Apartment Income REIT Corp. (NYSE:AIRC) Q4 2023 Earnings Call Transcript

Apartment Income REIT Corp. (NYSE:AIRC) Q4 2023 Earnings Call Transcript February 9, 2024

Apartment Income REIT Corp. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Welcome, and thank you for attending today’s AIR Communities Third (ph) Quarter 2023 Earnings Conference Call. My name is Kriti and I’ll be your moderator for today’s call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. [Operator Instructions] I would now like to pass the conference over to Lisa Cohn, President and General Counsel of AIR Communities. You may proceed.

Lisa Cohn: Thank you, and good day. My name is Lisa Cohn and I am President and General Counsel of AIR Communities. During this conference call, the forward-looking statements we make are based on management’s judgments, including projections related to our 2024 expectations. These statements are subject to certain risks and uncertainties, a description of which can be found in our SEC filings. Actual results may differ materially from what may be discussed today. We’ll also discuss certain non-GAAP financial measures such as FFO and AFFO. These are defined and are reconciled to the most comparable GAAP measures in the supplemental information that is part of the full earnings release published on AIR’s website. Our comments today come from Terry Considine, our CEO; Keith Kimmel, President of Property Operations; Josh Minix, our Chief Investment Officer; and Paul Beldin, our CFO.

Other members of management are also present and all of us will be available during the Q&A session, which will follow our prepared remarks. I will now turn the call to Terry Considine. Terry?

Terry Considine: Good morning, and thank you, Lisa, and all of you on this call. I read the first takes this morning, and last night and set aside my prepared remarks to address what I understand to be on your minds. There’s considerable consensus on AIR’s good operations. There’s confusion about $0.07 of the increase in 2024, expected interest expense. $0.04 was the result of the third quarter refinancing fully disclosed in our third quarter report. It reflects the acceleration by a year or so of the difference between legacy interest rates, and then current market rates. This will occur in every REIT balance sheet as debts reprice.$ 0.01 reflects the impact of fourth quarter share repurchases funded by borrowing at a somewhat higher interest rate than in the third quarter.

And was considered in our underwriting. $0.02 reflects a $50 million increase in expected 2024 borrowings to fund accretive property upgrades. We have underwritten past and future investments at substantial accretive spreads to our cost of capital. The higher interest expense in 2024 is the price paid for a higher quality portfolio with faster free cash flow growth in ’24, but more importantly in 2025 and later. There is some suggestion that leverage increases variability, and lower leverage would reducing. Financial leverage does introduce exposure to changing interest rates. This was especially pronounced last year when, for example, the 10-year fluctuated from 3.25% to 5% and back to 4%. But even the highest rates are well below the returns on AIR investment.

The bigger point is the use of the borrowed proceeds to upgrade the AIR portfolio and create shareholder value. We are focused on the long term values of a better portfolio with higher earning power and look past the short-term noise of interest rate changes. Any discussion of leverage needs to consider risk. AIR leverage at 30% loan to value, to stabilize properties is safe. Comparison to others needs to consider the stability of stabilized properties as owned by AIR with the risk of other business models with development risk, the implicit financial leverage of unfunded completion costs, and the risk of second mortgage lending where the much higher leverage from senior debt is off balance sheet, but remains real. There were some concerns about paired trades with minor year one FFO and free cash flow impacts.

The state the concern is to answer it. We’re comfortable with the relatively minor year one noise, if we see considerable long-term value creation. We are confident that 2023’s paired trades will outearn their cost of capital. There were some similar concerns about the complexity of joint ventures. This complexity is addressed by transparency, as for example, shown in Schedule 2(b), which provides a clear path from GAAP to economics. It fails to consider the benefits to shareholders, which we saw in 2023 and anticipate in 2024, including the opportunity to upgrade our portfolio by the sale of partial interest in an otherwise illiquid market and the opportunity to reinvest the proceeds in other properties, often at discounts to their construction costs, with higher free cash flow growth rates, all while others are sidelined.

The long-term benefits to portfolio construction are real and predictable. The creation of additional service income lowers AIR’s already low G&A. A corollary benefit to stock investors might be the reassurance that the most sophisticated global real estate investors chose, and choose to co-invest alongside AIR. There was some discussion of nonrecurring income. It’s just that nonrecurring. It’s cash and needs to be reported. It was exaggerated in 2022 when we accelerated the termination of continuing agreements between AIR and Aimco. It declined considerably in 2023. AIR’s focus on long-term free cash flow will naturally reduce nonrecurring income, but when it’s available, shareholders will be better off if we take it, disclosing as we do that it’s nonrecurring.

