UNITED STATESSECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2007
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to .
Commission File Number: 001-32269
EXTRA SPACE STORAGE INC.
(Exact name of registrant as specified in its charter)
Maryland
20-1076777
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
2795 East Cottonwood Parkway, Suite 400Salt Lake City, Utah 84121(Address of principal executive offices)
Registrant’s telephone number, including area code: (801) 562-5556
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
The number of shares outstanding of the registrant’s common stock, par value $0.01 per share, as of July 31, 2007 was 64,837,892.
EXTRA SPACE STORAGE INC.TABLE OF CONTENTS
STATEMENT ON FORWARD-LOOKING INFORMATION
3
PART I. FINANCIAL INFORMATION
4
ITEM 1. FINANCIAL STATEMENTS
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
23
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
34
ITEM 4. CONTROLS AND PROCEDURES
35
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
ITEM 1A. RISK FACTORS
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
36
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS
SIGNATURES
37
2
Certain information set forth in this report contains “forward-looking statements” within the meaning of the federal securities laws. Forward-looking statements include statements concerning our plans, objectives, goals, strategies, future events, future revenues or performance, capital expenditures, financing needs, plans or intentions relating to acquisitions and other information that is not historical information. In some cases, forward-looking statements can be identified by terminology such as “believes,” “expects,” “estimates,” “may,” “will,” “should,” “anticipates,” or “intends” or the negative of such terms or other comparable terminology, or by discussions of strategy. We may also make additional forward-looking statements from time to time. All such subsequent forward-looking statements, whether written or oral, by us or on our behalf, are also expressly qualified by these cautionary statements.
All forward-looking statements, including without limitation, management’s examination of historical operating trends and estimate of future earnings, are based upon our current expectations and various assumptions. Our expectations, beliefs and projections are expressed in good faith and we believe there is a reasonable basis for them, but there can be no assurance that management’s expectations, beliefs and projections will result or be achieved. All forward-looking statements apply only as of the date made. We undertake no obligation to publicly update or revise forward-looking statements which may be made to reflect events or circumstances after the date made or to reflect the occurrence of unanticipated events.
There are a number of risks and uncertainties that could cause our actual results to differ materially from the forward-looking statements contained in or contemplated by this report. Any forward-looking statements should be considered in light of the risks referenced in “Part II. Item 1A. Risk Factors” below and in “Part I. Item 1A. Risk Factors” included in our most recent Annual Report on Form 10-K. Such factors include, but are not limited to:
· changes in general economic conditions and in the markets in which we operate;
· the effect of competition from new self-storage facilities or other storage alternatives, which could cause rents and occupancy rates to decline;
· potential liability for uninsured losses and environmental contamination;
· difficulties in our ability to evaluate, finance and integrate acquired and developed properties into our existing operations and to lease up those properties, which could adversely affect our profitability;
· the impact of the regulatory environment as well as national, state, and local laws and regulations including, without limitation, those governing real estate investment trusts, which could increase our expenses and reduce our cash available for distribution;
· difficulties in raising capital at reasonable rates, which could impede our ability to grow;
· delays in the development and construction process, which could adversely affect our profitability; and
· economic uncertainty due to the impact of war or terrorism, which could adversely affect our business plan.
Extra Space Storage Inc.Condensed Consolidated Balance Sheets(in thousands, except share data)
June 30, 2007
December 31, 2006
(unaudited)
Assets:
Real estate assets:
Net operating real estate assets
$
1,641,120
1,382,055
Real estate under development
35,906
35,336
Net real estate assets
1,677,026
1,417,391
Investments in real estate ventures
91,303
88,115
Cash and cash equivalents
45,790
70,801
Short-term investments
90,331
—
Restricted cash
35,528
44,282
Receivables from related parties and affiliated real estate joint ventures
8,321
15,880
Other assets, net
35,640
33,356
Total assets
1,983,939
1,669,825
Liabilities, Minority Interests, and Stockholders’ Equity:
Notes payable
875,730
828,584
Notes payable to trusts
119,590
Exchangeable senior notes
250,000
Line of credit
Derivative instrument associated with Preferred Operating Partnership units (Note 14)
15,268
Accounts payable and accrued expenses
25,363
25,704
Other liabilities
22,960
17,234
Total liabilities
1,308,911
991,112
Commitments and contingencies
Preferred Operating Partnership units, net of $100,000 note receivable (Note 14)
6,465
Minority interest in Operating Partnership
37,020
34,841
Other minority interests
277
317
Stockholders’ equity:
Preferred stock , $0.01 par value, 50,000,000 shares authorized, no shares issued or outstanding
Common Stock, $0.01 par value, 200,000,000 shares authorized, 64,833,425 and 64,167,098 shares issued and outstanding at June 30, 2007 and December 31, 2006, respectively
649
642
Paid-in capital
824,088
822,181
Accumulated deficit
(193,471
)
(179,268
Total stockholders’ equity
631,266
643,555
Total liabilities, Preferred Operating Partnership, minority interests, and stockholders’ equity
See accompanying notes to unaudited condensed consolidated financial statements.
Extra Space Storage Inc.Condensed Consolidated Statements of Operations(in thousands, except share data)(unaudited)
Three months ended June 30,
Six months ended June 30,
2007
2006
Revenues:
Property rental
48,392
42,020
94,623
81,195
Management and franchise fees
5,143
5,181
10,351
10,340
Tenant insurance
2,688
971
4,831
1,892
Development fees
182
175
237
225
Other income
145
184
284
249
Total revenues
56,550
48,531
110,326
93,901
Expenses:
Property operations
17,352
15,248
34,248
29,990
1,217
589
2,190
1,222
Unrecovered development and acquisition costs
159
24
409
342
General and administrative
8,968
8,747
18,208
17,992
Depreciation and amortization
9,123
9,057
17,919
18,333
Total expenses
36,819
33,665
72,974
67,879
Income before interest, minority interests and equity in earnings of real estate ventures
19,731
14,866
37,352
26,022
Interest expense
(15,437
(12,784
(28,833
(24,769
Interest income
3,668
148
5,116
630
Minority interest - Operating Partnership
(515
(225
(899
(279
Minority interests - other
56
40
Equity in earnings of real estate ventures
1,192
1,087
2,389
2,226
Net income
8,695
3,092
15,165
3,830
Net income per common share
Basic
0.13
0.06
0.24
0.07
Diluted
0.23
Weighted average number of shares
64,439,138
51,625,135
64,356,827
51,606,618
69,248,845
55,991,088
69,214,313
55,983,086
Cash dividends paid per common share
0.46
5
Extra Space Storage Inc.Condensed Consolidated Statement of Stockholders’ Equity(in thousands, except share data)(unaudited)
Common Stock
Paid-inCapital
AccumulatedDeficit
Total Stockholders’Equity
Shares
Par Value
Balances at December 31, 2006
64,167,098
Issuance of common stock upon the exercise of options
76,048
1
1,032
1,033
Restricted stock grants issued
90,529
Restricted stock grants cancelled
(600
Conversion of Contingent Conversion Shares to common stock
500,350
Compensation expense related to stock-based awards
875
Dividends paid on common stock at $0.455 per share
(29,368
Balances at June 30, 2007
64,833,425
6
Extra Space Storage Inc.Condensed Consolidated Statements of Cash Flows(in thousands)(unaudited)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of deferred financing costs
1,560
1,546
Stock compensation expense
1,016
Income allocated to minority interests
859
279
Distributions from operations of real estate ventures in excess of earnings
2,332
2,280
Changes in operating assets and liabilities:
Receivables from related parties
7,559
11,890
Other assets
3,353
5,349
(341
(8,775
2,624
516
Net cash provided by operating activities
51,905
36,264
Cash flows from investing activities:
Acquisition of real estate assets
(98,148
(87,964
Development and construction of real estate assets
(19,381
(15,118
Proceeds from sale of real estate assets
728
(6,022
(4,835
Net purchases of short-term investments
(90,331
Change in restricted cash
8,754
(11
Principal payments received on notes receivable
118
Purchase of equipment and fixtures
(501
(768
Net cash used in investing activities
(205,629
(107,850
Cash flows from financing activities:
Proceeds from exchangeable senior notes
Proceeds from notes payable, notes payable to trusts and line of credit
46,147
97,602
Principal payments on notes payable and line of credit
(30,137
(24,598
Deferred financing costs
(6,408
(647
Loan to Preferred Operating Partnership unit holder
(100,000
Redemption of Operating Partnership units held by minority interest
(775
Net proceeds from exercise of stock options
127
Dividends paid on common stock
(23,561
Distributions to Operating Partnership units held by minority interest
(1,779
(1,740
Net cash provided by financing activities
128,713
47,183
Net decrease in cash and cash equivalents
(25,011
(24,403
Cash and cash equivalents, beginning of the period
28,653
Cash and cash equivalents, end of the period
4,250
7
Supplemental schedule of cash flow information
Interest paid, net of amounts capitalized
24,931
22,900
Supplemental schedule of noncash investing and financing activities:
Acquisitions:
Real estate assets
157,079
21,009
(31,010
(7,926
Notes receivable
(10,298
Preferred Operating Partnership units
(121,733
Investment in real estate ventures
(502
(2,785
(3,834
8
Extra Space Storage Inc.Notes to Condensed Consolidated Financial Statements (unaudited)Amounts in thousands, except share data
1. ORGANIZATION
Extra Space Storage Inc. (the “Company”) is a fully-integrated, self-administered and self-managed real estate investment trust (“REIT”), formed as a Maryland corporation on April 30, 2004 to own, operate, manage, acquire and develop self-storage facilities located throughout the United States. The Company continues the business of Extra Space Storage LLC and its subsidiaries, which had engaged in the self-storage business since 1977. The Company’s interest in its properties is held through its operating partnership, Extra Space Storage LP (the “Operating Partnership”), which was formed on May 5, 2004. The Company’s primary assets are general partner and limited partner interests in the Operating Partnership. This structure is commonly referred to as an umbrella partnership REIT, or UPREIT. The Company has elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended. To the extent the Company continues to qualify as a REIT, it will not be subject to tax, with certain limited exceptions, on the taxable income that is distributed to its stockholders.
The Company invests in self-storage facilities by acquiring or developing wholly-owned facilities or facilities held through joint ventures with third parties. At June 30, 2007, the Company had direct and indirect equity interests in 585 storage facilities located in 33 states and Washington, D.C.
The Company operates in two distinct segments: (1) property management, acquisition and development; and (2) rental operations. The Company’s property management, acquisition and development activities include managing, acquiring, developing and selling self-storage facilities. The rental operations activities include rental operations of self-storage facilities. No single tenant accounts for more than 5% of rental income.
2. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2007 are not necessarily indicative of results that may be expected for the year ending December 31, 2007. The Condensed Consolidated Balance Sheet as of December 31, 2006 has been derived from the Company’s audited financial statements as of that date, but does not include all of the information and footnotes required by GAAP for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 as filed with the Securities and Exchange Commission (“SEC”).
