First Industrial Realty Trust, Inc. (FR) Earnings Call Transcript & Summary

Everyone, welcome to the 5:10 p.m. and final session at Citi's -- at the second day of Citi's 2020 Global Property CEO Conference. I'm Manny Korchman with Citi Research. Pleased to have with us First Industrial's CEO, Peter Baccile. Session is for investing clients only, and if media or other individuals are on the line, please disconnect now. Disclosures are available here and on the webcast. Here in the room or on the webcast, please use liveqa.com, enter code, [ Citi2020 ] to submit any questions. Peter, I'll turn it over to you to introduce your company and management team. Please provide the audience 3 reasons why investors should buy your stock today. Thanks.

All right. Thank you. Good afternoon, everyone. Thanks for joining our session today, and thanks to you, Manny and to Michael and the whole Citi team, for the opportunity to participate again this year. With me today are Jojo Yap, our Chief Investment Officer; Scott Musil, our Chief Financial Officer; and Art Harmon, our Vice President of Investor Relations and Marketing. For those of you that don't know us very well, First Industrial is a U.S.-only industrial REIT operating in the nation's top markets. And we have a pretty straightforward business model. We serve our customers' logistics needs and drive cash flow by owning, developing and acquiring high-quality, well-located logistics facilities. Our occupancy was 97.6% at year-end, which shows the strength of our portfolio and our business as well as continued growth in e-commerce and in the economy overall. Rent growth has been strong in our markets and in our portfolio. We delivered 13.9% cash rental rate growth in 2019, a new record for our company. And our forecast for 2020 is for more of the same, with rents for new and renewal leasing expected to grow 10% to 14%. Rent growth in coastal markets continues to significantly outpace the national average, and that is certainly true in Southern California. Southern California is our largest market and accounted for 20% of our rental income in Q4 in 2019. We've also been allocating capital to other higher-barrier markets, including South Florida, where we have several new exciting investments underway. At First Industrial, portfolio management is an integral component of our value proposition where we focus on monetizing lower-growth assets to free capital to invest in higher cash flow growth and value-generating opportunities. From 2010 through year-end 2019, the ins and outs in our portfolio have totaled approximately $3.8 billion with $2.2 billion of developments and acquisitions and $1.6 billion of sales. Our recent sales have further refined our portfolio and footprint, as we effectively exited the Indianapolis, St. Louis and Tampa markets. The results of our efforts have been reflected in our long-term performance. Over the past 10 years, First Industrial ranked #3 of all real estate companies tracked by REIT zone with a compounded average annual total return of 25.1%. Our total market capitalization today is approximately $6.8 billion. We think our size is a competitive advantage. We're large enough to have operational scale, yet small enough to remain agile and well positioned to quickly capitalize on opportunities in our target markets, opportunities which significantly move the needle in terms of cash flow growth and value creation. We have been deploying capital primarily in speculative development in our target markets. Through our team's strong efforts, we produced industry-leading margins for the past several years. This included margins of 42% to 52% for the $325 million of developments we placed in service in 2019, representing approximately $1.18 per share in NAV creation. We expect to produce similar margins on our current pipeline of developments in lease-up and under construction if we achieve our underwriting. I'll wrap up with one last point. Cash flow growth and value creation over the long term is part of our identity. At our last Investor Day in November 2017, we put forth a goal of achieving $200 million in AFFO by the end of 2020. If we achieve the midpoint of our 2020 guidance, we will deliver on that goal and will have achieved cash flow growth of 9% per annum over the 3-year period. In addition, we've significantly grown our dividend over the period, including the 8.7% increase for Q1 '20 versus the prior period. Three reasons to own our stock. First of all, we all have tremendous cash flow growth opportunity, but we also have a proven track record of value creation and development. Over the last 4 years, we've invested $800 million at a 7.3% yield and a 60-plus or minus percent margin. You can refer to Page 17 in the deck that's online for that. Secondly, very strong cash flow growth, 13.9% last year and targeting 10% to 14% this year. And lastly, we still believe there's a valuation gap that's unwarranted between where we trade and the peer group trades. The reconfiguration of our portfolio that I took you through has been highly successful, and I refer you to Page 8 in our presentation for that information. And with that, Manny, I'll turn it back to you. Thank you.

