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

Good morning, everyone, again. Welcome to the 9:00 a.m. session at Day 2 of Citi's 2022 Global Property CEO Conference. I'm Manny Korchman with Citi Research; [ Chris McCurry's ] and my team as well. We're pleased to have with us First Industrial CEO, Peter Baccile. This session is for Citi clients only, if media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. At this point, everyone knows how to ask questions, but I'll remind you, anyway, put them in the box. Peter, we'll turn it over to you to introduce your company and any members of management here with you today, and then we'll turn it over to Q&A.

Great. Sounds great. Thank you, Manny. It's great to be here with everyone today. Many thanks to Citi for hosting this conference, which is our first live conference since the same event 2 years ago. Joining me today are Scott Musil, our Chief Financial Officer; Peter Schultz, Executive Vice President; and Art Harmon, Vice President of Investor Relations and Marketing. A lot has happened since we were last here together. Our people and our portfolio performed admirably during the COVID-19 pandemic as we maintained high occupancy levels, collected virtually all of our 2020 rents in 2020, and continued to push rental rates on new and renewal leasing. We, like others, paused development in 2020 to assess the potential impact of COVID. However, the pandemic had the effect of accelerating the adoption of e-commerce across ever more categories of goods, driving incremental demand for logistics space. To meet some of that demand, we relaunched our development program in the fourth quarter of 2020. Our first projects out of the gate were here in the South Florida market, which is a strategic focus for us. The centerpiece of our investment in South Florida is First Park Miami, a multiphase development in the Medley airport submarket. We just completed the first 3 buildings totaling about 600,000 square feet and $91 million of investment with a projected yield of 5.6%. Given the strong tenant activity we are seeing, we just started another 200,000 square foot building at that park. When fully built out, First Park Miami will total around 2.5 million square feet in the best submarket in South Florida. We also successfully completed and leased 2 other projects totaling more than 500,000 square feet in South Florida in 2021. Importantly, we have substantially increased our development pipeline to capture the opportunities we have in our target investment markets while delivering very attractive margins to shareholders. Our first quarter 2022 starts include a new project in Southern California, which is our largest market by rental revenue at 23%. Our new starts are in the Lehigh Valley, Denver and Chicago as well as the new building in Miami I just mentioned. Including our new first quarter development starts, our developments in process totaled 7.1 million square feet with a total investment of $802 million and are currently 32% leased. At a projected cash yield of 6.4%, our expected overall development margin is around 80%. For context, 7 million feet is a significant amount of growth when you consider that our in-service portfolio totaled approximately 61 million square feet at the end of last year. We're excited about the opportunity to continue to build on our track record of profitable new development. Currently, we have land positions that can support an additional 14.4 million square feet with a potential investment of $1.6 billion at today's cost of construction. Additionally, our market leaders are continually working hard to find new attractive opportunities to replenish our development pipeline. While we're excited about the significant growth we can deliver from profitable new developments, we also want to highlight the growth we are generating within our existing in-service portfolio. We ended the year at 98.1% occupancy and established a new annual record for cash rental rate growth of 16.1%. Thus far, our 2022 cash rental rates are on pace to surpass that. As of our earnings call last month, we had taken care of 54% of our 2022 expirations at a cash rental rate increase of more than 19%. Everything we do is focused on driving cash flow growth and creating value for our shareholders. Our dividend growth is aligned with the cash flow growth we are producing, and we're pleased that our board recently increased our quarterly dividend rate by 9.4%, while keeping our AFFO payout ratio below 70%. With that, Manny, we'll take some Q&A.

Great. Thank you, Peter. Maybe we'll start with what are the top 3 reasons an investors should buy your stock today instead of any other listed property company?

Well, I covered some of this in my opening remarks, but just to emphasize, I think, number one, we have a proven development and leasing platform that is driving best-in-class margins and long-term shareholder value creation. Secondly, as I said, our current landholdings support the development of 14.4 million square feet. Our JV in Phoenix, our share of it is another 3.8 million square feet. That's over 18 million square feet on a base of 61 million square feet. Taken together, these first 2 factors drive an investment pipeline that has scale relative to our current total capital position to really move the needle on cash flow and value creation. And this is all in addition to the $802 million development pipeline that I mentioned earlier.

Perfect. Maybe we'll start with -- and I've got a question in queue already. Can you discuss the land portfolio and development pipeline? Just what's in there, and where are you going with it?

Talking about the geographics [indiscernible].

