Prologis, Inc. (PLD) Earnings Call Transcript & Summary

[Audio Gap] The Prologis roundtable. Very happy to have Tim with us, CFO. I think everyone knows him, so I won't go through the bio. So maybe do you want to just give us sort of 5, 10 minutes update, and then we'll move into Q&A?

Sure. And I'll be really brief in talking through the company, as I'm sure most of you know us pretty well, but just the 1 minute is we're the world's largest public logistics REIT. We have about $200 billion of AUM that we own or manage. A little over 50% of that, we run through strategic capital vehicles. The rest of it is wholly owned on our own balance sheet. We are principally in the U.S., about 60% of our holdings would be in the U.S. by right of our ownership through all those vehicles. It's more on the order of 81% today, and that all precedes the Duke acquisition, which many of you will know about, and we expect to close early in the fourth quarter. I think I'll just maybe start by stepping through the markets, and maybe that will launch into some questions. But we've been providing some mid-quarter updates, which are really necessary, I would say, in the pace of this market anymore. Quarterly updates doesn't really capture everything that's happening. And thus far, in the third quarter, we've got occupancies that have been historically very high, as most of you will know, continue to climb. We have an increase, a slight uptick in our average occupancy in the quarter. Rent change on new commencements of leases that are commenced in these first 2 months are up 52%, which every time we have a leasing update on rent change, it's going to be a high watermark for a while, and we see that again this quarter. In the second quarter, that number was about 46%, I believe. One thing that we've been highlighting in a lot of our meetings is that when we're reporting rent change, we do that on the day that the lease commences. And for Prologis, the way we negotiate and execute new leases, we're often negotiating and signing leases 3 to 6 months before that commencement date. So that kind of leads you to a question of, well, your commencement start -- your commencement rent change is interesting, but what are you signing this quarter? What's happening this quarter? And our rent change on signings this quarter has been 84%, which is a global number. It's closer to 100%, I think just shy of 100% on a U.S. basis. And the reason I think that's important to call out is it's not that, that's a big surprise with regard to where we've pegged rents and our lease mark-to-market and what we've explained we expect in, in rent growth from here, but it sort of speaks to questions I've seen come up a lot in the second quarter, which was are tenants really signing at these rates? Aren't you getting a lot of pushback? And I think this is just one thing that underscores their understanding that this is where market rents are, and we can spend a little more time on that, but we're really pleased to see that strength continuing. We've had a lot of focus on our more forward-looking metrics. We unveiled more of those in the second quarter on our call, so we could spend some time there. But they continue the theme that we tried to lay out on that call, which was some of those metrics are a little bit off the very frenetic pace that we saw in the middle of COVID, let's say, the middle of '21, the back half of '21. But on a historical basis, still very, very strong.

3 Okay. Maybe we'll just get Duke you out of the way.

Sure.

Just -- can you spend just a minute or 2 on that, some of the next steps towards integration? And where you see the incremental drivers there in the earnings impact?

Yes, sure. So we have shareholder votes of each company in a couple of weeks. Most of you probably know, we will close -- I'll say, immediately after that, we expect the first day of the close to be October 3, actually. So just as you're thinking about numbers and results, you're going to see a clean Prologis quarter in the third quarter, and then we will start the fourth quarter with Duke. I would say there have been -- we've gotten some questions, any surprises in the last few months or everything while we're going through the integration process? No, and I would say that by right of the big deals that we've done over the last 5, 6 years, we've gotten quite good. And in the shorter due diligence period that we had through May and June, we really uncovered everything that we needed to know there. We have a bond exchange outstanding, and we'll be bringing their bonds over into the Prologis. Prologis has the obligor. And then just more kind of softer issues internally. I mean the Duke team has been wonderful to work with. There's been a great partnership in getting this thing closed. Systems-wise and in the market overlap, we have very good market overlap. As many as you know, we plan to hold 95% of their assets. So everything has lined up really well that, I think, actually across all the deals we've done this is probably one of the smoothest.

Okay. Why don't you guys move around. We've got like 4 chairs, 3 chairs around here just -- so any one want to drill into Duke anymore before we move on, on that? No? Okay. Maybe then let's come back to some of the metrics that you gave us before. Your supplemental data is great. Can you speak about how some of those leading indicators you publish are trending very, very recently?