Certain amounts in the 2006 financial statements and supporting note disclosures have been reclassified to conform to the current year presentation. Such reclassification did not impact previously reported net income or accumulated deficit.
Recently Issued Accounting Standards
Emerging Issues Task Force (“EITF”) Topic D-109, “Determining the Nature of a Host Contract Related to a Hybrid Financial Instrument Issued in the Form of a Share under FASB Statement No. 133”(“Topic D-109”), discussed at the March 15, 2007 EITF meeting, is effective at the beginning of the first fiscal quarter beginning after June 15, 2007 (even if that period is other than the first fiscal quarter of the registrant’s fiscal year). Topic D-109 provides the SEC staff’s view as to how one must evaluate whether a preferred stock “host” contract is a debt host or an equity host. It states that the determination of the nature of the host contract for a hybrid financial instrument (that is, whether the nature of the host contract is more akin to debt or to equity) issued in the form of a share should be based on a consideration of economic characteristics and risks. The SEC staff believes that the consideration of the economic characteristics and risks of the host contract should be based on all the stated and implied substantive terms and features of the hybrid financial instrument. This may represent a change from the way these instruments were analyzed in the past.
The Company has elected to early adopt Topic D-109 which specifically relates to the AAAAA Rent-A-Space acquisition that was completed during the quarter ended June 30, 2007. See Note 14.
9
3. NET INCOME PER SHARE
Basic earnings per common share is computed by dividing net income by the weighted average common shares outstanding, less non-vested restricted stock. Diluted earnings per common share measures the performance of the Company over the reporting period while giving effect to all potential common shares that were dilutive and outstanding during the period. The denominator includes the number of additional common shares that would have been outstanding if the potential common shares that were dilutive had been issued and is calculated using either the treasury stock or if converted method. Potential common shares are securities (such as options, warrants, convertible debt, Contingent Conversion Shares (“CCS”), Contingent Conversion Units (“CCU”), exchangeable preferred Operating Partnership units and convertible Operating Partnership units) that do not have a current right to participate in earnings but could do so in the future by virtue of their option or conversion right. In computing the dilutive effect of convertible securities, net income or loss is adjusted to add back any changes in earnings in the period associated with the convertible security. The numerator also is adjusted for the effects of any other non-discretionary changes in income or loss that would result from the assumed conversion of those potential common shares. In computing diluted earnings per share, only potential common shares that are dilutive, those that reduce earnings per share, are included.
The Company has $250.0 million of exchangeable senior notes issued and outstanding that also can potentially have a dilutive effect on its earnings per share calculations. The exchangeable senior notes are exchangeable by holders into shares of the Company’s common stock under certain circumstances per the terms of the indenture governing the exchangeable senior notes. The exchangeable senior notes are not exchangeable unless the price of the Company’s common stock is greater than or equal to 130% of the applicable exchange price for a specified period during a quarter, or unless certain other events occur. The exchange price was $23.48 per share at June 30, 2007, and could change over time as described in the indenture. The price of the Company’s common stock did not exceed 130% of the exchange price for the specified period of time during the second quarter of 2007, therefore holders of the exchangeable senior notes may not elect to convert them during the third quarter of 2007.
The Company has irrevocably agreed to pay only cash for the accreted principal amount of the exchangeable senior notes relative to its exchange obligations, but has retained the right to satisfy the exchange obligations in excess of the accreted principal amount in cash and/or common stock. Though the Company has retained that right, FAS 128, Earnings Per Share, requires an assumption that shares will be used to pay the exchange obligations in excess of the accreted principal amount, and requires that those shares be included in the Company’s calculation of weighted average common shares outstanding for diluted earnings per share computation. No shares were included in the computation at June 30, 2007 because there was no excess over the accreted principal for the period.
For the purposes of computing the diluted impact on earnings per share of the potential conversion of Series A Participating Redeemable Preferred Operating Partnership units into common shares, where the Company has the option to redeem in cash or shares as discussed in Note 14 and where the Company has stated the positive intent and ability to settle at least $115 million of the instrument in cash (or net settle a portion of the preferred Operating Partnership units against the related outstanding note receivable), only the amount of the instrument in excess of $115 million is considered in the calculation of shares contingently issuable for the purposes of computing diluted earnings per share as allowed by paragraph 29 of FAS 128. As of June 30, 2007 only nine of the ten properties had closed. As such, $106,465 (the pro rata portion of the $115 million referenced above) was excluded from the calculation.
For the three months ended June 30, 2007 and 2006, options to purchase approximately 325,934 and 1,143,380 shares of common stock, and for the six months ended June 30, 2007 and 2006, options to purchase approximately 204,315 and 1,148,173 shares of common stock, respectively, were excluded from the computation of earnings per share as their effect would have been anti-dilutive.
10
The computation of net income per share is as follows:
Three months endedJune 30,
Six months endedJune 30,
Add:
Income allocated to minority interest - Operating Partnership
515
899
Net income for diluted computations
9,210
3,317
16,064
4,109
Weighted average common shares oustanding:
Average number of common shares outstanding - basic
Operating Partnership units
4,012,379
3,825,787
49,949
25,113
Dilutive stock options, restricted stock and CCS/CCU conversions
747,379
540,166
819,995
550,681
Average number of common shares outstanding - diluted
4. REAL ESTATE ASSETS
The components of real estate assets are summarized as follows:
Land
419,038
361,569
Buildings and improvements
1,296,813
1,085,269
Intangible assets - tenant relationships
29,937
25,436
Intangible lease rights
5,900
3,400
1,751,688
1,475,674
Less: accumulated depreciation and amortization
(110,568
(93,619
11
5. PROPERTY ACQUISITIONS
The following table shows the Company’s acquisition of operating properties for the six months ended June 30, 2007 and does not include purchases of raw land or improvements made to existing assets:
Property Location(s)
Number ofProperties
Date ofAcquisition
TotalConsideration
Cash Paid
LoanAssumed
NetLiabilities /(Assets)Assumed
Value of OPUnits Issued
Number ofOP UnitsIssued
Source of Acquisition
Notes
California
6/26/2007
11,216
196
2,822
8,197
61,398
Unrelated third party
(1)
California (6) & Hawaii (2)
6/25/2007
126,623
11,154
1,933
113,536
847,677
Georgia
6/14/2007
13,693
13,594
99
Unrelated franchisee
18,703
867
14,062
(60
3,834
218,693
(2)
6/6/2007
14,942
8,128
6,834
(20
6/1/2007
4,020
4,036
(16
Florida
5/31/2007
8,975
8,882
93
5/24/2007
5,585
5,575
4/17/2007
12,670
5,428
7,292
(50
3/27/2007
6,320
6,257
63
1/11/2007
14,334
14,348
(14
Tennessee
1/5/2007
3,684
3,672
12
Arizona
1/2/2007
4,361
4,527
(166
Related joint venture
Total
22
245,126
86,664
31,010
1,885
125,567
1,127,768
Notes:
(1) - - Preferred Operating Partnership Units
(2) - Common Operating Partnership Units
6. INVESTMENTS IN REAL ESTATE VENTURES
Investments in real estate ventures consisted of the following:
Excess Profit
Equity
Investment balance at
Participation %
Ownership %
Extra Space West One LLC (“ESW”)
40%
5%
1,742
1,918
Extra Space Northern Properties Six, LLC (“ESNPS”)
35%
10%
1,684
1,757
PRISA Self Storage LLC (“PRISA”)
17%
2%
13,303
13,393
PRISA II Self Storage LLC (“PRISA II”)
10,839
10,821
PRISA III Self Storage LLC (“PRISA III”)
20%
4,513
4,534
VRS Self Storage LLC (“VRS”)
4,584
4,547
WCOT Self Storage LLC (“WCOT”)
5,308
5,287
Storage Portfolio I, LLC (“SP I”)
25%
18,743
19,260
Storage Portfolio Bravo II (“SPB II”)
45%
14,956
15,264
Other minority owned properties
10-50%
15,631
11,334
In these joint ventures, the Company and the joint venture partner generally receive a preferred return on their invested capital. To the extent that cash/profits in excess of these preferred returns are generated through operations or capital transactions, the Company would receive a higher percentage of the excess cash/profits than its equity interest.
On March 1, 2007, the Company acquired a 39.5% interest in U-Storage de Mexico S.A., an existing Mexican corporation (“U-Storage”), which currently manages, develops, owns and operates self storage facilities in Mexico. Included in Other Minority Owned Properties is $5,086 relating to the Company’s investment in Mexico. Kenneth T. Woolley, a former Senior Vice President of the Company and son of Kenneth M. Woolley, the CEO of the Company, also acquired a 0.5% interest in U-Storage de Mexico S.A.
The components of equity in earnings of real estate ventures consist of the following:
Equity in earnings of ESW
348
341
696
681
Equity in earnings of ESNPS
41
38
87
74
Equity in earnings of PRISA
185
132
355
256
Equity in earnings of PRISA II
147
115
221
Equity in earnings of PRISA III
71
30
134
53
Equity in earnings of VRS
62
123
75
Equity in earnings of WCOT
77
73
Equity in earnings of SP I
248
301
453
601
Equity in earnings of SPB II
181
242
371
473
Equity in earnings/(losses) of other minority owned properties
(168
(193
(254
(281
Equity in earnings of SP I and SPB II includes the amortization of the Company’s excess purchase price of approximately $22 million of these equity investments over its original basis. The excess basis is amortized over 40 years.
7. SHORT-TERM INVESTMENTS
The Company accounts for its investments in debt and equity securities according to the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities, which requires securities classified as “available-for-sale” to be stated at fair value. Adjustments to fair value of available-for-sale securities are recorded as a component of other comprehensive income (loss). A decline in the market value of equity securities below cost, that is deemed to be other than temporary, results in a reduction in the carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established. At June 30, 2007, the Company had $90,331 in highly-liquid auction rate securities (“ARS”), government and corporate bonds and variable rate demand notes classified as available-for-sale securities. Although these ARS have long-term stated contractual maturities, they can be presented for redemption at auction when rates are reset which is typically every 7, 28 or 35 days. The Company had no realized or unrealized gains or losses related to these securities during the three and six months ended June 30, 2007. All income related to these investments was recorded as interest income. In accordance with the Company’s investment policy, the Company only invests in ARS with high credit quality issuers and limits the amount of investment exposure to any one issuer.
13
8. NOTES PAYABLE
The components of notes payable are summarized as follows:
Fixed Rate
Mortgage and construction loans with banks bearing interest at fixed rates between 4.65% and 8.33%. The loans are collateralized by mortgages on real estate assets and the assignment of rents. Principal and interest payments are made monthly with all outstanding principal and interest due between March 1, 2008 and January 1, 2023.