Thanks, Peter. ESG is of increasing importance for all company stakeholders. What's one thing your company is doing to improve your overall ESG score over the next 12 months?

So we have just posted our first Corporate Responsibility Report, and we have a committee led by Art Harmon that includes people from every discipline in our company, environmental, legal, HR, et cetera. And so we are -- everything that we're doing and focused on right now is in this report. We're very focused on it. And we're proud of -- this report will continue. It'll be a living, breathing document. We'll continue to update it on a regular basis. And that committee reports to me and the Board.

Right. So maybe we can begin with what markets in the U.S. are you most worried about, whether it be because of supply or something else that could disrupt trends there?

Sure. So there's been primarily large-format oversupply in a handful of markets. And a lot of that comes from the weight of capital looking to find a home in the space, teaming up with local and merchant builders. And the only way to get big dollars out is to build big buildings. So you see some oversupply of million footers in South Dallas. There's a lot of new supply coming in Atlanta, Northeast Atlanta as well as South. And there's a little bit of additional supply in Central Pennsylvania. A year ago, we would have referenced 11 or 12 empty big buildings there, but there's been some pretty good lease take-up in Central PA. But those are the markets that we are staying away from, and we're not going to build into that excess supply. What's encouraging is that there -- the space is being taken up. So at least for now, it looks like it was a bit ahead of its time. We haven't seen or heard of any big concessions being granted to tenants. So that's a good sign as well. In terms of the rest of the country, the coastal markets are very, very strong. It's difficult to get land, and we haven't seen that same phenomenon. Typically, where there's plenty of land available and plenty of money, you're seeing a little bit oversupply.

Given the lack of land availability, how do you plan for your next batch of developments and have land bank in the right places and ready to go?

Sure. I'll start with this and then Jojo can add to it. We have a number of offices across the country. We're consistently out looking for new opportunities, making many, many, many unsolicited offers on land that's not actually currently for sale. So we'll find out who the owner is. We'll harass them literally until they finally come around and say, "Hey, you know what, I can't take it anymore." And they'll call a couple of others in as well. But when you're talking to somebody for 1.5 years or 2 years about their real estate, they tend to want to trade with you because you have become familiar with them. So you won't see us participating in broadly around the auctions to buy land. We're out there digging it up, dirt under the fingernails, literally, to go find these sites. Jojo, do you want to...

Yes. In addition to all of that, so we have various relationships in the market. So there's various participants, attorneys, general contractors, vendors, users, tenants, all we contact to try to get some information on available land and that we would pursue on. We're also very, very good at entitling land. So for example, Southern California, we're batting 1,000% there. And in addition to that, we're very good in constructing buildings. So overall, over a 7-, 8-year span period, we've always been in budget on quality and on schedule and on time. So given all that -- and we have a great leasing team. So if you combine all that, that should result in a profitable investment.

Okay. How has tenant activity been for your recently completed developments and everything you have in process?

So tenant activity has been pretty good. We've got a number of assets that we're completing in Northwest Dallas, Louisville. And we've got some strong leasing there already and a lot of activity around those assets. And we've got a number of projects that are going to complete in the second and third quarter of this year that we're also very excited about. Jojo, you want to add anything there?

Sure. And then I just want to let you know that in the completed bucket, so we basically leased a 643,000 square foot building in Phoenix basically at completion. Large deal, we really like that. And also, there's a project -- just to add some more color, there's a project in Northwest Dallas that's 434,000 square feet, and that's not scheduled to be done until third quarter this year. We already have that 77% preleased.

Just generally, have you been seeing trends in the types of tenants that you're talking to that want to take spaces or anyone that's really itching to accelerate the logistics strategy?

