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 First Industrial CEO, Peter Baccile, who is to my right. Peter will introduce the rest of the management team and provide opening remarks, and then we'll turn to Q&A. Peter, thanks for being with us.

Thanks, Ki Bin, and thank you all for joining us here today in New York and on the webcast. With me today from First Industrial are Scott Musil, our Chief Financial Officer; and Art Harmon, Vice President of Investor Relations and Marketing. As a brief introduction to those not familiar with us, we're a U.S.-only industrial owner, developer and manager. Our portfolio covers 15 top logistics markets with 56% of our rental income concentrated in coastal-oriented markets. This includes 25% in Southern California, the nation's largest industrial market. As of the end of the first quarter, our portfolio was almost full at 98.7% occupied. We delivered a quarterly record for cash rental rate increases of 58.3%. Our outlook for the full year 2023 is also very strong. Per our first quarter earnings call, we expect full year cash rental rate change to be 45% to 55% helped by some sizable rollovers in Southern California. Over the years, our development platform has helped to shape the makeup of our portfolio while creating significant value for shareholders. Since 2012, we've developed and leased 24 million square feet, accounting for nearly 40% of our in-service portfolio. We have an additional 5.8 million square feet under construction or in lease-up with a strong emphasis in coastal markets. We also have future growth and value creation opportunities in our land holdings, which can support 14 million square feet of additional development. These sites are primarily concentrated in supply-constrained coastal markets and have an estimated market value of $800 million, which is more than 2x our book value. Overall, fundamentals in our industry remain strong as national vacancy sits at approximately 3.4%. This low vacancy rate has encouraged new development and there is a fair amount of supply underway nationally that will be delivered within the next 12 to 18 months. Given our emphasis on coastal markets, we like the competitive positioning of our new projects. We've also seen new starts slow thus far in 2023 and responded to higher financing costs and the evolving economic environment. This significant drop off in new starts is a positive for future fundamentals. Finally, we are well positioned from a capital standpoint with low leverage and no maturities until 2026 assuming we exercise extension options. Through all environments, we take a disciplined approach to new investment, portfolio management and capital management that aligns with driving long-term cash flow and dividend growth. Ki Bin, back to you.

Thanks, Peter. So from a high-level standpoint, we're lapping a couple of very strong years of industrial demand and rent growth. Today, there's about 600 million square feet of new supply underway. And there's some concern that we're potentially facing some slowdown in demand given the macroeconomic situation. How would you describe the nature of supply and demand dynamics for your portfolio? And what does this ultimately mean for rent growth?

Yes. So national vacancy rate, 3.4%. Vacancy rate in our portfolio, 1.3%. So we start in a pretty good place. Thinking about the pace of demand, net absorption did slow in the first quarter. Rising interest rates, a slowing economy and consumer demand have all led to a slower time frame for making decisions, especially for the larger space users. We look at right now as a demand normalization. We had extreme growth in '21 and the beginning of '22. That was off the back of almost no activity in 2020. In fact, in 2020, Amazon leased about 70 million square feet, and that was more than the next 30 largest tenants combined. So all of those entities and more took an enormous amount of space in '21. Now we're back down to a normalization. And for us, that means our new projects where in '21 and the beginning of '22, we might have had 5 or 6 potential prospects for new space. Now it's 2 to 3, which is identical to what we had in '18 and '19. And if you think back to '18 and '19, the fundamentals were such that they were the best years anyone can remember in the industrial business. So we're just taking that peak off, and we think we're going to resume a normalized level of growth, both in new space and rents.

What do you think rent growth will be this year for your portfolio -- market rent?

Market rent growth generally across the country is probably in the 5% to 10% range. Closer to 10% in the coastal markets, closer to 5% in the Midwest. You might get into the 11%, 12% area in California. That sounds maybe not too impressive when you're coming off of 25% and 28%. But again, that's still very, very, very strong growth.

And what kind of feedback are you hearing from your tenants and prospects? And how have they shifted their near-term appetite for industrial space, if at all?

