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

Welcome to the 4:20 p.m. session at Citi's 2023 Global Property CEO conference. I'm Craig Mailman with Citi Research, and we're pleased to have with us First Industrial and 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. For those in the room or on the webcast, you can sign on to liveqa.com and enter code GPC23 to submit any questions if you do not want to raise your hand during the session. Peter, we'll turn it over to you to introduce your company, any members of management that are with you today and provide any introduction that you'd like to, and then we'll turn it over to Q&A.

Great. Thank you, Craig, and thank you, Citi, for the opportunity to participate in your conference again this year. With me here today are Scott Musil, Chief Financial Officer; Peter Schultz, Executive Vice President; and Art Harmon, Vice President of Investor Relations and Marketing. We just finished an outstanding year at First Industrial across all aspects of our business. We ended the year at 98.8% occupancy for our in-service portfolio and delivered cash rental rate growth on new and renewal leases of 26.7%. These results contributed to cash same-store NOI growth of 10.1%. All 3 of these metrics were new records for the company. We have maintained occupancy at high levels and driven additional cash flow by capturing rent growth in our portfolio on new and renewal leases as well as through embedded annual escalators. For leases signed to date with 2023 commencements, our cash rental rate increase is 33%, and we expect the full year to be between 40% and 50%, helped by a few significant rollovers in Southern California. Southern California now represents 25% of our rental income. Coastal markets overall now account for 55% of rental income, which is the high end of the target range we established for year-end 2023 at our Investor Day in November 2020. Our primary external growth driver is speculative development. Since 2012, we placed in service nearly 24 million square feet of developments accounting for 38% of our in-service portfolio today. Over the past 6 years, we've delivered outstanding margins of around 65% or approximately $1 billion on $1.6 billion of total investment. That's about $8 a share. We're equally excited about our current pipeline. We have land positions to support future growth and a development platform to execute on these opportunities and source new ones. We manage the risk that comes with speculative development through conservative underwriting, a rigorous approval process and our self-imposed speculative leasing cap, which stands today at $800 million. Our balance sheet is in great shape. From a maturity standpoint, we have no debt coming due in the next 3 years, assuming extensions for our term loan and line of credit. Our only floating rate debt is our line of credit. Lastly, regarding our dividend, we align our dividend growth with cash flow growth while retaining capital for reinvestment. Our Board of Directors recently increased our dividend by 8.5% to $0.32 per share which represents approximately a 70% AFFO payout ratio per the definition in our supplemental report. With that, Craig, turn it back to you. Thanks.

Perfect. Well, thanks for the overview, Peter. So we've been kicking it off, asking everyone to kind of frame up for us the top 3 reasons that investors should buy your stock today.

Sure. First, our ability to create value through our development program, as I just discussed. We've created approximately $1 billion in value over the past 6 years, and we have a strong group of recently completed projects in lease-up, and the 3.6 million square feet we have under construction today are located entirely in coastal-oriented markets and have a potential margin of around 75%. Secondly, we can continue to create future growth by developing on our existing land positions, which can accommodate nearly 14 million square feet or $2 billion of future total investment. Given our ability to achieve significant development margins, as we've demonstrated over the past several years, that $2 billion of investment could generate as much as $1.5 billion in additional value at today's costs. More than 50% of that potential square footage is in coastal-oriented markets, and that figure is higher in terms of value. Lastly, we have the opportunity to drive additional cash flow from our portfolio through capturing rent growth on our new and renewal leases. As noted in my introductory remarks for '23, we're currently at 33% cash rent increase and expect the full year to be between 40% and 50%.

Great. So you hit on development as an opportunity for you guys, and it's been a source of execution upside over the last 5 to 10 years. You guys have predominantly been speculative. Can you kind of frame up or remind us what the internal risk mitigation is for speculative development, the cap that you have, how much capacity you currently have under that cap?