Sure. The land pipeline is spread around the country, primarily targeted in our Coastal markets. So here in Florida, significant land positions in the Inland Empire in Southern California, a site in Chicago that we've owned for a couple of years. We also have sites in Pennsylvania and Denver, so fairly well spread out across the country in our coastal and targeted markets.

And are you actively looking for new land as well as other opportunities?

Yes. We're constantly -- our teams are constantly out looking to replenish the development pipeline. They literally make 100s of unsolicited offers a week. We have about a dozen teams across the country. We avoid, if said, all possible broadly auctioned opportunities. Everything that we buy is also unentitled. It's pretty difficult to buy entitled land these days, and that entitlement process has really stretched out over the last 24 months or so. It used to be about 18 months, maybe a little less, and now it's 24 months or longer. So when we get these projects in-house and we get them entitled, there's already significant value creation there. And actually, today, our landholdings at cost are about $360 million, and the value is about $760 million. And remember that we don't go out and buy big chunks of land to land bank. We buy land that's near-term developable. The definition of near-term is a bit longer because of the entitlement process, but we don't carry a lot of old land.

So near-term, in your mind is what, 3 years out? Is that about right?

Say that again?

So near-term would be, what, 3 years out, roughly?

If it takes 24 months to entitle, yes, we deliver the property in 3 years. Yes.

And that's -- Just to add to that, Manny, to Peter's point. Some of the sites are a little bit sooner than that. So 24 months would be, as an example, in California, some of the markets a little bit faster into production.

And are you guys thinking about any shifts at all over that next 24 to 36-month timeline? Like, you have to think 36 months out, but trends change pretty quickly. And so is it -- are there new markets you're exploring that may be aren't on our radar? So are there new types of tenants? Is the actual bricks and sticks changing at all in terms of property type? Anything that once you deliver in 3 years will look different than it does today?

Well, we're really focused on the highest consumption zones and those really don't change. I mean, people do move from state to state, but the bulk consumption zones don't change. So that's not something that we're really concerned about over a 2 or 3-year, longer period. Just to give a little bit more specificity on our land because I think you'd find it interesting. We can build 1.3 million square feet in Northern California. We can build 2.5 million square feet in the Inland Empire. We have a small site in Seattle. We can build -- we have about 383 acres in our venture in Phoenix. We have 31 acres in the portfolio right now in South Florida. We have 194 acres in Orlando. So these are all very, very, very strong markets, so the breakdown of those holdings is significantly high barrier.

Great. In your 3 reasons, one thing that, I think, notably was missing was anything about valuation. And I have a question here in the queue from someone in the audience, which is why do you think you trade at a discount to your peers, and how do you eliminate the gap? And I think they're probably the same question, so could you address that?

Well, we get this question, and that gap used to be quite large. And right now, it's pretty narrow. We're going to continue to focus on long-term value creation and cash flow growth, and that gap will continue to narrow.

And just to get a more point and answer to sort of what we've been speaking about thus far, we've been asking what's the biggest growth opportunity that you believe the market is not giving you credit for? My gut tells me you're going to say something about development, but I guess the second part of that question is maybe more important, what the market is not giving you credit for. And I think people realize that you're a developer, so is there anything else that the market may not be as [ it truly ] focused on versus where your land is or what your development potential is?

I think I would emphasize certainly the resiliency of our existing portfolio as we saw in COVID. I believe we are the only one in the sector to collect all our 2020 rents in 2020. Of our approximate 1,000 tenants at the time, we only signed 14 rent deferral agreements, and again, they were all -- they all called for rental payments in 2020. So the portfolio has changed dramatically and is now very resilient, and that's part of the strategy is to have a portfolio and a strategy that will outperform through the cycle. And we got a small glimpse of that during COVID. And then, of course, the sustainability of strong margins on future investments and new developments as well as our ability to continue to replenish that development pipeline. So this isn't a short-term thing. This is something we feel bullish about that we can continue to do year in and year out.

In your operating portfolio, where are you currently signing rent bumps or contractual rent bumps?

So the average for the portfolio now is 2.8%. Of course, all new discussions start at 4%, and the longer the lease term and the larger the deal, it's tougher to get a rent bump that high, but that's where all the discussions start.

Earlier, you mentioned that e-commerce was accelerant for demand across the supply chain, I guess. A lot of the conversations I have now are trying to pinpoint how much e-commerce is the actual driver versus those other pieces of the supply chain, if you will. Could you help us get to sort of a better answer that, how much e-commerce, specific leasing are you doing? And what other industries are you seeing demand from today?