Demand for industrial is still very broad-based coming from all sources. We don't see any particular sector having any weakness. Again, on rollovers, the rent growth that we're achieving is pretty spectacular. And those decisions are happening pretty quickly. So that gives you a sense that the business needs that are in place today, there's a lot of confidence on the part of those tenants that, that's going to continue. So again, we've had some tenants move out because we can't accommodate their need for growth, given that we're 98.7% leased, and we've backfilled those spaces very quickly at very substantial rent increases. So again, demand is broad-based and strong.

And if you had to bifurcate out that demand, is there any type of noticeable regional strength, whether that's coastal versus noncoastal, Sunbelt versus not?

Coastal markets do better. Land is scarce. Therefore, rents grow the fastest. Alternatives are also scarce. So when -- that's what we like. We like it when tenants don't have alternatives. And so that's why we're focusing most of our capital growth in the coastal markets. With respect to property size, et cetera, that really depends on the submarket and the dynamics of the submarket. We have an amazing project in Medley, near Miami. We're building 2.5 million square feet there. You might know the project, it's 1 where we're filling in an old rock quarry. And as soon as we finish those buildings, which are about 200,000 square feet, they get leased up. It wouldn't be the market to bring a 1 million square foot building to because that just doesn't fit the profile and the need of the tenants in that market.

And turning to your -- 1 of your largest markets, Southern California, we've been fielding just growing investor questions regarding the strength of L.A. Inland Empire maybe is cooling off from a very hot level from the COVID era. Given that you're generating nearly 25% of your rents from SoCal, I was wondering if you can give your pulse on the market and share any insights that you're seeing.

Sure. So vacancy rate in the Inland Empire is 2.6%. Vacancy rate in L.A. is 1.4%. So again, those markets are very, very tight. There's about 30 million square feet coming to the Inland Empire on a base of 600. So 5%, which traditionally is a pretty healthy addition to the base. 58% of that 30 million feet is pre-leased. 19 million square feet of that comes this year and about 11 million square feet will be completed next year. Given how tight that market is and given the strength of those markets over the past many years, that new space won't significantly alter the dynamics there. And of course, the dynamic that the landlord enjoins today over the tenant is not going to be -- is not going to change.

And in the first quarter, and you mentioned in your opening remarks, you generated a very strong cash lease spreads of 56%-58%. Do you think this level of elevated lease spreads can continue into '24?

So cash leasing spreads are heavily dependent on the mix in a given portfolio. For 2023, California rollovers represented a disproportionately high share of the rollovers relative to California's contribution to the portfolio as a whole and you see the resulting very high quarterly cash growth in the rent. Next year, in '24, rollovers in California represent a lower proportion of the portfolio. So you can expect that cash rent spreads might be a little bit lower in 2024.

Let me pause here to see if anyone had a question in the audience.

[indiscernible]

So we've increased our development yield requirements as well as our IRR requirements or total return investors at the end of the day. Our cash yield requirements are in the 6.5% range with IRR is about 8%.

[indiscernible]

The yield -- the cash yield that we make. Yes. So our development pipeline now 6.7%?

Yes, about 7.3%.

7.3% on this one, I think yes. 7.3% is what we're going to generate now. Again, when we underwrite new deals, we pro forma 6%, 6.5% minimum. And we've outperformed over these years, largely because rents have grown a lot faster than we've put in our own model. We do, I guess -- well, you could say we've been conservative because that would -- that's what a look back would say. And we never really changed our underwriting as hot as the market's got. We always use 12-month downtime on our leasing assumption. We used pretty conservative rent growth assumptions. And of course, we've outperformed on the rent growth. So that's why the yields are much higher than the original underwriting.

Any other questions? I'll jump ahead a little bit, but sticking with that same topic, developing at a 6.5% in Canton, Ohio versus L.A. It means 2 different things. Can you talk about the value creation and your profit margins that you experienced over time?

