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

The 3 p.m. session at Citi's 2023 Global Property CEO Conference. I'm Nick Joseph here with Craig Mailman with Citi Research. We're pleased to have with us Prologis' CEO, Hamid Moghadam. This session is for Citi clients only. Media or other individuals, who are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. For those in the room or the webcast, you can log on to live QA to submit any questions if you do not want to raise your hand. Hamid, I'll turn it over to you to introduce your company and any members of management that are with you today provide any opening remarks, and then we'll get into Q&A.

Great. Thank you, and good afternoon, everyone. To my left is Tom Olinger. No, he's not to Tom Olinger, it's Tim Arndt, our newly minted CFO, who's been with the company for about 20 years. And to my right is Dan Letter, who's our newly appointed President, also with the company for about 20 years. So if you ask any general questions, I'll answer real; estate questions, Dan will take; and any financial questions, I think Tim will handle.

Well, yes, we're starting off every session with the same opening question. What are the top 3 reasons an investor should buy your stock today?

Yes. Fundamentally, the backdrop is that we are in a sector where fundamentals of the demand and supply are very strong. Vacancy rates are in the mid-3s. Demand is moderating, but it's still very strong. Supply is moderating even more as we speak. So the fundamentals of the business are really good. Second reason is that our portfolio has a 67% mark-to-market already embedded in it, regardless of what rents may do from here on forward. We have almost guaranteed built on growth rate from that mark-to-market or leases. Our average lease is about 5.5 years. So as those leases roll over, we capture that spread. And then we have taken this real estate and built a couple of really valuable franchises on top of it. The one that you know the best is our private capital franchise that this year -- this past year, generated $1 billion of EBITDA and has been -- that was a high number, but it's a very profitable business. It doesn't take a whole lot of capital. But we started a bunch of new businesses that we call Prologis Essentials that are in the energy sustainability, mobility, labor, different areas that our customers need to do what they need to do in our buildings. And because of our scale, we can do that in a very profitable way for us and in a very [indiscernible] way for our customers.

And Hamid, you mentioned that fundamentals are still extremely strong here, and you guys started earnings season, I think better than people had expected from a same-store NOI growth expectation number and it really helped differentiate you guys relative to other property types, especially shorter lease term, where second derivatives are rolling over. But at the same time, there still seem to be some concerns out there about the sustainability of demand, particularly with talk of pending recession maybe in the second half of the year. Can you just talk about what you guys are seeing? What your expectations are there? And I know we talked about it a little bit on the earnings call, but what it would really take to throw a wrench in the gears of market rent growth and demand for industrial at this point?

Sure. Let me start, and then I'll pitch it over to Dan for some more color on the markets. But there's the imponderables that we have nothing -- no control over geopolitical stuff, all those things. But those aside. I can't do anything about them, and nobody seems to be able to predict those anyway. But with respect to the things that are going on with our customers, the trends that drive the long-term success of our business, whether it's e-commerce, whether it's general economic demand, whether it's rebuilding of inventories for resilience all those structural long-term factors are in place. So I really can't see anything that is going to derealize. I suppose extra supply can. We're going to have a fair amount of supply this year. I think this will be one of the only years since the global financial crisis where supply may actually exceed demand. But vacancy rates, no matter how you stress test supply and demand have a hard time getting it much higher than the low 4s even if stuff doesn't lease from this point forward. So in that kind of environment, I think there's pricing power, we had an exceptionally strong year in terms of rental growth last year, way above our expectations. and this year is starting off slightly better than our expectations for the first quarter, but we got a long way to go. Dan, color?

Yes. A couple of things to pile on here. First of all, even as the vacancies expand due to some supply amount coming on this year, starts have come to a screeching halt over the last couple of quarters. And we don't really see starts ramping up in any sort of meaningful way until the back half of the year. And I think there's only a few of us that will actually be able to do that. So we think that occupancy will actually come -- maybe correct back to where it is today a year plus out. As it relates to demand, we are pleased every quarter and we look at our very robust leasing pipeline, and it's a very diverse broad-based customer base, whether it be from e-commerce, apparel, customer goods, we just -- we are continuing to see very strong momentum.

Yes. One other thing that I failed to say, we leased 1 million square feet a day. I mean today, since I've been here, we've leased 1 million square feet around the world. So you get a lot of visibility, you get a lot of data points. You guys are in a tough position, because you get those data points once a quarter and you get it among 120 other companies, and there's a lot going on. But we watch this stuff every day. So we've got an advantage in seeing where the market is going.