Yes. I think that -- so we looked at 4 things, I think, 3 or 4 things that we highlighted on the call. So one was just gestation. That's how long our lease negotiation is going. That's one that I would say is pretty much at the same length of time interval that we reported in the second quarter. I'm sorry, are we going to see enough of a variance in that number that it's a very useful leading indicator? I think the jury is out on that, but I will say that there's no slowdown in customer decision-making from that gestation metric. Another that we looked at was proposals, which we report on our supplemental, the nominal amount of proposal activity, but we supplemented that in our verbal remarks on the call, just how much proposal activity is occurring per available space. And we noted that, that was at an all-time high, actually. And as I said in the introduction, it's a little bit off of that high mark, probably by 3, 4 percentage points. We'll report on it for early -- report on it fully on our call, but still historically strong. And then the third of them was just looking at the approaching 12 months of lease expirations, how active are discussions on that upcoming role. We had a percentage of what has been already locked up versus -- or together with what is an active dialogue, and that is similarly just a few points off of the 2Q mark, but historically above average. So decision-making, the need for space is continuing.

Any rate across you can give us in terms of inventories and how some of the underlying users of the space are approaching that? Obviously, it's a big issue.

Yes. The inventories are honestly confusing to understand. There's a lot of perspectives on it. I think in terms of utilization of space, which is something we'll report on, we've seen utilization tick down very marginally to -- it's just a nudge over 85%, and we would call 85% normal, our historical normal range. So that's -- I think that's a function, in my view of some retailers being able to ultimately clear out some of these inventories that they've been saying they want to kind of flush through sales or getting things out and create space for the more seasonally appropriate goods to come in into their facilities. We spent a lot of time looking at the inventory-to-sales ratio. We've been talking about it for several quarters now. We would see it still below a pre-COVID average, and that would not yet incorporate what we see as a need for an additional 10%-or-so safety stock from our customers, which I want to underline is not -- it's not that we just believe they ought to want that. That's what we hear from them through very active dialogue with them either on -- in our daily conversations, but also we have a number of advisory boards in sessions where we sit down with them on a strategic level and just talk about their upcoming space needs and what they're going to need to operate more efficiently. And that's one of the things that's been very clear amongst them that they will require.

And any other differences when you look at the conversations that you're having now versus the prepandemic in terms of their approach? It's just you've mentioned already that they're accepting of the rents now. You've got changes in that discussion?

No, I think that, that piece is becoming well understood. I think the -- just the appreciation -- I think COVID just educated us all in a lot of ways we hadn't expected and our customers included just the reliance that they have on their supply chain. And the theme that I've seen, especially this year, as we've seen retailers how they've had to deal with inventories and missing sales, their appreciation for the need to carry enough space to carry the right inventory in the right place, have it arrive at the right time, build in more capacity for lead time comes up frequently. I think those are all some new lessons learned or appreciation that they're going to incorporate into the coming CapEx plans.

And you're saying, I mean, it's not really, really recent, but with the changes in energy costs that's going to feed through to transport costs, is that impacting the decision much more than before in terms of where they need to be?

Yes, I believe it has. I think the -- my take on that is a little bit different. I'll explain. One thing that we'll get asked frequently is customers facing 50% or 80% increases in rents, how can they really be stomaching that in the context of their supply chain costs? But I encourage you to think about a company that has 10 or 20 or 30 facilities, if you think about it from that perspective, many of their logistics base aren't renewing rents, right. They're 5-year leases. So many of them are the same. Maybe 20% of them are rolling over. So their increase in logistics expenses kind of the inverse of our same store. So we have these large rent increases, but if they only come 15%, 20% a year, our same-stores, call it 8%, their increases are likewise about 8%. So where I think that's interesting in the context of their overall supply chain cost is you've got their logistics facilities, which make up 3% to 5% of the overall cost, may be rising that 8% in this example, together with transportation or labor or fuel cost, probably increasing at similar levels such that nothing has really found itself being out of proportion.

Okay. Okay. Can we take a step back and sort of look global? Are these trends the same everywhere in the market that you're operating?