So demand is very broad-based. What's interesting to us is in 2020, as you know, Amazon leased about 75 million square feet. That was more than the next 30 most active tenants. Well, this year, coming into this year, those 30 tenants had an extreme sense of urgency to build out their footprint and improve their competitive position because they lost a lot of ground to Amazon, in particular, in 2020. And that demand is very broad-based. And many of the, call it, brick-and-mortar sellers of goods are all trying to adopt some kind of online presence, and they need a lot of space to do that. And the inventory issue is very real. Typically, the inventory to sales ratio needs to be about 1.4x, 1.5x. Today, it's 1.1x. So not only do you have the ever increasing share of sales going to e-commerce, but you also have this need to dramatically increase the actual existing inventory base. So that -- both of those things are a very, very strong tailwind to demand in our space.

I'm going to get through the rest of the questions I have to do, and then we do have a bunch of questions in the queue I want to get to. So what is your #1 ESG priority in 2022?

So we're focused right now on the implementation of LEED certification. That's not something we had done in the past. And in most cases, we're going to be building LEED [ Silver ] across all of our new developments going forward. That's really the emphasis this year.

Okay. I'm going to thank you, audience for sending me a lot of questions, so we're going to fly through these. What percentage of total cost do rents represent to your tenants today?

Well, given the rapid increase in the cost of transportation and labor, it's actually come down a little bit. Notwithstanding that we're pushing rents up, in some cases, 20%, 40%, 80%. It's about 4%, 4.5% of their overhead. They're really grappling with the rapid increase in transportation and labor right now.

Is that to say that they spend then less focus on rental costs, or more focus on rental costs?

They don't like it when we come in with a 40% rent increase, but in the grand scheme of things, it's not a lot of dollars relative to everything else they have to focus on.

But I guess is that the way they're thinking about it? Are they thinking about it in terms of relative increase? Are they thinking about it in terms of dollar spend? It's -- in my mind, it's kind of like, we all look at the gas prices. And oh my god, gas is up 30% in the last 2 weeks. Nobody says, I only spend $80 in the grand scheme of things, like that's not a big cost to my personal consumption.

They have to have a place to operate from, and it's just a cost of doing business. I think they look at it that same way, yes.

Okay. Next question here. Where are market cap rates in your markets today?

Do you want to cover that?

Sure. So in the high-barrier coastal markets, California, New Jersey, in particular, kind of 3, sub-3 in the other major markets, 3 or 4, and we continue to see cap rates stay pretty tight even with the volatility in the interest rates today.

New capital coming into the market is making a strong bet on growth, rental rate growth, especially in the higher-barrier markets. So we haven't seen any indication of cap rate widening with the increase in rates.

In your Investor Day last year, the company indicated it would dispose assets in the Midwest. Can you provide an update on this?

Yes. We set out an objective then that 50% to 55% of our revenue would come from coastal markets and 95% would come from our 15 core focus markets. At the end of last year, we were about 51% coastal and right around 90% in our core markets, so we feel pretty bullish about our ability to meet our goals by the end of next year.

All right. There's been a bit of merger activity in the industrial space. What are your thoughts on either acquiring or merging with another listed REIT to expand your asset base?

So we've looked at a number of opportunities over the last handful of years. The issue, and you know we've come a long way with our own portfolio over the past 12 years or so, we've really transformed the portfolio. We're pretty focused on functionality and geographic location, and most of the portfolios we looked at, 35% or 40% of the assets we didn't want. And we're very aware of all of the public company goings on, and we wouldn't want a lot of those assets either. So it doesn't seem to make a lot of sense to us to take big steps backward and have to pay retail. Nothing's cheap. And then go out and have to sell 35% or 40% of the portfolio because it doesn't fit with our go-forward strategy. So we've chosen instead to focus our capital investment in our new development pipeline.

Are you looking at all at acquiring standing assets? Or is it all development [indiscernible]?

We are, yes. We would love to buy more. Again, the assets in which we would like to invest don't typically come to market to start with. And when they do, they're typically broadly bid out, and so the pricing gets to a point where we feel that too much of the returns in the residual and the buyers of those assets are giving the seller a lot of their own upside. So -- but we do acquire, but the volume is going to be fairly low each year, something sub $100 million. Again, we'd like to buy more, but [indiscernible].

And remind us where are your development yields currently? And what would those assets trade at?

So the $802 million portfolio that we have -- our development pipeline that we have underway right now will yield about 6.4%, and those are in markets that have an average cap rate of about 3.5%, so the value proposition is significant relative to trying to buy assets and hope for the best.

What is the biggest threat to the company and sector?

