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

The industrial REIT analyst at the Bank of America U.S. research team. I'm also joined here by fellow colleagues, Sarah Cooper, who is global sales as well as Andrew Bian -- Andrew Berger and Dan Yuan. And we're excited to kick off the next roundtable session with Prologis. Representing the company is Tim Arndt, CFO. And when we just ask for -- to kick off each session with a quick over of the business before diving into Q&A.

Okay. Well, thank you for that. I'll start just with an update on what we've seen so far in the quarter, and we have a book out this week that you can see some of these updates. But through the end of August or the first couple of months, we have occupancy relatively flat to the end of the second quarter. We were 97%, down from 97.2%, sitting here a few weeks into September, we've built some occupancy further and expect overall to end the quarter with occupancy higher than it was in June. We're also disclosing in the book right adjacent to that. We're updating folks on our rent change on signings. Typically, we're reporting on rent change on commencements, but there's about a 3- to 6-month lag between signing a lease and commencing logistics. So to give you a more contemporaneous view of what's happening right now, we've been supplementing information with what are signings. And if you look at that on the page in our book in the second quarter, the signings number was, I think, 87%. You'll see the first 2 months of the third quarter was 73%. I'm underlining that to emphasize that is only mix. That is not some view that rents have come in by that delta. It's just had some heavier lease mark-to-market portfolio leasing in the second quarter than we do in the first couple of months of the third quarter. The bottom line of that is really just to say that we've been hitting the rents in our forecast. And really that most everything is playing out to our expectations for the balance of the year.

And within that update, how has demand been trending through August and early September?

I think it's good. I'd characterize it as good. I know everyone is probably getting sick of hearing, I'm sick of saying normalization, but it's really what our numbers continue to tell us. A few things that we look at beyond just the main operating stats is when we measure activity in leasing. When we look at the volume of proposals compared to how much space there is to quote upon or how is gestation, decision-making time of our customers. Those sorts of metrics not consistent with 2022. That was a very frenetic pace on those kinds of metrics. But they look a lot like 2019, which we've often said was a very good year. And I would say, quarters and quarters are going by building on that theme that things look like 2019. And I emphasize that because as we started saying that in maybe last fourth quarter, say of 2022, the question I have that you probably have is, will you have, but are we going to drive past normal? And we haven't seen that. Things have really stuck into that historically strong range.

But if we look at one of those charts in that update, you put out a slide on the leasing status, which shows activity is tracking above 2019 levels. So to clarify, does this also include your development pipeline or it's just the operating portfolio?

That's just our operating portfolio that you're looking at on that page. And I'd say pre-leasing and development is pretty normal. I mean we're on average between 40% and 45% pre-leased in our development portfolio. It's a combination of what's occurring in build-to-suits together with the status of spec leasing. You should understand -- I don't know if that sounds low at all, but 40% to 45% it's always historically in that level because the moment something gets leased, it's ejected from the pool, obviously. So we've seen that trending in a normal range as well.

And can you comment on the occupancy outlook in this more normalized demand environment?

Yes. So we have seen -- and we have guidance for vacancy that would build despite what I said earlier about as being pretty strong in the quarter so far, we've been bracing for a pickup in vacancy throughout the year even at the market level. And that's been a function of a large amount of under construction properties getting delivered into the market. We've talked about that imbalance over the course of the year. We said that could add about 50 basis points further vacancy into the market before we see a strong case for reversing that trend into '24. And that's because as we look at new starts, we have a page on this in our book as well, but starts and logistics are down significantly. They're down about 47% in the first half from '22 highs. We actually think that could get a little lower still in the balance of this year. And that's going to create this dearth of new supply coming into the market sort of at the back end of '24 and then into 2025. With starts being almost a bit higher, frankly, in the first half than we thought we would have had. We thought they would fall off a bit more than they did. But now we see more decline from here. I think that gives some real maybe longevity and maybe more significance to what that occupancy build could be towards the end of '24 and then even into '25. So I think on a pretty balanced and normalized, as you said, demand picture, that supply picture is looking pretty good for our fundamentals.

And can we -- just given that PLD is the only industrial REIT with a global view, would you be able to provide some color on the key themes that you're seeing in your regions, either similar or different?

