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

All right. I think we're going to get started. Hello, everyone. My name is Ron Kamdem. I'm the Head of U.S. REITs and Commercial Real Estate Research here at Morgan Stanley. Thrilled to be doing this panel with the Prologis team. We've got about 30 minutes. We're going to try to get through some questions and leave some time at the end to the extent that there's any questions from the audience. We're happy to take it.

So I think we're just going to jump right in. So we'll start with the macro. We've recently had some bank failures. We know the Fed is trying to slow the economy. As you sit here today, can you talk about whether it's space utilization, business activity, you're seeing a slowdown in the ground and any signs from your customers that the bank's tightening is slowing the economy?

Thanks for having us, everybody. And thanks, Ron. By the way, I'm Tim Arndt. I'm CFO at the company. And this is Scott Marshall, who is our Chief Customer Officer. So he should help pick up on some of this customer conversation. I would say no in a word, not that there's nothing, but that is relatively muted right now. We do have -- we have all of our operating metrics, which tend to be rearview mirror in nature. And we understand that, that our occupancy and our rent change and almost everything we do is a function of things decided some months ago. So we try to focus on our proprietary metrics that are more real time and leading in nature. So we do have our IBI index. This is a metric that we assemble and publish that just tells the state of industrial health from the perspective of our customers. That has been registering strength and growth in logistics consistently. In particular, the last month, we saw a tick up in that. Again, we do measure utilization. As you referenced, that is at historical averages of about 85%, which we and our customers consider pretty full on that basis. We're looking at gestation, which is really deal-making time, which, interestingly, I'm a bit surprised, if I'm being honest, shortened again. We had seen decision-making elongate a bit in the first quarter, which we thought was a natural byproduct of some concerns that customers have in the economy. But that's actually shortened up recently in the first 2 months, at least of this quarter, where decision-making has improved. So those sorts of metrics, together with things like bad debt or agings, all of that is registering pretty well. One thing, and maybe I'll throw it to Scott here, is we probably see some slowdown in the take-up of new space. So there's a lot of customers staying in place. Retention is very good. We've seen very few surprises on customers that we expect to retain, particularly in places where so or understandably, there's been a lot of focus, we see customers staying put. But is that something you can expand on?

Yes. So I would say Tim's points around all of our proprietary metrics that we're putting to within our portfolio are causing us optimism. When we have discussions with our customers, we executed a customer advisory Board. We had 2 in the Americas -- 2 of the U.S., excuse me, that we do. We do a customer advisory board in Mexico. We just did one last week in Amsterdam with our European customers. And I think they're all still balancing this idea of scarcity within the marketplace with hesitation around what's going on with the economy, whether it's the global economy, whether it's domestic or European around pending recession, but scarcity is still what's causing them to act. And so our metrics are still pointing to the fact that there's a lot of health in the marketplace. We are seeing renewals uptick a bit where customers are more willing to stay in place versus maybe taking another place, taking expansion. But all in all, I would say the picture is -- continues to be healthy, and we continue to be pretty diligent about making sure we're looking for signs of weakness for the future.

Yes. So just staying on the core business. So you've got over 1 billion square feet, 98% occupied. And you've talked about vacancy rates, and your markets are pretty low 3.5. I guess the question is really rent growth has surprised to the upside in the industrial space for the past 5-plus years, and we're looking for another 10% this year. When you're thinking about your customer, what's the value proposition to them that makes them continue to pay these rents? And the other side of that is, can you talk about the occupancy cost and their ability to continue to sort of take rent increases?

Well, okay. So let's boil it down to when a customer enters the market and they're looking at spaces. We can try whatever we want. But at the end of the day, we're going to be boiled down into a spreadsheet where we're compared with other options within the marketplace. And that comparison is a series of columns of what can we offer, what do we offer versus what is our competition offer. Our differentiation is we're offering more columns of things within our buildings that our competitors can't even touch. And so things like our Essentials business, which we can talk about for a bit. Helping our customers meet their essentials or their sustainability goals. The idea of rolling out solar or LED across our platform. Helping them with move in or move out. We don't want them to ever move out. But if they do, we help them with move out. Maybe it's move out from somebody else's facility in ours. How about that? But it's move in, move out. So what can we offer these customers within our portfolio that differentiates versus our competition? One, but two, maybe more importantly, it takes burden off of them to not have to build in-house capability. We just had a meeting with a very prominent 3PL. They're trying to roll out LED lighting across our entire portfolio. Mandated from on top, handed the real estate department, roll out LED. They don't have their hands and arms and legs to be able to do that. So they come to us to say, how can you make LED come alive within our portfolio. So I think the answer would be what can we help them do for their portfolio that others can't that takes rent. And obviously, rent will always be a column on that spreadsheet. But how can we offer 4 or 5 other things? Fully lighting up our spaces with technology or with Internet, so they don't have to wait 6 months to be able to light that. What other comps can we add that competitors can't?