Most real estate cycles are supply-driven. The supply always stays slightly ahead of demand because there's capital, they can get the money to invest and to develop, and this cycle is more demand-led. We can't keep up in our sector with the needs for space, so the risk to us is that is it's demand somehow drops and falls off. And it's really a question of are people going to start buying less? Because we're at a point now where the infrastructure that supports the economy of our business is very strong and broad and widespread. So it has to be a demand shock that causes the party to end, I guess, if you want to say it that way, more as opposed to a supply issue. Of course, if demand goes away, supply issues come to, but chicken and egg demand is what we were focused on.

You and peers have talked about the inventory to sales ratio being quite low right now. Is there a risk that that's a more permanent shift? And rather than resupply, re-inventory, retailers just learn to operate under the lower inventory levels?

That's a pretty razor-thin margin to not having a good and service in a world where someone can just click 2 seconds later and buy it from someone else. In other words, you can't sell what you don't have, so I doubt it. I doubt that that's a permanent state. Even if it is, the -- with a 3.2% vacancy rate, 3.2% vacancy rate across about 18 billion square feet, you've got to deliver a lot of empty space over a period of years for the dynamic between landlord and tenant to shift away from the landlord's favor.

The audience is getting really involved in this one. I love it. On supply, what do you make of the 500 million square feet under construction? Wouldn't that significantly outpaced demand if it does, in fact, all deliver?

Current estimates are for the deliveries of that number. This year, about 346 million square feet, with absorption slightly ahead of that. So don't forget that those are measurements of starts, not deliveries. And yes, I mean, if you look back historically, that replication or that addition of space relative to the existing supply is a high number and traditionally led to softness in the market. It did. We have a lot of different dynamics today, and it's really the reason that we focus our new investments where we do, where there's very little land because those markets will certainly outperform again when the clouds roll in, and we know trees don't grow to the sky. So we prepare for that every day.

Maybe going back to development yields and margins for a second. How big of a headwind has inflation been? And how do you navigate that?

Yes. So the cost of inputs has gone up pretty significantly, certainly starting with land. Land cost were used to be 30% -- 25% or 30% of a total development budget. Now, it's pushing 50. And then you've got on top of that, the rising cost of inputs, steel, roofing materials, et cetera. The good news is that rental rate growth has exceeded the increase in those costs. So whereas a few years ago or 2 years ago or 1 year ago when we were asked about margins, we always said, well, we expect margins to moderate somewhat. Instead, they've gone the other way because rent growth has exceeded, I think, everybody's expectations. At some point, that won't happen, but also there won't be any upward pressure on the input that anymore either. So it should lead to a moderation as opposed to a dramatic falloff.

If I go back to a question I asked earlier on development yields, what are your development yields on new -- that you're underwriting on new land acquisitions rather than your existing pipeline, which is on...

So we have not really altered our underwriting much at all, notwithstanding how hot the markets have gotten. And so we continue to underwrite with about a 100 plus or minus basis points of required development yield above prevailing market cap rates. We still use our 12-month leasing downtime. And as you know, even these days, sometimes we're leasing prior to completion, which part of our investment pipeline right now is already leased. So that's a conservative assumption. And in terms of rent growth, we continue to underwrite what I would call modest rent growth. We do look at it for the next 2 years, is it a little bit higher rental growth rate than the -- the year 3 and 4 and 5 and out to year 10. But we don't follow the market participants, projections of rent growth in our underwriting. So we're conservative there. And so if deals pencil out with our underwriting, that generally means we're going to do really, really well in reality. But we continue to underwrite that 100 basis point yield spread, and we're obviously doing far better than that with almost 250 or 300-point yield spreads by the time we're done.

But I guess, just to put in real numbers, then you're comfortable underwriting a [ spec ] deal in the high 4s sort of yield range right now?

Yes.

Okay. How do you think about autonomous driving? Is it a challenge or opportunity?

It's a good question. I think it's both. I've tried to think through this a little bit. We've had some conversations amongst the team. If they ever got to a point where a lot of inventory was rolling around on trucks all day and never was stored anywhere, I guess that could be a risk. It's hard to imagine that being an impactful proportion of the overall business, but I suppose on the margin, that could have an impact, but certainly have a bigger impact in a soft market. On the other hand, it might just increase the flow of goods. It might be one of the solutions to the port issues, and all of that would be good for us. Because now the goods are getting out of the logjam and they're getting distributed, and that's good for us. So it's an interesting Rubik's Cube, I suppose.

