartment | Years Ended December 31, | Dollar | Percentage | |||||||||||||||
| Property Revenues ($ in thousands) | Homes | 2017 | 2016 | Change | Change | |||||||||||||
| 2017 Same-Properties: (1) | ||||||||||||||||||
| Southern California | 21,998 | $ | 559,113 | $ | 538,738 | $ | 20,375 | 3.8 | % | |||||||||
| Northern California | 13,892 | 436,876 | 425,823 | 11,053 | 2.6 | % | ||||||||||||
| Seattle Metro | 10,238 | 229,871 | 217,259 | 12,612 | 5.8 | % | ||||||||||||
| Total 2017 Same-Property revenues | 46,128 | 1,225,860 | 1,181,820 | 44,040 | 3.7 | % | ||||||||||||
| 2017 Non-Same Property Revenues | 128,465 | 103,903 | 24,562 | 23.6 | % | |||||||||||||
| Total property revenues | $ | 1,354,325 | $ | 1,285,723 | $ | 68,602 | 5.3 | % |
| (1) | Same-property excludes properties held for sale. |
2017 Same-Property Revenues increased by $44.0 million or 3.7% to $1.2 billion for 2017 compared to $1.2 billion in 2016. The increase was primarily attributable to an increase of 3.3% in average rental rates from $2,095 per apartment home for 2016 to $2,164 per apartment home for 2017.
2017 Non-Same Property Revenues increased by $24.6 million or 23.6% to $128.5 million in 2017 compared to $103.9 million in 2016. The increase was primarily due to revenue generated by Palm Valley, which was consolidated in January 2017.
Management and other fees from affiliates increased by $1.3 million or 15.7% to $9.6 million in 2017 from $8.3 million 2016. The increase is primarily due to property management fee revenue from joint venture development communities that went into lease-up from the third quarter of 2016 until the fourth quarter of 2017.
Property operating expenses, excluding real estate taxes increased $9.4 million or 3.8% to $259.2 million in 2017 compared to $249.8 million in 2016, primarily due to expenses generated by Palm Valley, which was consolidated in January 2017. 2017 Same-Property operating expenses excluding real estate taxes, increased by $5.5 million or 2.4% to $238.1 million in 2017 compared to $232.6 million in 2016, primarily due to a $4.3 million increase in utilities.
Real estate taxes increased $7.1 million or 5.1% to $146.3 million in 2017 compared to $139.2 million in 2016, primarily due to property taxes at Palm Valley, which was consolidated in January 2017 and due to increases in tax rates and property valuations. 2017/2016 Same-Property real estate taxes increased by $4.1 million or 3.3% to $130.1 million in 2017 compared to $126.0 million in 2016 due to increases in tax rates and property valuations.
Depreciation and amortization expense increased by $27.2 million or 6.2% to $468.9 million in 2017 compared to $441.7 million in 2016, primarily due to depreciation at Palm Valley, which was consolidated in January 2017.
Interest expense increased $3.2 million or 1.5% to $222.9 million in 2017 compared to $219.7 million in 2016, due to an increase in average outstanding debt primarily due to the $350.0 senior unsecured notes due May 1, 2027 issued in April 2017 and the $450.0 million senior unsecured notes due April 15, 2026 issued in April 2016, which resulted in $19.1 million of interest expense for 2017 compared to 2016. These additions were partially offset by various debts that were paid off or matured and regular principal amortization during and after 2016, which resulted in a decrease in interest expense of $14.5 million for 2017. Additionally, there was a $1.4 million increase in capitalized interest in 2017 compared to 2016, which was due to an increase in development costs as compared to the same period in 2016.
Total return swap income of $10.1 million in 2017 consists of monthly settlements related to the Company's total return swap contracts that were entered into during 2015, in connection with issuing $257.3 million of fixed rate tax-exempt mortgage notes payable. The decrease of $1.6 million or 13.7% from $11.7 million in 2016 was due to less favorable interest rates in 2017.
Interest and other income decreased $2.7 million or 9.9% to $24.6 million in 2017 compared to $27.3 million in 2016, primarily due to a decrease of $3.8 million in income from the gain on sale of marketable securities and other investments combined with a decrease of $3.5 million in income from insurance reimbursements, legal settlements, and other, partially offset by an increase of $4.6 million in marketable securities and other interest income.
Equity income from co-investments increased by $37.7 million or 77.4% to $86.4 million in 2017 compared to $48.7 million 2016, primarily due to the sale of two properties by BEXAEW and one property by Wesco I during 2017, which resulted in a total gain of $44.8 million, as well as increases in preferred equity income of approximately $7.5 million. In 2016, two co-investment properties were sold, resulting in gains of $13.0 million for the Company during 2016.
