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 Securities. [indiscernible], we have Peter Baccile, CEO of First Industrial. He will first introduce the rest of his management team and then open it up with some opening remarks before we turn to Q&A. So let me hand the call over to Peter.

Thanks, Ki Bin, and thank you all for joining us here today in New York and on the webcast. Joining me today from First Industrial are Scott Musil, our Chief Financial Officer; and Art Harmon, Vice President of Investor Relations and Marketing. We're a U.S.-only industrial developer owner and manager, our investment focus is on 15 markets with Southern California being the largest, representing 23% of our rental revenue. Our portfolio is 98% occupied, and market vacancies in the top U.S. markets are 3% or less. So we are able to drive internal growth from increasing rents on new and renewal leasing and from built-in contractual escalators. In addition, our development platform is a significant source of external growth and value creation, given the high margins we've been achieving. We have a total of 6.3 million square feet under construction across a range of markets. Our on-balance sheet land holdings can support an additional 14 million square feet. That's a fairly sizable long-term growth opportunity when you consider that our in-service portfolio, is approximately 62 million square feet today. Given that we are all working through a highly volatile market with high inflation, rising interest rates, and geopolitical and other uncertainties. It's important to emphasize that we pursue long-term growth with a focus on profitability first and proper risk management, all backed by a strong balance sheet. With that, Ki Bin, turn it back to you.

Thanks, Peter. So maybe we're going to stick with that topic on inflation. Can you explain how inflation is impacting your business?

Yes, sure. I mean inflation is impacting the cost of everything. At 98% leased, though, we have very little leakage on property expenses. And this includes about 60% of our employment or our employees. Our maintenance people, regional staff and property and accounting folks are all part of the pass-through. So -- and then corporate wage expenses and other costs for the other 60 or so people are being impacted, but our G&A increases year-to-date have been pretty modest. Our structure has a lot of operating leverage. We have 162 people across that 62 million square feet I mentioned earlier and the 6.3 million we have under construction. Construction costs also continued to rise, but so far, the rent growth in our key markets has been significantly higher. And lastly, as you know, interest rates have increased our debt cost of capital has gone up probably about 170 basis points since the fourth quarter of last year. The good news for us is we have no major long-term debt maturities until 2026. We will need new capital for growth, but our developments under construction and currently handily outweigh our cost of capital. So we'll continue to generate profitable opportunities through this market.

And Amazon had a pretty soft quarter this time around and announced that they were slowing down the pace of warehouse absorption. And there are reports that are going around that there thinking about subletting some space back across a range of markets. What is your take on how that is going to impact your markets?

Right. So -- in 2020, Amazon took about 80 million square feet, that was more than the next 30 active tenants combined. In '21, they took another 80 million square feet. The rest of the market also picked up. So now they find themselves at 380 million square feet. Perhaps they over-expanded or expanded too rapidly, but they were doing so to try to deliver a knockout punch to their competition in 2020 when the competition was weaker. We have long expected them to begin to rationalize their space. Their space takeup has grown at a faster pace than their sales for a very long time, a typically a long time. And so now they have announced they're going to sublet, I've seen 10 million feet. I've seen 30 million feet or 40 million feet. A couple of things will be interesting. What will the term of those subleases be, 1 or 2 or 3 years, i.e., short-term? Or will they be coterminous with the underlying lease obligation that they have? There's 2 very different messages from whichever one of those is the outcome. The other thing is that even if they sublease all 40 million feet, coterminous with the underlying lease term, and that space really does come back on the market. It's literally about 25 basis points of the existing supply nationally. So it's really not going to move vacancies that currently stand at 3.1% nationally. So the headline maybe is a little bit more impactful than the on the ground impact. This company will continue to grow, and we're not that concerned about what they've announced. We also suspect that they're trying to manage perhaps having too many people, a labor issue. And so at least talking about down sizing their space puts them in a better leverage position in those conversations.

And any change in the state of leasing demand in the market today compared to a few months ago, especially for your development pipeline? And what are the most active industries that you're seeing?