Yes. We've generated very, very large margins pretty much every year. In 2022, if you look at our published information, you'll notice the margins dropped somewhere in the neighborhood of 30% down to kind of 40% to 50% from 70% to 80%. And that was largely because to try to be intellectually honest when you have markets in turmoil, even though there are no trades. You can't put your finger on what cap rates really are because nobody is transacting. When the cost of capital goes up, it would stand to risen cap rates also had to go up. So we built in an additional 125 basis points into our assumption to generate those paper margin estimates. But when we go in to look at a new opportunity, we still target 100, 125 basis point yield that's above the prevailing market yield for cash flowing properties.

And you guys have done a great job in developing and delivering some of the widest margins in the industry. You have self-imposed speculative leasing cap of $800 million. Can you remind investors what that means and how that works?

So a number of years ago, we put in place a risk mitigant that we call our speculative leasing cap -- self-imposed speculative leasing cap. And we put it in place given that we're largely a speculative investor, speculative developer. And that was calculated as 9% of the total equity and debt market cap believing that, that amount of money at risk was appropriate for the size of the company. And that's still the formula. So what it means is, right now, that self-imposed cap is $800 million. Any time that we acquire a property that requiring tenancy we do a forward, make a commitment or we commit to a start. It's on committed capital, not invested. The dollars associated with that decision use up the cap. So if we have a $100 million committed development, we end up leasing half the building, $50 million of capacity is now regenerated under the cap. Typically, we take assets out altogether when they get above 90% leased. And since we've been leasing everything to 100%, it hasn't been a challenge. But that's -- it's a great risk mitigant. It forces a great leasing discipline on the team. The same people that want to build new assets are responsible for managing and leasing those assets. We don't have silos. So that also creates a great discipline there on leasing.

And you have a land bank that can accommodate 14 million square feet of development. As you sign additional leases on your development assets, should we expect you to replenish that pipeline in this type of market?

So yes, we can build 14 million feet. That's on land we currently own. It's about 70% of that is entitled. That equates to approximately $2 billion of new investment. So we've got quite a strong pipeline. As far as there's 2 definitions to replenishment, I suppose. One is new starts and 2 is new land for future new starts. We continue to make unsolicited offers for new land opportunities. Of course, our offers are far below what sellers want to achieve on those properties. And that's the case across our business. That's why there's not -- you're not seeing that many transactions. Those of us who have to raise capital in the current reality, have a certain expectation of value and those who have owned for a long time, I think it's 2021. In terms of new starts based off the portfolio that we have or the land that we have, that's going to be heavily dependent on 2 things. One is the strength and the fundamentals of the submarket that we are looking at potentially creating a new start and two, our lease-up, again, here is the speculative cap. We, today, have about $25 million available under that cap. Not too many of our projects are that small. So we need to do more leasing before we can generate new starts.

And not all development is created equally. A significant portion of your projects are located in some of the best markets in this country, like Southern California and South Florida. How would you describe the level of tenant interest for your development projects today?

It's been really strong for many years and continues to be today. Again, we try to buy land in markets where there are near-term opportunities to meet unmet demand. We don't go out and buy land and say, "Oh, it's in the path of growth. And someday, this is going to be a home run. And because it takes so long to get entitlements, et cetera, this strategy works fine. You don't miss out on an opportunity in taking that approach. And we've focused the vast majority of our investment capital in the higher-barrier markets. If you were to look at the pipeline of opportunities we have to call it, replenish after we lease up the stuff that's underway now, most of that is in California and South Florida. It's an excellent pipeline. So we're paying very close attention to what's going on in the economy. Of course, we pay attention to what the Fed says because that causes everybody to either be happy or lose their minds. And so that matters more than anything right now. But so far, the fundamentals in our business are outstanding. And if we free up some space under the cap, and we have a start we can achieve in the West Coast or in South Florida. That's a pretty low-risk way to take a risk. If that makes any sense.

And could you comment on construction cost trends and how this might be impacting the development underwriting?