811,008
743,511
Variable Rate
Mortgage and construction loans with banks bearing floating interest rates (including loans subject to interest rate swaps) based on LIBOR. Interest rates based on LIBOR are between LIBOR plus 0.66% (5.98% and 6.01% at June 30, 2007 and December 31, 2006, respectively) and LIBOR plus 2.00% (7.32% and 7.35% at June 30, 2007 and December 31, 2006, respectively). The loans are collateralized by mortgages on real estate assets and the assignment of rents. Principal and interest payments are made monthly with all outstanding principal and interest due between October 25, 2007 and June 11, 2009.
64,722
85,073
Real estate assets are pledged as collateral for the notes payable. The Company is subject to certain restrictive covenants relating to the outstanding notes payable. The Company was in compliance with all covenants at June 30, 2007.
In October 2004, the Company entered into a reverse interest rate swap agreement (“Swap Agreement”) to float $61,770 of 4.30% fixed interest rate secured notes due in September 2009. Under this Swap Agreement, the Company will receive interest at a fixed rate of 4.30% and pay interest at a variable rate equal to LIBOR plus 0.66%. The Swap Agreement matures at the same time the notes are due. This Swap Agreement is a fair value hedge, as defined by SFAS No. 133, and the fair value of the Swap Agreement is recorded as an asset or liability, with an offsetting adjustment to the carrying value of the related note payable. Monthly variable interest payments are recognized as an increase or decrease in interest expense.
The estimated fair value of the Swap Agreement at June 30, 2007 and December 31, 2006 was reflected as an other liability of $1,800 and $1,925, respectively. The Company recorded additional interest expense relating to the Swap Agreement of $264 and $186 for the three months ended June 30, 2007 and 2006, respectively. Interest expense was increased by $525 and reduced by $148 for the six months ended June 30, 2007 and 2006, respectively.
9. NOTES PAYABLE TO TRUSTS
During July 2005, ESS Statutory Trust III (the “Trust III”), a newly formed Delaware statutory trust and a wholly-owned, unconsolidated subsidiary of the Operating Partnership, issued an aggregate of $40.0 million of preferred securities which mature on July 31, 2035. In addition, the Trust III issued 1,238 of Trust common securities to the Operating Partnership for a purchase price of $1.2 million. On July 27, 2005, the proceeds from the sale of the preferred and common securities of $41.2 million were loaned in the form of a note to the Operating Partnership (“Note 3”). Note 3 has a fixed rate of 6.91% through July 31, 2010, and then will be payable at a variable rate equal to the three-month LIBOR plus 2.40% per annum. The interest on Note 3, payable quarterly, will be used by the Trust III to pay dividends on the trust preferred securities. The trust preferred securities may be redeemed by the Trust with no prepayment premium after July 27, 2010.
During May 2005, ESS Statutory Trust II (the “Trust II”), a newly formed Delaware statutory trust and a wholly-owned, unconsolidated subsidiary of the Operating Partnership, issued an aggregate of $41.0 million of preferred securities which mature on June 30, 2035. In addition, the Trust II issued 1,269 of Trust common securities to the Operating Partnership for a purchase price of $1.3 million. On May 24, 2005, the proceeds from the sale of the preferred and common securities of $42.3 million were loaned in the form of a note to the Operating Partnership (“Note 2”). Note 2 has a fixed rate of 6.67% through June 30, 2010, and then will be payable at a variable rate equal to the three-month LIBOR plus 2.40% per annum.
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The interest on Note 2, payable quarterly, will be used by the Trust II to pay dividends on the trust preferred securities. The trust preferred securities may be redeemed by the Trust with no prepayment premium after June 30, 2010.
During April 2005, ESS Statutory Trust I (the “Trust”), a newly formed Delaware statutory trust and a wholly-owned, unconsolidated subsidiary of the Operating Partnership issued an aggregate of $35.0 million of trust preferred securities which mature on June 30, 2035. In addition, the Trust issued 1,083 of trust common securities to the Operating Partnership for a purchase price of $1.1 million. On April 8, 2005, the proceeds from the sale of the trust preferred and common securities of $36.1 million were loaned in the form of a note to the Operating Partnership (the “Note”). The Note has a variable rate equal to the three-month LIBOR plus 2.25% per annum. The interest on the Note, payable quarterly, will be used by the Trust to pay dividends on the trust preferred securities. The trust preferred securities may be redeemed by the Trust with no prepayment premium after June 30, 2010.
The Company follows Financial Accounting Standards Board (“FASB”) Intrepretation No. 46R, “Consolidation of Variable Interest Entities” (“FIN 46R”), which addresses the consolidation of variable interest entities (“VIEs”). Under FIN 46R, Trust, Trust II and Trust III are VIEs that are not consolidated because the Company is not the primary beneficiary. A debt obligation has been recorded in the form of notes as discussed above for the proceeds, which are owed to the Trust, Trust II, and Trust III by the Company.
10. EXCHANGEABLE SENIOR NOTES
On March 27, 2007, our Operating Partnership issued $250.0 million of its 3.625% Exchangeable Senior Notes due April 1, 2027 (the “Notes”). Costs incurred to issue the Notes were approximately $5.7 million. These costs are being amortized as an adjustment to interest expense over five years, which represents the estimated term of the Notes, and are included in other assets in the condensed consolidated balance sheet as of June 30, 2007. The Notes are general unsecured senior obligations of the Operating Partnership and are fully guaranteed by the Company. Interest is payable on April 1 and October 1 of each year beginning October 1, 2007 until the maturity date of April 1, 2027. The Notes bear interest at 3.625% per annum and contain an exchange settlement feature, which provides that the Notes may, under certain circumstances, be exchangeable for cash (up to the principal amount of the Notes) and, with respect to any excess exchange value, for cash, shares of our common stock or a combination of cash and shares of our common stock at an initial exchange rate of approximately 42.5822 shares per $1,000 principal amount of Notes at the option of the Operating Partnership.
The Operating Partnership may redeem the Notes at any time to preserve the Company’s status as a REIT. In addition, on or after April 5, 2012, the Operating Partnership may redeem the Notes for cash, in whole or in part, at 100% of the principal amount plus accrued and unpaid interest, upon at least 30 days but not more than 60 days prior written notice to holders of the Notes.
The holders of the Notes have the right to require the Operating Partnership to repurchase the Notes for cash, in whole or in part, on each of April 1, 2012, April 1, 2017 and April 1, 2022, and upon the occurrence of a designated event, in each case for a repurchase price equal to 100% of the principal amount of the Notes plus accrued and unpaid interest. Certain events are considered “Events of Default,” as defined in the indenture governing the Notes, which may result in the accelerated maturity of the Notes.
The Company has considered whether the exchange settlement feature represents an embedded derivative within the debt instrument under the guidance of FAS 133 Accounting for Derivative Instruments and Hedging Activities, EITF 90-19 Convertible Bonds with Issuer Option to Settle for Cash Upon Conversion, and EITF 01-6 The Meaning of “Indexed to a Company’s Own Stock” that would require bifurcation (i.e., separate accounting). The Company has concluded that the exchange settlement feature has satisfied the exemption in SFAS 133 because it is indexed to the Company’s own stock and would otherwise be classified in stockholders equity, among other considerations. Accordingly, the Notes are presented as a single debt instrument (often referred to as “Instrument C” in EITF 90-19) in accordance with APB 14 Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants due to the inseparability of the debt and the conversion feature.
11. LINE OF CREDIT
The Company, as guarantor, and its Operating Partnership have entered into a $100.0 million revolving line of credit, which includes a $10.0 million swingline subfacility (the “Credit Facility”).
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The Credit Facility has an interest rate of 175 basis points over LIBOR (7.07% and 7.10% at June 30, 2007 and December 31, 2006, respectively). The Operating Partnership intends to use the proceeds of the Credit Facility for general corporate purposes. As of June 30, 2007, the Credit Facility had approximately $81 million of capacity based on the assets collateralizing the Credit Facility. No amounts were outstanding on the line of credit at June 30, 2007 or December 31, 2006. The maturity date on the line of credit is September 2007. The Credit Facility is collateralized by mortgages on certain real estate assets.
12. RELATED PARTY AND AFFILIATED REAL ESTATE JOINT VENTURE TRANSACTIONS
The Company provides management and development services for certain joint ventures, franchise, third party and other related party properties. Management agreements generally provide for management fees of 6% of cash collected from properties for the management of operations at the self-storage facilities. The Company earns development fees of 4%-6% of budgeted costs on developmental projects.
Management fee revenue for related party and affiliated real estate joint ventures is summarized as follows:
Entity
Type
ESW
Affiliated real estate joint ventures
109
103
218
204
ESNPS
104
216
206
PRISA
1,294
1,259
2,595
2,491
PRISA II
1,048
1,018
2,090
2,018
PRISA III
474
456
942
908
VRS
283
280
568
553
WCOT
387
364
768
723
SP I
316
303
626
SPB II
254
261
517
Extra Space Development (“ESD”)
Related party
188
110
Various
Franchisees, third parties and other
923
1,457
1,913
Development fee revenue for related party and affiliated real estate joint ventures is summarized as follows:
122
78
Effective January 1, 2004, the Company entered into a license agreement with Centershift, a related party software provider, to secure a perpetual right for continued use of STORE (the site management software used at all sites operated by the Company) in all aspects of the Company’s property acquisition, development, redevelopment and operational activities. The Company paid Centershift $266 and $190 for the three months ended June 30, 2007 and 2006, respectively, and $455 and $368 for the six months ended June 30, 2007 and 2006, respectively, relating to the purchase of software and to license agreements.
Related party and affiliated real estate joint ventures balances are summarized as follows:
Receivables:
2,869
2,633
Other receivables from properties
5,452
13,247
Other receivables from properties consist of amounts due for management fees and expenses paid by the Company on behalf of the managed properties. The Company believes that all of these related party and affiliated joint venture receivables are fully collectible. The Company did not have any payables to related parties at June 30, 2007 or December 31, 2006.
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13. MINORITY INTEREST IN OPERATING PARTNERSHIP
The Company’s interest in its properties is held through the Operating Partnership. ESS Holding Business Trust I, a wholly owned subsidiary of the Company, is the sole general partner of the Operating Partnership. The Company, through ESS Holding Business Trust II, a wholly owned subsidiary of the Company, is also a limited partner of the Operating Partnership. Between its general partner and limited partner interests, the Company held a 94.17% majority ownership interest therein as of June 30, 2007. The remaining ownership interests in the Operating Partnership of 5.83% are held by certain former owners of assets acquired by the Operating Partnership, which include a director and officers of the Company.
