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

Good afternoon, everyone. Thank you for joining the First Industrial Realty Trust presentation. My name is Ki Bin Kim, Managing Director at Truist. It is my pleasure to introduce the First Industrial management team and Peter Baccile, CEO. Peter will introduce the rest of the team and provide some opening remarks, then we will open it up to the audience for Q&A. Peter, thank you for being here with us.

Thanks, Ki Bin, and good morning, and thank you for joining us, everyone. With me today are Peter Schultz, Executive Vice President of our East region; Scott Musil, Chief Financial Officer; and Art Harmon, Vice President of Investor Relations and Marketing. For those of you who may not know us quite as well, we're a U.S.-only industrial REIT with a total market capitalization today, equity plus debt, of approximately $8.5 billion. All of our new investment is focused on 15 of the nation's top logistics markets, as we outlined during our Investor Day last November. Our portfolio and our team performed very well during and through the height of the pandemic last year, and we are well positioned for growth with a number of exciting new development projects underway. Our portfolio is highly leased at 95.7% as of the end of the first quarter, and we continue to deliver strong rental rate growth. Cash rents were up 13.5% in 2020, the second highest growth rate in our history. In 2019, we achieved a record of 13.9% cash rent growth. In 2021, we're looking to deliver another year of strong rental rate growth of 10% to 14%. E-commerce remains a driving force of demand for logistics real estate. Tenant requirements, driven by accelerated e-commerce adoption, helped our sector perform very well through a volatile 2020. This strength is reflected in national leasing metrics. U.S. national net absorption exceeded 100 million square feet in both the fourth quarter of 2020 and the first quarter of '21. This is the first time this has happened in consecutive quarters. Given the long runway for e-commerce and the economic recovery that is underway, we're very excited about the growth opportunities ahead, both from our existing portfolio and through new profitable investments, primarily speculative development. We reinitiated our development efforts late last year after a 6-month pause due to the pandemic and now have the strongest pipeline we've had since before the Global Financial Crisis In 2008. We recently started a number of new developments, 2 projects in South Florida, along with new buildings in The Inland Empire in Southern California, Phoenix and Nashville. This quarter, we're starting projects in Denver and Dallas. In total, we have 3.3 million square feet under construction with an estimated investment of $318 million. We have land sites that can support 14 million square feet of additional growth, and our team is always working hard to uncover new opportunities. Our development margins have been sector-leading, averaging over 60% when comparing our realized development yields with prevailing market cap rates. These high-quality new developments will contribute to strong portfolio cash flow growth for many years to come. At our Investor Day in November of 2020, we highlighted the opportunity to grow AFFO by an average of 9-plus percent from 2021 through 2023. This growth in cash flow also supports strong dividend growth as reflected in the 8% increase for our first quarter 2021 dividend versus the prior period. With that, Ki Bin, I'll turn it back over to you.

Great. So when we talk about the drivers for industrial demand, a lot of times e-commerce takes center stage. How much of the demand that you're seeing is e-commerce driven last year versus this year? And what do you think will happen going forward?

Yes, sure. So last year, second, third quarter, those were not great leasing markets. Obviously, with the economy shutdown, e-commerce tenants did take up most of the space that was leased in those quarters. Amazon last year took 75 million square feet, which was more than the next 30 most active lessees combined. So e-commerce was a big factor in 2020. In the fourth quarter, though, we began to see the reemergence of the tenants that are typical -- more typical users of industrial historically. So demand broadened out, and that momentum carried into and through the first quarter and in the last few months has really taken off. So we've seen strong demand from omnichannel retail, consumer goods, auto related, food and beverage, home improvement, paper and packaging, et cetera. So the market is extremely robust and broadened out considerably.

Great. So how does that translate into market rent growth? Do you have an internal forecast, what you think for your markets that you're operating in, what market might growth will do?

We think overall, market rent growth is going to be quite high this year, ranging -- and this is a wide range, we understand, but I'll explain it in a minute -- kind of 5 to 15-plus percent. You're going to see it at that higher end of the range in places like L.A. and The Inland Empire. We think you'll see high single digits to low double digits in other higher barrier coastal markets. Typically, we have -- in 2019, we were looking at rent growth of 5% to 7%. So we think rent growth in 2021 is going to be considerably higher.

Great. So how does that translate into your revenue line item? So the rent roll on leases that are expiring, any kind of forecast you can share with us?

Yes. So we have signed, through the end of Q1, 72% of our '21 rollovers. We're up about 12.8% cash rent growth on those rollovers, and we're bullish for the balance of the year.