Yes. I would say this is we're being much more diversified not just across the U.S., but globally has really shown up as a positive for the portfolio. So Europe, for example, is -- it has been better occupied than the U.S. for a while now. And that difference has continued. We're about 50 basis points better occupied in Europe than the U.S. today. That's a place where there has been good rent growth in Europe. There was some years there as cap rates were declining more significantly, I'm thinking about kind of an era 10 years ago, but cap rate compression in Europe was much more significant that serves to hold off market rent growth, but that's all kind of righted itself, and we've had a good period of market rent growth. Probably a year behind what we had seen in the U.S., but particularly in Central and Eastern Europe and Northern Europe as well. I don't know that we would have ever seen rent climb to the kind of levels and building up to the lease mark-to-market that we've now had in the United States. And then further, all of that has been interrupted with what has been this last year of elevated yields and discount rates. But still, market rent growth from here and very strong. Mexico is a big part of our story right now. Mexico is depending how you measure it, probably our best market at this moment. We have about 99% occupancy in our Mexico portfolio. And the phenomena on nearshoring is what's really shown up lately that was impacting our border markets there, but also I would add to it now Monterrey is benefiting greatly from -- you are all probably reading about expansions into that market. I think the market is 98.5% occupied and having very strong market rent growth as well. Value is also in Mexico on the rise. So that's been a very bright spot. It seems to me that the secular drivers across logistics that you all know well by now, just e-commerce, and I think there is a strong evidence that we're seeing resiliency build and resiliency will continue to build is playing out in all of our markets. It just happens in different phases and to a different degree, but they are long-term drivers of demand in every region that we operate.

So then can we narrow a bit down into the U.S.? SoCal has been an area of key investor concern. What are you seeing around rent affordability?

Well, one thing I'd highlight is the 73% rent change on signings in the first 2 months of the quarter that I referenced, the SoCal component of that was roughly 115% in that neighborhood. So it is -- we have to all remember for all of the SoCal discussion, it is a strong market, and there's a lot of cash flow sitting there for us to untap and very significant rent change that we've been achieving. It's our highest lease mark-to-market from here even with some of the softness that we would see. On your question on rent affordability, I speak to SoCal in this way. I think there are 3 or 4 circumstances that are fairly unique to SoCal that explain its softness. One is just kind of what you're referencing here, just the quantum of rent increase that, that market saw in the last 3 years. Rents of roughly 2.5x in our markets, what they were at the end of 2019, it just provides this headroom for certain actors who have different motivations, more bespoke circumstances, whether it's to a financing or following through on a development that they may not need that last $0.05 or $0.10 of rent. And they act differently than large owners of a portfolio who are incentivized to uphold rents across the market. So we're carefully balancing how we think about occupancy and rent change in that market. But everywhere that we're operating, we still are very much in preference for driving rent change everywhere that we can. The affordability issue is, I think, a cousin of that phenomenon, which is that some users have found for what they are doing, whether it's their entire operations or some component of their supply chain they may not need to be in Inland Empire West, one of the most expensive submarkets in the U.S. They can actually do that further East, as far east as Phoenix or maybe Vegas. So we have seen some demand, leave the market on that basis, and that's a function of just that overall, the rent is too high kind of issue. And then thirdly, just speaking to the circumstances in the market that are specific. Clearly, the port labor renegotiation of their contracts that went on probably a year longer than anybody had hoped was just recently settled and fully ratified by the union. I think it's a bit too late for this holiday season. So we're not going to see much of the impact of that here in '23. I would think, but by '24, some of the more normalized port volumes should return. We think about half of that volume will come back to the port of L.A. and that source of demand, both in the South Bay and Inland Empire should return. But broadly, the market just has to contend with all of those issues. The good news is that there is very limited new supply getting started in those few submarkets. And I think the outlook for new supply is also -- it's challenged everywhere that we operate. We see that. That's a good thing for us. And I think it's more pronounced in this broader market as well. So in the long term, after this kind of rights itself, and we're done being sideways on rents there, I think the growth thereafter will be strong.

Okay. So it doesn't sound like you really have a view that there are structural issues going on in LA.

Not like permanent ones. I think these are all issues that will be slowly worked through as people, I kind of call it use justify where they need to be. Do they need to be that close in to the port or can they be elsewhere? That will be a transition that will run ends and end, and then the supply picture similarly.

I'm just checking the floor. It's -- we're really filled up. We had to bring in extra chairs because the room is high interest. So in case anyone has any questions.

Question on development. Considering that the demand continues to be strong, growth continues to be somewhat, why is supply slow, not seeing in other areas [indiscernible] multifamily and storage. Why is it dropping at all?

I can't really -- do you want me to-- go ahead...

Just for the webcast, the question was, why is supply slowing?