3PLs are very active in taking up new space. But by and large, the demand base is still very broad. Approximately 25% or 30% of the incremental demand is from e-commerce users. But that leaves 70% to 75% that's still from the traditional user of industrial, and that makes for a pretty -- obviously, a very healthy market. We don't see any particular pockets of weakness. Most -- when a tenant rolls and leaves us, they roll and leave us because we can't accommodate their need for growth. At 97% occupancy, we don't have a lot of extra space.

Okay. Given your balance sheet is so conservatively capitalized and given where rates are today, does it ever make sense to increase leverage a bit?

So our stated operating range is 5 to 6x EBITDA. We're at about 4.6x now. We like to have a conservative balance sheet so that we have access to liquidity and don't find ourselves, at any point, needing equity to re-equitize the balance sheet when markets fall 20%, like they just did. So yes, it's tempting. But we're -- our strategy for the company in terms of the balance sheet as well as new projects and investments is to try to have a business that's going to be resilient through the cycle. And so to lever up now and then have things come that we can't predict, like the virus situation, we're not going to -- I don't think you guys pay us to go to the casino like that. It's -- with the 10-year hitting 90-something basis points today, it's -- yes, it's -- look, we'll take advantage of the cheap financing rates that exist today. But in terms of order of magnitude, we're probably not going to change that operating range of 5 to 6x.

Peter, in your opening remarks, you talked about being sort of the right size, not too big, not too small. What we've heard from a lot of your larger peers, competitors, et cetera, is scale matters, scale is a big benefit, especially in the industrial business. Help us reconcile those 2 viewpoints.

So I would say that large scale gives one an opportunity to invest in R&D that -- for example, that we wouldn't -- I'll reference PLD's 2-story building in Seattle. I love that building. But if that didn't go right for them, given they have $2.250 billion of NOI, it's not really going to show up. It would show up for us if we did that building and it didn't work out. So from that standpoint, having that kind of scale is a help. But in terms of cost of capital and our ability to go ferret out new opportunities that generate big margins on the development side and profits for our shareholders, it's -- we like what we can do. When we do a new project that's large with a big margin, it changes our profile meaningfully, and that's what we mean about being kind of the right size.

Right. If you were a larger company today, would your market and asset makeup be the same as sort of you see today? Would you have changed anything on your way to being a larger company?

I think our strategy would continue to be the same where we're trying to take capital out of lower-growing assets to reinvest into higher-growth opportunities, quite naturally, over time. If you look in the presentation that's online, there's a map that shows where we are. And certain of those circles, I'll call them the blue circles, they're more in the Midwest circles, will continue proportionately to get smaller. It just so happened this past quarter that they got so small in Indianapolis and St. Louis that they're not on there anymore, or Tampa. So we don't really have any plans to wholesale exit markets, but we have plans to get out of lower growing assets. And I think if we were twice as big as we are, we'd still do the same thing. We're in the markets we want to be in. So I don't think we'd add new markets, but you might see some of the existing markets shrink or go away.

Yes. You've indicated, as you just touched on, desire to reduce in some of the traditional core Midwest markets, and you've been expressing that goal for some time. We've been through, maybe still in, the best industrial market transactions, performance, et cetera, for the -- maybe ever, so why hasn't this happened faster? If not now or recently, when?