So construction costs were going up so fast, luckily rents were going up faster. But they are going up so fast, we were ballooning out our assumptions on contingencies and expense growth, et cetera. That has eased substantially. The growth rate has eased. Construction costs are still going up, but it's more on an inflationary, I'll say, older inflationary pace, 3%, 4%, not the 8%, 9%, we were getting 10% a year for a while. The other factor there is supply chain and the ability to get roofing materials and dock packages and not new steel, but the -- for electric. Transformers, thank you. I forgot that word for a minute. And that has eased somewhat too. The roofing materials are not so hard to get now. Transformers are really hard to get. And you have to order those 1 year out and sometimes they're even delayed beyond that. And what's frustrating, of course, is you have a building that's finished and a tenant that signed a lease and you can't get a CO if you don't have a transformer obviously. So -- but the construction challenges and the rise in construction costs have eased, and we expect them to continue to ease, especially because starts are way off. starts are way off. In the first quarter, estimates 40% to 50% year-over-year. We think that's going to continue throughout the year. The lack of construction financing. We don't use that. We borrow on balance sheet. But the vast majority of the developers that create product in our sector are property level borrowers and construction financing is very difficult to get. If you can get it, it's 50% loan to cost at the high end. Debt used to cost 4%, 4.5%, now it costs 8.5% or 9%. And a lot of the deals that were underwritten were underwritten under the old -- when you can borrow 65% and it costs you 4%, 4.5%. So those deals don't pencil and that's created this dynamic now where starts have dropped way off. And that -- obviously, that's a tailwind for our business. And it probably shows up in the math in the third quarter or fourth quarter of next year.

And when you take a step back and look at your portfolio composition, you've built this portfolio very methodically over the years, being careful with your asset sales programs. Generally speaking, are you in the right markets and the right concentrations? Where would you like to trim or add to?

Yes, we're going to -- we're now, like I said earlier, 56% coastal. That number will grow. We're about 1 percentage point away from our goal of having of 95% our square footage in the 15 target markets. That will happen. That will happen largely due to lightening up of some of the assets that we have targeted for disposition. So we'll invest new capital in the coastal markets and the assets that we sell by and large be in the Midwest, Detroit and Cincinnati, Minneapolis. This is good real estate, by the way, but the barriers to entry aren't quite as high there. And so we'll lighten up there and take that capital and reinvest it.

And turning to the transaction markets. What are you seeing in terms of pricing for industrial assets in terms of cap rates?

Not seeing any deals. It's tough to peg cap rates and everyone will have a view and what I'm going to tell you may sound low, but if you were going to try to buy a Class A asset or portfolio, first of all, you can't. But if you -- cap rates are going to be between 4% and 5%. And that sounds low given what I just said about how much debt costs, what I said about what our total return expectations are. But I think when the transaction market picks up again, you're going to be in that range, obviously, closer to 4% in the coastal markets and 5% or north of 5% in the lower barrier and middle barrier market. So again, this is an estimate, a guesstimate, if you want to call it that. There have been 1 or 2 trades here and there. There's always an interesting story around one-off deals in a quiet market. So we'll see. I mean we need to have 2 things happen for this to free up. One, we need buyers and sellers to both agree on what's happening with the cost of money. Right now, there's no agreement. Once that happens, then there will be a coming together probably with the seller is getting a little bit more realistic because cost of capital has gone up a lot, not a little, and if you expect treasuries tenure, let's say, don't forget in 2006, everybody is making a lot of money and the tenure was 3.5. So that's not a stunning thing. But that's not in anybody's underwriting now. So again, that's why I think that buyers and sellers have to agree that the cost of money has stabilized. Spreads are much, much wider now than they probably need to be. Again, once there's more certainty about what the Fed is doing with rates and when there's more certainty about whether or not we're going to have a recession. So we've got a ways to go before you're going to see the gates open and a lot more deals happen.

Maybe pause there for another second. Anyone have a question from the audience?

