Extra Space Storage Inc. - Quarter Report: 2014 March (Form 10-Q)

Table of Contents

 

 

UNITED STATES
SECURITIES 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 March 31, 2014

 

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)

 

 

2795 East Cottonwood Parkway, Suite 400

Salt Lake City, Utah 84121

(Address of principal executive offices)

 

Registrant’s telephone number, including area code:  (801) 365-4600

 

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

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 April 30, 2014, was 115,942,427.

 

 

Table of Contents

 

EXTRA SPACE STORAGE INC.

TABLE OF CONTENTS

 

STATEMENT ON FORWARD-LOOKING INFORMATION	3
PART I. FINANCIAL INFORMATION	4
ITEM 1. FINANCIAL STATEMENTS	4
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)	10
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	35
ITEM 1. LEGAL PROCEEDINGS	35
ITEM 1A. RISK FACTORS	35
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	35
ITEM 3. DEFAULTS UPON SENIOR SECURITIES	35
ITEM 4. MINE SAFETY DISCLOSURES	35
ITEM 5. OTHER INFORMATION	36
ITEM 6. EXHIBITS	36
SIGNATURES	37

 

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STATEMENT ON FORWARD-LOOKING INFORMATION

 

Certain information presented 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 estimates 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:

 

·                  adverse changes in general economic conditions, the real estate industry and the markets in which we operate;

 

·                  failure to close pending acquisitions on expected terms, or at all;

 

·                  the effect of competition from new and existing self-storage facilities or other storage alternatives, which could cause rents and occupancy rates to decline;

 

·                  difficulties in our ability to evaluate, finance, complete and integrate acquisitions and developments successfully and to lease up those properties, which could adversely affect our profitability;

 

·                  potential liability for uninsured losses and environmental contamination;

 

·                  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 (“REITs”), tenant reinsurance and other aspects of our business, which could adversely affect our results;

 

·                  disruptions in credit and financial markets and resulting difficulties in raising capital or obtaining credit at reasonable rates or at all, which could impede our ability to grow;

 

·                  increased interest rates and operating costs;

 

·                  reductions in asset valuations and related impairment charges;

 

·                  the failure of our joint venture partners to fulfill their obligations to us or their pursuit of actions that are inconsistent with our objectives;

 

·                  the failure to maintain our REIT status for federal income tax purposes;

 

·                  economic uncertainty due to the impact of war or terrorism, which could adversely affect our business plan; and

 

·                  difficulties in our ability to attract and retain qualified personnel and management members.

 

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PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

Extra Space Storage Inc.

Condensed Consolidated Balance Sheets

(amounts in thousands, except share data)

 

		March 31, 2014			December 31, 2013
		(Unaudited)
Assets:
Real estate assets, net		$	3,862,679		$	3,636,544
Investments in unconsolidated real estate ventures		89,326			88,125
Cash and cash equivalents		47,015			126,723
Restricted cash		20,026			21,451
Receivables from related parties and affiliated real estate joint ventures		8,966			7,542
Other assets, net		95,479			96,755
Total assets		$	4,123,491		$	3,977,140
Liabilities, Noncontrolling Interests and Equity:
Notes payable		$	1,664,872		$	1,588,596
Premium on notes payable		4,053			4,948
Exchangeable senior notes		250,000			250,000
Discount on exchangeable senior notes		(15,637		)	(16,487		)
Notes payable to trusts		119,590			119,590
Lines of credit		87,000			—
Accounts payable and accrued expenses		52,886			60,601
Other liabilities		37,543			37,997
Total liabilities		2,200,307			2,045,245
Commitments and contingencies
Noncontrolling Interests and Equity:
Extra Space Storage Inc. stockholders’ equity:
Preferred stock, $0.01 par value, 50,000,000 shares authorized, no shares issued or outstanding		—			—
Common stock, $0.01 par value, 300,000,000 shares authorized, 115,869,909 and 115,755,527 shares issued and outstanding at March 31, 2014 and December 31, 2013, respectively		1,158			1,157
Paid-in capital		1,976,597			1,973,159
Accumulated other comprehensive income		7,528			10,156
Accumulated deficit		(235,009		)	(226,002		)
Total Extra Space Storage Inc. stockholders’ equity		1,750,274			1,758,470
Noncontrolling interest represented by Preferred Operating Partnership units, net of $100,000 note receivable		80,843			80,947
Noncontrolling interests in Operating Partnership		91,042			91,453
Other noncontrolling interests		1,025			1,025
Total noncontrolling interests and equity		1,923,184			1,931,895
Total liabilities, noncontrolling interests and equity		$	4,123,491		$	3,977,140

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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Extra Space Storage Inc.