Right. So our decisions to sell assets are based on 2 things: one, having a strong bid; and two, having a good leasing situation. So you saw in 2019, we ended up selling $261 million, which was significantly higher than the guidance that we'd given in the beginning of the year. Our team did a great job leasing some assets in Indianapolis that traditionally were in the mid-80s in terms of occupancy, and they leased them up to 100%. So maximizing the cash flow in the asset. The buyers for our assets are 1031 buyers. Users, by about 30%, and high net worth individuals, local entrepreneurs are also big component of the buyer set. They aren't the big institutional investors buying assets in St. Louis and Indianapolis and Detroit and Cleveland, et cetera. So we need to maximize the cash flow from a leasing opportunity, have a strong bid in the market. So again, we don't want to just have one horse. And that's when we choose to pull the trigger on the lower-growing assets. We wouldn't -- we think there'd be somewhat of a portfolio discount because we're selling from disparate locations to put that together and take it out, we don't think we'd do as well on the value side. The other thing I'll point out is that we're -- we take a very long-term view on growth. And even though, for example in Detroit today, when a tenant rolls, most of our product is 50,000 to 100,000 feet. There's no new supply being built there. The new supply is 400,000, 500,000, 600,000, 700,000 square footers. So when tenants roll there, they don't have any place to go. And we're getting strong high single-digit rent increases on those roles, in addition to the bumps we have in our leases anyway. But we're not going to sit here and say, "Oh, through the cycle for the next 10 years, we're going to have that phenomenon." So it's a market where we think historically, rent growth has been low. So over time, we'll begin to continue to shrink there.

So do I take it you're speculating that you're going to lease up and the market is still going to be there? Like isn't there a trade-off between now compelling time to sell versus getting that extra last nickel?

Absolutely. Absolutely, we'll look at the strength of the markets. We've had that conversation amongst ourselves and with the Board, and we feel good about the markets. And if we thought there was going to be some big negative shock to those particular markets, we might have a different approach.

One of the non-Midwest markets you mentioned was Tampa, but you have these other 2 big green dots in Florida. So how does Tampa sort of not fit into the Florida equation?

So we didn't really like what we owned in Tampa. It was mostly flex. And for many, many years, there was no bid for that asset. In the last couple of years, a strong bid had emerged and gave us the opportunity to exit those assets in Tampa. The population growth in Atlanta and South Florida is dramatically better and the tenant velocity in Orlando and South Florida is better. So that's why we're focusing our new capital investments there.

Okay. Pier 1, which we've spoken about for a while with you guys, has declared bankruptcy. Update on them, and then update on anyone else on your watch list.

Sure. As far as -- I'll do Pier 1 last. As far as the watch list is concerned, no one else is on it. We did do our bad debt assessment for January, and it was $60,000, so a very low month. As far as Pier 1 is concerned, we did receive their March payment yesterday. They did file Chapter 11 bankruptcy about a week or so ago. If you read their bankruptcy documents and press releases, the plan is to try to sell the business to another investor. They're giving themselves until the end of April to do that. So we think we're going to be paid April's rent as well. So a couple of things could happen. One is they could be successful, selling it to another investor. We think they're utilizing our building very much. So hopefully, that'll give us more traction to keep them in the building. If they can't sell it, I guess, another option could be Chapter 7 bankruptcy liquidation. If that were to happen, that would probably happen end of April, May, they're still going to have inventory in our building. So we're hopeful that we're going to be able to get a couple of more months of rent out of them. So if that happens, if we get rent through June, worst-case scenario, we don't get it for the last half of the year, we would suffer about $1.5 million NOI loss for that time frame. We'd have to write off about a $700,000 noncash deferred rent receivable. So that would be about $0.015 per share. Now some of you in the room have been on our earnings calls and had meetings with us. We provided a bad debt allowance forecast of $2 million for 2020. Our bad debt has been coming in about $0.5 million a year the last couple of years. So if we have the same type of experience in '20 and we don't get Pier 1 to pay the last 6 months, you pretty much zero out from an NOI point of view, no impact to same store. You still would have to write off that deferred rent receivable, but that's noncash. So that's the status of -- at Pier 1. And we'll update you as we hear more information.

They're really the only name on our watch list. The rest of our portfolio is doing fine. And we'll take a close look, lease by lease, on a quarterly basis. So we're on top of it. The other thing I'd say is if Pier 1 leaves tomorrow, then that building is highly leasable. 650,000 feet in the I-95 corridor in Baltimore and it's -- the rents there today are about 5% or 10% below market. So we'd suffer some downtime, for sure, but we're confident we can re-lease it pretty quickly.