I think so. Asia has always has a different set of drivers in the end. So that kind of gets an asterisk. But in Europe, it's the same story, the same need for space and resiliency. We see those themes continue. Everything is just a bit more muted and/or maybe not so much now, but 3, 4 quarters behind has been a long, long way we've described Europe, and I see the same as of late. Rent growth was slow in coming in Europe, market rent growth, but we've seen that change pretty materially in the last several quarters. Some of that just behavioral on the part of our teams, but we've seen a much better ability to push on rents and achieving higher rents. There are some different implications from the conflict and war there on supply that we can talk about here in a bit. But on the operational basis, things are very strong there as well.

So -- and then if you look at the U.S., the submarkets, where is the rent growth going to be the best?

Well, it's the same story. There's a bit of a bifurcation in the coastal markets, Seattle, San Francisco, L.A., Miami, D.C., Baltimore area, New York, New Jersey. We would fold into that. Toronto has been a great market for us. We actually own all of Toronto on balance sheet. So that's been very good in the interim. Chicago has been surprisingly strong. Submarkets in Texas have been surprisingly strong. So it's not on the order of those first 6 markets, but pretty robust.

Okay. Anyone want to jump in? Or I'll just keep going?

[indiscernible].

Yes. Cap rates have been very hard to understand lately, I think. Doing a little bit of history, our view is cap rates expanded about 10 basis points in the first quarter, something closer to 25 in the second quarter. This quarter, we probably put them between 25 and 35. That's kind of on a dearth of transaction activity. There's not a lot of sellers who want to come into the market and sell here, right? With the strength of the fundamentals that I'm describing, if you don't need to be selling, this is not the right environment. So I would take that perspective on how you look at the sales market. Cap rates expanding in my -- I've been in this sector for 20 years. There's kind of a knee-jerk reaction to, oh, that means values are dropping. But that's not what -- that's not what's happening, right? In fact, I think a different way of describing cap rates as of late would be that yields are increasing because of rent growth increases and overcoming any expectation in return requirements. And that's exactly what you saw in the first and second quarter, at least, where we can kind of log what had occurred. You had expanding cap rates, but; also really sharp increases in value still in the first and the second quarter. The third quarter, we will see, I think, ultimately, if 35 basis points, to pick a number, was the latest expansion in cap rates that we might expect, we need a read on what rent growth did in the quarter to see, ultimately, what do we think from that mathematical sense is going on in values. One thing we've been highlighting the last couple of days is just that the appraisers have a different view. They don't take a mathematical or that kind of view on value. So they're going to look more at comps in the market. And we use appraisers quite a bit in our fund business. They ultimately establish fair value of our assets, which establishes the NAV of our open-ended funds where investors come in and out. One near-term implication of that could be we have a promote that's earned every 3 years, one of them coming up out of Europe here in the third quarter. And that's put a bit of an x factor around well, where are they ultimately going to settle on values in the quarter, could see a step back from their view of transaction value. So we're watching that closely. We have no update on it at this time, but that's something that's probably a little more volatile in the quarter than we had thought it might be.

Okay. Just on that point, what do you see in terms of capital appetite assets coming in? It's been the hottest sector, and then you hear all of these old world direct investors that ended up so overweight, office and retail, and then across the board maybe they're underweight real estate anyway. But everyone is taking a bit of a pause and everyone's worried about cap rates being low. Is the capital still coming? Is it kind of full? I just want to wait and see for a few months?

Yes. I made the mistake of asking our fund team to keep me apprised of every investor conversation. They do this really well in this very fancy system, and I overload with about 2025 notes a day of what investors are doing. And so I'm reading it all. And I think my synthesis of what I've seen in this quarter is it's about balanced, I would say, the ins and outflows. We spoke on our second quarter call that we do have redemptions coming in. It's for varied reasons. A lot of it would be gain harvesting or denominator issues of where people have wound up being, by right of other values, over allocated on logistics and needing to rightsize their portfolio, that's understandable. But I've seen a lot of investors who are seeing still very favorable fundamentals and opportunity to get into the queue. So we've, at the same time, had good fundraising activity as well, good inflows. The one thing that has been sort of a hindrance to fundraising has been we'll get an engaged investor, they'll want to put in a $100 million commitment or something into a fund and we lay out when we think the capital is going to get called. And it's far out, frankly, because our existing queues have been so large, and that can have the effect of ultimately chilling those new commitments. Now I think there's a bit more visibility for those kinds of investors to see that their commitments may actually get called, and I think that's opened up a new sector of fundraising. But we're eyes wide open that redemptions have been occurring, will occur, may increase and planning around it.