Yes, there's really been no change. The demand is very robust. It's very broad based, the most active lessees this quarter or so far this year are the 3PLs some of their space take-up is for e-commerce. Some of it's for broader sources of traditional demand for our space. So we haven't seen any changes in the markets that we're in. Again, we target 15 markets across the U.S. The second part of your -- who's active? yes, 3PLs are the most active. Food and beverage, again, traditional and omnichannel retailers, health care and government, home improvement, all the likely suspects. Auto is off a little bit, as you can imagine, can't make a lot of cars without the chips that they can't get, but the demand has not slacked at all across our 15 markets.

Let me pause here for a second to see if anyone in the audience has a question. All right. With the overall market at just 3% vacancy, market rents continue to grow, do you still expect cash rents to be up 20-plus percent on your 2022 rollovers?

Yes. So through our first quarter call, we had dealt with 72% of our rollovers for this year, up 20% cash rent increase. We still expect that number at the end of the year to be 20% to 23%. We've got a lot of great new leasing opportunities there, and the rent growth again in the markets has been really strong. So yes, that hasn't changed even with all the news since April and everything else that's going on in the markets.

Got it. And how are you thinking about the next wave of development investment, given some of the uncertainty in the economy with inflation and interest rates and maybe possibly weakening consumer.

Yes. Good question. Fundamentals remain strong. Of course, now our development process takes a little bit longer than it used to. I mean if you really want to start at the beginning, it takes 2 years to get entitlements. The construction process has lengthened because of the supply chain issues. So it's 12 to 14 months or so to build. So we're delivering into markets that are, say, 3 years out from when we take that decision to take on that start. We, of course, evaluate not only the existing supply in the given submarket, but also what's on the come, what's under construction, what's planned. And we're always focused on trying to deliver those near-term opportunities into pockets of unmet demand. So that hasn't changed. Our new starts are, of course, governed by our self-imposed speculative leasing cap, which, to remind you, it's $800 million. As of the end of the first quarter, we had $158 million of capacity there. And -- so we're going to -- we have raised our -- we've told our teams. We're increasing our required hurdle rates, even if it's just for a short time like it was in 2020. And so again, we have always had a very healthy margin between our delivered yields and our cost of capital. and we continue to be able to achieve that.

And sticking with that same topic, like you said, you've had very favorable margins in our development pipeline. Do you see that -- your ability to continue that going forward?

Again, so far, our rent growth is making up for increased construction costs, land prices have gone up tremendously in the tightest markets in California. I would say that land is about 50% of our development budget now. Typically, it's 25-ish, 25% to 30%. And yes, the margin -- we expected some erosion in our margins in 2020 and 2021 and going forward. And actually, the rent growth has made us wrong. In fact, our margins on our current $750 million pipeline are around. And again, these are paper margins, okay? Yield versus in-place cap rates for cash flowing properties in those submarkets. Our margins on that portfolio are going to be about 100%.

Maybe pause again for a second. Anyone else have a question in the audience? Do you want to speak into the mic, please? They're very formal here.

It's like the school board meeting.

Against your warehouse in my local internship.

Are you guys gearing towards or away from infill development versus more regional development as a lot of the products back in the market and land costs are -- I mean, I guess, everything is increasing? Has there been a shift in focus between those 2 product types?

So pretty much everything we do is infill now. You can't do anything in Southern Cal, for example, that is in the Empire east and west are both sub 1% vacant. And that's why we pick these markets. That's where land prices are growing. Land is scarce and therefore, rents grow the fastest, and that's where we want to be. Obviously, also in any kind of a downturn situation, those markets should outperform as well. So for the past many years now, we have been focused on investing the vast majority of our capital in the higher barrier coastal markets.

Anyone else have a question? Are there any markets in which you're building that you're worried about too much new supply coming online?

Again, no, because vacancy nationally is 3.1%. It's lower than that, where we're operating for all the reasons that I have outlined. And it's supply is coming, but the demand take-up is immediate, and there are just aren't alternatives for tenants. So in fact, typically, cycles are supply-driven. This one is demand-driven. We can't keep up as a sector with -- in the infill markets. I'm not talking about markets that we're not in secondary and tertiary markets within the -- within the coastal and higher barrier markets, you just -- we can't keep up with the tenant requirements.