Yes. And to that point, I mean, quarter-to-date here, are you seeing any material shifts in demand from tenant verticals. I know e-commerce had slowed. It seems to be coming back. And the silver lining actually was Amazon is not the only guy in the market anymore, right? You're seeing a broadening of demand there, which is actually healthier for the market than just having one dominant tenant. I mean is there anything on the horizon from a tenant credit or industry group that you're seeing a shift at all?

Well, there are a couple, but they don't concern me. First of all, leasing, as I mentioned to you, and rent achievement is a little bit higher than we thought, going into the year and at the time of our earnings call. So that's a positive. The other thing is that we have the normal cast of characters retailers, some of whom are struggling. We have a couple of Bed Bath & Beyond. We have Wayfair. We have weaker tenants in our spaces, but most of those spaces are literally half the market rent, and they're perfectly generic buildings. So actually, there's upside in the case of a possible default, but our defaults have not crept up in any meaningful way. Just to give you a context for that, our average over the last 10 or 15 years has about -- has been about 20 basis points. During the first couple of months of COVID, when everybody was losing their job and things were really bad, we got up to about 50 basis points. Global financial crisis, we got to about 50 basis points. So credit is not a consideration. There are individual cases in any -- at any point in the market cycle. And we have not seen -- the third thing is that we have not seen inventories jump back up to the level that they need to be to support the needs of the customers and also to build in that resilience that they all desperately need to insulate themselves from events like the pandemic.

And it's interesting, right, because you have take a tenant like Target, right, where they just announced 6 more sortation centers, but at the same time, they're taking larger format stores to have that e-commerce in the back and be able to fulfill more. I mean, it's been talked about using brick-and-mortar in a different way. And you guys a long time ago, had a retail background. I mean, do you ever think that, that could supplement some of the space teens? Or is it just too small of a contributor relative to inventory restocking and the wave of SKUs that need to be in a warehouse to fulfill same day, next day and all the kind of the move towards getting things to people as quick as possible?

Yes. So there's no question that retail space, particularly big box retail space, is 80% warehouse and maybe 20% display and selling area. So the 80% can be deployed to drop on a curve or have somebody pick it up from the back and all that. So I think omnichannel and leveraging the retail infrastructure is certainly going to be part of the solution. But if you were going to build it from scratch, today, you would build a new logistics channel, which handles parcels. Fundamentally, warehouse space handles pallets, large bulky things that go in a truck. An e-commerce warehouse handles parcels. They need to get packaged. They need to get wrapped, they're smaller packages. So you can mix on the warehouse side, the traditional warehouse that fulfills a retail store and mix it with an e-commerce store. They've got to be 2 separate operations. And this parcel situation takes up 3x of that space that the infrastructure for retail takes. So yes, some of the demand is going to be fulfilled by the space on the back of the stores for omnichannel fulfillment, but there is such a powerful multiplier on the pure e-commerce channel that demand for warehouse space has really stepped up, and I think -- and I think we're in the early stages, just like you said, the Amazon is pretty advanced, but everybody else is running to catch up. And if one thing happened in the pandemic is that people are no longer putting their head in the sand and saying, this e-commerce thing shall pass as well. They're scrambling to build those channels.

And going back to the rent side of things, I'm going to mix in mark-to-market and market rent here to make things confusing for everyone. But as we sat here last year, your mark-to-market was sub-40%. As you sit here today, it's closing in on 70%, right? Market rents, you guys are always seem to be around that 10%. I don't know if you guys pay Chris Caton on beating that expectation every year, but...?

Yes, he actually pays me, because he's lost every single bet that he's ever had on rent growth. I'm always higher than what he has.

But it just feels like given where you mentioned supply could meet that absorption, but you're not getting to a point where you're losing pricing power, right? So with that backdrop plus the fact that transportation costs are still elevated, labor is still difficult to get, and you're seeing additional cost increases on the low end from Walmart, Home Depot and whomever else, right? I mean, tenant's ability to push back. You've always said it's never a top 5 reasons reason tenants leave. At the same time, you're talking 1 million square feet a day. Like what are you guys seeing from your internal rent curve today? And how is this just continuing to kind of march higher? And how does that impact that mark-to-market maybe as we sit here in a year from today?