Any questions in the room? So we've spoken a bit about development. How do you think about sort of development as a piece of your overall organization and exposure that comes with it and the amount of capital that needs to be put into it, especially with where we are in the broader cycle?

Yes. So as you know, we're primarily a speculative developer. For that reason, we have the self-imposed, what we call, speculative leasing cap. That was put in in about 2014 at a time when our balance sheet was not nearly as sound as it is today. And the formula that we use today is the same formula that we used back then. It was 9% of our total cap. We raised it in March of '18. And so it stands at 4.75% today. And you can do the math, 9% of our total cap today would be a higher number, but we're comfortable with where it is. What we like or what I should say, I like about it is, it enforces a lot of discipline on the development leasing front. If you want to put money out and build another asset, you got to lease what you have. And that's a great discipline. So we're in the game for build to suits, but because we choose not to carry a big land bank, when we reply to RFPs, we got one shot for that RFP. Others might have several locations where the prospective tenant could consider. We choose not to go that way. It's expensive to carry the land. We don't want to speculate and go out and buy 600 acres somewhere and find out the market and the path of growth didn't go that way. So we're focused on speculative development with the mitigant, the risk mitigant, of our speculative leasing cap. And we will make select acquisitions. You've seen us do that. Every time we put a dollar out, we want to make sure we're making money for our shareholders. You can see it pretty plainly in the development margins. That's kind of easy to talk about. But if you go through our acquisitions on an annual basis, you're also going to see that we're generating yields on those high-barrier market acquisitions that are above our cost of capital. So it's all about leasing bets and people make different bets. Our bets are probably more conservative than others. But we've been doing okay with that. So we're going to stay in our lane.

So you mentioned the stat earlier of 25% to 30% of, I guess, it was demand for your new products from e-commerce users.

That's an approximation, yes. Because sometimes it's hard to discern who is e-commerce and who is...

Right. So I guess just from a trend perspective, where would that number have been 2 or 3 years ago?

About the same.

Are you surprised that it wouldn't have gone up more?

I'm not surprised because there's been so much robust demand from the traditional users of industrial space. So we -- across all the businesses that are represented in our portfolio, they're growing. Their sales are growing. They're looking for more space and that's keeping up with -- I don't know, e-commerce is roughly 14% of retail sales now. I think 2 years ago, it was 10% or 11%. So the growth has been similar in terms of auto parts and home improvement, et cetera, et cetera. So I'm not surprised it's a similar proportion, and it's probably healthy for the business that it's that way, too.

You talked about that other 75% that's coming from your traditional user. Are they looking for anything different with the building, with the parking lot with the clear heights, et cetera, than they would have in the past? Or does the user base look the same and the building base looks the same?

Functionality...

Yes. So there are a lot of common things that I usually look for, ample parking, ample trailer stalls, the ceiling heights, good ingress and egress out of the property, loading docks, good amount of power and inside-the-building insulation, good lighting. One thing we do is that if we compare our building in all of the developments that we do, we typically over-spec the property over and above a traditional merchant building. What do I mean by that? First of all, our coverage is slightly lower. Why is that? Because when you have a lower covered building, you actually can devote more space to parking, auto and trailer, and you have bigger driveways. A lot of the logistics companies like that. It makes it easier for your truck drivers to maneuver in and out of your property. The other thing we do is that we add extra floor thickness, for example, because we're a long-term holder. Once we invest in a property, we're looking 20, 30, 40 years of ownership, we don't want to deal with that issue anymore. Insulation is just another thing that we do. We over insulate for energy efficiency. We have LED lighting. We add skylights if the -- if there's a lot of sun in a particular area of the market we're investing in. So we do all this, and these are all benefits for the users. So when you go to a market and when you see a First Industrial building, bar none, we are better than the merchant design. So that's -- we're very, very strict about that. So going forward, those are the things that we expect tenants would look for. Those are the things that I mentioned, the building quality and the types of qualities of a building that I've just mentioned. Those are the specifications that tenants are going to look for. Ceiling heights today vary from anything from 32-foot clear to 40-foot clear. That's going to be a long-term need. So don't expect significant changes in that.