[indiscernible]

So we build into our underwriting a 12-month downtime to lease up. Oh, yes, you want me to ask the question. The question is how long does it take us to lease up an asset once it's completed? And -- again, we build in 12 months downtime. In the last couple of years, we've experienced probably 6 months-ish, maybe a little less. But again, that's in a very peaky time that we had -- where we had this outsized demand in '21 because -- in the beginning of '22 because so much of the tenant base didn't do anything during the lockdown year. Our 12-month assumption, that's been the case since I got to the company in 2016. So we haven't changed that. Yes, we've outperformed it. We're happy when we do, but there's no reason to change that. And depending on what the new normal is, we'll see what our actual experience is. It might be closer to 12 than 6 months. Yes, sure.

[indiscernible]

Standard allowances, no big concessions, maybe half a month of free rent per year of the lease. If a tenant wants an above-standard TI package, we make them amortize it over the lease. And if we don't like the credit we make them put up an LC. The credit on us taking that risk. We don't take any tenants we don't not like the initial profile of. Yes, in the back.

[indiscernible] Are you making any changes to your strategy? [indiscernible]

Yes. Asking if we're making any changes to our strategy, if we have a recession in 12 to 18 months, yes. With pipelines like 600 million square feet coming. Here's the thing. Where are you -- if we are going to go into a recession, where you start from matters as much as anything else. And I already quoted our national vacancy rate is only 3.4%. Rent growth has been enormous. The credit quality of the tenant base actually has been pretty good, and you can -- that was tested in 2020 for sure. We collected all of our 2020 rents in 2020, the rent that was due in 2020 in 2020. So the position you start from matters. 600 million feet is on a base of 16 billion to 17 billion square feet. If none of that was leased, and I said earlier, about 28% of that is pre-leased. It's not going to make a change in the vacancy rate that is going to change the dynamic between the landlord and the tenant. That's not going to happen. You're not going to have 600 million feet. But if it did, it doesn't change the dynamic. Well, if that happened, that would change our strategy. Maybe we're not going to build anything for a bit. No one's going to build anything for a bit. So I mean some would until they find out the errors of their ways. But my point is we're starting in such a good position, a lot of bad things have to happen over a longer period of time than normal. And because of that, we'll have the opportunity of hindsight to say don't build anymore. So we're -- we'd be observing and we'd be paying attention to the math. But even though 600 million square feet is a large number, it's on a base of 16 billion to 17 billion. We have -- it's a big country, and people buy a lot of stuff here.

So a couple of years ago, you guys discussed the opportunity to grow cash flow per share at a 9% CAGR rate from '21 to '23, which I think you surpassed. Do you think that next couple of years could bring a similarly high level of cash flow per share growth rate?

Yes. Let me just summarize what Ki Bin was talking about. For our Investor Day, we talked about 2020. We think our AFFO this year, based upon our first quarter guidance will be about $255 million. We have a lot of developments that are in process that haven't been leased up. We spent a lot of money either via -- funding it via property sales or equity. We would earn another $32 million with that upon a lease-up, which would take us way north of that $260 million goal. So we're in very good shape when that is concerned. As far as a go-forward basis, the main drivers are going to be increases in rents on new and renewal basis. That's going to be a big driver. And I'd also say rental rate bumps as well. Prior to the last couple of years, rental rate bumps averaged about 2.9% in our portfolio. Right now, we're getting about 3.7%. So over the next couple of years, that's going to migrate closer to 4%, which is going to be another driver of cash flow. And then we talked about our wonderful developments that we have an under process and the ability to build out with our additional land. Again, our basis is $400 million. The fair value is $800 million. So the yields are going to be pretty juicy on that. So I'm not going to give you a percentage number, but I think over the next couple of years, it's going to be very, very good.

Okay. That brings us to the end of a session. Thank you, everyone, for joining, and thank you, Peter and Scott and Art.

Thanks, Ki Bin, and thanks, everybody, for coming.