And over the past several years, but especially in the past couple of years, you reported some very strong operating metrics, like leasing volumes, lease spreads, same-store NOI growth. When you think about the current macro outlook and concerns, how does the top of the funnel look like for you in terms of new leasing proposals coming into your company?

Sorry, didn't hear what you've said?

Top of the funnel demand. So a lot of the new activity and new proposals coming into you.

We have robust activity around every 1 of our availabilities, which at 98% leased isn't much. The interesting, I'll call it, change, and this isn't recent, it's the last 2, 3 years, is that we're having conversations about projects that we're not going to finish for several months. And that wasn't typically the case. Typically, you build it as a speculative developer, you build it, then you start the leasing conversation. And that's why we always had a 12-month downtime built into our pro forma. Now we're having those conversations during construction. In some cases, we're having to not call people back because we don't really want to have that conversation when we break ground if it's going to take a year to build a building. So -- because we want to take advantage of the increasing rents during that 12 months. So that's been the biggest change. Again, the demand, the activity is there. It's coming in sooner than it typically has.

And supply chain issues have impacted construction time lines. How long does it take you to complete a distribution building today versus pre-pandemic? And any signs that things might return to normal soon?

Unfortunately, I mean this may be the normal. Yes. So I mentioned it a little bit earlier. All the land we buy is unentitled. You can't even afford entitled land. So we're batting 1,000 on entitlements in our entire history. So we buy land on entitled that took 12 to 18 months, I would say, 4 or 5 years ago, and now it's 24 months at a minimum. We used to build a building 6 to 9 months. That's now 12% to 14%, and that's largely due to the supply chain disruptions. And on top of that, you have to anticipate your material needs and order those early. So steel, roofing and other materials, we have to order and then sometimes take in, in-store and in the cold shell of the building next to the 1 that we haven't built yet. So you have to get out in front on ordering those materials because the lead time now has grown to as long as a year. So if you do that, then you get back to the time frames, I mentioned. And you're looking at about a 3-year and a few month delivery from the time you start your entitlement process.

And are you facing greater difficulties and longer timelines for getting the necessary entitlements or approvals?

Yes. The municipalities are understaffed. They have enormous backlogs. Many of them are still working from home. And I can promise you, they don't work from home as efficiently as everyone in this room does, not even close. And it just takes time. And sometimes you run into a little bit of an attitude of while they're not really pro growth in pro industrial, even though they're told to approve this stuff. So that adds a little bit of time, too. The good thing for us is we've got really tenured people in all of our target markets with really good relationships with the people to municipalities. And so that helps squeeze these skids a little bit better, but it just takes time.

Anyone have a question in the audience? And you have a lot of built-in growth potential with your land holdings on your balance sheet that can support about 14 million square feet of development. What is your time line for developing all of that? And are you still pursuing additional land sites?

Yes. So that 14 million feet at today's cost is about $2 billion of investment. Again, all things being equal, that's maybe 3 to 5 years of inventory or new growth. Our teams are doing a great job continuing to replenish our land holdings as we put that land into monetization into development, construction and development. And again, it requires a lot of patience and a lot of relationships. We don't participate in auctions or broad auctions. Our teams are making literally hundreds of unsolicited offers a week basically chasing people until they cry uncle. But the funny part is that even if that owner eventually calls a couple of other potential buyers, we've been talking to them for 2 years. They're comfortable with us. They may not be as sophisticated as you might expect. And so that comfort is a big deal, and we're able to win that deal away from any other competition that we have. And that's kind of the model and that's why we can generate enormous margins. We are just not going to go pay top dollar at an eBay auction, you just can't make money for shareholders doing that.

And the land being, in my opinion, is a key differentiator for you guys because especially for relative to the size of the company, our land bank is actually pretty sizable, supporting 40 million square feet of potential development. How many of those land sites are -- can be put to use pretty quickly, meaning you have the entitlements, the market economic support that development.

Yes. So our land at cost $380 million, so not that big a number. And the value today is 2x at least just to start with, in terms of the 14 million feet. What was your -- I lost track.

So how many of those land sites...

How many are ready to go.

Yes. Ready to go exactly.