Sure. So because we're primarily a speculative developer, we decided a long time ago that we wanted to have a metric that would mitigate the risk from that business. And it really is a good tool and instills a lot of great leasing discipline. The calculation is simply 9% multiplied by the total equity cap plus total debt of the company. So it's effectively a measure of as against the size of the company. And that cap today is $800 million. If you actually did that math, this morning, that number probably would have been something like $850 million. But the cap is something that's addressed by the Board on approximately an annual basis. Again, today, it's $800 million, and we have deployed $755 million of new investment into projects that require lease-up. It's not just for development if we buy an empty building or we buy a building that we know is going to be empty soon. That investment also goes in the cap. Once we lease part or all of the building, those dollars go back into the capacity that we would have for new starts. So if we have $100 million development, we lease half the building, $50 million of capacity is freed up for other opportunities.

So the leasing environment clearly has been strong for the operating portfolio. You're running at high occupancy. I think you have maybe 1 or 2 large spaces left to lease up. Within the development pipeline, though, could you give us a sense of what the demand looks like that could ultimately free back up some of that capacity here over the next quarter or two to let you start the incremental project or two?

Do you want to talk about the completed?

Sure. Thanks, Craig. So demand around the country is very good. We would say it's a little bit more normalized after the sugar high of '21 and the first half of '22 coming out of the pandemic. But on our development projects, Craig, we have 7 completed in a lease-up around the country, Seattle, Denver, Chicago, Lehigh Valley in Pennsylvania, Nashville and here in South Florida. And we have active prospects for all or portions of those buildings. And we've seen activity pick up a little bit since the middle of January. And we continue to see fresh interest and RFPs coming in. So we feel pretty good about that. And I would say that the pace of those conversations is pretty good.

And I just want to clarify, if you guys were to start a build-to-suit or get a big build-to-suit commitment, you could start that without worrying about the cap because it would be fully leased?

A build-to-suit would not count against the cap.

So from a risk mitigation perspective, is there an opportunity to a little bit more of that? Or are you guys seeing more inbound kind of conversations about that in your various markets?

So we do. We are in the build-to-suit business. We don't do a lot. A lot of that has to do with the way we go about buying land. We target land that is near-term developable in the most land-constrained markets and that's going to meet near-term unmet tenant needs. So when we close on a site, we're immediately putting it into the entitlement process and working on it to be able to bring it to market. We don't have -- we don't bank land, maybe like in the old days when it was a -- you go out and buy several hundred acres. This is in the path of growth and in 2030, it's going to be ready. We don't do that. So we do bid on build-to-suits. We don't have a lot of different alternatives for those potential opportunities because of the way we buy land and where we build it, and we also make a lot more money buying the land in the highly constrained markets and building on a spec basis. The yields are much better.

So cost of capital or at least debt capital, right, equity valuations have come back some for the industrial group. But if you look at it on a stabilized basis, that spot cap rates probably understates what your cost of that good would be. So I'm just kind of curious, as that cost of equity has gone higher, your margins are still extremely healthy on the development side. But as you're thinking about those incremental starts internally, sort of how is the thinking in the underwriting committee about where returns need to be relative to that new cost of capital to make sense from a risk mitigation perspective?

So we've done a couple of things. You mentioned margins. While there haven't been enough trades to really be able to say, okay, cap rates in each submarket have moved x., clearly, to be intellectually honest with yourselves, you know cap rates have moved. So we added 100 basis points to the cap rate analysis in our margin analysis. So those margins that we're quoting now are after that change. So still very healthy as you point out. Thank you. Yes, our cost of capital has gone up, and we have adjusted our return requirements up pretty significantly. Prior to the current turmoil in the markets, let's say, end of '21, for example, we probably would have stretched to a 4.5% yield on a development in California. For example, today, the minimum yield is 6.5%. From an IRR standpoint, we've also added a couple of hundred basis points to our total return, and that's on an unlevered basis, obviously. So we think right now, that properly reflects the movement in our costs and retains the spread that we want to achieve for the risk that we're taking.