The minority interest in the Operating Partnership represents Operating Partnership units that are not owned by the Company. In conjunction with the formation of the Company and as a result of subsequent acquisitions, certain persons and entities contributing interests in properties to the Operating Partnership received limited partnership units in the form of either Operating Partnership units or Contingent Conversion Units. Limited partners who received Operating Partnership units in the formation transactions or in exchange for contributions for interests in properties have the right to require the Operating Partnership to redeem part or all of their Operating Partnership units for cash based upon the fair market value of an equivalent number of shares of the Company’s common stock at the time of the redemption. Alternatively, the Company may, at its option, elect to acquire those Operating Partnership units in exchange for shares of its common stock on a one-for-one basis, subject to anti-dilution adjustments provided in the Operating Partnership agreement.
As of June 30, 2007, the Operating Partnership had 4,012,379 and 174,307 Operating Partnership units and CCUs outstanding, respectively.
Unlike the Operating Partnership units, CCUs do not carry any voting rights. Upon the achievement of certain performance thresholds relating to 14 early-stage lease-up properties, all or a portion of the CCUs will be automatically converted into Operating Partnership units. Initially, each CCU will be convertible on a one-for-one basis into Operating Partnership units, subject to customary anti-dilution adjustments. Beginning with the quarter ended March 31, 2006, and ending with the quarter ending December 31, 2008, the Company will calculate the net operating income from the 14 wholly-owned early-stage lease-up properties over the 12-month period ending in such quarter. Within 35 days following the end of each quarter referred to above, some or all of the CCUs will be converted so that the total percentage (not to exceed 100%) of CCUs issued in connection with the formation transactions that have been converted to Operating Partnership units will be equal to the percentage determined by dividing the net operating income for such period in excess of $5.1 million by $4.6 million. If any CCU remains unconverted through the calculation made in respect of the 12-month period ending December 31, 2008, such outstanding CCUs will be cancelled.
While any CCUs remain outstanding, a majority of the Company’s independent directors must review and approve the net operating income calculation for each measurement period and also must approve any sales of any of the 14 wholly-owned early-stage lease-up properties.
As of June 30, 2007, there were 25,739 CCUs converted to Operating Partnership units. Based on the performance of the properties as of June 30, 2007, an additional 20,198 CCUs became eligible for conversion. The board of directors approved the conversion of these CCUs on August 1, 2007 as per the Company’s charter, and the units were issued on August 3, 2007.
14. PREFERRED OPERATING PARTNERSHIP UNITS
On June 15, 2007, the Operating Partnership entered into a Contribution Agreement with various limited partnerships affiliated with AAAAA Rent-A-Space to acquire ten self-storage facilities (the “Properties”) in exchange for the issuance of newly designated Series A Participating Redeemable Preferred Units (“Preferred OP Units”) of the Operating Partnership. The self-storage facilities are located in California and Hawaii.
On June 25 and 26, 2007, nine of the ten properties were contributed to the Operating Partnership in exchange for consideration totaling $137.8 million. Preferred OP units totaling 909,075, with a value of $121.7 million, were issued along with the assumption of approximately $14.2 million of third-party debt, of which $11,381 was paid off at close. The final property was purchased by the Company on August 1, 2007.
On June 25, 2007, the Company loaned the holders of the Preferred OP Units $100.0 million. The receivable bears interest at 4.85%, and is due September 1, 2017. The loan is secured by the borrower’s Preferred OP Units. In addition, any conversion of the Preferred OP Units prior to the maturity date requires repayment of the loan as of the date of the Preferred OP Unit
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redemption. Preferred OP Units are shown on the balance sheet net of the $100.0 million loan under the guidance in EITF No. 85-1, Classifying Notes Receivable for Capital because the borrower under the loan receivable is also the holder of the Preferred OP Units.
The Operating Partnership entered into a Second Amended and Restated Agreement of Limited Partnership (the “Partnership Agreement”) which provides for the designation and issuance of the Preferred OP Units. The Preferred OP Units will have priority over all other partnership interests of the Operating Partnership with respect to distributions and liquidation.
Per the Partnership Agreement, Preferred OP Units in the amount of $115.0 million bear a fixed priority return of 5% and have a fixed liquidation value of $115.0 million. The remaining balance will participate in distributions with and have a liquidation value equal to that of the common Operating Partnership units. Included in the June 30, 2007 financials statements was the pro rata amount of $106,464 related to the $115.0 million due to the Company not closing on the final property until August 1, 2007. The Preferred OP Units will be redeemable at the option of the holder on or after September 1, 2008, which redemption obligation may be satisfied, at the Company’s option, in cash or shares of its common stock.
In accordance with SFAS 133 Accounting for Derivative Instruments and Hedging Activities, SFAS 150 Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, EITF 00-19 Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, EITF Topic D-109, Determining the Nature of a Host Contract Related to a Hybrid Financial Instrument Issued in the Form of a Share under FASB Statement No. 133, and Accounting Series Release (“ASR”) No. 268, Presentation in Financial Statements of “Redeemable Preferred Stocks, the Preferred OP Units were classified as a hybrid instrument such that the value of the units associated with the fixed return are classified in mezzanine after total liabilities on the balance sheet and before stockholders’ equity. The remaining balance that participates in distributions equal to that of common stock has been identified as an embedded derivative and has been classified as a liability on the balance sheet and is marked to fair value on a quarterly basis with any adjustment being recorded to the income statement. As of June 30, 2007, the carrying value of the obligation associated with the Preferred OP Units approximated fair value.
The following table summarizes the components of the transaction:
121,733
Total amount of Preferred OP Units issued at June 30, 2007
(15,268
Derivative instrument associated with the Preferred OP Units presented as a liability
106,465
Value of Preferred OP units considered as mezzanine equity
Less note receivable to Preferred OP unit holder
Net value of Preferred OP units considered as mezzanine equity
15. STOCKHOLDERS’ EQUITY
The Company’s charter provides that it can issue up to 200,000,000 shares of common stock, $0.01 par value per share, 4,100,000 Contingent Conversion Shares, $.01 par value per share, and 50,000,000 shares of preferred stock, $0.01 par value per share. As of June 30, 2007, 64,833,425 shares of common stock were issued and outstanding, 3,388,493 CCSs were issued and outstanding and no shares of preferred stock were issued and outstanding. All stockholders of the Company’s common stock are entitled to receive dividends and to one vote on all matters submitted to a vote of stockholders.
Unlike the Company’s shares of common stock, CCSs do not carry any voting rights. Upon the achievement of certain performance thresholds relating to 14 early-stage lease-up properties, all or a portion of the CCSs will be automatically converted into shares of the Company’s common stock. Initially, each CCS will be convertible on a one-for-one basis into shares of common stock, subject to customary anti-dilution adjustments. Beginning with the quarter ended March 31, 2006, and ending with the quarter ending December 31, 2008, the Company will calculate the net operating income from the 14 wholly-owned early-stage lease-up properties over the 12-month period ending in such quarter. Within 35 days following the end of each quarter referred to above, some or all of the CCSs will be converted so that the total percentage (not to exceed 100%) of CCSs issued in connection with the formation transactions that have been converted to common stock will be equal to the percentage determined by dividing the net operating income for such period in excess of $5.1 million by $4.6 million. If any CCS remains unconverted through the calculation made in respect of the 12-month period ending December 31, 2008, such outstanding CCSs will be cancelled and restored to the status of authorized but unissued shares of common stock.
While any CCSs remain outstanding, a majority of the Company’s independent directors must review and approve the net
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operating income calculation for each measurement period and also must approve any sales of any of the 14 wholly-owned early-stage lease-up properties.
As of June 30, 2007, there were 500,350 CCSs converted to common stock. Based on the performance of the properties as of June 30, 2007, an additional 392,648 CCSs became eligible for conversion. The board of directors approved the conversion of these CCSs on August 1, 2007 as per the Company’s charter, and the shares were issued on August 3, 2007.
16. STOCK-BASED COMPENSATION
Options
The Company has the following two stock option plans under which shares were available for grant at June 30, 2007: 1) the 2004 Long-Term Incentive Compensation Plan, and 2) the 2004 Non-Employee Directors’ Share Plan. Under the terms of the plans, the exercise price of an option is the fair value of the stock on the date of grant. Each option becomes exercisable after the period or periods specified in the award agreement, which generally do not exceed 10 years from the date of grant. Options are exercisable at such times and subject to such terms as determined by the Compensation, Nominating and Governance Committee; options may not be exercised if such exercise would cause a violation of the ownership limit in the Company’s charter. Unless otherwise determined by the Compensation, Nominating and Governance Committee at the time of grant, stock options vest ratably over a four-year period beginning on the date of grant.
The following assumptions were used to estimate the fair value of options granted during the six months ended June 30, 2007 and 2006 using the Black-Scholes option-pricing model:
Six Months Ended June 30,
Expected volatility
%
Dividend yield
5.8
6.4
Risk-free interest rate
4.9
4.7
Average expected term (years)
The Black-Scholes model incorporates assumptions to value stock—based awards. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the estimated life of the option. The Company uses actual historical data to calculate the expected price volatility and average expected term. The forfeiture rate, which is estimated at a weighted average of 18.93% of unvested options outstanding as of June 30, 2007, is adjusted periodically based on the extent to which actual forfeitures differ, or are expected to differ, from the previous estimate.
The following table summarizes the Company’s activities with respect to its stock option plans:
Number ofShares
WeightedAverage ExercisePrice
Weighted AverageRemainingContractual Life
Aggregate IntrinsicValue as of June 30,2007
Outstanding at December 31, 2006
2,564,563
13.92
Granted
321,000
19.61
Exercised
(76,048
13.63
Forfeited
(104,251
14.32
Outstanding at June 30, 2007
2,705,264
14.53
7.85
6,256,459
Vested and Expected to Vest
1,973,200
14.34
7.77
4,837,556
Ending Exercisable
836,397
13.54
7.47
2,475,896
The aggregate intrinsic value in the table above represents the total value (the difference between the Company’s closing stock price on the last trading day of the second quarter of 2007 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on June 30, 2007. The amount of aggregate intrinsic value will change based on the fair market value of the Company’s stock.
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The Company recorded compensation expense relating to outstanding options of $196 and $250 for the three months ended June 30, 2007 and 2006, respectively, and $419 and $450 for the six months ended June 30, 2007 and 2006, respectively. The Company received cash from the exercise of options of $305 and $36 for the three months ended June 30, 2007 and 2006, respectively, and $1,033 and $127 for the six months ended June 30, 2007 and 2006, respectively. At June 30, 2007, there was $1,422 of total unrecognized compensation expense related to non-vested stock options under the Company’s 2004 Long-Term Incentive Compensation Plan. That cost is expected to be recognized over a weighted-average period of 2.01 years. The valuation model applied in this calculation utilizes subjective assumptions that could potentially change over time, including the expected forfeiture rate. Therefore, the amount of unrecognized compensation expense at June 30, 2007, noted above does not necessarily represent the expense that will ultimately be realized by the Company in the Statement of Operations.