Gain on sale of real estate and land decreased by $128.2 million or 82.9% to $26.4 million in 2017 compared to $154.6 million in 2016. The Company's 2017 gain was primarily attributable to the sale of the Jefferson at Hollywood community, which resulted in a gain of $26.2 million for the Company.
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. There were no such transactions during 2017.
Gain on remeasurement of co-investment of $88.6 million in 2017 resulted from the purchase of the Company's joint venture partner's 50% membership interest in the Palm Valley co-investment in January 2017. There were no such transactions during 2016.
Comparison of Year Ended December 31, 2016 to the Year Ended December 31, 2015
The Company’s average financial occupancies for the Company’s stabilized apartment communities or “2016 Same-Property” (stabilized properties consolidated by the Company for the years ended December 31, 2016 and 2015) increased 30 basis points to 96.3% in 2016 from 96.0% in 2015. The regional breakdown of the Company's 2016 Same-Property portfolio for financial occupancy for the years ended December 31, 2016 and 2015 is as follows:
| Years ended December 31, | |||||
| 2016 | 2015 | ||||
| Southern California | 96.4 | % | 95.9 | % | |
| Northern California | 96.3 | % | 96.1 | % | |
| Seattle Metro | 96.1 | % | 96.1 | % |
The following table provides a breakdown of revenue amounts, including the revenues attributable to 2016 Same-Properties:
| Number of Apartment | Years Ended December 31, | Dollar | Percentage | |||||||||||||||
| Property Revenues ($ in thousands) | Homes | 2016 | 2015 | Change | Change | |||||||||||||
| 2016 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 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 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 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 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 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 Properties, Inc. ("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 a private placement of bonds in 2016.
Total return swap income of $11.7 million in 2016 consisted 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, $10.7 million gain on the sale of Harvest Park before 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 were 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 $12.7 million. There were no gains on remeasurement of co-investments in 2016.
Liquidity and Capital Resources
The following table sets forth the Company’s cash flows for 2017, 2016 and 2015 ($ in thousands):
| For the year ended December 31, | ||||||||||||
| 2017 | 2016 | 2015 | ||||||||||
| Cash flow provided by (used in): | ||||||||||||
| Operating activities | $ | 766,151 | $ | 711,821 | $ | 618,168 | ||||||
| Investing activities | $ | (477,239 | ) | $ | (420,324 | ) | $ | (725,556 | ) | |||
| Financing activities | $ | (309,213 | ) | $ | (256,259 | ) | $ | 107,456 |
Essex’s business is operated primarily through the Operating Partnership. Essex 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 from operating as a public company which are fully reimbursed by the Operating Partnership. Essex itself does not hold any indebtedness, and its only material asset is its ownership of partnership interests of the Operating Partnership. Essex’s principal funding requirement is the payment of dividends on its common stock and preferred stock. Essex’s sole source of funding for its dividend payments is distributions it receives from the Operating Partnership.
As of December 31, 2017, Essex owned a 96.7% general partner interest and the limited partners owned the remaining 3.3% interest in the Operating Partnership.
The liquidity of Essex is dependent on the Operating Partnership’s ability to make sufficient distributions to Essex. The primary cash requirement of Essex is its payment of dividends to its stockholders. Essex also guarantees some of the Operating Partnership’s debt, as discussed further in Notes 6 and 7 to our consolidated financial statements included in Part IV, Item 15 of this Annual Report on Form 10-K. If the Operating Partnership fails to fulfill certain of its debt requirements, which trigger the Essex’s guarantee obligations, then Essex will be required to fulfill its cash payment commitments under such guarantees. However, Essex’s only significant asset is its investment in the Operating Partnership.
For Essex 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 Essex has satisfied this distribution requirement by making cash distributions to its stockholders, it may choose to satisfy this requirement by making distributions of other property, including, in limited circumstances, Essex’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. Essex 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, 2017, the Company had $44.6 million of unrestricted cash and cash equivalents and $190.0 million in marketable securities, of which $80.5 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 2018. 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, 2017, the Company had $275.0 million of private placement unsecured bonds outstanding at an average interest rate of 4.5% with maturity dates ranging from December 2019 through August 2021.
As of December 31, 2017, the Company had $2.9 billion of fixed rate public bonds outstanding at an average interest rate of 3.7% with maturity dates ranging from 2021 to 2027.
As of December 31, 2017, the Company had $350.0 million outstanding on its unsecured term loan. The unsecured term loan bears a variable interest rate of LIBOR plus 0.95%. The Company has five interest rate swap contracts, with an aggregate notional balance of $175.0 million, which effectively converts the interest rate on $175.0 million of the term loan to a fixed rate of 2.3%.