Condensed Consolidated Statements of Operations

(amounts in thousands, except share data)

(unaudited)

 

		For the Three Months Ended March 31,
		2014			2013
Revenues:
Property rental		$	132,001		$	102,923
Tenant reinsurance		13,463			10,221
Management fees		6,716			6,178
Total revenues		152,180			119,322
Expenses:
Property operations		43,482			34,437
Tenant reinsurance		2,567			1,910
Acquisition related costs		2,056			452
General and administrative		15,302			12,769
Depreciation and amortization		28,375			23,025
Total expenses		91,782			72,593
Income from operations		60,398			46,729
Interest expense		(19,598		)	(17,366		)
Non-cash interest expense related to amortization of discount on equity component of exchangeable senior notes		(662		)	—
Interest income		269			184
Interest income on note receivable from Preferred Operating Partnership unit holder		1,213			1,213
Income before equity in earnings of unconsolidated real estate ventures and income tax expense		41,620			30,760
Equity in earnings of unconsolidated real estate ventures		2,419			2,623
Equity in earnings of unconsolidated real estate ventures - purchase of joint venture partners’ interests		—			2,556
Income tax expense		(2,830		)	(2,008		)
Net income		41,209			33,931
Net income allocated to Preferred Operating Partnership noncontrolling interests		(2,492		)	(1,717		)
Net income allocated to Operating Partnership and other noncontrolling interests		(1,377		)	(789		)
Net income attributable to common stockholders		$	37,340		$	31,425
Earnings per common share
Basic		$	0.32		$	0.28
Diluted		$	0.32		$	0.28
Weighted average number of shares
Basic		115,438,325			110,314,668
Diluted		121,062,845			114,967,087
Cash dividends paid per common share		$	0.40		$	0.25

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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Extra Space Storage Inc.

Condensed Consolidated Statements of Comprehensive Income

(amounts in thousands)

(unaudited)

 

		For the Three Months Ended March 31,
		2014			2013
Net income		$	41,209		$	33,931
Other comprehensive income (loss):
Change in fair value of interest rate swaps		(2,747		)	1,571
Total comprehensive income		38,462			35,502
Less: comprehensive income attributable to noncontrolling interests		3,750			2,563
Comprehensive income attributable to common stockholders		$	34,712		$	32,939

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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Extra Space Storage Inc.

Condensed Consolidated Statement of Equity

(amounts in thousands, except share data)

(unaudited)

 

		Noncontrolling Interests															Extra Space Storage Inc. Stockholders’ Equity
		Preferred Operating Partnership									Operating														Accumulated Other Comprehensive			Accumulated			Total Noncontrolling Interests and
		Series A			Series B			Series C			Partnership			Other			Shares		Par Value			Paid-in Captial			Income			Deficit			Equity
Balances at December 31, 2013		$	30,202		$	33,568		$	17,177		$	91,453		$	1,025		115,755,527		$	1,157		$	1,973,159		$	10,156		$	(226,002	)	$	1,931,895
Issuance of common stock upon the exercise of options		—			—			—			—			—			69,265		1			1,055			—			—			1,056
Restricted stock grants issued		—			—			—			—			—			47,000		—			—			—			—			—
Restricted stock grants cancelled		—			—			—			—			—			(1,883	)	—			—			—			—			—
Compensation expense related to stock-based awards		—			—			—			—			—			—		—			1,121			—			—			1,121
Net income		1,751			504			237			1,377			—			—		—			—			—			37,340			41,209
Other comprehensive income		(22		)	—			—			(97		)	—			—		—			—			(2,628		)	—			(2,747		)
Tax effect from vesting of restricted stock grants and stock option exercises		—			—			—			—			—			—		—			1,262			—			—			1,262
Distributions to Operating Partnership units held by noncontrolling interests		(1,833		)	(504		)	(237		)	(1,691		)	—			—		—			—			—			—			(4,265		)
Dividends paid on common stock at $0.40 per share		—			—			—			—			—			—		—			—			—			(46,347		)	(46,347		)
Balances at March 31, 2014		$	30,098		$	33,568		$	17,177		$	91,042		$	1,025		115,869,909		$	1,158		$	1,976,597		$	7,528		$	(235,009	)	$	1,923,184

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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Extra Space Storage Inc.