Common Stock Granted to Employees
Common stock is granted to certain employees without monetary consideration under the Company’s 2004 Long-Term Incentive Compensation Plan. At the date of grant, the recipient has all rights of a stockholder including the right to vote and receive dividends subject to restrictions on transfer and forfeiture provisions. The forfeiture and transfer restrictions on the shares lapse over a two to four year period beginning on the date of grant.
The Company recorded compensation expense relating to outstanding shares of common stock granted to employees of $242 and $197 for the three months ended June 30, 2007 and 2006, respectively, and $456 and $383 for the six months ended June 30, 2007 and 2006, respectively.
The fair value of common stock awards is determined based on the closing trading price of the Company’s common stock on the grant date. A summary of the Company’s employee share grant activity is as follows:
Restricted Stock Grants
Weighted-Average Grant-Date Fair Value
Unreleased at December 31, 2006
156,300
15.94
19.25
Released
(27,500
15.72
Cancelled
18.24
Unreleased at June 30, 2007
218,729
17.35
17. SEGMENT INFORMATION
The Company operates in two distinct segments: (1) property management, acquisition and development and (2) rental operations. Financial information for the Company’s business segments is set forth below:
Balance Sheet
Rental operations
Property management, acquisition and development
373,759
223,402
1,610,180
1,446,423
20
Statement of Operations
8,158
6,511
15,703
12,706
Operating expenses, including depreciation and amortization
10,684
9,561
21,409
19,940
26,135
24,104
51,565
47,939
Income (loss) before interest, minority interests and equity in earnings of real estate ventures
(2,526
(3,050
(5,706
(7,234
22,257
17,916
43,058
33,256
(401
(186
(564
(386
(15,036
(12,598
(28,269
(24,383
Minority interests - Operating Partnership and other
(459
(859
Net income (loss)
282
(3,313
(2,013
(7,269
8,413
6,405
17,178
11,099
Depreciation and amortization expense
340
201
602
384
8,783
8,856
17,317
17,949
Statement of Cash Flows
18. COMMITMENTS AND CONTINGENCIES
The Company has guaranteed two construction loans for unconsolidated partnerships that own development properties in Baltimore, Maryland and Chicago, Illinois. These properties are owned by joint ventures in which the Company has 10% equity interests. These guarantees were entered into in November 2004 and July 2005, respectively. At June 30, 2007, the total amount of guaranteed mortgage debt relating to these joint ventures was $13,095. These mortgage loans mature December 1, 2007 and July 28, 2008, respectively. If the joint ventures default on the loans, the Company may be forced to repay the loans. Repossessing and/or selling the self-storage facilities and land that collateralize the loans could provide funds sufficient to reimburse the Company. The estimated fair market value of the encumbered assets at June 30, 2007, was $16,281. The Company has recorded no liability in relation to this guarantee as of June 30, 2007. The fair value of the guarantee is not material. To date, the joint ventures have not defaulted on their mortgage debt. The Company believes the risk of having to perform on the guarantee is remote.
The Company has been involved in routine litigation arising in the ordinary course of business. As of June 30, 2007, the Company was not involved in any material litigation nor, to its knowledge, was any material litigation threatened against it, or its properties.
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19. INCOME TAXES
The Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), an interpretation of FASB Statement No. 109 (“SFAS 109”) on January 1, 2007. As a result of the implementation of FIN 48, the Company recognized no material adjustment in the liability for unrecognized income tax benefits. At the adoption date of January 1, 2007, there were no material unrecognized tax benefits. At June 30, 2007, there were no material unrecognized tax benefits.
Interest and penalties related to uncertain tax positions will be recognized in income tax expense, when incurred. As of June 30, 2007, the Company had no interest and penalties related to uncertain tax positions.
The tax years 2003-2006 remain open to examination by the major taxing jurisdictions to which the Company is subject.
20. SUBSEQUENT EVENTS
On August 1, 2007, one property was contributed to the Operating Partnership in exchange for consideration totaling $14.6 million. Preferred OP Units of 80,905 with a value of $9.8 million were issued along with cash of approximately $4.8 million.
Extra Space Storage Inc.Management’s Discussion and AnalysisAmounts in thousands, except property and per share data
CAUTIONARY LANGUAGE
The following discussion and analysis should be read in conjunction with our “Unaudited Condensed Consolidated Financial Statements” and the “Notes to Unaudited Condensed Consolidated Financial Statements”contained in this report and the “Consolidated Financial Statements,” “Notes to Consolidated Financial Statements” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in our Form 10-K for the year ended December 31, 2006. The Company makes statements in this section that are forward-looking statements within the meaning of the federal securities laws. For a complete discussion of forward-looking statements, see the section in this Form 10-Q entitled “Statement on Forward-Looking Information.” Amounts are in thousands (except per share data and unless otherwise stated).
CRITICAL ACCOUNTING POLICIES
Our discussion and analysis of our financial condition and results of operations are based on our unaudited Condensed Consolidated Financial Statements contained elsewhere in this report, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). Our notes to the unaudited Condensed Consolidated Financial Statements contained elsewhere in this report and the Audited Consolidated Financial Statements contained in our Form 10-K for the year ended December 31, 2006 describe the significant accounting policies essential to our unaudited Condensed Consolidated Financial Statements. Preparation of our financial statements requires estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions which we have used are appropriate and correct based on information available at the time that they were made. These estimates, judgments and assumptions can affect our reported assets and liabilities as of the date of the financial statements, as well as the reported revenue and expense during the period presented. If there are material differences between these estimates, judgments and assumptions and actual facts, our financial statements may be affected.
In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require our judgment in its application. There are areas in which our judgment in selecting among available alternatives would not produce a materially different result, but there are some areas in which our judgment in selecting among available alternatives would produce a materially different result. See the notes to the unaudited Condensed Consolidated Financial Statements that contain additional information regarding our accounting policies and other disclosures.
RECENT ACCOUNTING PRONOUNCEMENTS
Emerging Issues Task Force (“EITF”) Topic D-109, “Determining the Nature of a Host Contract Related to a Hybrid Financial Instrument Issued in the Form of a Share under FASB Statement No. 133” (“Topic D-109”), discussed at the March 15, 2007 EITF meeting, is effective at the beginning of the first fiscal quarter beginning after June 15, 2007 (even if that period is other than the first fiscal quarter of the registrant’s fiscal year). Topic D-109 provides the SEC staff’s view as to how one must evaluate whether a preferred stock “host” contract is a debt host or an equity host. It states that the determination of the nature of the host contract for a hybrid financial instrument (that is, whether the nature of the host contract is more akin to debt or to equity) issued in the form of a share should be based on a consideration of economic characteristics and risks. The SEC staff believes that the consideration of the economic characteristics and risks of the host contract should be based on all the stated and implied substantive terms and features of the hybrid financial instrument. This may represent a change from the way these instruments were analyzed in the past.
We have elected to early adopt Topic D-109 which specifically relates to the AAAAA Rent-A-Space acquisition that was completed during the quarter ended June 30, 2007.
OVERVIEW
We are a fully integrated, self-administered and self-managed real estate investment trust formed to continue the business commenced in 1977 by our predecessor company to own, operate, manage, acquire and develop self-storage properties. We derive a majority of our revenues from rents received from tenants under existing leases at each of our self-storage properties. Additional revenue is derived from management and franchise fees from our joint venture and managed properties. We operate in competitive markets where consumers have multiple self-storage properties from which to choose. Competition has and will continue to impact our results. We experience minor seasonal fluctuations in occupancy levels, with occupancy levels higher in the summer months due to increased rental activity.
Our operating results depend materially on our ability to lease available self-storage space and on the ability of our tenants to make required rental payments. We believe we are able to respond quickly and effectively to changes in local, regional and national economic conditions by centrally adjusting rental rates through the combination of our revenue management team and our industry-leading technology systems.
We continue to evaluate a range of growth initiatives and opportunities including the following:
· Maximize the performance of properties through strategic, efficient and proactive management. We plan to pursue revenue generating and expense minimizing opportunities in our operations. Our revenue management team will seek to maximize revenue by responding to changing market conditions through our technology system’s ability to provide real-time, interactive rental rate and discount management. Our size and scale give us a greater ability than
the majority of our competitors to implement national, regional and local marketing programs, which we believe will attract more customers to our stores at a lower net cost.
· Focus on the acquisition of self-storage properties from strategic partners and third parties. Our acquisitions team will continue to pursue the acquisition of single properties and multi-property portfolios that we believe can provide stockholder value. Our July 2005 acquisition of Storage USA has bolstered our reputation as a reliable, ethical buyer, which we believe enhances our ability to negotiate and close acquisitions. In addition, our status as an UPREIT enables flexibility when structuring deals.
· Develop new self-storage properties. We have several joint venture and wholly-owned development properties and will continue to develop new self-storage properties in our core markets. Our development pipeline for the remainder of 2007 through 2008 includes 16 projects. The majority of the projects will be developed on a wholly-owned basis by the Company. The construction of many of these properties has already begun.
· Expand the Company’s management business. We see the management business as a future acquisition pipeline and expect to pursue strategic relationships with owners that should strengthen our acquisition pipeline through agreements which give us first right of refusal to purchase the managed property in the event of a potential sale. Twelve of the Company’s 2006 and seven of the Company’s 2007 acquisitions have come from this channel.
PROPERTIES
As of June 30, 2007, we owned or had ownership interests in 585 operating self-storage properties located in 33 states and Washington, D.C. Of these properties, 242 are wholly-owned and consolidated, one is held in joint venture and consolidated and 342 are held in joint ventures accounted for using the equity method. In addition, we managed 59 properties for franchisees or third parties bringing the total numbers of properties which we own and/or manage to 644. We receive a management fee equal to approximately 6% of gross revenues to manage the joint venture, third party and franchise sites. As of June 30, 2007, we owned or had ownership interests in approximately 42 million square feet of space and had greater than 300,000 customers.
Approximately 70% of our properties are clustered around the larger population centers, such as Atlanta, Baltimore/Washington, D.C., Boston, Chicago, Dallas, Las Vegas, Los Angeles, Miami, New York City, Orlando, Philadelphia, Phoenix, St. Petersburg/Tampa and San Francisco. These markets contain above-average population and income demographics for new self-storage properties. The clustering of assets around these population centers enables us to reduce our operating costs through economies of scale. The Storage USA acquisition has given us an increased scale in many core markets as well as a foothold in many markets where we had no previous presence.
We consider a property to be in the lease-up stage after it has been issued a certificate of occupancy, but before it has achieved stabilization. We consider a property to be stabilized once it has achieved either an 80% occupancy rate or has been open for three years. Although leases are short-term in duration, the typical tenant tends to remain at our properties for an extended period of time. For properties that were stabilized as of June 30, 2007, the median length of stay was approximately eleven months.
Our property portfolio is a made up of different types of construction and building configurations depending on the site and the municipality where it is located. Most often sites are what we consider “hybrid” facilities, a mix of both drive-up buildings and multi-floor buildings. We have a number of multi-floor buildings with elevator access only, and a number of facilities featuring ground-floor access only.