As of December 31, 2017, the Company’s mortgage notes payable totaled $2.0 billion, net of unamortized premiums and debt issuance costs, which consisted of $1.7 billion in fixed rate debt at an average interest rate of 4.6% and maturity dates ranging from 2018 to 2027 and $268.6 million of tax-exempt variable rate demand notes with a weighted average interest rate of 2.0%. 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, $10.8 million of which matured on January 1, 2018. $256.6 million is subject to total return swaps.
The Company had two unsecured lines of credit aggregating $1.03 billion as of December 31, 2017 including a $1.0 billion unsecured line of credit. As of December 31, 2017, there was a $179.0 million balance on this unsecured line of credit with an underlying interest rate of LIBOR plus 0.90%. In January 2018, the Company amended the $1.0 billion credit facility such that the line's capacity was increased to $1.2 billion and the scheduled maturity date was extended to December 2021, with one 18-month extension, exercisable at the Company's option. The underlying interest rate on the amended line is based on a tiered rate structure tied to the Company's corporate ratings and is at LIBOR plus 0.875%. The Company also has a $25.0 million working capital unsecured line of credit agreement. As of December 31, 2017, there were no amounts outstanding on this unsecured line with an underlying interest rate of LIBOR plus 0.90%. In January 2018, the Company amended the $25.0 million credit facility such that the line's capacity was increased to $35.0 million and the scheduled maturity date was extended to January 2020. The underlying interest rate on the amended line is based on a tiered rate structure tied to the Company's corporate ratings and is at LIBOR plus 0.875%.
The Company’s unsecured lines 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, 2017 and 2016.
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 lines 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 counterparty's 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, which effectively fix the interest rate on $175.0 million of the $350.0 million unsecured term loan at 2.3%. These derivatives qualify for hedge accounting.
The Company has entered into four total return swap contracts, with an aggregate notional amount of $256.6 million, that effectively converts $256.6 million of mortgage notes payable to a floating interest rate based on the Securities Industry and Financial Markets Association Municipal Swap Index ("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 all four of the total return swaps with $256.6 million of the outstanding debt at par. These derivatives do not qualify for hedge accounting.
As of December 31, 2017 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 a portion of the Company’s tax exempt variable rate debt. One interest rate cap, with a notional balance of $10.8 million, matured on January 1, 2018.
As of December 31, 2017 and 2016, the aggregate carrying value of the interest rate swap contracts was an asset of $5.4 million and $4.4 million, respectively and is included in prepaid expenses and other assets on the consolidated balance sheets and a liability of zero and $0.03 million, respectively. The aggregate carrying value of the interest rate caps was zero on the balance sheets as of both December 31, 2017 and 2016. The aggregate carrying value of the total return swaps was zero as of both December 31, 2017 and 2016.
Hedge ineffectiveness related to cash flow hedges, which is reported in current year income as interest expense, net was income of $0.1 million and $0.3 million for the years ended December 31, 2017 and 2016, respectively. Hedge ineffectiveness was not significant for the year ended 2015.
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 and debt securities of the Company, as defined in the prospectus contained in the shelf registration statement.
Essex 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. In 2017, the Company issued 345,444 shares of common stock, through its equity distribution program at an average price of $260.38 for proceeds of $89.1 million, net of fees and commissions. The Company did not issue any shares of common stock pursuant to its equity distribution program in 2016. During the first quarter of 2018 through February 15, 2018, Essex has not issued any shares of common stock pursuant to this program. Under this program, Essex 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, fund redevelopment and development pipelines, and for general corporate purposes. As of February 15, 2018, Essex may sell an additional 4,654,556 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, 2017, non-revenue generating capital expenditures totaled approximately $1,351 per apartment home. 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 or cost savings, and do not include expenditures incurred, due to changes in government regulations, that the Company would not have incurred otherwise, and expenditures in which the Company expects to be reimbursed. The Company expects that cash from operations and/or its lines of credit will fund such expenditures.
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, 2017, the Company's development pipeline was comprised of five consolidated projects under development, two unconsolidated joint venture projects under development and various consolidated predevelopment projects, aggregating 1,982 apartment homes, with total incurred costs of $557.0 million, and estimated remaining project costs of approximately $752.0 million, $572.0 million of which represents the Company's estimated remaining costs, for total estimated project costs of $1.3 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 assets, 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, 2017, the Company had ownership interests in five major redevelopment communities aggregating 1,727 apartment homes with estimated redevelopment costs of $138.8 million, of which approximately $43.6 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, 2017, the Company had an interest in 814 apartment homes in communities actively under development with joint ventures for total estimated costs of $0.6 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 10,810 apartment homes in operating communities with joint ventures for a total book value of $0.8 billion.