Yes. I wouldn't be surprised if a year from now, as long as the rents grow at a faster rate than the old leases coming up are being marked up and that calculation, the mark-to-market across the entire portfolio will grow. But whether it's 67% or 60% or 75%, it's a really big number, and most of it is in the bank. Construction costs have moderated, but they haven't yet declined. I expect them to decline maybe 5%, 10%. So the cost of building that marginal product is much higher. And with higher yield requirements, the rents you need to pencil development are getting higher and higher and the banks are no longer financing the merchant developers. As you heard from Dan, the pipeline has really come to a stop. So I think the market is working the way you think the market will work. Now with energy costs and labor costs going up, the real estate, the warehouse costs are about 3% -- actually 2% to 5% of the supply chain cost. So if you're going to spend that much of your supply chain costs, you might as well pick the best locations near the biggest population centers. So the dichotomy between rents in really good markets, and the so-so markets that have only going for them, the cost advantage has actually gotten wider, because you save on transportation, you can deliver it to serve your customers a lot faster. You can adjust to market trends much better. So actually, we continue to have a lot of pricing power. That's why our rents are ahead of what we thought they were, they would be. The only thing that's different, I don't want to tell you that everything is rosy, but from the second half of 2021 to the second half of 2022, that 12-month period was crazy. I mean, literally, we had people fighting over 10 different tenants over a piece of space, and we're 98.6% occupied. So that was crazy. So if that's your benchmark, the market is softer than that. But I've been doing this for 40 years. But if you look at any period other than that 12-month period, markets -- market brands and dynamics are as strong as I ever remember being by far and the number is supported.

Looking at U.S. -- major U.S. markets, where are land values today relative to peak levels? And are there reasons to be optimistic that transaction will pick up over the next year or 2?

Rents are higher. They're, by definition, higher than peak because in the U.S. rents have never declined.

No, I'm sorry. I mean land values, development land.

Nobody knows. I think land values should be down about 25% to -- maybe 25% to 1/3. If you look at the cap rate expansion and the erosion of terminal value, that should logically translate into a 25% to 1/3 difference in land values downward. But nobody is selling that land. Nobody's buying land, so nobody really knows. And even if you mark down the land significantly, our embedded cost basis is half of the market values, even with a decline of 1/3. So I don't spend a lot of my time honestly thinking about that. And we can, with our land bank, build another $39 billion of industrial real estate, over 200 million square feet. And we own some of the best land in the country, and it's entitled, and it's inventory for future development.

Thank you. If I recall correctly, e-commerce spiked to about 25% total retail sales in the pandemic. It's come off, I think, significantly since then. I can't think of anybody better to comment on where do you think e-commerce as a percentage of total retail sales will be when.

Not within my career and not within their -- these 2 guys careers because they are, I don't know, 20 years younger than I am, I think that number will keep going up because the first generation of kids that grew up with an iPhone, they're hitting their mid- to late 20s and they don't even know what a store is really. So I think that their propensity to spend online is much greater than the rest of the cohorts. And as they get into their prime buying age and all that, I think that percentage is going to keep going up. At a slower rate, I mean, we went from 0% to 25% in 15 years. We're not going to go in other 25% in the next 15 years. So it's going to moderate, but I think it's going to keep going up. And there are technologies that are being introduced as we speak that make the shopping experience online much more attractive in terms of fit, in terms of virtual reality, augmented reality, other technologies that retailers are employing that allow you to really experience a product in a very real way. So I think that number will keep going up. I will tell you a story. I'm on the board of the same for management company, which is the endowment. And we had 5 investors sitting on a panel, 1 major shopping center developer. On the other end, was the partner at Sequoia that does their e-commerce stuff. And then there was a distress that guy and a couple of other guys around. So if you ask them that question that you just asked me, the numbers range, this is like 3 or 4 years ago, from 12% from the owner of the malls to 100% from this to the Sequoia guy. So really, nobody knows. We're all guessing but it's going up. And by the way, the fact that it moderated and came off of the peak of e-commerce is something that we predicted in May of 2020 and put it in a paper. It's on our website. So it's not surprising us. If people have cooped up for 2 years. Of course, they're going to go on trips. Of course, they're going to go shop and have that experience. By the way, none of this is to say that good retail is going to struggle. I think good retail will do well, the enemy of retail has not been e-commerce, the enemy of retail has been too much retail, 28 square foot per capita, 5x anywhere else in the world. So it's not our fault, somebody else's fault.

Hamid, I just want to go back, someone had a follow-up question we were talking about market rent growth. And they're asking if market rent growth is expected to grow by 10% and your rent spreads are growing to be 60-plus percent. How can you maintain your mark-to-market heading into '24? So maybe just kind of explain how the math works with the mark-to-market versus the rent growth and how that kind of accretion goes?