Go ahead.

I would just add that there is -- maybe it's not well known, but the logistics rent as a component of the overall supply chain cost. It's just 3% to 5%. It's one of the smallest components. And so while market rent growth has been very exceptional in the last several years. I mean, in SoCal, we've been repeating off and reminding people is nearly 160% since the beginning of 2019. So it's been levels unseen. But on the low base of what it makes up the overall supply chain cost, what they're getting in trade for that, a more functional, better located and really top line eventuate rating kind of facility, they're not happy about the uptick in rents. And we -- Scott's job being Chief Customer Officer is to get with customers early and let them understand what the shape of market rent is. But ultimately, it's a very important and much more vital part of their overall business.

And then sticking with that, what segments of your customers are you seeing the most activity in? And where are there potential slowdowns? And the follow-up to that, two is, remember, 3 to 6 months ago, when we did this, you guys have talked about the retailers needing more inventory and to build inventory, and then there were headlines about retail as having too much inventory. So where are we in sort of the cycle of inventory build for the retailers as we're going forward?

Well, maybe let's touch the second half of that first. So the name of the game is the right inventory at the right time in the right location. And I think we saw during COVID, and after COVID, there were many moments where inventory was showing up maybe not the wrong DC, but definitely at the wrong time. You cannot have Halloween candy show up on November 15. Christmas trees are not as valuable on January 15 as they are on November 15. So you have to make sure your supply chain balances that inventory need and you get it to the right place to fulfill to the right customer. So I don't think that challenge has been met, and it's going to continue to be a journey for our customers along the way. When it comes to who's the most active, it's really interesting, we have this discussion a lot looking at our portfolio, saying who's the most active, where are we seeing weakness. And I get beat up by Tim and others for using the tire broad-based band. But it truly is across either our 3PL customers, our e-com users. We analyze what's going on within our warehouse space. So are they distributing a good to a front door? Are they distributing the goods to a warehouse? Are they distributing to another distributor? And we're seeing health across that business, across all of those. And I don't want to be too generalist, but e-com last quarter ticked back up. E-com ticking back up while Amazon is on the sidelines is a really good sign of health for the marketplace. E-com was the -- Amazon was the biggest consumer of space. For all intents and purposes, they're sitting and watching what's happening right now as they look at their own portfolio, and we're seeing other e-com providers pick up that demand. So Tim, I don't know if you want to add color to that.

No, I don't think so.

Yes. No. So PLD is interesting. So you're the largest REIT in the U.S. And usually with size, people think, gosh, it's going to be tough to grow. But when I think about PLD, there's a sort of massive mark-to-market opportunity in the portfolio. 68%, potentially could be going higher. Maybe can you talk about sort of the growth function for the next couple of years, right, that this mark-to-market creates and the visibility? Because I think out of the 16 different REIT subsectors that there are, there may be 1 or 2 that can grow double digits for that long.