Condensed Consolidated Statements of Cash Flows

(amounts in thousands)

(unaudited)

 

		For the Three Months Ended March 31,
		2014			2013
Cash flows from operating activities:
Net income		$	41,209		$	33,931
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		28,375			23,025
Amortization of deferred financing costs		1,641			1,510
Non-cash interest expense related to amortization of discount on equity component of exchangeable senior notes		662			—
Non-cash interest expense related to amortization of premium on notes payable		(895		)	(565		)
Compensation expense related to stock-based awards		1,121			1,023
Gain on purchase of joint venture partners’ interests		—			(2,556		)
Distributions from unconsolidated real estate ventures in excess of earnings		1,024			1,154
Changes in operating assets and liabilities:
Receivables from related parties and affiliated real estate joint ventures		(1,424		)	(277		)
Other assets		1,448			1,051
Accounts payable and accrued expenses		(7,715		)	(6,864		)
Other liabilities		(874		)	(316		)
Net cash provided by operating activities		64,572			51,116
Cash flows from investing activities:
Acquisition, development and redevelopment of real estate assets		(256,759		)	(18,754		)
Investments in unconsolidated real estate ventures		—			(589		)
Change in restricted cash		1,425			(3,181		)
Purchase of equipment and fixtures		(1,274		)	(821		)
Net cash used in investing activities		(256,608		)	(23,345		)
Cash flows from financing activities:
Proceeds from notes payable and lines of credit		291,157			81,776
Principal payments on notes payable and lines of credit		(127,881		)	(74,912		)
Deferred financing costs		(1,392		)	(1,340		)
Redemption of Operating Partnership units held by noncontrolling interest		—			(20		)
Net proceeds from exercise of stock options		1,056			1,635
Dividends paid on common stock		(46,347		)	(27,730		)
Distributions to noncontrolling interests		(4,265		)	(2,390		)
Net cash provided by (used in) financing activities		112,328			(22,981		)
Net (decrease) increase in cash and cash equivalents		(79,708		)	4,790
Cash and cash equivalents, beginning of the period		126,723			30,785
Cash and cash equivalents, end of the period		$	47,015		$	35,575

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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Extra Space Storage Inc.

Condensed Consolidated Statements of Cash Flows

(amounts in thousands)

(unaudited)

 

		For the Three Months Ended March 31,
		2014			2013
Supplemental schedule of cash flow information
Interest paid, net of amounts capitalized		$	16,445		$	15,909
Income taxes paid		1,244			589
Supplemental schedule of noncash investing and financing activities:
Tax effect from vesting of restricted stock grants and option exercises
Other assets		$	1,262		$	—
Paid-in capital		(1,262		)	—
Acquisitions of real estate assets
Real estate assets, net		$	—		$	2,251
Receivables from related parties and affiliated real estate joint ventures		—			(2,251		)

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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EXTRA SPACE STORAGE INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

Amounts in thousands, except property and share data, unless otherwise stated

 

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, develop and redevelop professionally managed 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, (“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 wholly-owned facilities or by acquiring an equity interest in real estate entities.  At March 31, 2014, the Company had direct and indirect equity interests in 800 operating storage facilities.  In addition, the Company managed 252 properties for third parties, bringing the total number of operating properties which it owns and/or manages to 1,052.  These properties are located in 35 states, Washington, D.C. and Puerto Rico.

 

The Company operates in three distinct segments: (1) rental operations; (2) tenant reinsurance; and (3) property management, acquisition and development. The rental operations activities include rental operations of self-storage facilities in which we have an ownership interest. No single tenant accounts for more than 5% of rental income.  Tenant reinsurance activities include the reinsurance of risks relating to the loss of goods stored by tenants in the Company’s self-storage facilities. The Company’s property management, acquisition and development activities include managing, acquiring, developing and selling self-storage facilities.

 

2.              BASIS OF PRESENTATION

 

The accompanying unaudited condensed consolidated financial statements of the Company are presented on the accrual basis of accounting 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 may not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (including normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2014, are not necessarily indicative of results that may be expected for the year ending December 31, 2014. The condensed consolidated balance sheet as of December 31, 2013 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, 2013, as filed with the Securities and Exchange Commission.