Finally, forecasts for 2024 are just that forecast. AIR has taken a conservative view to guidance of 2024 market rental rate growth. We also provided a range of guidance that shows a possible and substantial upside. Time will tell where results land. I encourage you to keep score at the end of the year, not at its beginning. My bottom line, given the consensus on the performance of AIR operations, and the continuing increases in the quality of the AIR portfolio and its growth rate, it seems likely that AIR shareholders at year-end will own an enterprise whose value will have increased considerably. Given that our diversified portfolio is largely insulated from today’s surge in new supply, I expect that our results will compare favorably to ours in 2023, and to peers in 2024.

The expected value creation will be the work of a stable and cohesive team, and the advice and oversight of an engaged Board of Directors. I thank both for their friendship and help. With that, I’d like to turn the call to Keith Kimmel. Keith?

Keith Kimmel: Thanks, Terry. I’m pleased to report we wrapped up a good 2023 with a solid fourth quarter. More importantly, AIR is well-positioned to begin 2024 in what we see as another good year ahead. Fourth quarter results met our expectations and were reflective of typical seasonality. AIR continues to benefit from Josh’s good work building a portfolio with broad diversification of markets and limited exposure to new supply. Revenue was up 6.2% with occupancy of 97.3%, up 200 basis points from the third quarter. Sign new leases were down 1.1% from the prior lease, as we pushed to build occupancy and pricing power. Renewals were up 4.7%. Expenses increased 30 basis points and net operating income increased 8.1%. The AIR Edge continues to drive outperformance with full year controllable operating expenses up only 20 basis points, in part due to AIR’s best-ever retention of 62.3%.

AIR’s operating margin also reached an all-time high of 76.7%, up 130 basis points from the fourth quarter of 2022. The AIR Edge also generates above market performance in our acquisition portfolio. In the fourth quarter, our classes of 2021 and 2022 had net operating income growth 300 basis points better than our same-store portfolio. And in particular, benefited from the efficiencies of AIR’s operating model and technology stack, with expenses down 4.5% from last year. Our Class of 2021, now owned for just over two years, has undergone a remarkable transformation. Compared to the fourth quarter of 2021, revenue is up 25%. Controllable expenses have decreased 21%. Net operating income is up 34%. Margins at these communities have expanded over 500 basis points from 68.6% at acquisition to 73.8% today.

Our Class of 2022 acquisitions, now entering same-store are expected to have net operating income growth this year, approximately twice that of the balance of the portfolio. At Southgate, owned now for one year, the rent roll has increased 14% from day one and we’ve had net [Technical Difficulty] income growth of 23% from the seller’s prior year. The combination of above market revenue growth and predictable expense savings from the AIR platform creates a reliable engine for repeatable growth. January results have strengthened from the fourth quarter and we are well-positioned to start the year. Occupancy continues to be strong at 97.7%. Our high occupancy brings pricing power, with new leases up 1.8%, renewals up 5.6%, and signed blended lease to lease of 3.8%.

Asking rents have increased 80 basis points year to date and leasing volume has grown sequentially each week as we see the first green shoots of the spring leasing season. We anticipate the balance of 2024 will reflect a typical pre-pandemic year, with strong demand, supply pressures, but only in pockets, waning inflation, and a premium placed on sales and operational excellence. Our anticipated 2024 revenue growth of 3.8% is based on 2.4% of earn-in from our 2023 leasing activity and current pricing, 40 basis points of growth in occupancy, 10 basis points improvement from bad debt, 50 basis points contribution from community upgrades, and asking rates that grow another 1% between now and peak season, resulting in a blended lease to lease of 3.5% in 2024.

We anticipate positive growth across all markets, with the South Florida, Boston, Washington DC, and San Diego expected to be our strongest markets, while the Bay Area continues to lag in revenue growth, though we remain optimistic for a strong recovery. My thanks to all AIR team members for a great year. Your dedication to serving our residents, innovative approach to our business, and consistent drive for results made 2023 one of AIR’s best years. I look forward to the year ahead. I’ll now turn the call over to Joshua Minix, our Chief Investment Officer. Josh?