The following table sets forth additional information regarding the occupancy of our stabilized properties on a state-by-state basis as of June 30, 2007 and 2006. The information as of June 30, 2006 is on a pro forma basis as though all the properties owned at June 30, 2007 were under the Company’s control as of June 30, 2006.
Stabilized Property Data Based on Location
Company
Pro forma
Location
Number ofUnits as of June30, 2007(1)
Number ofUnits as of June30, 2006
Net RentableSquare Feet as ofJune 30, 2007(2)
Net RentableSquare Feet as ofJune 30, 2006
Square FootOccupancy %June 30, 2007
Square FootOccupancy %June 30, 2006
Wholly-owned properties
2,260
2,254
280,180
276,640
93.9
97.8
31,758
31,744
3,014,121
3,011,778
84.4
85.7
Colorado
2,399
2,394
301,691
293,591
91.3
91.6
Connecticut
745
62,505
62,430
84.5
72.7
27
17,729
17,683
1,880,443
1,878,402
86.2
91.8
6,448
6,553
835,528
828,648
88.0
87.2
Hawaii
2,890
2,860
153,351
154,234
81.2
83.6
Illinois
2,674
2,691
266,454
265,487
87.8
83.2
Kansas
505
503
49,940
49,955
90.4
93.4
Kentucky
1,586
1,579
194,351
194,290
91.5
88.6
Louisiana
1,407
1,410
147,490
93.2
95.5
6,746
6,684
731,002
703,522
85.5
85.0
Massachusetts
13,519
13,440
1,432,541
1,433,441
86.0
84.0
Michigan
1,041
1,043
134,402
135,312
90.6
84.8
Missouri
1,349
168,907
169,187
87.1
85.2
Nevada
1,256
1,242
132,465
131,135
84.3
86.6
New Hampshire
1,006
125,609
125,309
81.9
82.5
New Jersey
17,103
17,127
1,670,303
1,672,472
86.7
New York
6,957
6,965
455,779
456,119
82.1
82.4
Ohio
2,040
2,048
275,401
276,355
Oregon
764
767
103,450
103,610
95.7
94.1
Pennsylvania
6,133
6,128
640,568
637,294
86.9
81.8
Rhode Island
731
730
75,241
75,816
South Carolina
2,067
2,068
245,734
245,684
92.1
94.7
3,535
3,533
477,547
469,922
87.3
91.4
Texas
11,881
11,956
1,335,850
1,323,521
91.1
88.2
Utah
1,535
1,524
210,490
209,965
96.6
92.8
Virginia
2,889
272,825
273,038
86.3
Washington
2,031
2,030
244,865
244,595
98.3
96.3
Total Wholly-Owned Stabilized
223
152,985
152,945
15,919,033
15,849,242
25
Joint-venture properties
Alabama
2,300
2,324
282,018
281,628
88.7
86.5
6,901
6,888
751,141
752,076
92.0
94.2
72
51,822
51,931
5,315,289
5,316,072
90.2
89.5
1,906
1,905
216,038
215,813
89.4
5,979
5,985
690,389
690,434
78.3
77.1
Delaware
71,655
94.3
20,344
20,355
2,080,172
2,079,353
1,891
1,916
246,406
251,530
79.4
82.9
4,033
4,031
433,562
436,977
82.8
77.3
Indiana
3,740
3,733
468,753
468,563
90.3
1,210
164,225
163,950
87.9
85.4
2,282
2,270
268,509
268,289
88.9
84.6
10,927
10,916
1,077,412
1,076,827
88.4
85.1
8,500
8,556
972,499
975,597
83.9
5,968
5,959
785,447
786,252
79.3
2,771
2,774
324,665
325,615
85.9
87.6
4,630
4,632
620,549
621,772
88.5
1,326
1,330
138,554
138,964
15,148
15,134
1,595,238
1,588,181
81.6
87.7
New Mexico
4,709
4,727
526,194
528,864
24,098
24,220
1,803,896
1,806,109
83.7
5,027
5,041
751,107
753,177
87.4
81.5
1,291
1,286
137,140
91.2
95.3
6,474
6,477
687,618
687,370
611
73,905
74,005
75.8
68.3
11,828
11,851
1,547,503
1,550,417
88.8
11,837
11,862
1,519,316
1,525,237
81.4
80.7
519
524
59,500
59,700
97.2
93.5
10,393
10,359
1,106,716
1,106,770
551
62,730
94.9
89.8
Washington, DC
1,536
102,003
101,990
Total Stabilized Joint-Ventures
335
231,148
231,483
24,880,149
24,903,057
Managed properties
3,273
3,271
401,655
398,455
77.9
80.9
513
56,240
570
572
56,485
57,125
90.5
96.4
4,530
4,559
485,472
486,372
3,124
3,093
256,511
255,698
80.0
436
442
61,235
61,510
79.5
1,096
1,089
131,472
131,642
93.3
1,576
1,584
171,555
171,355
888
131,130
131,330
95.0
1,147
1,133
135,410
130,286
92.2
46,955
99.4
98.7
1,431
1,433
136,412
146,587
85.6
1,255
111,759
111,809
Total Stabilized Managed Properties
31
20,210
20,207
2,182,291
2,185,364
Total Stabilized Properties
404,343
404,635
42,981,473
42,937,663
87.0
(1) Represents unit count as of June 30, 2007, which may differ from June 30, 2006 unit count due to unit conversions or expansions.
(2) Represents net rentable square feet as of June 30, 2007, which may differ from June 30, 2006 net rentable square feet due to unit conversions or expansions.
26
The following table sets forth additional information regarding the occupancy of our lease-up properties on a state-by-state basis as of June 30, 2007 and 2006. The information as of June 30, 2006 is on a pro forma basis as though all the properties owned at June 30, 2007 were under our control as of June 30, 2006.
Lease-up Property Data Based on Location
587
599
67,375
32.5
3,653
2,798
433,850
330,280
56.9
55.8
359
368
58,928
60,441
76.6
80.6
612
614
60,760
75.6
65.7
1,257
973
157,005
133,880
71.8
75.7
591
588
75,800
75,820
76.4
66.5
2,896
1,927
285,927
195,608
63.8
68.0
1,744
1,678
163,185
149,070
79.1
80.2
424
425
47,060
47,410
79.6
59.6
501
529
61,250
98.9
Total Wholly-Owned Lease-up
12,624
10,499
1,411,140
1,181,894
68.8
703
79,233
31.4
0.0
955
957
74,153
75,399
43.1
948
73,666
73,649
51.1
12.3
1,195
560
119,735
62,400
54.6
74.2
491
530
77,674
58,992
754
774
76,496
76,773
96.5
878
84,383
58.4
Total Lease-up Joint-Ventures
5,924
4,656
585,340
431,596
62.2
50.9
5,433
4,792
552,315
461,095
72.9
58.7
683
687
54,840
54,380
70.1
1,297
224,832
112,286
46.3
60.9
1,007
1,114
115,215
114,780
72.2
58.1
1,561
1,573
190,329
192,949
67.6
51.9
68,890
69,040
54.5
727
67,810
67,560
79.2
73.4
3,851
3,870
338,894
341,359
64.9
45.8
863
78,190
20.2
1,578
116,235
116,530
78.9
65.3
506
55,670
56,095
38.9
16.0
1,167
1,172
125,505
124,445
73.3
676
74,840
74,900
78.2
Total Lease-up Managed
28
20,871
18,582
2,063,565
1,785,419
67.8
57.3
Total Lease-up Properties
55
39,419
33,737
4,060,045
3,398,909
67.4
59.4
RESULTS OF OPERATIONS
Comparison of the three and six months ended June 30, 2007 and 2006
Overview
Results for the three and six months ended June 30, 2007 include the operations of 585 properties (243 of which were
consolidated and 342 of which were in joint ventures accounted for using the equity method) compared to the results for the three and six months ended June 30, 2006, which included the operations of 556 properties (208 of which were consolidated and 348 of which were in joint ventures accounted for using the equity method).
Revenues
The following table sets forth information on revenues earned for the periods indicated:
Three months ended June30,
$ Change
% Change
6,372
15.2
13,428
16.5
(38
(0.7
)%
0.1
1,717
176.8
2,939
155.3
4.0
5.3
(39
(21.2
14.1
8,019
16,425
17.5
Property Rental — The increase in property rental revenue for the three and six months ended June 30, 2007 consists of $4,500 and $9,240, respectively, associated with acquisitions completed in 2007 and 2006, $1,454 and $3,394, respectively, from rate increases at stabilized properties, and $418 and $794, respectively, from increases in occupancy at lease-up properties.
Management and Franchise Fees — Revenue from management and franchise fees have remained fairly stable. Increased revenues at our joint venture, franchise, and third-party managed sites related to rental rate and occupancy increases have been offset by lost management fees due to the termination of certain management agreements.
Tenant Insurance —The increase in tenant insurance revenues is due to the introduction of our captive insurance program at all wholly-owned properties in October 2006. In addition, during the six months ended June 30, 2007, we promoted the tenant insurance program and successfully increased sales of insurance policies in excess of 25%. Formerly, insurance revenues included only fee income paid by a third party insurance company.
Expenses
The following table sets forth information on expenses for the periods indicated:
2,104
13.8
4,258
14.2
628
106.6
968
135
562.5
67
19.6
2.5
1.2
66
0.7
(414
(2.3
3,154
9.4
5,095
7.5
Property Operations — The increase in property operations expense for the three and six months ended June 30, 2007 consists of $1,344 and $3,057, respectively, associated with acquisitions completed in 2007 and 2006, $760 and $1,201, respectively, from increases in utilities and advertising expenses at existing properties.
Tenant Insurance —The increase in tenant insurance expense is due to the introduction of our captive insurance program at all wholly-owned properties in October 2006.
Unrecovered Development/Acquisition Costs—Unrecovered development and acquisition costs have increased when compared to the prior year due to increased acquisition volume and competition for raw land and operating properties.
General and Administrative—General and administrative costs remained relatively constant due to the fact that the integration of the Storage USA properties was completed prior to the periods presented and as no similar large acquisitions have occurred.
Depreciation and Amortization—The decrease in depreciation and amortization expense for the six months ended June 30, 2007 is due primarily to the fact that the customer relationship intangibles related to the properties acquired in the Storage USA acquisition in July 2005 were fully amortized as of January 2007. This decrease is offset by additional depreciation and amortization expense from other acquisitions made in 2007 and 2006, causing the increase in depreciation and amortization expense for the three months ended June 30, 2007.