And geographically, do you think there's any difference in appetite, Asia, Europe very broadly?

For inflows, I would say, marginally towards the U.S. still, but more balanced between the U.S. and Europe. Our large -- this is a footnote, but our other open-ended fund right now is in China. And China, being pretty much closed still, has really precluded a robust ability to raise capital there. So I think when they open up, we'll start to see China reemerge.

Has it worked with the FX?

In what sense?

For the funds. He's hedging on the investor...

Yes. Yes. The investor needs to hedge their own book. We hedge ours. And I can -- I probably should speak to that if you'd like. But within the funds, they handle it themselves.

Okay.

[indiscernible].

No, not thus far. The beauty of our model is we're recycling so much within these geographies that we don't have to worry too much from that regard. Japan is a great example. I mean the yen at [ 142 ] or whatever it's...

[ 44 ], I think.

Where?

44.

44. Still bad. So Japan happens to be a place that -- we build a building for JPY 100, becomes worth JPY 120. We contributed into the fund. We get JPY 100 back and the 20 value creation remains and the -- I shouldn't say the fund, but our NPR public stock, now we own a fee stream and we've gotten our JPY 100 back to deploy to the next building. So we kind of stay in yen world that entire time. Where we have some implications are from time to time, if you've watched us do debt raises over the years. We raised a lot of yen that ultimately gets repatriated back to the U.S. And that would be a very attractive debt market for us because unlike the U.S. and Europe, instead of rates in the 4s, which is where we would be all in, yen is still in the 1s. We could borrow 10-year at 1.5 or maybe a little bit north. But I'd have to bring it back at [ 144 ], and I don't know that we're really excited to do that right now. So we're -- we haven't been approaching that market just yet. Maybe if I spend a little bit more time on FX, just to update everyone. I think -- we think of FX in 2 parts, the balance sheet and then earnings. In the balance sheet, if you know us, we've got about 95% of our equity base in dollars. So despite the global platform and maybe 40% of our AUM outside of the U.S., 95% of equity base is ultimately in dollars because of the strategic capital vehicles for one. We tend to own all those non-dollar assets in a fund where we might own anywhere from 15% to 50% of the assets. So that's a big haircut on the exposure. Then at the corporate level, we finance on an unsecured basis, but in these non-dollar currencies. And we favor the non-dollar currencies at that level. And then we may have a little bit of hedging on top of it, that kind of closes out the rest of it, gets us to that 95%. So we've been very well protected there. On the earnings side, you haven't heard us talk about guidance updates or anything where we're going to miss a nickel because of FX or anything because we've got a very robust earnings translation, hedging program in place that's actually hedging out to 2026, maybe even '27. By now, we do it in a laddered way where if we look at our either dollar or translated-to-dollar earnings, we're 100% protected this year. I think 99% next year, 97% in '24, something like that. So you should not hear any meaningful FX story out of Prologis just due to the management.

I think some stuff gets so cheap in other markets with the strength of the dollar that you're -- we'll let you get [indiscernible] on first before we...

I think you have to take a view, is it cheaper? Is it not cheap? Is sterling going back to [ 14 ] or not, you have to have that view. But if you think it is, it's -- things are certainly cheap.

Okay. Any other questions there? So where will your AUM be in 5, 10 years, do you think?

So we will be -- let me mark it at [ 225 ] post-Duke to pick a number, and it will vary. I think we would -- in 5 years, we should be growing that AUM $5 billion a year, something on the order. Let me just call it development activity. And let me say that acquisitions dispositions will offset. So $5 billion a year out of that. I don't want to prognosticate on value growth from there. So you'd have to pick some number. And then I don't know if this is your clever way to ask me about M&A, but I have no comment on any further M&As.

I wouldn't do that.

Okay.

Okay. Maybe we'll turn to supply. If that's okay with everyone? [ Unless no answers ].

[indiscernible].