Yes. And it's hard for me to probably contrast it against the other sector. So I'll just give you my read from a logistics point of view alone. I think -- and this is evident in our own behaviors, frankly, which if I take the last 6 months of 2022, and I remember being at this conference and the things were changing pretty rapidly in terms of how central banks were working, what discount rates were doing, us all starting to think about how values are going to be impacted in that period and the following 6 months, we're leading into, in our case, our budgets for '23, what is it that we want to start. We started new developments about $5 billion in 2022, and our guidance has us in the range of $2.5 billion to $3 billion this year. So people have asked why is that so much lower if things are so good. I think in that period, we were in the first part, trying to get our arms around the cost of capital and really understanding before committing to new development, what that cost was ultimately going to be and where returns were going to land. It seems by the first quarter, in my mind, the discount rate expansion in our property sector that we had seen, which I would characterize as about 150 basis points of expansion, had kind of completed. We haven't really seen IRRs move much off of mid 7s percent in a few quarters now. So that was good. Then I think we and others were just watching operating conditions to then see -- I mean, if you think about how frequent recession talk -- I mean, it still is, but was in the first quarter, we were all watching to see, well, how good our market's going to hold up. They've held up very well. We've lost very little occupancy in the markets. Rent growth has continued on putting SoCal to the site. And all those comments is -- hopefully, I've made my case that it's fairly bespoke conditions. And now I think that is manifesting. I think people see like, yes, operating conditions are strong. But now we come into the summer here where the Fed continues to ratchet rates. The 10-year has been not just high, but I would say volatile. I don't like either of those things, but I could at least deal with a 10-year treasury that stays put for more than 2 or 3 days. And that has people kind of on the sidelines and wondering when to move in, whether they're buying or starting new developments. Now why some of those factors might be different for an apartment guy, I couldn't say maybe their demand picture much better. I'm not positive on that. But we are not incentivized. We'll also get asked on the face of that, well, why don't you just start a bunch more. So for example, we have $38 billion of TEI of total expected investment in our owned land bank that we can go forward and build out. So we have a lot of projects we can go pursue and they will start coming through more naturally. I think our run rate of development in the third and fourth quarter, you will see tick up. I would expect that, that run rate will kind of sustain into 2024. So you might see a higher start year next year than this. It's not guidance yet, but that would be my personal guess. And we take each deal kind of one by one. We don't put out a mandate that says teams go find the next $0.5 billion or $1 billion in ratchet things up. They come organically from the teams because they are the ones who know best in a particular submarket or even a park, let's say, what new deliveries are going to be, what requirements are showing up to be and when the right time is to start new spec. I'll say one more thing, which is I think we've taken a view. You've heard this from us that writing a supply issue, to the extent we could on our own, which we couldn't, we're not that big. But that incentive is not really there in terms of the market being undersupplied is favorable to the other 1.2 billion square feet that we own and our ability to push rents kind of at a market level. So we have that in our thinking as well in terms of the urgency we look to in terms of starting more.

And just on that, could you update us on market rent growth year-to-date? And has anything changed for the outlook?

No, I'd say nothing has changed on the outlook. We have a range of 7% to 9% on a global basis. We adjusted that from a 9% view, so maybe down 1 point, if you take the midpoint of that range, you'll note we guided on one number. We've widened that out to a range. I think we're thinking a little more carefully about how to couch market rent growth potential. And I think you'll hear us talk in some small ranges. And also, I think what might be more useful than saying, well, what are rents going to be on December 31 of this year, which is in effect what we're doing when we talk about '23 rent growth may move into a mode of looking more at like the next 12 months, what do we foresee? I don't have that right now. But on the year, I think we'll hit our number.

Just given the context of new starts coming down, I guess what's your feel on pricing power like as we head forward. Do you see this as a potential tailwind with the lack of inventory or?

Yes. Yes, for sure. And it's not here yet because there's a lot under construction right now to finish off getting delivered and then absorbed. But yes, I think by the back half of '24, when you see strong -- reasonably strong demand, let's say, even that kind of environment, but with that dearth of new supply, we should regain some pricing power.

And maybe just touch on your expectations on peak re-leasing spreads within the portfolio?

