Earnings Call: Q2 2025

Oct 16, 2024

Summary

Strategy combines asset sales, indirect investment and buybacks to address sub-NAV pricing and a high cost of capital. FY2025 forecast total payout on equity is 8.2%, with rent growth and near-full warehouse occupancy supporting earnings.

Thank you very much for taking time out of your busy schedule today to participate in the financial results briefing for our 17th fiscal period ending August 31, 2024. In the J-REIT market, especially of the logistics REITs, the share price performance has continued to be difficult as in the previous fiscal period, and we recognize that we are expected to continue executing strategies for the share price to rise as the level has been cut down further in October. Since last October, LLR has been implementing a strategy of continuously disposing assets each fiscal year and allocating the proceeds to shareholder returns and indirect investments. In line with this strategy, yesterday we announced another disposition and our upgraded shareholder return program. The concept behind this strategy, which we have been executing for the past year, is based on the gap in the current capital market environment, including the cost of capital for public and private market, and the need to improve balance sheet management and capital efficiency. In the first part of this presentation, I will explain the basis of our strategy that we have been implementing for the past year. That is, we have systematically summarized our understanding of and efforts to manage our business with an awareness of the cost of capital and stock prices. After that, I will explain specific highlights of the financial results. Recently, listed companies are required to further management concept and initiative toward maximizing shareholder return with a focus on capital efficiency enhancement, as stated in the Tokyo Stock Exchange's request. We recognize that not only corporates, but also listed REITs are expected to maximize shareholder value by the investors. Please see page 4. Here, as part of our analysis of the current situation, we discuss our understanding of the cost of capital and market valuation of LLR. Three indicators, the implied cap rate, price to NAV, and dividend yield are visualized in a conceptual balance sheet diagram and trends over the past 2 years. For listed REITs, the implied cap rate is an effective direct measure of the cost of capital, and LLR is currently at 4.4%. In contrast, on the asset side of the balance sheet, the NOI yield based on the appraisal value of real estate is 3.9%, indicating that the real estate value and enterprise value has inverted for quite a long time. In other words, the cost of capital for the disposition of assets is lower than issuing new shares. Price to NAV is also consistently below 1 times. The market value of our assets are not factored into the current share price, and in order to close the 10% gap, we are expected to realize this gain through disposition of assets for shareholder return. In the case of LLR, the dividend yield, which is the expected return from the shareholder's perspective, has remained high at the 5% level, as the increased dividend from the gain on the disposition of the asset was not fully incorporated into the share price. This implies that this is a level LLR is required for capital earnings, and we recognize that our future investments will require even higher return. This was the analysis of our current situation. The next section on page 5 summarizes the basic concept of LLR's approach to earnings on capital based on our cost of capital and stock market valuation analysis under the current environment. In general, ROE is a common indicator for corporates, but considering the characteristics of REITs, we added a concept of total payout ratio in addition to ROE. REITs must distribute all of our profits, and for LLR, the dividend payout ratio exceeds 100% because of its constant excess earnings distribution. In addition, the dividend payout ratio is more than 100% in the case of LLR. Therefore, we believe it is appropriate to consider shareholder return as well as profit. Furthermore, since we are conducting a buyback program earlier this year, we are including not only the dividend return, but also the concept of total return. Based on this, the two components of the numerator of ROE are FFO, the so-called cash flow from rental income, and gain on disposition of assets. In other words, it is like EBITDA after interest. Since this is the dividend resource for REITs, it is also applied to the denominator of the total payout ratio, and the numerator is the sum of the total dividend and the amount of share buybacks. In terms of the balance sheet, as shown in the figure on the right, funds from the disposition of assets, depreciation, and gains on the disposition of assets all go to shareholder return. Since adding total payout ratio to ROE measures how much shareholder return is made to shareholders' equity, we have defined total payout on equity as an indicator of LLR's return on capital. See page 6. The following is a summary of our efforts over the past year to improve our return on capital, along with specific figures. We believe that there are three ways to improve our return on capital. We have separated the three into left and right