Yes. I think we have that capability, double-digit earnings growth. The question always surprises me a little bit are you too big to grow. Because when I think about the industry, we tend to focus on organic earnings. We want that to be a chief source of earnings. And most real estate companies within a sector kind of share the same raw ingredients of that just being market rent growth. Now we think we have a leg up on just in our market selection in our portfolio, but that's going to be the base of any business. And then there are just bells and whistles on top of that. So for us, it's a low cost of capital. it's the lowest, I think, if you look at REIT spreads or indicators like that, you would see that yourselves. Very low operating structure as measured by G&A to AUM. And we have the strategic capital business, a fee-generating business. It has a historical growth rate of low double digits percent annually. That is pretty much revenue that drops as that builds off of asset valuation growth straight to the bottom line. It's a highly leverageable business in and of itself. Development, I mean most players develop, but we have a very robust development pipeline, $5 billion last year. It's a bit smaller this year while we're working through kind of the malaise of 2023, but I expect we'll return to that kind of level of starts, which adds maybe about 150 basis points to an annual growth rate. And then we have this emerging Essentials business. We used to think of Prologis as having 3 legs of the stool: the operating business, which was the largest of them; but then strategic capital and development. And now Essentials, which encompasses the kinds of things that Scott was just talking about ways we can help our customers go through the very customary goods and services that they procure when they move into a new building. There's a lot of things that 90% of our customers are going to do when they move in or out and we can help them procure on our scale, helping apply our scale to them. But Essentials also uncovers the energy business which we should may be talk a little bit about it in another question, but there is a huge opportunity for us to put solar on our rooftops. We have 1.2 billion square feet of real estate, which kind of means we have 1.2 billion square feet of roof to put solar on, which is a great place to generate solar power. And we have brought in a very excellent team to execute that in a much more expeditious way. And then that's complemented with the emergence EV charging, which is going to be big in not just our industry, in all of our lives. We will probably all be driving EV vehicles at some point in the future. And it's certainly the future on the shipping and advanced side of things. and we are being proactive in building a business around that. This isn't just making it possible for them to have an EV charger on their building, this is actually being the provider of charging as a service. And so there's a business lying there. So underneath it all, I might just be more of a commercial. I think Prologis is a very innovative company is what's underneath all of those business lines. We could just operate real estate, and that would be a fine business, particularly on our cost of capital. But I'll credit Hamid, He might be listening out there, but he is always driving this business and this company forward. And this Essentials business, the addition of it as an entirely new business line is evidence of that.

So we've talked a lot about demand. It's broad-based, it's e-commerce. What about supply? We read a lot of articles about supply coming to the Sunbelt. Texas, I'm sure I've seen it. What do you guys -- what's your expectation for supply for the next 2 or 3 years? And how has that changed over the past couple of months?

So starts are down significantly. New development starts are off about 40% from the more recent pace. Immediately, starts prior to that, we're pretty elevated. But this is going to be a dearth of new deliveries into the market in 2024, and we've been talking about that with the market that the current under construction pipeline in our markets is sizable, around 500 million square feet. And we think that as that gets absorbed into stabilized portfolios over the course of the year, that could add some vacancy into our markets. We acknowledge that not just in our remarks, but it's sort of underneath the guidance that we gave on occupancy and same-store for the company. But we pivot that into 2024 and think the low level of this year starts is going to mean that there's maybe turning over of that, and we could see occupancies build again, maybe even seeing vacancies in our markets move back into the 3% range, where they had been through a large component of last year. There are markets where new supply is more sizable than is warranted, I'll say, and we try to measure this very actively in a metric we call true months of supply. I think it's published in our book, and we've talked about it on a lot of our earnings calls. But it's -- I really like it as a stat. We try to put everything into the blender here, where we say, okay, what is the unleased development that's coming into this market and what's the standing vacancy in the market. Let's put that together as everything that needs to be leased at some point and express that over what is the most recent pace of absorption, how strong is demand in this market. And out of that, you get how many months that would then take to absorb all that supply. And that's always going to be some number. And historically, that number has been in the 40- or 50-month range, I think. It reached down into, I think, 16 months at its thinnest in the middle of COVID. It's now been in some mid-20s, I think, as of late, which is very strong, maybe. It will move up from here. I got my fact checker here. But that's how we evaluate the overall market health. And then when we're at our investment committee or our individual teams are bringing new deals to market, that's a good, summarized way of saying, well, what's the appropriateness of bringing new supply into this market. And in the kind of, as you highlight, you're probably not going to see a lot of new start activity out of us. But I do think that each of them on our own. And Sunbelt in particular, we'll be able to handle it. It might just be a little bit longer time to lease that.

I thought that was an interesting comment on the call because so that suggested by the back half of '24, supply is potentially abating. Maybe there's some more pricing power to be had as that pulls back.

That would be the theory, and I want to stop short of given any kind of guidance or view on market rent growth in '24. But certainly, if we had vacancies return to kind of '22 levels of being in the mid-3s, that's certainly an environment where we ought to be pretty fully on pricing rents. I don't want to say -- I don't want to suggest we're not pressing rents right now because that's also not the case. Most of our markets and product categories like 1 million square footers, 0.5 million square footers fully leased, fully sold out. And then individual markets similarly, 99% or 100% leased. So we have most of our portfolio, I would say, we're able to be on our front foot in terms of pushing rents still.

Great. So that's good on the core business. So moving on to strategic capital business. You guys have been a little bit more proactive in terms of mark-to-market valuation, in terms of fulfilling redemptions. Can you talk about what you're seeing in terms of cap rate movement and how much more to expect in that business? And also, how is the business differentiated from the peer set?