 

Certain amounts in the Company’s 2013 consolidated financial statements and supporting note disclosures have been reclassified to conform to the current period presentation.  Such reclassifications did not impact previously reported net income or accumulated deficit.

 

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3.              FAIR VALUE DISCLOSURES

 

Derivative Financial Instruments

 

Currently, the Company uses interest rate swaps to manage its interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves. The fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash payments and the discounted expected variable cash receipts. The variable cash receipts are based on an expectation of future interest rates (forward curves) derived from observable market interest rate forward curves.

 

The Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees. In conjunction with the Financial Accounting Standards Board’s fair value measurement guidance, the Company made an accounting policy election to measure the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio.

 

Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by the Company and its counterparties. However, as of March 31, 2014, the Company had assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and determined that the credit valuation adjustments were not significant to the overall valuation of its derivatives. As a result, the Company determined that its derivative valuations in their entirety were classified in Level 2 of the fair value hierarchy.

 

The table below presents the Company’s assets and liabilities measured at fair value on a recurring basis as of March 31, 2014, aggregated by the level in the fair value hierarchy within which those measurements fall.

 

					Fair Value Measurements at Reporting Date Using
Description		March 31, 2014			Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Other assets - Cash Flow Hedge Swap Agreements		$	10,281		$	—		$	10,281		$	—
Other liabilities - Cash Flow Hedge Swap Agreements		$	(3,083	)	$	—		$	(3,083	)	$	—

 

There were no transfers of assets and liabilities between Level 1 and Level 2 during the three months ended March 31, 2014.  The Company did not have any significant assets or liabilities that are re-measured on a recurring basis using significant unobservable inputs as of March 31, 2014 or December 31, 2013.

 

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

 

Long-lived assets held for use are evaluated for impairment when events or circumstances indicate there may be impairment.  The Company reviews each self-storage facility at least annually to determine if any such events or circumstances have occurred or exist. The Company focuses on facilities where occupancy and/or rental income have decreased by a significant amount.  For these facilities, the Company determines whether the decrease is temporary or permanent, and whether the facility will likely recover the lost occupancy and/or revenue in the short term.  In addition, the Company carefully reviews facilities in the lease-up stage and compares actual operating results to original projections.

 

When the Company determines that an event that may indicate impairment has occurred, the Company compares the carrying value of the related long-lived assets to the undiscounted future net operating cash flows attributable to the assets.  An impairment loss is recorded if the net carrying value of the assets exceeds the undiscounted future net operating cash flows attributable to the assets.  The impairment loss recognized equals the excess of net carrying value over the related fair value of the assets.

 

When real estate assets are identified by management as held for sale, the Company discontinues depreciating the assets and estimates the fair value of the assets, net of selling costs.  If the estimated fair value, net of selling costs, of the assets that have been identified as held for sale is less than the net carrying value of the assets, then a valuation allowance is established.  The operations of assets held for sale or sold during the period are generally presented as discontinued operations for all periods presented.

 

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The Company assesses whether there are any indicators that the value of its investments in unconsolidated real estate ventures may be impaired annually and when events or circumstances indicate there may be impairment.  An investment is impaired if management’s estimate of the fair value of the investment is less than its carrying value.  To the extent impairment has occurred, and is considered to be other than temporary, the loss is measured as the excess of the carrying amount over the fair value of the investment.

 

In connection with the Company’s acquisition of self-storage facilities, the purchase price is allocated to the tangible and intangible assets and liabilities acquired based on their fair values, which are estimated using significant unobservable inputs. The value of the tangible assets, consisting of land and buildings, is determined as if vacant. Intangible assets, which represent the value of existing tenant relationships, are recorded at their fair values based on the avoided cost to replace the current leases. The Company measures the value of tenant relationships based on the rent lost due to the amount of time required to replace existing customers, which is based on the Company’s historical experience with turnover in its facilities. Debt assumed as part of an acquisition is recorded at fair value based on current interest rates compared to contractual rates. Acquisition-related transaction costs are expensed as incurred.

 

Fair Value of Financial Instruments

 

The carrying values of cash and cash equivalents, restricted cash, receivables, other financial instruments included in other assets, accounts payable and accrued expenses, variable-rate notes payable, lines of credit and other liabilities reflected in the condensed consolidated balance sheets at March 31, 2014 and December 31, 2013 approximate fair value.