And I would say -- add to that, the traditional user, you'll probably see improvements in technology for stacking, but they're not going to be like the e-commerce user that wants, like an Amazon, who wants 70 or 80 feet tall with 6 or 7 mezzanines and lots of robots. That's not there. That doesn't suit them. So by and large, we want to have assets that appeal to the broadest possible set of tenants. So that when times do get bad, we've got lots of takers for our assets. And so we're not going to chase tenants to markets we don't want to be in, and we're not going to build properties that look more like special purpose properties.

So I've heard from a lot of investors I speak to that industrial has the highest highs, the lowest lows and it happens quickly through a cycle. And it feels like we're at those high highs now. Then the flip side of that is people say it's different this time because of everything we talked about, e-commerce, supply chain and transformation, technology that moves towards the coasts and towards population centers, all that stuff. Where do you fit in on that sort of conversation?

Yes. I would say that -- and it's always dangerous to say it's different now because how many people have fallen on their sword after saying that. The difference now is that in -- certainly in the coastal markets, it's really tough to build. So the oversupply risk is much, much, much diminished in that market. If demand went away, that's a different risk. And probably on the coastal markets, the risk of demand going away from some shock, like coronavirus or something else that we can't think of today, is a higher risk than the overbuilding, the potential for overbuilding. That still leaves a lot of real estate in the United States where there's a lot of land and where oversupply could be a killer to rent growth. And those are the markets that we're not -- we're leaving, and we're not going to invest in. And so when you say it's different, I think you got to break it down between where. And I think 20, 30 years ago, every time there was any kind of upward rent pressure in a market for industrial, a ton of space would come online and just kill it. And that phenomenon doesn't exist now, certainly up and down the West Coast, Northern New Jersey, South Florida and even in the Baltimore, D.C. area. So in certain areas, I suppose you can say it's changed, and in others, it hasn't.

How do you decide when you're doing a spec building if it's 32 or 42 feet?

Yes. Do you want to cover that?

So it's -- it really depends on the size of the building. As you go smaller in size, for example, in 200,000 foot -- 200,000 square foot warehouse distribution building, we have not seen tenants need 40-foot clear. So typically, on those size range, you'd be about 32. Now when you go into like -- our experience in leasing, when you go towards 400,000 to maybe 500,000 square feet, 300,000 to 500,000 square feet, that's where you see some tenants now wanting 36-foot clear, so you build a 36. And when you look at the tenants and anything over like 600,000, 700,000 square feet, a lot of requirements out there actually don't need 40-foot clear. But as a long-term investor, we kind of want to future-proof our building, so we actually build 40 despite the fact that majority of tenants still need 36. Because, you know what, if it moves down, I think it's a good investment. And when you compare the additional investment and future-proofing the building, we'd take the latter, future-proofing it.

It's approximately $1.50 to $2 a foot to go from 36 to 40. So it's worth the investment in the long-term functionality of the asset.

There was only one question in the LiveQA and it came late, but we've got a minute. Would you consider sale of the company?

First of all, we're always going to do what's best for shareholders. We have a tremendous growth trajectory and look at the deals that have happened in the past. Until this slide, we were trading in the market at an implied cap rate that was inside some of the other trades. So when you have a growth trajectory like this, a lot of sources of capital, liquidity, a conservative balance sheet, it takes a pretty powerful godfather offer. But certainly, we're always going to do what's best for shareholders.

All right. With that, we can go to the rapid-fire questions. Will the industrial sector have more or fewer public companies a year from now?

You didn't give me a chance to say the same. More.

What will same-store NOI growth be for the industrial sector overall in 2021?

4.5%.

What will the 10-year treasury yield be 1 year from today?

Higher. 1.30%.

Number?

1.30%.

And what year will the U.S. enter a recession?

Last year, I said maybe this year because of the election. 2022.

Thank you.