On strategic and that fee business, yes, that's a good question. I don't have that recalibrated. I think the recalibration would come through, maybe picking a different discount rate. Ultimately, I guess it's obvious in your question, but that was ultimately a DCF of the fee stream, and then the 35x was just shorthand on what it resulted in. So maybe if I answer more generically on discount rates or return expectations, I think they've marched kind of in step with this cap rate march. So we're probably up roughly 50 basis points on the year. And that might be a turn or 2 on the strategic capital multiple if you looked at it in that way.

Okay. Can you talk to us about the 23 new construction deliveries and any preleasing comments you can make there? Or a little bit early?

Probably early. What we can say is, as we think about what the market will bring in '23 in terms of new supply and also absorption, while difficult to pick the right nominal amount, we've pegged the potential for an imbalance of around 50 million, 75 million square feet is what we're, I'll say, bracing for or kind of expecting. We've laid out that, that ought to translate to something on the order of 40 to 60 basis points of additional market vacancy, which is this becomes part of a different question, is that enough that it's really going to change the profile of the supply/demand dynamics and your negotiations on rent? And our view would be not at that level. You probably need to be talking about occupancies really closer to 95%, 94%, 95%, which we would say is more of a historical average and seems to be more of a crossover point where real leverage is gained or lost from tenants or customers or landlords. And we're just pretty far off from that number on the new supply side. That would be agnostic to whatever might happen in other occupancy loss that could occur in some kind of deep recession. But from that perspective, it seems pretty manageable.

Okay. And are you seeing any accelerated population migration trends that's changing the way that you're thinking about getting more land on balance sheet to meet that future demand in maybe non-coastal markets?

No. We do not see that being a story that's really playing out in any meaningful way. We're in the Bay Area. I know just living there, we've seen people leave the city, maybe going to the suburbs, but the greater MSA is not really impacted. Certainly, there's people leaving California for Texas and New York for Florida. But I think the net migration is not anything that's actually changing our overall thesis. I mean these are very sizable populations we're ultimately serving, and that wouldn't change. I think the one thing that has pushed us into some newer markets that has turned out to be really good is places like Phoenix or Las Vegas that have turned out to be a little bit of overflow from a really packed inland empire market. Many of you know how heated that market is. And actually now there are some new barriers to -- not very much new supply are going to be able to come into that market. And we've benefited from that by taking some views on those 2 -- I'd say 3 markets. Also Central Valley has become a beneficiary of that, but also Vegas and Phoenix, and that's been a part of our strategy that's been playing out.

Okay.

Do you start seeing that the [indiscernible].

Yes. We're not seeing anything more than you would, and I'll explain that in a way that much of our portfolio is geared at the consumption end of things anyway, ultimately fulfillment, and it's not on the manufacturing. And so we're not going to see a big pickup from that. Where we have seen some has been in Mexico. There's been more nearshoring. So our border Tijuana assets have benefited, for sure. But otherwise, we see what you've seen.

Can you talk about the Essentials business traction, how that's coming along and which products are getting more interest?

Yes. Right now, so -- and I'll step back on Essentials. Many of you probably know, but this is what -- I consider ourselves as being in 3 businesses and now an emerging fourth. The first 3 would just be our basic real estate operations, then development, strategic capital that we've talked about. Essentials is emerging as this fourth business line, which is vertical integration and extension into other goods and services for our customers. So you've heard us talk about this. It's -- there's an operations component of it, which deals with things like racking and forklifts. The next element of it is energy, and another is mobility. Those 2, I would say, are the most active or taking the most of the company's energy at the moment. And I'll just explain that on energy, for example, we updated our ESG goals where we had contemplated our rooftops generating solar at about 400 megawatts by the year of 2025. And we've been doing solar a little bit off the side of our desk, frankly, for the last 15 years or so. And by right of changes that we saw in the market and the need for power, which is very real, and our buildings being a great place to generate that power, have onboarded a wonderful team who is now really ramping up the pace of what that program can do, such that we updated the ESG goals to aim for a gigawatt of power production by that same year, 2025. So that business is very active. We've been making capital commitments to do large programs in the U.S., Europe, Mexico, China and Japan, almost everywhere that we're operating. We'll see much more activity there. And that's been, to date, one of the larger drivers within this Essential's umbrella. And then the next, just describing briefly is EV, and we're talking about EV installations at our facilities that are for the trucks, right? The shorter distance vans or vehicles, delivery vehicles. And this is a 2-sided market. We need more vehicles, but the vehicles need charging. So it's kind of slow growing, but we've similarly hired in a very capable team. We've got 5 pilot projects that are underway on EV charging. And this is -- think of this as charging as a service. This is procuring and delivering end-to-end, the power, the chargers, the software, we will ultimately bill for the kilowatt hours consumed. That's how this business will work. Both of these businesses, by the way, are Prologis businesses that are run at a level that's agnostic to who the building owner is across our funds. But the pipeline of that business is pretty deep. We're looking at a pipeline of 60, 70 new projects. And I think that's just going to really start to proliferate, one, as EVs do come into the capability of our customers. But also, we've seen out-of-platform opportunities here, where one of our first pilots, the customer is very happy with the install and what they need to do in other facilities and want us to help them deliver such capabilities at non-Prologis buildings. And we think that's an avenue for growth as well. So that's where there's a lot of activity. The operations segment that I spoke to, racking and forklifts, we have a lot of new innovations and designs and how we're delivering those products. And so I would say more to come on that, but those are the most active so far.