And thinking about your market exposure, you guys made a big move into Phoenix a couple of years ago with the land acquisition there. You've been big developers in the IE South Moreno Valley, you have exposure down in Texas. And just some of the kind of tailwinds coming out of COVID, right? You're kind of China Plus One now, which is driving a little bit of port diversification for some of your tenants. You have the nearshoring initiative going on that's driving some demand down to the border stage. You have built an Empire in their construction moratorium there in a market where you're basically full, right? So I'm just kind of curious from a market perspective because you guys are in a lot of these markets from an incremental dollar out, given some of these dynamics that are going on, your perspective on maybe the long-term view of FR on the desirability of some of these markets and where the puck may be going from a long-term valuation demand perspective?

Yes. So when you look at tenant demand or tenant needs, as stated, there are surveys that some of the brokerage companies do. The places where that always rank in the top 5 or 6 in terms of need for space, Phoenix, Chicago, Atlanta is on that list. Dallas is on that list. And so those markets, again, if those studies are accurate, we think, will continue to be pretty strong. California, 39 million people, enormous economy, challenges for sure. We have a great team there. They do a heck of a job finding new sites to replenish our pipeline once we develop assets there. And they have their finger on the pulse. They have a lot of relationships there. And so we feel pretty good about the way forward in California. You mentioned moratoriums, that's certainly something that we have to keep an eye out for. Yes, you'll have the upside if that does happen in some of these locations of what we own there is going to skyrocket in value, and certainly, rents will increase even more. So Phoenix, we have our joint venture in Phoenix. We're very happy with the way that's gone. We have made a lot of money for shareholders, both in our PV 303 venture, and our Camelback venture. Probably when we're done there, we're probably going to be satisfied in Phoenix for a while. And so the growth dollars are really going to continue to pour into the West Coast, South Florida, New Jersey, Eastern seaboard in certain markets, that's where the majority of our capital will go.

And shifting over, you had mentioned the 10% same-store growth that you guys did last year, can you remind us on where that growth stands for 2023? And as you look at your mark-to-market, which continues to grow every year, occupancy, although everybody -- models are coming down, it hasn't really budged for most people. What do you guys see as that longer-term normalized same-store growth rate given this continued upward move in mark-to-markets within portfolios?

Cover same-store?

Sure. Okay. I'll cover same-store first. So Craig, 2022, our same-store growth was 10.1%. We're guiding to 8% in 2023. The deceleration has to do with basically our occupancy is going to be flat in '22 and '23. Remember, we ended 2022 and 98.8% occupancy. In 2022 same-store, we picked up a couple of hundred basis points from that occupancy. So very strong there. As far as same-store growth on a go-forward basis, assuming a flat occupancy rate at the company, you should be probably in that 7% to 8% range based upon the increases that we're getting on new and renewal leasing.

Talk about the relationship between 98.8% and how fast we have to lease.

Yes. So we got questions, end to get 98.8% is a company record, okay? So our company turns about 13% to 15% expirations a year. Our retention is about 70%. In order to get a 98.8% occupancy level, you basically have to lease up almost immediately any move-outs that you have in the portfolio. So 30% that nonretained tenants, we're basically leasing it up within 1 day to 30 days. And Peter Schultz has a couple of great examples recently of 3 tenants that we had that experience.

Right. So we had 3 tenants move out at the end of the year in Philadelphia, Baltimore and Cincinnati, between 50,000 and 160,000 square feet. We had leases signed to backfill all those spaces before the expirations. Tenants took occupancy in 2 of the 3 cases the day after and in the third, within weeks of move-out. So back to your question around demand, that's what we continue to see around the country and backfilling the spaces quickly. The other thing I'd add is all the requirements that we're seeing are really about growth. So everybody needs more space. Most of the tenants that are moving out of our portfolio are doing so because we can't accommodate their growth because we're essentially full.

And remind me, is all post road in backfilled or is that a source of upside to occupancy and same-store if it gets?

That's a source of upside to the occupancy. So if that building, which is 644,000 feet, which represents essentially all but 60,000 feet of our vacancy in our portfolio as of year-end if that was leased, Craig, we would have been 99.9% occupied at year-end.

So there's still some upside because eventually, that will get leased, right?

There you go.

It's [indiscernible] in the quarter third quarter. So everyone knows.

Going back to the development side of things. Scott, maybe could you run through your capital needs to fund what you have under development and kind of what's in the plan to continue that growth?