And so when we look to 2022 and beyond, when you combine the market rent growth that you're seeing today and the vintage of leases that are rolling next year, is it reasonable to expect these very positive leasing spreads to continue on?

It's obviously about supply and demand. The demand right now is tremendous. We think that's going to carry on into the next couple of years. We had this pause in development last year when everybody stopped building. Supply will come, but it's going to be a little bit lagged because of the stoppage. And so yes, we're bullish on rent growth in '22 and '23.

How about any markets that concern you, whether that be new supply or are there some other factors?

I wouldn't say. Look, again, we're focused on these 15 markets. So we can't speak to all of the other markets in the secondary and tertiary locations. But if you look at major metro markets, all but one are operating at availability levels that are far below their long-term averages. Houston is operating approximately at its long-term average for availability, maybe a little bit higher. And I wouldn't say we're worried about Houston. But as we all know, Houston is a kind of a boom and bust market, and we're now coming off what I'll call the bottom, if you will. And in the last few months, tenant activity and our conversations there in our First Grand Parkway building, where we do have space to lease, have picked it up considerably. And so I think Houston is going to do much better for the balance of the year.

And that's a good segue into external growth. How is the leasing activity and competition in the markets where you have new developments underway?

So we have projects underway in primarily higher barrier markets. We're having good conversations everywhere. I would say, in a few places, we're having kind of conversations before we've even begun construction, where they know that something's coming. It's a tight market; there aren't a lot of alternatives. Maybe they've lost out on 1 or 2 bids, so they're now getting a little panicky about finding locations to house their growth. And so I would say that, again, it's -- I don't know if you want to call this a new up cycle, or the continuation of what was already a long and strong run, but the activity is pretty significant.

And you recently raised your self-imposed development or self-imposed spec leasing cap to $625 million. Can you remind investors how that cap works and where you stand versus the cap?

Sure. So we put that in place in 2012. The metric is really just a formula. It's 9% of the total market cap of the company, equity plus debt. When that formula was put in place in 2012, obviously, we didn't have the same portfolio and balance sheet that we have today. The portfolio and balance sheet today are significantly improved. So you might think that, that metric is a bit conservative, but it's 9%, continues to be 9% of our total market cap. We have adjusted it. It just so happens that we have adjusted at each of over a 3- year periods of '12, '15, '18, we adjusted it in March of this year, up to $625 million. Actually, if you were to look at our total market cap today, it would be well into the $700 million range. We are using about $400 million of it today. I'll point out that it is a cap on risk and not a target. So it's not like we sit here and say, gee, we have capacity. We have to go use it. We're still primarily focused on profit instead of volume. But we do expect to announce additional new starts in each of the next couple of quarters. And so we'll end up continuing to use up more of that cap.

Got it. And how many more development starts are you looking for in 2021?

I'm sorry, how many more what?

Development starts are you looking to do in 2021?

Yes. We're not going to get too specific on that. I'll say that there will be multiple starts and primarily in the higher barrier markets.

Got it. [Operator Instructions] So you have a strong track record of producing strong development gains. As you mentioned, north of 50% over just the past several years. Do you think you can continue to deliver those types of margins?

So there's definitely pressure on margins. We have competitive pressures. We have the fact that commodity input pricing has increased considerably, and we think it's still going to go up. You have the increased cost associated with potential delays and trying to get some of these commodity inputs. But so far, and this is another reason that we're investing where we're investing in the higher rent growth markets, rent growth has kept up with that increase in cost. I would say that you're going to see some slight erosion in some of those margins due to all these factors, but we still think we're going to be able to generate significantly high margins on our projects going forward.

And on that topic, steel prices and other input costs, including labor, have been rising. How is this impacting your development underwriting? And how much are all-in costs up year-over-year?

Sure. Ki Bin, it's Peter. So costs are up. As Peter said, it is having a little bit of an impact on our margins. And it's not just steel, we're seeing roofing, insulation and other commodities. And it's not just the cost, it's the timing and availability of, well, steel used to be 4 to 5 months, now it's 9, 10, 11 months. So it's elongating the construction cycle. So we're definitely having to underwrite a little bit longer construction. But in terms of the costs, the hard costs are up anywhere from 30% to 40% or more over a year ago, depending upon where you are in the country. And as Peter said, we think that's here to stay in the near term.

So when you think about it all in, so hard cost, labor cost, what would you say the percent increase is versus a year ago to build a building?

A year ago, they were rising 5% or 7%, and today that's probably 10%.

Or more.

10% to 12%.

Yes.

Not all of these components are huge components within the overall cost, but they are dragging the average increase up, yes.