 

The fair value of the Company’s note receivable from Preferred Operating Partnership unit holders was based on the discounted estimated future cash flows of the note (categorized within Level 3 of the fair value hierarchy); the discount rate used approximated the current market rate for loans with similar maturities and credit quality.  The fair values of the Company’s fixed-rate notes payable and notes payable to trusts were estimated using the discounted estimated future cash payments to be made on such debt (categorized within Level 3 of the fair value hierarchy); the discount rates used approximated current market rates for loans, or groups of loans, with similar maturities and credit quality.  The fair value of the Company’s exchangeable senior notes was estimated using an average market price for similar securities obtained from a third party.

 

The fair values of the Company’s fixed-rate assets and liabilities were as follows for the periods indicated:

 

		March 31, 2014						December 31, 2013
		Fair			Carrying			Fair			Carrying
		Value			Value			Value			Value
Note receivable from Preferred Operating Partnership unit holders		$	100,497		$	100,000		$	103,491		$	100,000
Fixed rate notes payable and notes payable to trusts		$	1,334,941		$	1,325,113		$	1,365,290		$	1,368,885
Exchangeable senior notes		$	262,343		$	250,000		$	251,103		$	250,000

 

4.              EARNINGS PER COMMON SHARE

 

Basic earnings per common share is computed using the two-class method by dividing net income attributable to common stockholders by the weighted average number of common shares outstanding during the period.  All outstanding unvested restricted stock awards contain rights to non-forfeitable dividends and participate in undistributed earnings with common stockholders; accordingly, they are considered participating securities that are included in the two-class method.  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 weighted average number of basic shares and 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 two-class, treasury stock or as if-converted method, whichever is most dilutive. Potential common shares are securities (such as options, convertible debt, exchangeable Series A Participating Redeemable Preferred Units (“Series A Units”) and Series B Redeemable Preferred Units (“Series B Units”), redeemable and convertible Series C Convertible Redeemable Preferred Units (“Series C Units”) and redeemable common Operating Partnership units (“OP Units”)) that do not have a current right to participate in earnings of the Company but could do so in the future by virtue of their option, redemption or conversion right. In computing the dilutive effect of convertible securities, net income 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 common share, only potential common shares that are dilutive (those that reduce earnings per share) are included.  For the three months ended March 31, 2014 and 2013, options to purchase approximately 18,100 and 24,950 shares, respectively, were excluded from the computation of earnings per share as their effect would have been anti-dilutive.

 

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The Operating Partnership had $250,000 of its 2.375% Exchangeable Senior Notes due 2033 (the “Notes”) issued and outstanding as of March 31, 2014.  The Notes could potentially have a dilutive effect on the Company’s earnings per common share calculations.  The Notes are exchangeable by holders into shares of the Company’s common stock under certain circumstances per the terms of the indenture governing the Notes.  The exchange price of the Notes was $55.69 per share as of March 31, 2014, and could change over time as described in the indenture.  The Company has irrevocably agreed to pay only cash for the accreted principal amount of the Notes relative to its exchange obligations, but retained the right to satisfy the exchange obligation in excess of the accreted principal amount in cash and/or common stock.  Though the Company has retained that right, Accounting Standards Codification (“ASC”) 260, “Earnings per Share,” requires an assumption that shares would be used to pay the exchange obligation 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 the diluted earnings per share computation.  For the three months ended March 31, 2014, no shares related to the Notes were included in the computation for diluted earnings per common share as the per share price of the Company’s common stock during this period did not exceed the exchange price.

 

For the purposes of computing the diluted impact on earnings per common share of the potential exchange of Series A Units for common shares upon redemption, where the Company has the option to redeem in cash or shares and where the Company has stated the positive intent and ability to settle at least $115,000 of the instrument in cash (or net settle a portion of the Series A Units against the related outstanding note receivable), only the amount of the instrument in excess of $115,000 is considered in the calculation of shares contingently issuable for the purposes of computing diluted earnings per common share as allowed by ASC 260-10-45-46.

 

For the purposes of computing the diluted impact on earnings per common share of the potential exchange of Series B Units for common shares upon redemption, where the Company has the option to redeem in cash or shares and where the Company has stated the ability to settle the redemption in shares, the Company divided the total value of the Series B Units outstanding as of March 31, 2014 of $33,568 by the average closing price of the Company’s common stock for the three months ended March 31, 2014 of $46.35 per share.  Assuming full exchange for common shares as of March 31, 2014, 724,232 shares would have been issued to holders of the Series B Units.  These shares were excluded from the computation of earnings per share as their effect would have been anti-dilutive.