I'd like to reiterate what Peter said in his opening remarks, we do not have any debt coming due until 2026, if you give us credit for extension options on a couple of pieces of bank debt that we have. So for the developments that we have under construction at the end of the year plus the new stock didn't start we announced. We'll need about $225 million of capital in 2003 to fund that. We gave sales guidance of $50 million to $150 million, so call it $100 million is coming from that. The company generates about $75 million of excess cash flow. The remaining $50 million is basically going to come from borrowings on the line of credit. We've got $600 million of capacity. So we're set up really well from that point of view. Now if we continue to lease up developments, we'll make a decision whether we want to start new developments. So that would require new capital. The benefit for us of starting new spec developments is we have a land bank that we can pull land off that's already paid for and the development cycle is about 12 months. The funding cycle is about 15 months. So starting new developments isn't going to be like a severe day 1 drain on our cash flow. So Craig, I would say we're sitting in very, very good shape.

And just given the growth in the portfolio and the developments that you have delivering, from a leverage perspective, are you -- are these leverage neutral to fund the $200-plus million? Or are you ultimately delevering over time because of that internal growth plus the NOI coming off developments?

Well, the company policy is debt-to-EBITDA 6x or less. We've been hovering around 5x that. I think we want to be 5.5x and less in this type of environment. But I would say funding that definitely would be leverage neutral just because of the increase of the EBITDA of the portfolio that's really, really helping it. Also in our supplemental, you should take a look because we also have a pro forma metric on leverage. So -- if you give us credit for what we've spent in our developments for which we do not have EBITDA, that 5.1x leverage goes down to 4.6x. So we look at that metric as well.

And on the acquisition front, I know you have disposition, you have the development. Kind of how are you thinking about that leg of the stool in this environment? Are they in markets that are interesting from -- that you'd be willing to maybe pay up a little bit because you just think the long-term growth profile is that good? Or are you kind of just pulling back in general because pricing is a little bit harder to discern?

We'd like to buy more. We are going to be opportunistic in this environment, and that doesn't mean that we expect to see distress because we don't. There's just too much capital on the sidelines looking for a home in the sector. So we like to buy more. Typically what we want to buy either isn't for sale or it's being broadly auctioned and the pricing gets silly. We want to make a good spread on our investment, obviously. And in the high-barrier markets, if there were assets, we would definitely buy, we have bought assets in those markets. They typically have a little hair on them. There's an opportunity to fix a lease or to redevelop or to expand or something and we go in and we'll make those acquisitions. So acquisitions will, in all likelihood, remain a smaller component of our investment capital going forward, but we're certainly in the market for cash flowing assets.

And Scott or Peter, I want to go back to the commentary of the $50 million to $150 million of sales this year. You guys have done a large amount of repositioning over the last decade of culling some of the lower growth assets. I mean, in this $50 million to $150 million bucket, kind of how much of that is just asset management and selling where value has been maximized in the near term versus continuing to kind of pare down noncore market exposure?

I mean we're continuing to pare down noncore markets, selling the lower growth components of the portfolio likely will be in the Midwest as we've done, as you've seen. It doesn't mean there might not be an asset here or there in other of our markets that we might choose to sell. Sometimes we get unsolicited offers on assets that maybe we weren't looking to sell, but certainly with a great price, we'd consider it. So it's really portfolio management at the end of the day. It's the ongoing annual portfolio management that we undertake. And as we continue to refine our holdings into really just our 15 target markets.

On the tenant side of things, can you just give an update on maybe what tenants could be on the watch list, percent of ABR, kind of what bad debt is that's baked into same-store?