Well, I like the second part of that question. I'll start there. I just -- well, we -- look, the third quarter of '22 was a surprising quarter for me, and probably a lot of us. A lot changed in a very short period of time. We saw valuations on a move that we had not expected, and discount rates started moving swiftly. And we had, in our portfolios, a big influx of redemption requests at numbers that we hadn't really seen before. We always have redemption requests in our open-ended funds, but they're always quite small and manageable. And here, we had hundreds of millions come in. And Hamid rightly, he had -- Hamid Moghadam, our CEO, if anyone is not aware, had seen this movie a few times and knew that this was going to take some quarters for appraisals, which ultimately drive the NAVs and the values at which people can in turn exit the fund, that those appraisals were going to take some number of quarters to ultimately find the right footing. And as I look back on that almost a year later or 9 months later, we see that Europe, in this case, I think had moved about 4% in that quarter. I think it moved up to about a 12% decline by year-end, ultimately landed about 18% down at the end of the first quarter. So he was right. Had we redeemed everybody in October, a lot of people would have got in and out at what were not really the right value. So we are very clear in our communication to how we wanted to run that. What we felt was best for all of the constituencies, investors coming and going. And we made a call at the end of the first quarter that it felt like European values had found their footing, at least had sufficient time to get to a fair place, and then we transacted on the redemptions this quarter in Europe. Same path of all that activity for the U.S., except delayed by about a quarter. We think this second quarter is necessary to get U.S. values, kind of fully to where they deserve to be, if you will, and we'll commence on redemption activity in our U.S. funds in July. But I'd say that in regards to the way you phrased your question, that I think those are just good brand-building opportunities for the fund, the way we want to conduct ourselves and the governance and the fund and being more than anything really transparent about how we want to execute and then following through on that execution. So I'm very proud of the company for the way it handled all of that. You asked about cap rates. Cap rates are -- let me start with discount rates or IRRs. I think discount rates and IRRs are kind of stabilizing. We've called it mid-7s. We don't have a very different view on that and mid-7s is in a range. There's going to be markets where a low 7 is going to be appropriate for the strength of the market, and that can range up to the higher 7s. Cap rates are similarly stable for that reason, but we are going to see market rents continue to grow to a degree that's in our forecast. So something that I think we've all learned, especially in logistics in the last year or 2, is that increases in cap rates does not have to equal value decline. That's probably the knee-jerk math we've all thought for 20 years. But at the rate of rental growth that we've had, you can actually have rents grow, cap rates grow and values grow. I mean it can be now done in any combination. So what we've tried to focus a lot of, particularly on the sell side, just a deeper understanding of what is going on in cap rates, in particular, the difference between market cap rates and in-place cap rates. There was a long period of our existence where it would be fine to not really distinguish between the 2. You could kind of intermix either of them and get to the right value roughly of what our portfolio or any logistics portfolio is worth because the lease mark-to-market in our space, which you correctly cited about 68%, was never so extreme. But now that's kind of the level of difference, you have to have in the cap rate, too, because the level of income is wildly different between the 2. So we've been trying to highlight that more. You'll see a few pages dedicated to that topic in the book that we put online. And one of them, in fact, is one that highlights on the sell side as a result of the challenge in that math and the necessity to really understand what cap rate you're using against what income, you get a really wide range of per square foot values of our portfolio. Like probably a 70% range, which is resulting in some really wild NAVs that are out there. So we're trying to home people in on that, a long kind of soapbox speech there. But one of the ways to do that is to ultimately, yes, use cap rates to understand values. But I would encourage investors and the Street to look at per square foot values as well as kind of a sanity check on, well, what is replacement cost and logistics real estate, and that's a good check on that calculation.

Great. I got 1 or 2 more, and then we'll take some from the audience. So I talked about -- the business is already $140 billion in enterprise value. One of the significant growth opportunities is the land bank. I mean you've got $40 billion tied up there already. And you said this year, it's about, I think, $2.5 billion to $3 billion of starts. So the question is, what do you need to see to start dialing that up? And can you talk about sort of the flexibility in the process to be able to actually dial that up and down through the cycle?