Most of it's ready to go. There may be a few sites in California that are still in the process of entitlement, but the rest of it is ready to go.

You also have an interesting joint venture in the Phoenix market with a pretty sizable land game. Can you talk a little bit more about that and that market as well?

Yes. We can build at our share of 3.8 million feet there. That market is extremely robust. When we first got out there, we were not the only one. ones, but certainly amongst the pioneering group and now it's just packed. And all of the land is owned, much of it is built. We still have development opportunities at our PV 303 site that we bought from the venture. So that venture is wrapped up, generated enormous returns for our partner and us. And now we have the Camelback land a little bit north of there. And we're currently working on that, working on monetizing that. So that market is extremely robust. There is some space coming there. But we like where we are. We're in -- we kind of [indiscernible]. We have the filet in the marketplace there, and that comes from being there first, I suppose. But it's a great opportunity for us going forward.

Great. And we have a question from the audience.

Just given the land supply story you've been talking about [indiscernible] about the space at what [indiscernible] in multi-storey markets.

Yes. Good question. We are probably not going to be the ones who experiment with multi-storey. Why? It's very expensive, a lot of concrete, steel, and it requires very high rents relative to the rest of the market. I know I'm not the expert on multi-storey. I will admit that. But I'm curious in a bad market in this country. I know it works well in Japan and some other places. There's really nowhere else to go. But I'm curious if we got oversupplied in this market, -- and the tenant could move from a multi-storey building closer to downtown, where they're paying $22 a foot and pay $8 a foot 30 miles away if they would just go ahead and do that. So I don't know what the dynamic on multi-storey is going to be here. Some have built them. And when I say multi-storey, I mean traditional 2-storey concrete truck ramps. I'm not talking about the 7 or 8 mezzanine stories with all the robotics. That's a different conversation. And so we have a couple here. We don't seem to have a lot, and we don't seem to see a lot underway. And I wonder if that's why, but that's kind of my view on it. We don't need to put the R&D into that. If it turns out to be a great thing, someday, we can always jump into. I'm a little skeptical. If that's it, you can hear that in my voice.

Does anyone else have a question? Given the higher rate environment, are you seeing any changes in the competitive landscape for development or building acquisitions?

Yes. It's a little early. Certainly, logic would say that the highly levered buyer is going to be less competitive. So we expect to see that. There is a developing wider bid-ask spread on cash flowing sales. We don't buy a lot, and we don't buy a lot because we don't believe that with the pricing today that we can add a lot of value for shareholders. So we buy some here and there. There's always a story to it. It's typically got some hair on the deal and a way for us to come in and add value and that's when we buy. But we haven't seen a lot of data points yet on that. I think that the assets that appeal to deep pocket institutional capital will continue to trade at the cap rates they've traded at because they're underwriting enormous rent growth. And so even though the cap rate is below a funding rate, pick your number, with the rent growth, their total return is still very substantial. So it would be okay with us. If the increase in interest rates caused there to be fewer merchant developer buildings going up. So we'll see. It's too early to tell. You would expect that to happen. We'll see what happens.

So if cap did rise, where would that show up the earliest?

Probably going to show up in the longer-term leased assets in the secondary and tertiary markets first. I don't -- yes. I mean, again, theoretically, cap rates have to have gone up. Cost of capital has gone up. There's no denying it, but there's no data yet. It's really a bid ask and the brokerage community kind of says, yay and nay. So it's early. Ask me this in the fall, and I might have more data points around it.

So Scott, can you give us a recap on your sources and uses needs for this year on your balance sheet and maybe an update on the capital markets? And what kind of pricing you're seeing for your debt?

Right. So we have about $275 million of needs to fund our development pipeline this year. We've given sales guidance of $100 million to $150 million, that will be a piece. We've got excess cash flow from -- after paying dividend and CapEx, that will be a piece. We also have [ number of ] line of credit -- to the extent we start new investments, as Peter mentioned, or by other land parcels, we'll have to take a look at a couple of options. It could be future more property sales could be more indebtedness, could be equity if we like the stock price. As far as the capital markets are concerned on the lending side of it, there really haven't been many, if any, prints on the 10-year side of the market. Although we did -- I just got an e-mail today from a banker that a private placement price 170 basis points over. So the treasury today is close to 3%. So you're looking at about a 4.7% all-in rate, which is about 170 basis points above what we saw, say, in the fourth quarter year. So it seems like if I talked to my banker colleagues about 2 months ago, maybe that was a 150, 160 spread. Now it's 170. But again, there hasn't been a lot of trades in the market to get clarity on that.