 

For the purposes of computing the diluted impact on earnings per common share of the potential exchange of Series C Units for common shares upon redemption, where the Company has the option to redeem in cash or shares and where the Company has stated the ability to settle the redemption in shares, the Company divided the total value of the Series C Units outstanding as of March 31, 2014 of $17,177 by the average closing price of the Company’s common stock for the three months ended March 31, 2014 of $46.35 per share.  Assuming full exchange for common shares as of March 31, 2014, 370,585 shares would have been issued to holders of the Series C Units.  These shares were excluded from the computation of earnings per share as their effect would have been anti-dilutive.

 

The computation of earnings per common share was as follows for the periods presented:

 

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		For the Three Months Ended March 31,
		2014			2013
Net income attributable to common stockholders		$	37,340		$	31,425
Earnings and dividends allocated to participating securities		(117		)	(120		)
Earnings for basic computations		37,223			31,305
Earnings and dividends allocated to participating securities		—			120
Add: Income allocated to noncontrolling interest - Preferred Operating Partnership (Series A Units) and Operating Partnership		3,128			2,494
Subtract: Fixed component of income allocated to noncontrolling interest - Preferred Operating Partnership (Series A Units)		(1,438		)	(1,438		)
Net income for diluted computations		$	38,913		$	32,481
Weighted average common shares outstanding:
Average number of common shares outstanding - basic		115,438,325			110,314,668
Series A Units		989,980			989,980
Common OP Units		4,334,118			2,755,650
Unvested restricted stock awards included for treasury stock method		—			495,256
Dilutive stock options		300,422			411,533
Average number of common shares outstanding - diluted		121,062,845			114,967,087
Earnings per common share
Basic		$	0.32		$	0.28
Diluted		$	0.32		$	0.28

 

5.              PROPERTY ACQUISITIONS

 

The following table summarizes the Company’s acquisitions of operating properties for the three months ended March 31, 2014, and does not include purchases of raw land or improvements made to existing assets:

 

						Consideration Paid									Acquisition Date Fair Value
Property Location		Number of Properties		Date of Acquisition		Total			Cash Paid			Net Liabilities/ (Assets) Assumed			Land			Building			Intangible			Closing costs - expensed			Notes
Virginia		17		1/7/2014		$	200,588		$	200,525		$	63		$	53,878		$	142,840		$	2,973		$	897
Texas		1		2/5/2014		14,191			14,152			39			1,767			12,368			38			18
California		1		3/4/2014		7,000			6,974			26			2,150			4,734			113			3			(1)
Connecticut		1		3/17/2014		15,138			15,169			(31		)	1,072			14,028			—			38
Alabama		1		3/20/2014		13,813			13,752			61			2,381			11,224			200			8
2014 Totals		21				$	250,730		$	250,572		$	158		$	61,248		$	185,194		$	3,324		$	964

 

(1) This property was owned by Spencer F. Kirk, the Company’s Chief Executive Officer, and Kenneth M. Woolley, the Company’s Executive Chairman.  The Company acquired the building on March 4, 2014.  In a separate transaction on March 5, 2014, the Company acquired the land for $2,150 from a third party unrelated to the Company’s executives and terminated the existing ground lease.

 

6.              VARIABLE INTERESTS

 

The Company has an interest in one unconsolidated joint venture with an unrelated third party which is a variable interest entity (“VIE”). The Company holds an 18% equity interest and a 50% profit interest in the VIE joint venture (“VIE JV”), and has 50% of the voting rights in the VIE JV. Qualification as a VIE was based on the determination that the equity investment at risk for this joint venture was not sufficient based on a qualitative and quantitative analysis performed by the Company. The Company performed a qualitative analysis for the joint venture to determine which party was the primary beneficiary. The Company determined that since the powers to direct the activities most significant to the economic performance of the entity are shared equally by the Company and its joint venture partner, there is no primary beneficiary. Accordingly, the interest is recorded using the equity method.

 

The VIE JV owns a single self-storage property. This joint venture is financed through a combination of (1) equity contributions from the Company and its joint venture partner and (2) amounts payable to the Company. The amounts payable to the Company consist of expenses paid on behalf of the joint venture by the Company as manager and mortgage notes payable to the Company. The Company

 

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performs management services for the VIE JV in exchange for a management fee of approximately 6% of cash collected by the property. Except as disclosed, the Company has not provided financial or other support during the periods presented to the VIE JV that it was not previously contractually obligated to provide.