Contractual Obligations and Commercial Commitments
The following table summarizes our obligations at December 31, 2017 ($ in thousands):
| For the Fiscal Years Ending | ||||||||||||||||||||
| 2018 | 2019 and 2020 | 2021 and 2022 | Thereafter | Total | ||||||||||||||||
| Mortgage notes payable | $ | 202,131 | $ | 1,255,310 | $ | 87,312 | $ | 435,808 | $ | 1,980,561 | ||||||||||
| Unsecured debt | — | 75,000 | 1,150,000 | 2,300,000 | 3,525,000 | |||||||||||||||
| Lines of credit | — | — | 179,000 | — | 179,000 | |||||||||||||||
| Interest on indebtedness (1) | 222,057 | 366,826 | 223,740 | 272,432 | 1,085,055 | |||||||||||||||
| Ground leases | 2,916 | 5,832 | 5,832 | 104,054 | 118,634 | |||||||||||||||
| Operating leases | 1,807 | 3,792 | 4,043 | 8,307 | 17,949 | |||||||||||||||
| Development commitments (including co-investments) (2) | 294,098 | 277,402 | — | — | 571,500 | |||||||||||||||
| $ | 723,009 | $ | 1,984,162 | $ | 1,649,927 | $ | 3,120,601 | $ | 7,477,699 |
| (1) | Interest on indebtedness for variable debt was calculated using interest rates as of December 31, 2017. |
| (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 the value of the tax exempt bond structure. |
Variable Interest Entities
In accordance with accounting standards for consolidation of variable interest entities ("VIEs"), the Company consolidates the Operating Partnership, 16 DownREIT limited partnerships (comprising eight communities), and eight co-investments. The Company consolidates these entities because it is deemed the primary beneficiary. The Company has no assets or liabilities other than its investment in the Operating Partnership. The consolidated total assets and liabilities related to the eight consolidated co-investments and 16 DownREIT limited partnerships, net of intercompany eliminations, were approximately $837.7 million and $265.5 million, respectively, as of December 31, 2017, and $746.1 million and $221.3 million respectively, as of December 31, 2016. Noncontrolling interests in these entities were $66.7 million and $45.4 million as of December 31, 2017 and 2016, respectively. The Company's financial risk in each VIE is limited to its equity investment in the VIE. As of December 31, 2017, the Company did not have any other VIEs of which it was 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 and estimates relate principally to the following key areas: (i) accounting for business combinations; (ii) consolidation under applicable accounting standards for entities that are not wholly owned; (iii) assessing the carrying values of our real estate properties 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 Accounting Standards Codification ("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
Net operating income (“NOI”) and Same-Property NOI are 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. 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. In addition, because prospective buyers of real estate have different financing and overhead structures, with varying marginal impacts to overhead by acquiring real estate, 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, including property taxes. Please see the reconciliation of earnings from operations to Same-Property NOI, which in the table below is the NOI for stabilized properties consolidated by the Company for the periods presented ($ in thousands):
| 2017 | 2016 | 2015 | |||||||||
| Earnings from operations | $ | 446,522 | $ | 420,800 | $ | 331,174 | |||||
| Adjustments: | |||||||||||
| Depreciation and amortization | 468,881 | 441,682 | 453,423 | ||||||||
| Management and other fees from affiliates | (9,574 | ) | (8,278 | ) | (8,909 | ) | |||||
| General and administrative | 41,385 | 40,751 | 40,090 | ||||||||
| Merger and integration expenses | — | — | 3,798 | ||||||||
| Acquisition and investment related costs | 1,569 | 1,841 | 2,414 | ||||||||
| NOI | 948,783 | 896,796 | 821,990 | ||||||||
| Less: Non Same-Property NOI | (91,096 | ) | (73,549 | ) | (71,589 | ) | |||||
| Same-Property NOI | $ | 857,687 | $ | 823,247 | $ | 750,401 |
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 and Section 21E of the Securities and Exchange Act, including statements regarding the Company's expectations, estimates, assumptions, hopes, intentions, beliefs and strategies regarding the future. Words such as "expects," "anticipates," “may,” “will,” "intends," "plans," "believes," "seeks," "estimates," and variations of such words and similar expressions are intended to identify such forward-looking statements. 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, expectations 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 2018 Same-Property revenue generally and in various areas, and 2018 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 may 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 acquired properties may prove to be inaccurate, that there may be increased interest rates and operating costs, 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 actual non-revenue generating capital expenditures may exceed the Company's current expectations, that there may be a downturn general economic conditions, the real estate industry and 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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