And demand for new development projects and how do you balance rising cost versus green lighting projects? Could we potentially see some projects take a little bit longer for you to green light them because of these rising costs?

Well, what takes time where we're building is really the entitlement process because we are buying unentitled land. It's really the best way to achieve the profits that we are. And that takes -- in California, that takes 18 months. It doesn't take that long everywhere, but that's really the time-consuming process in terms of green lighting. So what we did -- our delay's potentially in greenlighting. What we did in the second and third quarter is we focused all of our efforts on 2 things: one, securing new land sites; and two, getting entitlements for the land that we already own so that we were effectively ready to go. So building these new delays into that time line, we're in pretty good shape, Ki Bin. We've got a really strong pipeline. It's the best pipeline, as I said, that we've had since pre-2008, biggest we've had since pre-2008. And just from a quality standpoint, from geography and functionality, it's the highest quality pipeline we've ever had. So -- and here, we're operating in this market with fundamentals that we've never seen before. So it's a super opportunity to generate cash flow growth and value for shareholders. And we're lining up the aircraft, and we're dealing with potential delays and increase in costs. I don't think you'll see us slowing down on announcing new starts because of these issues, not in the near-term. If this were to continue for years and years, that might begin to impact the pace of new starts.

And you have key land sites that can accommodate 14 million square feet of development. It's actually interesting because that land bank as a percent of the size of the company is actually a big plus for you guys. It's bigger than other companies. Any thoughts on what you might start over the next couple of years off that land bank?

So that land bank, we can build about $1.5 billion of new products. And you know where we own land. Most of it is in really key locations. And as I said, most of it's now ready to go. In terms of where we're going to start -- and announce new starts in the third and fourth quarter, again, I would just say that it's higher barrier markets. And the profile of that development pipeline will be similar to the profile that you've seen in the last couple of years.

And are you still finding new opportunities for land sites?

Yes. So it's a system we've had in place for quite a while. We've got offices on over 12 cities across the country. They're staffed by very, very experienced people who've been there a long time. We have great relationships with the brokerage community and with ownership. And they make literally hundreds of unsolicited offers a week for new development sites. And so where -- that process never stops. And we always say we got to have a lot of balls in the air because you never know what you're going to win and what you're going to lose. And again, we're maintaining our discipline on profits versus volume. And so we want to have options. And the best way to make money is to always have options.

Great. And one of your bigger concentrations in your land bank is in Phoenix. Can you just talk about the market dynamics in Phoenix because it is important to your growth story? What are the supply and demand? What is the tenant demand interest in that particular market?

So tenant demand in Phoenix, where we are at PV 303, and we have balance sheet land there, and we have JV land. As you know, our JV at PV 303 has been incredibly successful. And the original plan where we had a building on balance sheet that we leased to UPS and they wanted to buy the building. We didn't really want to sell it. Long story short, we viewed them as a magnet for other users, and we went long land there, and it's worked out incredibly well. The demand base is, again, broad based. We've sold some of the land that we bought off to people like Fairlife, the milk producer; XPO, a large data company that is well known; and we've built other properties there. So demand is broad-based there, Ki Bin, and we haven't had any issue leasing. We're underway there with a project, as you know, and we're having a lot of good discussions with potential tenancy there.

And one of the reasons, besides being a good developer, that you've been able to achieve like these very attractive margins is that you've chosen to do a little bit more spec than just doing build-to-suit. So just help me understand that dynamic a little bit better. Are you just not in the market and submitting RFPs for build-to-suits? Or when you do get something inbound, do you choose to proactively keep that land for a spec project? How does that all kind of balance out?

It really goes back to our whole philosophy about land and how much we want to own and carry on the balance sheet. We prefer to buy land that's near-term developable that meets pockets of unmet demand as opposed to holding a lot of land and having a long-term optionality, but really no plan. We like to have a plan. We want to have a plan of attack. We don't want to bear the cost of carrying a lot of land. We also don't like the potential dynamics where you might have bad incentives to develop on land if you own a ton of land. And so that's worked very well for us. What it means is that we are going to be far more active in speculative development because we do respond to RFPs for build-to-suits. We do it all the time. It is part of our business. But when we respond, because we don't own so much land, our offerings are more limited than perhaps some of our competition might be. And so you'll see us win build-to-suit, 1 or 2 a year, every other year, here and there, but it's not going to be a major component of our growth in all likelihood.

Great. [Operator Instructions] So in terms of markets and cap rates for assets, what are you seeing for industrial pricing? And how is that affecting your thinking on acquisitions?