 

The Company’s maximum exposure to loss for this joint venture as of March 31, 2014 is the total of the amounts payable to the Company and the Company’s investment balance in the joint venture. The Company believes that the risk of incurring a material loss as a result of its investment in the property is unlikely and, therefore, no liability has been recorded. Also, repossessing and/or selling the self-storage facility and land that collateralize the amounts payable to the Company could provide funds sufficient to reimburse the Company.

 

The following table compares the liability balance and the maximum exposure to loss related to the Company’s VIE JV as of March 31, 2014:

 

								Amounts			Maximum
		Liability			Investment			Payable to the			Exposure
		Balance			Balance			Company			to Loss			Difference
Extra Space of Sacramento One LLC		$	—		$	(1,107	)	$	10,547		$	9,440		$	(9,440	)

 

The Operating Partnership has three wholly-owned unconsolidated subsidiaries (“Trust,” “Trust II” and “Trust III,” together, the “Trusts”) that have issued trust preferred securities to third parties and common securities to the Operating Partnership.  The proceeds from the sale of the preferred and common securities were loaned in the form of notes to the Operating Partnership.  The Trusts are VIEs because the holders of the equity investment at risk (the trust preferred securities) do not have the power to direct the activities of the entities that most significantly affect the entities’ economic performance because of their lack of voting or similar rights.  Because the Operating Partnership’s investment in the Trusts’ common securities was financed directly by the Trusts as a result of its loan of the proceeds to the Operating Partnership, that investment is not considered an equity investment at risk.  The Operating Partnership’s investment in the Trusts is not a variable interest because equity interests are variable interests only to the extent that the investment is considered to be at risk, and therefore the Operating Partnership cannot be the primary beneficiary of the Trusts.  Since the Company is not the primary beneficiary of the Trusts, they have not been consolidated.  A debt obligation has been recorded in the form of notes for the proceeds as discussed above, which are owed to the Trusts.  The Company has also included its investment in the Trusts’ common securities in other assets on the condensed consolidated balance sheets.

 

The Company has not provided financing or other support during the periods presented to the Trusts that it was not previously contractually obligated to provide.  The Company’s maximum exposure to loss as a result of its involvement with the Trusts is equal to the total amount of the notes discussed above less the amounts of the Company’s investments in the Trusts’ common securities.  The net amount is the notes payable that the Trusts owe to third parties for their investments in the Trusts’ preferred securities.

 

Following is a tabular comparison of the liabilities the Company has recorded as a result of its involvement with the Trusts to the maximum exposure to loss the Company is subject to as a result of such involvement as of March 31, 2014:

 

		Notes payable			Investment			Maximum
		to Trusts			Balance			exposure to loss			Difference
Trust		$	36,083		$	1,083		$	35,000		$	—
Trust II		42,269			1,269			41,000			—
Trust III		41,238			1,238			40,000			—
		$	119,590		$	3,590		$	116,000		$	—

 

The Company had no consolidated VIEs during the three months ended March 31, 2014.

 

7.              DERIVATIVES

 

The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity and credit risk primarily by managing the amount, sources and duration of its debt funding and by using derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposure that arises from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s investments and borrowings.

 

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Cash Flow Hedges of Interest Rate Risk

 

The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish these objectives, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.

 

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income (“OCI”) and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings.  A portion of these changes is excluded from accumulated other comprehensive income as it is allocated to noncontrolling interests.  During the three months ended March 31, 2014 and 2013, such derivatives were used to hedge the variable cash flows associated with existing variable-rate debt.

 

The following table summarizes the terms of the Company’s 22 derivative financial instruments as of March 31, 2014:

 

Hedge Product		Current Notional Amounts		Strike		Effective Dates		Maturity Dates
Swap Agreements		$4,749 - $95,739		2.79% - 6.32%		7/1/2009 - 1/1/2014		7/1/2014 - 4/1/2021

 

Fair Values of Derivative Instruments

 

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the condensed consolidated balance sheets:

 

		Asset (Liability) Derivatives
		March 31, 2014					December 31, 2013
Derivatives designated as		Balance Sheet		Fair			Balance Sheet		Fair
hedging instruments:		Location		Value			Location		Value
Swap Agreements		Other assets		$	10,281		Other assets		$	13,630
Swap Agreements		Other liabilities		$	(3,083	)	Other liabilities		$	(3,684	)