Other Revenues and Expenses
The following table sets forth information on other revenues and expenses for the periods indicated:
Six months ended June30,
Other revenue and expenses:
(2,653
20.8
(4,064
16.4
3,520
2,378.4
4,486
712.1
(290
128.9
(620
222.2
Minority interest - other
(100.0
105
9.7
163
7.3
Total other expense
(11,036
(11,774
738
(6.3
(22,187
(22,192
Interest Expense — The increase in interest expense for the three and six months ended June 30, 2007 when compared to June 30, 2006 consists primarily of $1,181 and $2,475, respectively, related to new loans on properties acquired in 2007 and 2006, and $1,596 and $1,221, respectively, related to increased corporate interest related primarily to the exchangeable senior notes offering in March 2007.
Interest Income — The increase in interest income was due to the larger amount of cash and short-term investments held during the three and six months ended June 30, 2007 compared to the prior year. The excess cash was generated primarily by the exchangeable senior notes offering in March 2007.
Minority Interest — Operating Partnership—Income allocated to the Operating Partnership represents 5.59% and 6.88% of the net income before minority interest for the six months ended June 30, 2007 and 2006, respectively. The increase in the amount allocated to the minority interest in 2007 is due to the increase in net income.
Equity in Earnings of Real Estate Ventures — The change in equity in earnings of real estate ventures for the three and six months ended June 30, 2007 relates primarily to increases in income at the properties owned by the real estate ventures.
FUNDS FROM OPERATIONS
Funds from Operations (“FFO”) provides relevant and meaningful information about our operating performance that is necessary, along with net income and cash flows, for an understanding of our operating results. We believe FFO is a meaningful disclosure as a supplement to net earnings. Net earnings assume that the values of real estate assets diminish predictably over time as reflected through depreciation and amortization expenses. The values of real estate assets fluctuate due to market conditions and we believe FFO more accurately reflects the value of our real estate assets. FFO is defined by the National Association of Real Estate Investment Trusts, Inc. (“NAREIT”) as net income computed in accordance with U.S. generally accepted accounting principles (“GAAP”), excluding gains or losses on sales of operating properties, plus depreciation and amortization and after adjustments to record unconsolidated partnerships and joint ventures on the same basis. We believe that to further understand our performance, FFO should be considered along with the reported net income and cash flows in accordance with GAAP, as presented in our unaudited condensed consolidated financial statements.
The computation of FFO may not be comparable to FFO reported by other REITs or real estate companies that do not define the term in accordance with the current NAREIT definition or that interpret the current NAREIT definition differently. FFO does not represent cash generated from operating activities determined in accordance with GAAP, and should not be considered as an alternative to net income as an indication of our performance, as an alternative to net cash flow from operating activities as a measure of our liquidity, or as an indicator of our ability to make cash distributions. The following table sets forth the calculation of FFO (dollars are in thousands, except for share data):
29
Plus:
Real estate depreciation
7,830
6,648
15,416
13,121
Amortization of intangibles
807
1,951
1 ,614
4,504
Joint venture real estate depreciation and amortization
1,026
1,247
2,087
2,447
Joint venture loss on sale of properties
Income allocated to Operating Partnership minority interest
Funds from operations
18,878
13,163
35,186
24,181
Weighted average number of shares - basic
Common stock (excluding restricted shares)
OP units
68,451,517
55,450,922
68,369,206
55,432,405
Weighted average number of shares - diluted
Common stock
65,236,466
52,165,301
65,201,934
52,157,299
69,249,845
SAME-STORE STABILIZED PROPERTY RESULTS
We consider our same-store stabilized portfolio to consist of only those properties which were wholly-owned at the beginning and at the end of the applicable periods presented that have achieved stabilization as of the first day of such period. The following table sets forth operating data for our same-store portfolio. We consider the following same-store presentation to be meaningful in regards to the properties shown below. These results provide information relating to property-level operating changes without the effects of acquisitions or completed developments.
Three Months EndedJune 30,
Percent
Six Months EndedJune 30,
Change
Same-store rental revenues
39,624
37,980
4.3
78,534
74,748
5.1
Same-store operating expenses
13,815
13,308
3.8
27,519
26,830
2.6
Same-store net operating income
25,809
24,672
4.6
51,015
47,918
6.5
Non same-store rental revenues
8,768
4,040
117.0
16,089
6,447
149.6
Non same-store operating expenses
3,537
1,940
82.3
6,729
3,160
112.9
Total rental revenues
Total operating expenses
Same-store square foot occupancy as of quarter end
87.5
88.1
Properties included in same-store
The increase in same-store rental revenues for the three and six months ended June 30, 2007 was due to our ability to maintain occupancy and increase rental rates to existing customers. The increase in same-store operating expenses was primarily due to increases in property taxes and advertising.
COMMON CONTINGENT SHARES AND COMMON CONTINGENT UNIT PROPERTY PERFORMANCE
As described in the notes to our unaudited Condensed Consolidated Financial Statements, upon the achievement of certain levels of net operating income with respect to 14 of our pre-stabilized properties, our contingent conversion shares (“CCS”) and our Operating Partnership’s contingent conversion units (“CCU”) will convert into additional shares of common stock and Operating Partnership units, respectively.
As of June 30, 2007, there were 500,350 CCSs and 25,739 CCUs converted to common shares and common Operating
Partnership units, respectively. Based on the performance of the properties as of June 30, 2007, an additional 392,648 CCSs and 20,198 CCUs became eligible for conversion. The board of directors approved the conversion of these CCSs and CCUs on August 1, 2007 as per the Company’s charter, and the shares and units were issued on August 3, 2007.
The table below outlines the performance of the properties for the three and six months ended June 30, 2007 and 2006:
CCS/CCU rental revenues
2,967
2,508
18.3
5,853
4,890
19.7
CCS/CCU operating expenses
1,333
0.2
2,631
2,655
(0.9
CCS/CCU net operating income
1,634
1,178
38.7
3,222
2,235
44.2
Non CCS/CCU rental revenues
45,425
39,512
15.0
88,770
76,305
16.3
Non CCS/CCU operating expenses
16,019
13,918
15.1
31,617
27,335
15.7
CCS/CCU square foot occupancy as of quarter end
74.7
Properties included in CCS/CCU
The increase in CCS/CCU rental revenues was due to increased rental rates and occupancy.
CASH FLOWS
Cash flows provided by operating activities were $51,905 and $36,264, respectively, for the six months ended June 30, 2007 and 2006. The increase in cash provided by operating activities was due primarily to an increase in net income related to the addition of new properties through acquisitions and interest income from short-term investments. Additionally, there have also been lower cash funding requirements relating to our lease-up properties as occupancy has increased.
Cash used in investing activities was $205,629 and $107,850, respectively, for the six months ended June 30, 2007 and 2006. The increase is due primarily to the purchase of short-term investments during the six months ended June 30, 2007.
Cash provided by financing activities was $128,713 and $47,183 for the six months ended June 30, 2007 and 2006, respectively. The financing activities during the six months ended June 30, 2007 consisted primarily of the issuance of exchangeable senior notes for $250,000, additional net borrowings of $16,010, offset by $29,368 paid in dividends.
OPERATIONAL SUMMARY
For the three and six months ended June 30, 2007, we continued our same-store property revenue growth with a revenue increase of 4.3% and 5.1%, respectively, compared to the same periods in 2006. Occupancy at our stabilized properties was fairly consistent on a year-to-year basis, reaching 87.5% as of June 30, 2007 compared to 88.1% as of June 30, 2006.
Property revenue growth was evident in the majority of markets in which we operate. The growth in property revenue is the result of increases in occupancy and rental rates to both new and existing customers. Property expenses increased primarily as a result of increases in property taxes due to re-assessments on properties that we have acquired and other annual tax re-assessments.
OUTLOOK
In the second quarter, we continued to see a generally positive climate for self-storage in the United States. Rental activity was flat overall when compared with the second quarter of 2006. Despite the lack of increased demand, we were able to raise same-store and overall portfolio revenue through increased rental rates to existing customers. The key economic indicators that affect self-storage demand are mixed, and we are looking to rental activity in the second quarter of 2007 as an indicator
of our results for the remainder of the year.
We seek to drive rental activity and revenue growth by actively managing both pricing and promotional strategies through our revenue management team and utilizing the yield management features of our technology system. In-house training, operational initiatives and marketing promotions, including national cable television advertising, continue to be implemented. These activities also provide support for increased rentals at the store level.
Our discounting strategies continue to evolve. Higher levels of discounting were utilized in the first six months of 2007 compared to 2006 due to special promotions associated with the 30th anniversary of the Company. We will selectively discount certain sites and units based on occupancy, availability, and competitive parameters that are controlled through our centralized, real-time technology systems and revenue management team.
Property taxes are seen as a primary driver of expenses in the coming year. As we acquire existing self-storage facilities, tax reassessments will continue to occur. Snow removal expenses, usually a major contributor to expense increases, were lower in the first six months of 2007 due to lower snowfall amounts than anticipated in the northeast and mid-Atlantic regions.
We anticipate continued competition from all operators, both public and private, in all of the markets in which we operate. However, we believe that the quality and location of our property portfolio, our revenue management systems, and the strength of our self-storage fundamentals will provide opportunities to grow revenues in the remainder of 2007.
LIQUIDITY AND CAPITAL RESOURCES
As of June 30, 2007, we had $45,790 available in cash and cash equivalents, and $90,331 in short-term investments. We intend to use this cash to purchase additional self-storage properties and fund other working capital needs during the remainder of 2007. Additionally, we are required to distribute at least 90% of our net taxable income, excluding net capital gains, to our stockholders on an annual basis to maintain our qualification as a REIT. Therefore, it is unlikely that we will have any substantial cash balances that could be used to meet our liquidity needs. Instead, these needs must be met from cash generated from operations and external sources of capital.
During September 2004, we, as guarantor, and our Operating Partnership entered into a $100 million revolving line of credit (“Credit Facility”), which includes a $10 million swingline sub facility. The Credit Facility is collateralized by self-storage properties. The Operating Partnership intends to use the proceeds of the Credit Facility for general corporate purposes and acquisitions. As of June 30, 2007, the Credit Facility had approximately $81 million of available borrowings based on the assets collateralizing the Credit Facility. As of June 30, 2007, we had no amount outstanding under the Credit Facility.
As of June 30, 2007, we had approximately $1,245.3 million of debt, resulting in a debt to total capitalization ratio of 52.3%. As of June 30, 2007, the ratio of total fixed rate debt and other instruments to total debt was 94.8%. The weighted average interest rate of the total of fixed and variable rate debt at June 30, 2007 was 5.1%.
Real estate assets are pledged as collateral for our debt. We are subject to certain restrictive covenants relating to our outstanding debt. We were in compliance with all covenants at June 30, 2007.
We expect to fund our short-term liquidity requirements, including operating expenses, recurring capital expenditures, dividends to stockholders, distributions to holders of Operating Partnership units and interest on our outstanding indebtedness out of our operating cash flow, cash on hand, short term investments and borrowings under our Credit Facility.