Josh Minix: Thank you, Keith. In 2023, we grew our AIR Edge portfolio with four acquisitions. One located in Miami Beach; Florida, one in Bethesda, Maryland, and two in Raleigh, Durham, North Carolina, where we added a third this year. The acquisitions were funded in a leverage-neutral manner by two new joint ventures, the 2023 sale of our last New York City properties, the issuance of both operating partnership units, and the assumption of below market fixed rate debt. We did not have any transaction closings in the fourth quarter, though we remain focused on improving the portfolio and expanding our AIR Edge allocation. In 2023, the acquisition classes of ’21 and ’22 were 13% of our portfolio and accounted for 22% of our growth.

The ’23 and ’24 acquisitions expand our AIR Edge allocation to 20% of the portfolio, which bodes well for future portfolio NOI growth. In 2024, we continue our work to improve the portfolio quality and growth through transaction activity that allocates capital to AIR Edge properties. The class of ’22 joins the same store for ’24. We expect to execute transactions in ’24 to replace and expand that AIR Edge allocation. We are off to a great start in Close Sunnybrook and Raleigh, North Carolina this quarter. To fund these acquisitions, we expect to sell property either outright or JVs to maintain a leverage-neutral position. Our investment philosophy remains the same. We focus on generating a positive spread to our cost of capital and on improving portfolio quality, leveraging our great advantage created by Keith and his team to apply the AIR Edge to generate outsized returns as newly acquired assets benefit from his expertise.

With that, I’ll turn the call over to Paul Beldin, our Chief Financial Officer. Paul?

Paul Beldin: Thank you, Josh. Today I will discuss AIR’s strong and flexible balance sheet, full year 2023 results, our expectations for 2024 and conclude with a brief comment on our dividend. The AIR balance sheet is well-positioned. It is investment grade, long in duration, fixed rate, two-thirds non-recourse, and about 30% loan to value, low leverage when you consider our business is focused on stabilized properties and has no exposure to new construction or mezzanine loans or short-term rentals. We have abundant liquidity with just under $2 billion available, sufficient to refinance substantially all maturing debt through 2027. Fourth quarter leveraged EBITDA was a 10th of a turn above our expectations, a result of opportunistic fourth quarter share repurchases.

I was comfortable ending the year about $45 million above our leverage expectation due to the strength of the balance sheet, anticipated 2024 EBITDA growth that absent changes in leverage, is anticipated to be sufficient to reduce leverage by one-half a turn, and the accretive use of proceeds. The share repurchases are part of a balanced capital allocation program. In the past two years, we have used approximately 25% of our available capital to repurchase 8% of the company at a discount to NAV. To the extent AIR shares continue to trade at a significant discount, NAV, we anticipate that we will continue to allocate a portion of any proceeds raised to repurchase additional shares in a leverage-neutral manner. To support us in this activity, our Board of Directors granted a new $500 million authorization.

As we look to grow the company, we have excellent access to dry powder to fund future acquisitions through our evergreen joint ventures with two large global investors. Turning to full year results. Pro forma FFO equaled the midpoint of guidance at $2.41 per share. Run rate FFO, which excludes costs or income that are not anticipated to recur in future periods, was $2.36 per share, equal to the midpoint of our expectations, and up 7.8% from 2022 and up 20% cumulatively since 2021. Run rate AFFO was $2.09 per share, up 7.7% from 2022 and up 23% cumulatively since 2021. Looking forward, we anticipate that free cash flow and AFFO will grow at a faster rate than NOI and run rate FFO, respectively. As we look forward to of 2024, we expect 2024 run rate AFFO per share at the midpoint will be $2.12, up 1.4% from 2023.

We expect run rate FFO to be $2.38, up 80 basis points from ’23. We expect this growth at the midpoint to be the result of $0.11 per share of incremental contribution from the same store portfolio driven by NOI growth of 3.8%. Result of 3.8% revenue growth previously discussed by Keith, expense growth of 3.8% comprised of controllable operating expense growth of approximately 120 basis points elevated above AIR’s 13-year trend of negative growth by about half of expected CPI. Real estate taxes are expected to increase between 5% and 8%. 2024 is a particularly difficult year to forecast with two contrasting forces at play. Real estate values declined by approximately 30% during the past two years, a result of rising interest rates. While this provides a positive argument when challenging assessments, it is mitigated by continued healthy NOI growth.