Yes. The process is we have -- of that $38 billion, let's call it 25% of it entitled and ready to go, with the next 50% of it, so approaching $30 billion of it, similarly entitled within about 12 months. So the dialing up and dialing down, we can be very, very reactive to. And our business plan would contemplate a level of starts above our guidance. We typically have more options that we're evaluating that we commit to in guidance. You're going to see it starts increase the second quarter, I think, into a $300 million or $400 million range. That puts the next 2 quarters of the second half around $1 billion each. I feel very good about getting those numbers. Scott's been active with his team on the build-to-suit side, and maybe he could comment a little bit on that. But we will get there, and I would expect without giving guidance. Depending on if this recession, the scheduled recession is coming, I don't know where it is exactly, but depending on if and when and its depth, but it's relatively benign, which I probably expect it would be, I would think '24 would be a larger start here. But you want to comment on build-to-suits on?

Yes. I would just say, as we've seen customers getting more prudent on the decisions that they're making and we're seeing, as you referenced earlier, what's going on in the credit markets, the competitive set is definitely changing on who we're competing with for these build-to-suits in the market. So we have this well-curated land bank with, as Tim referenced, working on 80% of that entitled and ready to go, we can turn the quarter quickly. Simultaneously, we've got competitors that are either out of the business or on the sidelines. We become not only the developer of choice with the land of choice, but we've got these customer relationships, where they're actually helping inform our land acquisitions and our land strategy. We're going to them as we're entitling and picking up land with our top relationships so that they're helping us inform what we should be doing. So it's just -- it's a process that we can leverage those relationships that we have with customers to be able to really take advantage of this moment in the cycle for build-to-suits.

Great. And my last one is we can't talk about Prologis without talking about the balance sheet, and it's one of the strongest in the REIT space right now. And I think this sort of environment is when you could potentially shine, right, because capital is scarce and so forth. So I have you guys at 4x that to EBITDA. But can you talk about where you could issue today and what that -- what the balance sheet, what opportunities that could potentially create?

Yes. Unfortunately, with all of the credit we have in the balance sheet, and I appreciate you calling it out, the cost of debt is still high. I think we will have one of the lowest spreads. Let me call that 150 over on a 10-year right now, but it certainly bounces around in a range. But base rates are still kind of elevated, and that would put us into the 4.25 kind of ZIP code on new U.S. debt in 10 year. Now many of you know, we are pretty big borrowers and currencies outside of dollars, and there's a number of those that are more attractively priced than dollars. So we tap those markets as frequently as we can. We limit that to how much equity do we have in these regions to even repatriate that capital. We don't want to find ourselves shorting any currency for that reason. So again, this is the one that comes to mind. Again, you can still do 1.5%, maybe 2% kind of debt these days. We are very happy to go do as much as that as possible, but it is limited by how much equity we continue to fill there.

Great. Any questions from the room? Time for 1 or 2. Yes?

For your destocking [indiscernible].

The question is for the new spec deals, what kind of downtime are you underwriting? What kind of development yields are you looking for?

So development yields are going to very great around our markets in the globe, not to give you a non-answer. But I would say, if you pick a market cap rate, if you get a sense of one in a market, you can think of the development yield as needing to be about 20% higher than that roughly. That's going to give you when you unwind all that kind of margin that we would generally proceed in a deal to do. In terms of downtime, we often underwrite about a year if we really don't know. If we know something more specific extraordinary...

Delivery, plus a year.

Volume requirements.

Delivery, plus a year.

Yes, post our completion. But our experience is far inside of that, You won't be surprised as we ranges between 5 and 7 months on spec to get most deals stabilized.

Not [indiscernible] of course, but for a market like New Jersey or South Florida or province out there what [indiscernible] has developed.

Same question for markets like New Jersey and Southern California.

I don't know if I could drive that in much more specifically. I mean market cap rates are probably in the high 4s there to guide it that way and then -- but there's going to be a wide range we wind up looking at.

Great. So for the ESG investors in the room, you guys have committed to net zero carbon emissions by 2050, which is, I think, 10 years ahead of the Paris to 2040 -- 2040, excuse me. 2050 is when you have to do it or the Paris Accord, I guess. So 10 years ahead of that is the point. One of the few REITs we've done is 160 is probably less than 5 that have done that. How do we get there? What's the process?

Well, one of the first stops, and I see we're out of time. The first stop is getting to a gigawatt of solar production is an important milestone for us for 2025. Matched with that is carbon neutral construction by the same day, that's a big part of it. And then it's solar and EV charging, as you can imagine. Those are 2 very important business opportunities for us. They have an appealing commercial returns, double-digit kind of IRRs in those businesses, but they are certainly on the path to achieving that ultimate net zero goal.

Excellent. Thanks so much, everyone. Have a good one.

Thank you.