Yes. So this year, I think we said on our last call, we expect rent change this year to be about 80%. If you look at our lease expiration schedule, interestingly, next year's expiring rent is a little bit below what remains in '23. That's a strange outcome driven by mix, but it's just something to look at, like, do we have much harder comps. And at least on that basis, you wouldn't see it. And then if you looked actually ahead to 2025 as well, you see that the expiring rents in '25 are only, I think, a few percentage points above '24. So there are some good comps out there to deal with in the next few years. The real answer to your question is when our peak spreads requires a view on market rent growth. from here, what is it from here? So you would have to take that into account to make that official call. But I think we said on our prior call, we expected that '24 could have stronger rent change than '23.

Is there enough pricing stability contributions into the funds?

There is. I think so. A good way to answer your question. I might take it a little bit different direction for a moment, but just is in our strategic capital business, we had in this quarter last year, a building amount of redemption requests in our open-ended vehicles. And if you followed our story, you know that over the last few quarters and since that date, we had said we were going to honor those redemptions. We now have, I'll speak to that in a moment. But we are going to wait for values to settle because we knew on September 30, the appraised values that were coming in, we're not going to be right. There's going to be a lag. We have seen this kind of sharp market adjustment before. And I just like -- I like highlighting that if we take the case of Europe, for example, we indeed had seen some big write-downs in Europe in the fourth quarter. These values look good. Now we think the right amount of new information has come into the market, and we proceeded on the European redemptions then in April, I think it was. And sure enough, European values were relatively flat over the second quarter. It seems they're going to be relatively flat here in the third quarter. So we kind of got that right. And then further, when we were announcing that we said, but the U.S. looks like it needs 1 more quarter, values had adjusted very significantly by March of '23. We said let's give that 1 more quarter. We had U.S. values move, I think it was 5% in the second quarter. I said, okay, these values are good to redeem upon carried out that redemption activity in July then. And sure enough, I think the third quarter U.S. values look relatively flat. So a very long answer to your question, but I think all that says we have demonstrated confidence in values from here that our willingness to sell is there. It takes a willing buyer on each of the funds. There's not a much put must take. Now it's just an issue of what is the capacity of any of the fund vehicles to buy and they are rebuilding their equity queues and capital for continued investment from here. That's for all the reasons I said about 10 minutes ago about people jumping in, that capital raising has been a little bit slower than we would have liked. But I see genuine interest out there from our investors to come further in, but probably a quarter behind what I would have thought it would be. But those contributions will resume. We had -- and I don't know the number right now, but it's some hundreds of million in the second quarter of contribution activity to two vehicles in Japan. We have our NPR vehicle, which is raising capital. Our Mexico vehicle and FIBRA raised capital. We also formed a new venture in Japan. So all of those vehicles took assets from Prologis in the second quarter. There will be a little bit more of that in the second half. So that engine is on just not kind of in full gear right now.

And can we touch on like while staying on the transaction market valuations. Recently, you completed that deal with Blackstone. You mentioned you can deliver an 8% unlevered IRR returns at a property level. What are some other returns that Prologis can generate from here?

Yes. So yes, 8% unlevered IRR. I would highlight, we tend to underwrite more conservatively than most. So I'll just as a side comment, say that would have a pretty high vacancy allowance, a pretty high kind of bad debt credit loss allowance, we would be careful about CapEx. We would expand the cap rate on exit. So there's a number of ways that I think we could easily outperform would be my expectation that 8%. But -- this was the first -- I've seen all of Prologis and AMB's major M&A deals at this point. This is the first one I've seen where not only are we bringing in no corporate overhead but there's no property related overhead that we're bringing in. It's a 14 million square foot portfolio. You might often have some property managers or some leasing people that need to come and help support that volume. By right of being a 100% hold portfolio into all existing markets and submarkets, there is enough scale for us to utilize that there's none of that personnel. So I just highlight that because there's property management revenues. It's not something we talk a lot about. It's nothing you probably really noticing on the P&L. But all that revenue will be generated reimbursed by customers. And there's actually no incremental expense going along with it. It all dropped to the bottom line, that is not in the 8% IRR. This portfolio as another example, I got to get this number, but either had 0 or 1 building had solar, it had essentially no solar on it. And that's a ripe opportunity for our Essentials team to now have 14 million more square feet to build out solar. That is not in the 8% IRR. So we looked at the deal very, very finely. I mean we've been clear, we don't think we stole it. We think we got a very fair pricing. We think the returns that you are hearing us say are understated in a few ways and don't account for everything we're going to be able to do. The other thing I would add, it doesn't account for would be we've talked about Duke and leasing performance on Duke. So we bought Duke last year now. And we measure what is our leasing spread performance to how we underwrote that portfolio. And we normalize that number for differences in market rent growth that have occurred. So we try to compartmentalize what are all the areas of the outperformance. And we see about 5 points of outperformance on leasing from that portfolio. Now there hasn't been a ton of leasing out of Duke just yet. It's been 9 or 10 months at this point. But that's something we experience and know and are working hard to measure. You never really know the counterfactual, but it's something that repeatedly comes through when we do these evaluations. And it's you have properties that are coming into Prologis clusters, we call them. These are dense areas of ownership of properties where the information flow is just very strong. And we know what the other availability is for customers. We know about their CapEx. We know what other requirements are coming into the markets. And I think it gives us a real upper hand in driving rents. So that kind of outperformance just plugged into the Prologis platform would also not be in the 8% IRR, I would say, and I would expect some outperformance there as well.