So there's -- we're 98.6% of these. We've already dealt with half of the vacancies coming up in this coming in 2023. So half of it is put away. We know what it is. So when you capture -- you're capturing the 67%, actually, probably more than that, because the oldest leases have the biggest mark-to-market. On a very small on half of the 15% that rolls over, but you're getting the 10% rent growth on 99% whatever the balance, 90-plus percent of your portfolio. So that [ CSA ] still is in favor of increasing spread. But at some point, it will reverse. I mean if it doesn't reverse this year, it will probably reverse next year. When do you think, Tim, it is going to reverse?

Yes. I think if we have say, 3% to 5% market rent growth thereafter, after this year, if we were to just slow. The slope that we see this lease mark-to-market market declining at is maybe 10 points a year or something. It's got a very long tail ultimately wind down.

We are not going to have 10%, much less 30% or 40% rental growth forever. The business is good. It's not that good.

Another question coming in just on the integration of Duke, how is that going? Number one. And then number two, there's been just a little bit of M&A in the industrial space over the last couple of years. The question is, would you consider doing another large-scale M&A deal in the near term? And then thoughts on the Summit industrial transaction in Canada as well as Indus in the U.S.?

Any others you want to ask about.

It's a four-part question. Duke integration.

Duke integration, done. It was done the day after we closed the deal. It was actually done before we closed the deal. We've gotten really good at integrating these companies and we were fortunate to get a lot of good Duke people along with it. About 70 colleagues came over from Duke and they've really found a new home and they're pretty happy and the Board is going fine with Jim on the Board. And we got the synergies before the deal closed. And we're getting a bit more revenue out of their portfolio than we thought? What would you guess that is today?

I would guess, we're getting 11, 12 -- call it, 12% or 13% more revenue than we underwrote, assume 8% of that's coming from the market, so outperforming pretty handsomely.

So 4 or 5 points more than the rest of our portfolio, we're getting out of that portfolio right now. We think it was a little more -- a little less leased than ours, and we're capturing that on the first go around. With respect to M&A, we're always looking at M&A. We do a lot of $5 million acquisitions. We look at everything. I mean it's not a mystery for somebody, who has a piece of real estate that they want to sell or sometimes when they don't want to sell, to call [ 1-800 ] Prologis. I mean we're the obvious candidate we're seeing the right kind of deal. Summit was not our kind of deal. It's very appropriate for other types of buyers that are traffic in that kind of space. It's not our kind of profile.

And not to belabor the point because I don't want to ask you questions you're not going to answer. But in the past, after you've done a big deal, whether it's DCT or Liberty, maybe now Duke, it always seems like there was a year or 2 digestion period, not that you haven't integrated it. But is that sort of a good time frame to think of from your standpoint to demonstrate to the market the justification of the previous M&A deal before you would go out and do more, especially at this point where industrial valuations, some froth was taken off last year, but this year, the group's done a little bit better? Maybe on a stabilized basis, we could argue that the group still looks relatively attractive, particularly against the REITs on sort of a stabilized implied cap rate given your growth. But just kind of broader thoughts on maybe that angle of the question?

Boy, if it took us a year to integrate DCT and Liberty, you know something that I...

No, no, not integrate. But before you went out and did the next big deal, right? There was that...

You got to do the deals when -- we have a target list of companies that are a good fit for us. And you got to look at the right time and the right place. I mean a lot of these things are driven more by social circumstances than the economics of the deal. The economics are very compelling, because we have the ability to pay a premium. These are acquisitions, not mergers. And we kind of have dialed in what the synergies are certainly on the cost side. And our target -- and the way these deals usually work out is that they're slightly accretive on an AFFO basis, on a cash basis. On accounting, they're accretive, but that's [indiscernible]. On cash, they're slightly accretive. And once the revenue synergies come through, essentials, private capital, all this other stuff that we do on top of the real estate, then they become really widely accretive. The other thing that happens in some of these deals is that when we bought DCT and Liberty, we indicated to everybody, how -- what portion of the portfolio we were going to keep, what portion of the portfolio we were going to sell. By the way, don't forget KTR. That was private, but it was a big deal. I think we've exceeded cumulatively our projections for selling the noncompliant assets by 40%, and that represents billions of sales over the last couple of years. So I think we know what we're doing in this area. That would be the last thing I would worry about.

And you guys have the benefit of being global, right? If you -- from a capital allocation perspective today and where valuations are, what's the most attractive market to deploy capital in your portfolio today?