Any interest in new markets? We're seeing -- or changing the approach. I mean we're seeing ESR in Japan offering [indiscernible] facilities free in their Japanese assets so that they can get more females into the workforce, so these companies can tick that box. So we're seeing a lot of interest in some of the Southeast Asian markets because of the growth and the move away from China. We've heard a lot about Japan today. Any -- sorry, India?

Yes. India, yes.

Any thoughts?

Well, first, just a comment on Japan that I've heard that, and I would say more of our inventive new features and services do often come out of Japan that those kinds of services are needed. The workforce is challenging to attract there. It's challenging to get them to facilities. I mean most of our customers have these issues around the globe, but they're pronounced in Japan, and they're certainly very creative in that regard. I think in terms of other markets, we are in most of the places that we want to be. We cover a large amount of the world GDP. We cover a large amount of activity. India does arise. It's on our watch list that we continue to evaluate. But a lot of the other markets that get named tend to be more production-oriented, which, for my earlier comment, isn't really our thesis. So that's why you haven't seen us and maybe some of the others, Southeast Asia economies. And I think, by and large, we view the large markets that we're in, L.A., New York, London, Tokyo, all these places, as large as we are, we're not that large. There's a lot of opportunity to still go deeper within our existing markets and continue to build scale. And that's most of our focus outside of the few things I mentioned.

Okay. All right. We're almost at time. So just 4 quick ones. So any underlying trends that you think we're missing or not appreciating that are going to impact real estate and logistics in the years ahead?

I just -- I think I would just -- you need to watch these operating results. I appreciate how it might be sort of unbelievable, how strong they are in the context of all the other headlines that we're reading every day in all corners of the economy. But if you believe in the thesis of these secular drivers, there is continued e-commerce penetration occurring. There's markets that we're in, where penetration levels are pretty low still and going to grow. That remains a real secular driver. We believe and see this resiliency case building that, that's going to uphold demand as well. So our view is that demand is going to stay strong. I don't think we believe we're going to sit at 97.5% occupancy forever, by any means. But a lot of the conditions that are driving what we see in the space are a little bit detached from the headlines and GDP and even the consumer in some sense. I mean it's going to be logical that consumption ultimately would hit warehouse demand and logistics demand. I think that's fair that, that's what we're storing. But our customers, by right of the strategic nature of the space, which has changed, our thinking beyond this quarter's consumption print, and next quarter's -- they have to think about 3 and 5 years if someone like Home Depot is, for example, they're thinking about what they want to do in terms of next-day delivery. That takes years of planning, and that requires taking down and securing everything that they're going to need, including the facilities to execute. So we feel very good across the cycle about the business.

Okay. We've got 3 rapid fire questions to finish. First one is, which of the following is the greatest macro challenge facing U.S. public REITs today? A, risk of higher rates; b, a recession; or c, the rise of private equity and nontraded rates?

Higher rates in the near term, if I can qualify it. I think that's going to jar things in the near term, but in many of the businesses it can wind up panning out.

Okay. Two, which of the following is the greatest sector-specific risk: labor, supply or liquid capital markets?

Liquid capital markets.

And the last one, are you seeing any signposts of weakening demand?

No.

All right. Terrific. Thank you so much.

Thank you.

Thanks, everyone.