I guess, buried in the question and the conversations I've had with people is, do you then start to look at land, call it, 200 miles away from port? Whereas previously that required -- that was one truck turn a day and all of a sudden, you've devoted a truck and a driver to it. Now, it becomes 3 turns a day because the trucks are doing it themselves. And does that, to your logjam analogy, does it allow for a different type of supply or supply relief [ valve ]?

That's a real pioneering, I guess, strategy. I think that tenants want to be -- whether it's 1 mile or 5 miles or 60 miles, they want to be as close as they can be to the consumption zone, especially today with the cost of transportation going up as it is. And in the case that you're mentioning, the labor cost would be lower. But at some point, everybody digests that level, and they still want to be closer. They still want to save whatever it is they can save from being closer. I think what's going to drive people 200 miles out is just the fact that we developed everything within 200 miles, there's no more land. So I think that's -- I don't think that would be a driver. I don't think that would be a driver.

When does that type of land become more appealing to you? You guys have not -- you still have your lands to [ 18 million ] square feet. When you think about the next batch, do you consider that scenario of, look, we've built out everything we can within 30 miles of New York City with ripping down an office building? Do we have to look further out? Same thing in L.A. and same thing in Miami, and everywhere else, are you tempted or [ UTs ]? Are you sort of against it? Like what -- where are you telling your teams on that? Let's use that instead of 1.5 hours, that 3-hour sort of scenario.

Yes. We're not focused on that right now. Closer is better. In some cases, bigger is better. So the team is out, again, making unsolicited offers. The finding, when we say there's no land to buy, there's always a parcel here and there, and those are the ones that we're finding. And given the way that we go about it, it actually -- it's efficient for us to do that where it may not be efficient for others. We're long tenured in these markets. We have great relationships with the brokers, a lot of owners, and so we can still continue to find these assets. The further out strategy hasn't really entered except for one place, and that would be Inland Empire and going east of the East, Outdoor Banning, Beaumont Banning, even all the way to Palm Springs, and you're starting to see some activity in Palm Springs. That would be the closest example I can give you to that strategy.

And then we have a question here on what you're seeing in terms of conversion or convertible real estate. Specifically, this person has asked about suburban office, but there's certainly other things you could tear down.

It's interesting. A few years ago, the economics just didn't work. Industrial rents weren't high enough, and the expectation on the owners of suburban office or even retail were much higher. And today, I think some of those expectations have come down and our industrial rents have gone up, where now the economics begin to make sense to go out and take down a suburban office building and replace it with a warehouse. The issue you're going to have with some of this and a lot of this is there's a growing anti-industrial sentiment on the part of the municipalities that we're dealing with. And so the thought of taking down what's at least somewhat-- a nice looking office building and putting in an ugly box and having 53-foot trailers rolling through the neighborhood all day and a lot of cars for the staff of that warehouse doesn't really appeal to them. The economics, though, for the first time are beginning to make sense, and so we are looking at some of those opportunities. And the very first thing we do, of course, is go meet with the city or the municipality and say, hey, would you consider a rezone here? So that's out there. It will present some opportunity. I don't think it's going to present, call it, a fourth leg of the stool, though, in terms of new strategy that everybody is going to focus on. But covered land plays, redevelopment of existing uses, certainly, that will be an opportunity, yes.

And multi-story. Is it still too early there?

I don't think that we'll be doing a lot of multi-story. I'm intrigued on multi-story. And when I talk about multi-story, I'm talking about 2-story warehouse, not the multi-mezzanine levels, which we've seen built. The challenge, I think, is that tenants in soft markets -- first of all, the rents on those multi-story buildings are very high. They have to be to justify the concrete and rebar and everything else that went into that. And I'm concerned that in soft markets, those tenants do have alternatives. They can move further out, and they can pay a lot less rent. That's not possible in places like Japan when there's no land, and so the multi-story works quite well. In fact, it's a necessity. I'm just not sure in the U.S. if that's something that's going to be long-term and value-added, so we're going to continue to stick to our bread and butter and not do the multi-story.

Is that still true with land at 50% of development costs, which you mentioned earlier?

Sure. I mean, rent growth, as I said, has been tremendous and justify the 50% ratio.

Okay. We're going to go to a rapid fire as the session is about to end. What will same-store NOI growth be for the industrial sector overall in 2023?

Assuming stable occupancy, because that has a huge impact on same-store, we're guessing 5% to 6%.

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

[ $2.25 million ] to [ $2.5 million ].

And will the industrial sector, more or fewer public companies a year from now?

More.

Right. Thank you.

Thank you.