 

Effect of Derivative Instruments

 

The tables below present the effect of the Company’s derivative financial instruments on the condensed consolidated statements of operations for the periods presented. No tax effect has been presented as the derivative instruments are held by the Company:

 

		Classification of		For the Three Months Ended March 31,
Type		Income (Expense)		2014			2013
Swap Agreements		Interest expense		$	(2,293	)	$	(2,153	)

 

		Gain (loss)			Location of amounts		Gain (loss) reclassified from OCI
		recognized in OCI			reclassified from OCI		For the Three Months
Type		March 31, 2014			into income		Ended March 31, 2014
Swap Agreements		$	(5,040	)	Interest expense		$	(2,293	)

 

		Gain (loss)			Location of amounts		Gain (loss) reclassified from OCI
		recognized in OCI			reclassified from OCI		For the Three Months
Type		March 31, 2013			into income		Ended March 31, 2013
Swap Agreements		$	(582	)	Interest expense		$	(2,153	)

 

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Credit-risk-related Contingent Features

 

The Company has agreements with some of its derivative counterparties that contain provisions pursuant to which, the Company could be declared in default of its derivative obligations if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender.

 

The Company also has an agreement with some of its derivative counterparties that incorporates the loan covenant provisions of the Company’s indebtedness with a lender affiliate of the derivative counterparty. Failure to comply with the loan covenant provisions would result in the Company being in default on any derivative instrument obligations covered by the agreement.

 

As of March 31, 2014, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk related to these agreements, was $3,083. As of March 31, 2014, the Company had not posted any collateral related to these agreements. If the Company had breached any of these provisions as of March 31, 2014, it could have been required to settle its obligations under the agreements at their termination value of $3,374.

 

8.              EXCHANGEABLE SENIOR NOTES

 

On June 21, 2013, the Operating Partnership issued $250,000 of its 2.375% Exchangeable Senior Notes due 2033 at a 1.5% discount, or $3,750.  Costs incurred to issue the Notes were approximately $1,672.  These costs are being amortized as an adjustment to interest expense over five years, which represents the estimated term based on the first available redemption date, and are included in other assets in the condensed consolidated balance sheets.  The Notes are general unsecured senior obligations of the Operating Partnership and are fully guaranteed by the Company.  Interest is payable on January 1 and July 1 of each year beginning January 1, 2014, until the maturity date of July 1, 2033.  The Notes bear interest at 2.375% per annum and contain an exchange settlement feature, which provides that the Notes may, under certain circumstances, be exchangeable for cash (for the principal amount of the Notes) and, with respect to any excess exchange value, for cash, shares of the Company’s common stock, or a combination of cash and shares of the Company’s common stock, at the Company’s option.  The initial exchange rate of the Notes is approximately 17.96 shares of the Company’s common stock per $1,000 principal amount of the Notes.

 

The Operating Partnership may redeem the Notes at any time to preserve the Company’s status as a REIT.  In addition, on or after July 5, 2018, 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 the 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 July 1 of the years 2018, 2023, and 2028, and upon the occurrence of certain designated events, 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.

 

GAAP requires entities with convertible debt instruments that may be settled entirely or partially in cash upon conversion to separately account for the liability and equity components of the instrument in a manner that reflects the issuer’s economic interest cost.  The Company therefore accounts for the liability and equity components of the Notes separately.  The equity component is included in paid-in capital in stockholders’ equity in the condensed consolidated balance sheets, and the value of the equity component is treated as original issue discount for purposes of accounting for the debt component.  The discount is being amortized as interest expense over the remaining period of the debt through its first redemption date, July 1, 2018. The effective interest rate on the liability component is 4.0%.

 

Information about the carrying amount of the equity component, the principal amount of the liability component, its unamortized discount and its net carrying amount for the Notes was as follows for the periods indicated:

 

		March 31, 2014			December 31, 2013
Carrying amount of equity component		$	(14,496	)	$	(14,496	)
Principal amount of liability component		$	250,000		$	250,000
Unamortized discount - equity component		(12,469		)	(13,131		)
Unamortized cash discount		(3,168		)	(3,356		)
Net carrying amount of liability component		$	234,363		$	233,513

 

The amount of interest cost recognized relating to the contractual interest rate and the amortization of the discount on the liability component of the Notes were as follows for the periods indicated:

 

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