Anywhere we have existing land that's entitled and ready to be developed in a tight market so a lot of places. I think it's a type of deal that's most accretive as opposed to necessarily a geography. If I were going to give you a geographical answer I would tell you that the markets that are the lowest cap rate markets are the best markets for doing that development, because unlike what most people think, the markets that have had the lowest appreciation are actually the ones that are going to have the lowest depreciation in terms of rents, because people are becoming much more location-sensitive. Now we don't have a lot of that stuff. But the tighter maybe coastal markets, some people call them coastal markets, but there are markets with decent demand dynamics that have really antigrowth regulations and entitlement processes that constrain development. Those are the places where we like to deploy capital.

And shifting maybe to the strategic capital business, you guys made the conscious decision to kind of hold off on contributions until the back half of this year. I guess, twofold. Number one, kind of what are you guys seeing on the capital queue side of the house from demand there? Is there an opportunity for you guys potentially to deploy capital to the extent investors are looking to reduce exposure there? And then just -- what kind of go with those two...?

Well, I would say the last 2 quarters of last year were slow fundraising times, and there were more redemptions than Qs. So the Qs basically are down to 0, but we are 13% levered in our U.S. portfolio, we're 19% levered in our European portfolio. By the way, each one of these is a $25 billion, $26 billion company, and they're unsecured borrowers. So these are huge entities with lots of balance sheet capability. So -- and we could have made our queues 4x as long, but the investors want to see their money invested. So we weren't taking new money when you could raise money, because we didn't want to be -- have the pressure of putting the money out in nonsensical way. So that's the dynamic of the allocation. We will -- we did in 2009, 2010, and we will when the valuations reflect the marketplace as we see it. Again, our valuations are done by third parties, not by us, unlike some other situations. So when the valuations reflect what we believe is true market value, we will step up and put money in our own funds. We love our own funds. I mean, they are the properties we know and like and it's a great place to deploy capital. Unfortunately, our policy is to give our investors the first right to do that. And I think they're going to take up most of that opportunity. And if it works out the way it did in 2009, 2010, all those redemption requests will be withdrawn receded, because that's exactly what happened when we put money in these guys putting money in their own funds, it's got to be a good deal. So having a balance sheet in this business and being in a fund management business is a great thing. And it's not just a place that you put your developments. It's also a place where you can deploy capital at the right point on the side. And that helps your customers and investors.

And the other questions you guys have contribution starting in the second half. What are you seeing on the valuation front? Or what's the trigger from your vantage point to get comfortable that there's enough -- a lack of volatility where it makes sense to start contributing again where you're not maybe feeling like you're forcing these assets into the funds?

Well, there are 3 things we can do, and they're all related. We can continue contributions or start contributions at a given time. We can redeem people at a certain price and we can deploy capital at the same price. All 3 of those things have to work around one price. And that price is the right price. So when the price in our view is right, we will restart contributions, we will deploy capital into our funds and we are already redeeming people, and we'll keep redeeming people as those requests come. But we don't think there are going to be then any request because, again, when the portfolio is attractively priced, people want to be invested in high-quality industrial real estate. Some people early in an inflection point, want to jump in, in front of everybody, put in a redemption request and sell the properties as yesterday's values versus the declining values of today because of interest rates. And the mechanism in the funds are such that there is 1 to 2 quarters of lag to avoid that problem, but they will get their money back. They just get their money back at the right valuation.

From a technical perspective, I've gotten this question for, do your funds have gates like you're seeing at some of the other fund companies out there that they've thrown down? Or are you guys -- because you have the balance sheet to buy out, there's never really a limit on redemptions?

We do have some limits on redemptions that have actually, in a few instances, been triggered, but we've completely ignored them, because we have the ability to redeem and we like the value will redeem. It's the -- look, it's not about redemptions and holding assets for AUM fees and all that. It's all about making sure that you're doing the right thing for all the remaining investors in your fund. If 5% of the fund once you get in really fast before the appraisals reflect reality, I don't want to disadvantage the other 95%. That's why we've set up this mechanism when there is a lag until values adjust, but we're going to redeem everybody. And by the way, we've had this conversation, obviously, with our private capital investors, and they love what we're doing.

Okay. Well, with the minute left, we'll run to the rapid fire. So same-store NOI growth for the industrial group, not PLD specifically in 2024?

6% to 7% and will be 200 basis points above that.

Best real estate decision today for PLD buy, sell, hold, develop or redevelop?

Develop on our existing land bank in markets that require space.

And then last question. For the Industrial group, are there going to be more or less or the same amount of public companies a year from now?

I take the fifth on that. You're on there.

Well, thank you guys so much.

Thank you.

Enjoy the rest of the conference.