Right. Okay, Craig, I'll answer that question. So we have $1 million allowance built into our guidance. And if you were to look over the past 5 or 6 years, exclude COVID because it was a little bit higher, our bad debt expense has been under $500,000. We think that's great. As far as tenants on the watch list, nothing material at this point in time, but we do -- we have alerted people in our meetings in our fourth quarter call. We have a tenant called ADESA that's owned by Carvana. They're having some liquidity issues with their company. Their stock has gone down. We own at least 7 sites to them. They're current on their rent. I would say that's a vital part of their business. The ADESA company is very profitable. I would also say if things turned south and they rejected their leases. I would say that would be a massive opportunity for the company because the land locations are in great, great markets. And I would say this also, if you were to look at the NAV value of those assets with the tenants in place, and you compare it to them leaving and freeing up the value of that land because there's not a lease you would have -- the NAV would probably triple related to that. And I don't think you can say that much about any type of real estate where you have a tenant that left because of bankruptcy. So they keep on paying, that's great. If something happens, where they reject the leases, we're going to get spec some great land parcels that's going to provide some great external growth in the future.

It's a very valuable asset to the creditors of Carvana. So we don't expect to get it. But if we did, we'd be happy.

And what's the percent of ABR that, that would represent?

I think it's about 1.8% to $7 million of NOI.

Okay. I have a question coming in that I'm going to try to massage a little bit here, but we have seen some consolidation in the industrial space over the last couple of years. Your valuation -- I think you guys are continuing to argue it's discounted, right? But the market has started to give you more credit, started to understand the quality of the portfolio relative to maybe the perception from several years ago. I mean, what are you doing to further narrow the gap relative to what internally you think the value is versus the perception of the market?

Clearly, with the transformation of the portfolio that we've undertaken over the last 12 years, our performance across all metrics has significantly improved. And yes, the valuation has improved. And so we're really just doing our thing, so to speak, and continuing to create value and to invest dollars that generate enormous margins for our shareholders. And obviously, we're going to also continue to hone down our holdings, get rid of much of what we have in the Midwest, other than Chicago and continue to invest new dollars on the coast. And that has changed the outlook considerably.

Then shifting to ESG. It's been an increasingly big topic within the REIT space. So I'm just trying to get a sense of everyone's top 1 or 2 biggest initiatives for '23. I was just hoping you could give us a sense of what FR is most focused on?

So we received last year approval from the U.S. Green Building Council of our prototype. And so our focus now is to take all in process as well as all new development projects and lead through the lead process. We hadn't done that. Now a lot of what we built -- have built is in California, and that's pretty much lead standard anyway, but we're going to do that now across the whole country.

Does anyone in the audience have any questions? I know we've been kind of going nonstop. All right. Perfect. Going back to the M&A question. This is more of a your view on some of the valuations that the industrial REITs have paid and what that -- Indus, I had estimated it was a 5-cap, but it was a little unique, existing shareholder, GIC then you had [ Duke ] PSP. I mean, given those valuations and the assets that you guys are selling and the growth profile that you have, I guess, without asking directly what you think your discount to NAV is, I mean, how happy are you with the process -- the progress that you have made kind of educating the market? Because I think you guys did a good job at the Investor Day a couple of years ago showing your relative metrics and dispelling some of the myths or misunderstandings.

What's the question again? You kind of lost me.

I guess you guys have traditionally been on the list of people's potential going away. And just your view of what you guys have executed on the internal growth that you guys have and that perception versus as a management team, as the Board viewing what your ultimate upside could be from a continuing ongoing concern.

So the -- as I mentioned, we have 38% of the portfolio now we've built in the last 10 years. So it is about 24 million square feet. We also sold billions of dollars, and we did all of this on a pretty accretive basis, overall. And the pipeline that we have now for growth is probably the best that we've ever had. It's certainly located in the best markets and submarkets that we've ever had. So the growth opportunity that's ahead of us is tremendous. Our balance sheet is fully rock solid, and we have plenty of capital to execute our plan. So right now, we're focusing on adding shareholder value through executing the plan, as we have in the past, and we're going to keep doing that with the pipeline that we have.

Move on to rapid fires. Same-store NOI for the Industrial group, not necessarily FR in 2024?

7%.

Best real estate decision for FR today? Buy, sell, build, redevelop or hold?

Build in supply-constrained markets.

And then a year from now, will there be more, fewer, the same number of industrial public REITs?

Fewer given the pending Indus transaction that you mentioned.

Great. Well, thank you, guys. And we still have a couple of minutes left if anyone has any questions from the audience? All right. Great. Well, I appreciate your time. And I hope everyone enjoys the rest of the conference.