Yes. So cap rates -- every year, we say cap rates are coming in, and we think that they can't come in anymore. But I would say that in the last 7 or 8 months, cap rates have come in 25 to 50 basis points. I'd say it's the higher end of that range in the secondary markets because of the capital flows into those secondary markets just because it's available. And the lower end of that range in the highest barrier markets where opportunities are few. So with respect to acquisitions, we have a few challenges. One, we only want to own things where we want to own things. As you know, we've spent the last 10 or 12 years disposing of assets in lower growth opportunity areas. So we're not going to buy anything in those areas. So geographically, we're very focused on those higher barrier markets. Secondly, functionality is -- we're all about functionality. We want great properties that are going to be competitive over decades to come. And so that combination of factors, there isn't a lot on the market with those combination of factors. And if and when it does come, sellers are smart. They hire a broker, they bid it out to 40 or 50 players and they get a fantastic price. And in that environment, it's difficult for us to justify how we make money for shareholders buying those assets. So we're far better off taking that capital and investing in new speculative developments where we, as you said earlier, generated tremendous margins and returns for our shareholders. You'll see us do some acquisitions. I'm not saying we'll never do any. But typically, when we do, there's a story around it. There's a history that we have involved in the asset. There's hair on the deal. There's something about it that makes it fit for us in all those categories that I mentioned. And the volume, though, is never going to be very high.

Got it. So at your Investor Day in November, you discussed the opportunity to grow AFFO per share at 9% compounded annual growth rate to 2023. Can you just remind us how you get there? What are the various components?

Sure. Ki Bin, it's Scott. We would have to grow AFFO to about $260 million at the end of 2023, and that number is about incremental $57 million of cash flow. At Investor Day, we've laid out opportunities to grow cash flow by about $64 million. So our opportunities are about $7 million in excess of what the number we needed to achieve. Four items or 4 areas we'll have to hit in order to hit that goal. First is rental rate bumps that represents about $20 million of that number. Currently, our rental rate bumps are about 98% of our long-term leases and our bumps are about 2.8%. And I would say in order to achieve that goal, we need to keep occupancy between 96% to 97%, which we feel is very doable in this market. Rent growth was another $12 million, and I would say the assumption that we included in the modeling was a 12% increase in rents, new and renewal leasing, and we're already ahead of that with the leases we signed this year that Peter discussed for, like, a 12.8%. And I think we'll beat the numbers that we had in there for 2022 and 2023. The next area is completed and developments in process, leasing those up. We're getting a full 12 months of cash flow, that's about $25 million. We've discussed and walked through all of our developments in process with you, Ki Bin, and folks on the call. We build high-quality assets in infill markets so there's no question that we'll get that -- those dollars. And then the last is interest savings from debt that we have coming due the next couple of years. That was about $7 million, and we're working on a couple of things currently that will chip away at that number. So again, we think it's very achievable. I think the main thing that we have to do is keep the portfolio leased 96% to 97% over the next couple of years. I think that's very achievable.

So it sounds like you're on the right path. So what does that mean for the dividend? I know you've increased it 8% in the first quarter. What are your thoughts on the future paces of increases?

Yes. So the Board determines the dividend. They approve the dividend. But the policy has been in the past to grow the dividend as we grow cash flow. We laid out a plan here that we just discussed, by growing cash flow 9% a year over the next couple of years. So I think that should be a pretty decent indicator of what you could see from a dividend growth point of view. Obviously, also, Ki Bin, we want to keep the payout ratio as low as possible. Right now, as we stand, we've got about $65 million or $70 million of excess cash flow that's being used to fund these -- our investment pipeline, primarily spec developments, which we're getting these great margins. So I think we're going to have a pretty good growth rate when it comes to the dividend. Again, we want to control that AFFO payout ratio, though, keep it as low as possible so we have those excess dollars to invest in our development pipeline.

Yes. Great. And when I look at your portfolio, you really don't have too many big pockets of vacancy, right? The one asset that's probably a topic that comes off frequently with investors is the Pier 1 building in Baltimore. Any updates you can share?

Sure, Ki Bin. It's Peter. We've seen some activity on the building. It's in our guidance to be leased September 1. That's a market that has very little choices for tenants and a very limited supply pipeline. So we're optimistic about the opportunity there. And we've talked about last year what we viewed as the mark-to-market there of 5% to 10%. And given what I just said, we think that there's an opportunity to outperform there, and we look forward to keeping everybody updated on our progress as September 1 is coming soon.

Great. So we're almost out of time. Let me just pause for one second to see if there's any questions from the audience. All right. Well, thank you for joining us, and thank you to the FR management team. Everyone, have a good day.

Thank you, Ki Bin. Take care.

Thank you.

Thanks, Ki Bin.