And is there any disconnect between the pricing you're getting from the unsecured bond markets versus private bank debt?

It definitely is. So we did a term loan last year, and I see a couple of folks in the room here that help me fund that. Thank you very much. We did a term loan last year, and the spread on that was 85 basis points over LIBOR. Now you have to add another 10 basis points to it because we converted to the sulfur rate. We just did a deal that we in April, we had the same spread, okay? So there's no movement on those spreads since then. My understanding, based upon conversations, I don't want to put pressure on my banking friends in the room, but the spread still today, we think, are 85 basis points for our credit level plus the 10 basis points so for adjustment. So that market has held steady. But again, if you look at the investment grade market, spreads have popped up 50 basis points since last year. So that was one of the reasons that we did the $425 million bank loan execution in April, we thought it was a good play.

Well time, Scott. Let me pass or one last time for any questions from the audience.

Do you guys have a framework, thinking about, if you go out 3 years [indiscernible] we're in?

Yes. Well, we used to say that we were full at 97% because we felt like functional vacancy, frictional vacancy was about 2.5% or 3%, but we're now 98% leased. So I guess that wasn't right. Who knows where vacancies are going to be 3 years from now. But if you look at the math, we have 17 billion square feet of industrial. That's everything from the newest shiniest distribution center to lean towards that people call warehouses, sheds. And we're 3.1% vacant. So for that number to move meaningfully, you're talking about hundreds of millions of square feet to be delivered with not 1 foot leased, not 1 square foot lease. One of the things that we learned during the great recession is we learned it the hard way, is when occupancy gets to about 92% or 91% the leverage moves from the landlord to the tenant. So you're looking at 5 points plus of vacancy would have to come to that $17 billion square foot market before we stop seeing rent growth, forget rents going down. That would require more vacancy. So we think that for the foreseeable future, there's going to be pretty strong rent growth.

Can I just a follow-up on -- what is the delta as you go from 92% [indiscernible] percentage points go up or what -- how much pricing power we give you to raise rent then you go from [ 94 ] -- like I'm assuming at [ $0.99 ] like your ability to ask for higher rent is significantly higher and it's probably not a [indiscernible]

And the best way I can answer that is that in this market, where we're operating in the coastal markets and the higher barrier markets, I don't know this to be a fact. Okay? This is an observation. There could be cases where this is not correct, but it seems that every new deal, whether it's a sale of a cash-flowing property or sale of land or new lease is at a record price. So at these 97% 98%, 99% occupancy levels, that's what happens. Every new deal is a record. And it's kind of a point of pride for the brokerage community. Well, he got $0.52 a foot and you're getting $55. You got it last Friday, it's Tuesday, you're getting $55. And that's what's happening in the markets with the kind of low vacancies that we have nationally.

What I would say is that 92%, you're getting positive increases in rents on the renewal side of it. Then the new leasing comes probably a percentage point or 2 higher in the occupancy rate. But the vast majority of leasing that we do as a company is renewal leasing.

The question in the back?

Just kind of tell here. So if you look differently at the [ tenure ] of your leases speand with all these tailwinds [indiscernible] kind shorten the terms and getting higher annual rental in those longer contracts? How do you guys [indiscernible]

Yes. We're asked why we don't build that $2 billion right now. And I guess the best answer to that is there's risk in this business, no matter how well we're doing leasing is our lifeblood, if that ever slows down, life changes. And so we push rents as hard as we can. We build with a disciplined risk/reward mentality, and we never forget that there's risk in this business. And that's why we have it self-imposed. Nobody told us we had to have a speculative leasing cap. So risk, risk exists, and that's the answer.

Okay. Well, thank you, everyone, for joining the First Industrial session. And thank you, Peter and the team at First Industrial. Have a good day.