While the exact growth rate is subject to some uncertainty, I do know for certain that we’ll be very active in appealing all assessments. Insurance expenses are also difficult to predict. Despite minimal losses being tendered to our carriers during the past decade, our property and casualty insurance costs for like properties increased by approximately 30% in 2023. In 2024, I anticipate a significantly lower rate of growth, the amount of which I’ll be able to address more specifically after our March 1st renewal. Outside of our same-store portfolio, we anticipate 2023 paired trades to result in $0.01 of NOI dilution, but be $0.01 accretive to free cash flow. Please note this calculation compares the NOI loss from properties sold in 2023 to the properties acquired with their proceeds, including the January acquisition of Sunnybrook.

It also includes the benefit from share repurchases. Declared trades are anticipated to be accretive to NOI later this year. We also anticipate interest expense to increase by $0.07, or approximately $11 million year-over-year. I understand that the increase in interest expense was a little more confusing than I anticipated, so let me spend a moment diving into the details. More since the increase is due to higher weighted average interest rates, in 2023, our weighted average interest costs increased from approximately 4.1% at the beginning of the year to 4.3% at the end of the year. As a result, and all else held equal, the effective interest rates are expected to be 21 basis points higher in 2024. The increase was a result of our third quarter refinancing activity which extended duration, but marked our debt to current rates of market interest, accelerating interest expense that would have otherwise occurred in future periods.

Economically, the acceleration neither harmed nor benefited AIR as the swap acceleration income, which is excluded from run rate FFO, offsets the higher interest cost. In order to appropriately reflect 2023 interest expense, we bifurcated the swap acceleration income between the amounts that were attributable 2023 which we include as an offset to ’23 interest expense, and allocated the remainder of the swap income which was otherwise to be earned in 2024 and 2025 through other income and therefore excluded from run rate FFO. The result was to lower fourth quarter interest expense by $2.3 million. For those of you that are annualizing our fourth quarter interest expense as a proxy for 2024 interest expense, you would need to increase our reported $33 million by the $2.3 million.

This results in an annualized expense of $141.2 million. There are then two other adjustments necessary to fourth quarter interest expense to arrive at our $147 million guide for ’24. First, our average effective interest rate increased by 4 — 5 basis points during the fourth quarter due to changes in the mix of our debt driven by increased levels of borrowings. Applying this increase to our 12/31 debt balance, increases 2024 interest expense by additional $1.6 million or $0.01. Second, we anticipate $50 million of incremental borrowings to fund property upgrades and other improvements whose ROI is included in our guidance. The impacted interest expense after consideration of any capitalized interest is approximately $3 million or $0.02. Few other quick notes on guidance.

First, run rate FFO at the midpoint of $2.38 per share is $0.02 above the 2023 run rate FFO, but $0.03 per share below our 2023 pro forma results, which included $0.05 of net earnings that are anticipated to be nonrecurring. Second, third-party service income is anticipated to be about $0.11 per share, $0.06 of which is anticipated to be earned through the execution of our currently in place property and asset management agreements. The remaining $0.05 will be earned from short-duration service income, an amount that is similar to that achieved in 2022 and 2023. Third, as our guidance indicates, we anticipate being active in the transaction market through paired trades and in partnership with our joint venture partners. However, given uncertainties surrounding the cost of capital, volume of transactions, operating plans, and timing, we are not providing additional guidance on the impact of these activities to 2024 results.

Fourth, quarterly leveraged EBITDA will likely fluctuate during the year based on the timing of transactions and changes in EBITDA that is anticipated in 2024 at approximately 6:1. Finally, the AIR Board of Directors declared a quarterly cash dividend $0.45 per share. On an annualized basis, the dividend reflects a yield of 5.7% based on the current share price. With that, we will now open the call for questions. Please limit your questions to two per time in the queue. Operator, I’ll turn it over to you for the first question.

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Q&A Session

Operator: Thank you, Paul. [Operator Instructions] And your first question comes from the line of Eric Wolfe from Citi. Your line is open.

Eric Wolfe: Hey. Thanks for taking the questions. You mentioned that the $0.04 increase was due to your 3Q refinancing activity. I was just wondering if you could give sort of more detail on exactly what that was, what were the amounts, where did the rates go to and from? And just kind of like how you get to that sort of $6 million extra increase in interest expense. I’m just backing to that from the $0.04. Thanks.