Long-Term Liquidity Needs
Our long-term liquidity needs consist primarily of distributions to stockholders, new facility development, property acquisitions, principal payments under our borrowings and non-recurring capital expenditures. We do not expect that our operating cash flow will be sufficient to fund our long term liquidity needs and instead expect to fund such needs out of additional borrowings, joint ventures with third parties, and from the proceeds of public and private offerings of equity and debt. We may also use Operating Partnership units as currency to fund acquisitions from self-storage owners who desire tax-
32
deferral in their exiting transactions.
On October 13, 2005, we filed a universal shelf registration statement with the Securities and Exchange Commission, which permits us to sell, from time to time, up to $800 million of our common stock, preferred stock, depositary shares, warrants and rights to the extent necessary or advisable to meet our liquidity needs. We have issued approximately $406 million of securities under this shelf registration statement to date, leaving us with availability of approximately $394 million.
FINANCING STRATEGY
We will continue to employ leverage in our capital structure in amounts determined from time to time by our board of directors. Although our board of directors has not adopted a policy which limits the total amount of indebtedness that we may incur, we will consider a number of factors in evaluating our level of indebtedness from time to time, as well as the amount of such indebtedness that will be either fixed or variable rate. In making financing decisions, our board of directors will consider factors including but not limited to:
· the interest rate of the proposed financing;
· the extent to which the financing impacts flexibility in managing our properties;
· prepayment penalties and restrictions on refinancing;
· the purchase price of properties acquired with debt financing;
· long-term objectives with respect to the financing;
· target investment returns;
· the ability of particular properties, and the Company as a whole, to generate cash flow sufficient to cover expected debt service payments;
· overall level of consolidated indebtedness;
· timing of debt and lease maturities;
· provisions that require recourse and cross-collateralization;
· corporate credit ratios including debt service coverage, debt to total capitalization and debt to undepreciated assets; and
· the overall ratio of fixed- and variable-rate debt.
Our indebtedness may be recourse, non-recourse or cross-collateralized. If the indebtedness is non-recourse, the collateral will be limited to the particular properties to which the indebtedness relates. In addition, we may invest in properties subject to existing loans collateralized by mortgages or similar liens on our properties, or may refinance properties acquired on a leveraged basis. We may use the proceeds from any borrowings to refinance existing indebtedness, to refinance investments, including the redevelopment of existing properties, for general working capital or to purchase additional interests in partnerships or joint ventures or for other purposes when we believe it is advisable.
OFF-BALANCE SHEET ARRANGEMENTS
Except as disclosed in the notes to our unaudited Condensed Consolidated Financial Statements, we do not currently have any relationships with unconsolidated entities or financial partnerships, such entities often referred to as structured finance or special purposes entities, which typically are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, except as disclosed in the notes to our unaudited Condensed Consolidated Financial Statements, we have not guaranteed any obligations of unconsolidated entities nor do we have any
33
commitments or intent to provide funding to any such entities. Accordingly, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in these relationships.
Our exchangeable senior notes provide for excess exchange value to be paid in cash or shares of our common stock if our stock price exceeds a certain amount. See the notes to our financial statements for a further description of our exchangeable senior notes.
CONTRACTUAL OBLIGATIONS
The following table summarizes our contractual obligations as of June 30, 2007:
Payments due by Period:
Less Than
After
1 Year
1-3 Years
4-5 Years
5 Years
Operating leases
63,722
5,365
10,197
8,678
39,482
Notes payable, exchangeable senior notes and notes payable to trusts
Interest
454,474
63,396
111,409
68,531
211,138
Principal
1,245,320
298,990
179,680
762,137
Total contractual obligations
1,763,516
73,274
420,596
256,889
1,012,757
SEASONALITY
The self-storage business is subject to seasonal fluctuations. A greater portion of revenues and profits are realized from May through September. Historically, our highest level of occupancy has been as of the end of July, while our lowest level of occupancy has been in late February and early March. Results for any quarter may not be indicative of the results that may be achieved for the full fiscal year.
Market Risk
Market risk refers to the risk of loss from adverse changes in market prices and interest rates. Our future income, cash flows and fair values of financial instruments are dependent upon prevailing market interest rates.
Interest Rate Risk
Interest rate risk is highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control.
As of June 30, 2007, we had $1.2 billion in total debt of which $64.7 million was subject to variable interest rates (including the $61.8 million on which we have a reverse interest rate swap). If LIBOR were to increase or decrease by 100 basis points, the increase or decrease in interest expense on the variable rate debt would increase or decrease future earnings and cash flows by approximately $0.7 million annually.
Interest rate risk amounts were determined by considering the impact of hypothetical interest rates on our financial instruments. These analyses do not consider the effect of any change in overall economic activity that could occur. Further, in the event of a change of that magnitude, we may take actions to further mitigate our exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, these analyses assume no changes in our financial structure.
The fair value of fixed rate notes payable and notes payable to trusts at June 30, 2007 was $1.1 billion. The carrying value of these fixed rate notes payable at June 30, 2007 was $1.2 billion.
(i) Disclosure Controls and Procedures
We maintain disclosure controls and procedures to ensure that information required to be disclosed in the reports we file pursuant to the Securities Exchange Act of 1934, as amended, are recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure based on the definition of “disclosure controls and procedures” in Rule 13a-15(e) of the Exchange Act. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can only provide a reasonable assurance of achieving the desired control objectives, and in reaching a reasonable level of assurance, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
We have formed a disclosure committee to ensure that all disclosures made by the Company to its security holders or the investment community will be accurate and complete and fairly present the Company’s financial condition and results of operations in all material respects, and are made on a timely basis as required by applicable laws, regulations and stock exchange requirements.
We carried out an evaluation, under the supervision and with the participation of management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
(ii) Changes in internal control over financial reporting
There were no changes in our internal control over financial reporting (as such term is defined in Exchange Act Rule 13a-15(f)) that occurred during our most recent quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
We are involved in various litigation and proceedings in the ordinary course of business. We are not a party to any material litigation or legal proceedings, or to the best of our knowledge, any threatened litigation or legal proceedings, which, in the opinion of management, will have a material adverse effect on our financial condition or results of operations either individually or in the aggregate.
There have been no material changes in our risk factors from those disclosed in “Part I. Item 1A. Risk Factors” in our 2006 Annual Report on Form 10-K. Please refer to that section for disclosures regarding the risks and uncertainties related to our business.
As described in the notes to our unaudited Condensed Consolidated Financial Statements, upon the achievement of certain levels of net operating income with respect to 14 of our pre-stabilized properties, our CCSs and our Operating Partnership’s CCUs will convert into additional shares of common stock and Operating Partnership units, respectively. Subject to certain lock-up periods and adjustments, the units are generally exchangeable for shares of common stock on a one-for-one basis or an equivalent amount of cash, at the option of the Company.
As of June 30, 2007, there were 500,350 CCSs and 25,739 CCUs converted to common shares and common Operating Partnership units, respectively. Based on the performance of the properties as of June 30, 2007, an additional 392,648 CCSs
and 20,198 CCUs became eligible for conversion. The board of directors approved the conversion of these CCS and CCUs on August 1, 2007 as per the Company’s charter, and the shares and units were issued on August 3, 2007. The shares and units were issued in private placements in reliance on Section 3(a)(9) and Section 4(2) of the Securities Act of 1933, as amended, and the rules and regulations promulgated thereunder. We received no additional consideration for the conversions.
On June 14, 2007, the Company acquired one self-storage facility located in San Francisco, California from an unrelated third party for cash of $867, a loan assumption of $14.1 million, assumed net liabilities of $60 and 218,693 Operating Partnership units valued at $3,834. The units were issued in a private placement in reliance on Section 4(2) of the Securities Act of 1933, as amended, and the rules and regulations promulgated thereunder. Subject to certain lock-up periods and adjustments, the units are generally exchangeable into common stock of the Company on a one-for-one basis or an equivalent amount of cash, at the option of the Company.
On August 1, 2007, one property was contributed to the Operating Partnership in exchange for consideration totaling $14.6 million. Preferred OP Units of 80,905 with a value of $9.8 million were issued along with cash of approximately $4.8 million. The units were issued in a private placement in reliance on Section 4(2) of the Securities Act of 1933, as amended, and the rules and regulations promulgated thereunder. Subject to certain lock-up periods and adjustments, the Preferred OP Units will be redeemable at the option of the holder on or after September 1, 2008, which redemption obligation may be satisfied, at the Company’s option, in cash or shares of its common stock.
None.
We held our annual meeting of stockholders on May 23, 2007. The first item of business was the election of seven members of the board of directors. The votes were tabulated as follows: 50,964,913 votes were cast for Kenneth M. Woolley and 700,456 votes were withheld; 51,058,067 votes were cast for Anthony Fanticola and 607,302 votes were withheld; 51,039,772 votes were cast for Hugh W. Horne and 625,597 votes were withheld; 47,530,424 votes were cast for Spencer F. Kirk and 4,134,945 votes were withheld; 51,193,682 votes were cast for Joseph D. Margolis and 471,687 votes were withheld; 51,063,979 votes were cast for Roger B. Porter and 601,390 votes were withheld; and 51,119,011 votes were cast for K. Fred Skousen and 546,358 votes were withheld. The second item of business was a proposal to ratify the selection of Ernst & Young LLP as our independent registered public accounting firm for the year ending December 31, 2007. The votes were tabulated as follows: 51,598,167 were cast for, 47,285 were cast against, and 19,914 abstained.
Exhibits
10.1
Contribution Agreement, dated June 15, 2007, among Extra Space Storage LP and various limited partnerships affiliated with AAAAA Rent-A-Space (incorporated by reference to Exhibit 10.1 of Form 8-K filed on June 18, 2007).
10.2
Second Amended and Restated Agreement of Limited Partnership of Extra Space Storage LP, dated June 25, 2007 (incorporated by reference to Exhibit 10.1 of Form 8-K filed on June 26, 2007).
10.3
Promissory Note, dated June 25, 2007, among Extra Space Storage LP, H. James Knuppe and Barbara Knuppe (incorporated by reference to Exhibit 10.2 of Form 8-K filed on June 26, 2007).
10.4
Pledge Agreement, dated June 25, 2007, among Extra Space Storage LP, H. James Knuppe and Barbara Knuppe (incorporated by reference to Exhibit 10.3 of Form 8-K filed on June 26, 2007).
10.5
Form of Registration Rights Agreement among Extra Space Storage LP, H. James Knuppe and Barbara Knuppe (incorporated by reference to Exhibit 10.4 of Form 8-K filed on June 26, 2007).
31.1
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certifications of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Registrant
Date: August 8, 2007
/s/ Kenneth M. Woolley
Kenneth M. Woolley
Chairman and Chief Executive Officer
(Principal Executive Officer)
/s/ Kent W. Christensen
Kent W. Christensen
Executive Vice President and Chief Financial Officer
(Principal Financial Officer)