And can we get your thoughts on capital allocation and the balance sheet? Because with this deal, you also raised $2 billion in debt to finance the acquisition. So why choose that route and why not consider other sources of lower cost of capital?

Well, it's that or equity, let's say, and our equity cost cap is far too high right now. I think we're trading far away from where we should be. You won't be shocked to hear me say that, but that's not even in the calculus. But I think more importantly, we are under-levered from what I would call what might be more optimal for a company of our size and our rating. I would characterize us at about to 4.5x debt to EBITDA. I think we're about 20x on loan to value. I think we would be more optimally levered at something between 5% and 5.5% on debt-to-EBITDA, probably another 5 points on LTV. And we get that question from equity investors all the time, why don't you lever up a bit. So that was a logical mode for us to use and capitalizing this deal. But I'll highlight something else that just talks about at our scale and numbers, some non-obvious things I think, start to flow through. And one would be on the debt to EBITDA that I just told you about. I expect EBITDA growth ought to be something like 8% to 10% for some years running. When you think about the same-store levels, we think we can achieve and lever that a little bit with operational leverage. So that says, if you think about if you're a credit minded person thinking about credit ratios, the EBITDA side of that ratio is going to grow 10%. Well, then the debt side can grow 10% and the ratio would be unchanged. So that's actually kept it hard to lever up in these last several years where both EBITDA and valuation growth has been so significant. So I think it's very logical for us to continue to utilize the debt markets. We have a very good reputation and name in the fixed income markets. I'm grateful for that. We have tapped about 5 different currency markets in the last year. I think raised something on the order of $7 billion of unsecured debt. I don't want to say easily, but we've got a very good relationship with that investor base and have a lot more that we can do there.

We have time for probably one more question before we go into rapid fire. If anyone in the room has any? Okay. Maybe I'll go. As you evaluate the evolving nature of logistics, how do you think about the composition of the portfolio by unit size? Or do you have a greater or lower preference for infill versus big box?

Well, yes, I think unit size on its own, we probably don't think about by itself. Infill, we certainly favor. We like having a portfolio that serves everything that our customers tend to need. They need a broad range of space sizes and capabilities, and we like being able to offer that to an Amazon or a DHL or whomever it is. But we are certainly strong proponents of owning infill. That goes back to our founding and Hamid starting of this business 40 years ago that logistics was not only kind of the cheapest house on the block, but infill real estate was going to be destined to be something else in many cases, not all, but there would be higher and better use out there for logistics. And it's turned out that a lot of that property has not converted to anything other than logistics. But its our strongest rent growth property. It's probably some of our narliest-looking property. I've joked about that lately. We should show you some of the buildings we have in some of the very infill South San Francisco, Jersey, these kinds of markets. But the proximity that it has to the population base is in very high demand and is driving rents and values significantly.

Okay. Thank you. We'll now go over to our rapid fire questions. The first one on the Fed. Do you believe the Fed has done hiking, Yes or no?

No, sadly.

Do you expect the Fed to cut in '24? Yes or no?

Yes.

And then second, do you believe real estate transactions will meaningfully pick up by A, the fourth quarter of '23, B the first half of '24 or C, second half of '24?

I'll say first half of '24.

And third, are you using AI today to help you run your business, yes or no?

Yes, I think so. I don't think we called it AI 3 or 4 years ago as we started developing, I think, some pretty good revenue management and site location kind of tools. But I think on the way the term is being used these days, we're definitely AI users and think we can do much, much more. The amount of data we have on our platform is significant. That is the raw material for effective AI, obviously. And I think we will be -- we will stand apart on that basis.

Okay. So I can mark you down as a yes?

Yes. Did I qualify it too much?

Yes.

Thank you.

Thank you, everyone.