Paul Beldin: Yeah, Eric. This is Paul. And there’d be two ways I’d direct you to look at that. The first and probably the quickest and easiest way would be to compare the weighted average interest rate, as disclosed in Schedule 5 for the first and second quarters to our weighted average interest rate in the fourth quarter. If you do that, you’ll see an increase of about 20 basis points. If you apply that 20 basis points to our debt balance at year-end, you get about $6.5 million to $7 million, that’s the $0.04.

Eric Wolfe: Sure. So, I guess I’m asking, but what drove that increase? Meaning, like what drove the 20 basis point increases? It sounds like it’s something you did in third quarter. So what was it in the third quarter that drove that 20 basis point increase?

Paul Beldin: Yeah. There were two items. We refinanced to extend duration of $325 million of term loans that were otherwise coming due in 2024 and 2025 before consideration of extension options and refinanced that $325 million with five-year and seven-year debt that had an average interest rate of about 5.5%, 5.4%. The effective rate on that debt previously was about 4% — 4.1%. The second thing we did in one of our joint venture transactions, our joint venture partner assumed debt, and so that reduced — that was at a lower than market rate of interest which we were paid for in the transaction. But if you just focus solely on the impact to average interest rates, the result of removing that lower cost debt inflated the balance of the portfolio.

Eric Wolfe: Okay. And then just last question. Your 1Q guidance bridge didn’t show sort of any impact from the higher interest expense. Is this something that ends up kicking in later in the year, second quarter through the fourth quarter? Just trying to understand, because it seems like. I understand the offsetting adjustment you made in 2023, but I would think that it would just go to a more normal level in the first quarter of 2024.

Paul Beldin: Eric, that’s a good question. And the reason you don’t see it pop in our bridge walking 4Q results to the first quarter results is that you probably noted in supplemental Schedule 5, we talked about fixing our interest rates on our revolver and also adjusting our hedges to match — better match the maturities of our term loans, and the net effect of that was to give us a little bit of a pop of about a $0.01, $0.015 or so in the first quarter. So that’s why we’re consistent on a 4Q versus 1Q basis. And you’ll see the increase then in Q2 and beyond.

Eric Wolfe: Okay. Thank you.

Operator: And your next question comes from the line of John Kim from BMO Capital Markets. Your line is open.

John Kim: Thank you. One of the takeaways from last quarter was the recent acquisitions that you’ve had. Once it’s on your platform, it would be growing significantly faster than the rest of your same-store pool. So I wanted to focus on your Class of 2022 portfolio as well as other real estate. The Class of 2022, the growth slowed considerably since the last quarter. I realize it’s only four assets. There’s probably some volatility in that. But can you just comment on that slowdown and what you’re expecting for the remainder of the year?

Terry Considine: John, I’ll start and see if Keith wants to add anything. Specifically on Class of ’22, what you’re seeing is the impact of a tax revaluation that was — that occurred in the fourth quarter of 2023. And so that’s — that incremental tax expense is what’s driving the slowdown in NOI growth. Keith, anything you’d add on the revenue side?

Keith Kimmel: Yeah. I think the other thing that I would just point to, John, is that we basically — we could see that the NOI growth of the Class of ’22 is going to be about double that, what we’re seeing in our same-store portfolio as we look forward. So it’s a combination of things. In the early days of that transition, we are repopulating our residents in some degree, repositioning how we staff the communities. There’s a whole series of different things that we go through, and there could be some volatility in those early parts of the year or for about a year or so. And then we start getting into the stabilization of the Air Edge taking hold.

John Kim: And can you remind us what’s in the other real estate bucket, those four assets? And if you see double-digit growth from this group,

Terry Considine: John, the four assets that are included in other real estate are the four properties that we held a leasehold interest in at the separation from Aimco. And Aimco completed their redevelopment, and upon completion of that redevelopment work, we bought out the value of the improvements. And so that occurred in the summer of 2022, and so that — those assets will be included in our same-store pool in 2024. And as far as the expected growth rate relative to the same-store population as a whole, we’d anticipate growth rate in that portfolio to be fairly similar to the legacy same-store population, because Keith and his great team were involved with the lease-up and have been operating those properties from day one.