columns to make it easier to understand the relationship between our efforts and the results on the balance sheet. On the left, on the asset side, a total of approximately JPY 30 billion in asset dispositions will be done over five fiscal years. This is equivalent to approximately 7% of total assets. In order to improve income, the funds from the disposition of the assets will be used for indirect investments that have higher return than directly acquiring on LLR balance sheet, which currently is approximately JPY 7 billion total. Estimated investment return of more than 8%. Realized gains through the disposition of assets totaled JPY 6 billion over five fiscal periods, which is equivalent to 7% of the total unrealized gains of the entire portfolio, or approximately JPY 89 billion. On the right side, on the capital side, LLR is implementing large-scale and continuous share buyback and changes to its dividend policy in order to improve capital efficiency and shareholder return. The buyback period has been extended for a year, until next October. We believe that the key to creating shareholder value under the current market environment is to allocate funds from left to right on the balance sheet, as shown by the red arrow. Flexibly changing the direction of this arrow, depending on the environment of the capital market and real estate markets, is the right way of conducting management concept and initiative towards maximizing shareholder return with a focus on capital efficiency enhancement, considering the characteristics of listed J-REITs. At the end of chapter one, on page seven, we reiterate our investment strategy, which we have presented since the last announcement. We hope you will understand that our analysis of the current situation, our approach to capital earnings, and our efforts to date, as explained in the previous pages, are in line with this strategy that we presented in the last announcement. Under the current environment, LLR will continue with this strategy. We will focus on internal growth and asset trading, ALM-based financial strategies, an increased shareholder return price band, and off-balance-sheet economic expansion through the use of strategic capital. We will now move on to the explanation of the operational highlights of the current financial results, starting on page nine. As usual, I have summarized them in five points, but I have covered the first point in the previous explanation, so I will discuss the second and subsequent points. We have now announced our third property replacement transaction. LOGIPORT Kawagoe will be disposed of in two parts, in the August 2025 and February 2026 fiscal periods, with gains on the sale to be recorded in each of the two fiscal years. Also, the subject of this exchange is a 15% interest in LOGIPORT Kawasaki Bay, which is not on LLR's balance sheet, and we plan to make an indirect investment in this property at the time of settlement next year. Third, we have recently adopted a new resolution regarding the share buyback. The total amount of buyback will be doubled to JPY 12 billion, up to 4.6% of the total number of investment units issued and outstanding, and the period will be extended for one year, until October of next year. Regarding the fourth point, strengthening shareholder return policy, we have changed our distribution policy in a manner that is also related to share buyback. If the current environment continues, we will aim for a total payout on equity of 8% as our target for earnings on capital. Regarding the fifth point, internal growth and financial strategy, we will continue to manage our properties based on ALM in preparation for an inflationary environment. We achieved strong internal growth again this fiscal period, and in particular, we achieved strong rent increase offers in the three LOGIPORT Higashi Ogishima properties. Please see page 10. The total amount of the disposition, including the newly announced transaction, is JPY 30.5 billion, which is equivalent to about 7% of the total assets. This represents approximately 7% of our total assets. We continue to consider the remaining 50% of LOGIPORT Nagareyama B as a candidate property for disposition and are continuing discussions with the quasi co-owners. If this disposition were to be realized, the cumulative total amount of sales would amount to JPY 48 billion, equivalent to 12% of the total portfolio value, which would be relatively large among logistics REITs. Realized unrealized gains amounted to JPY 6 billion through the third installment, which is equivalent to 7% of the total unrealized gains. The FFO payout ratio is expected to remain in the upper 80% range for the next five fiscal years, which we believe is also one of the highest among logistics REITs. We hope you are reminded of the continuity of our strategy since last October and the magnitude of the disposition. See page 11. While LLR positions the sale of properties as a means of raising funds, this page shows our approach to capital allocation and how we will allocate the funds from the disposition of properties up to the third sale. In conclusion, our main policy is to allocate the JPY 30.5 billion of the total disposition in a 2-to-1 ratio between new investments and shareholder return. The blue area shows new investments. The total amount of property acquisitions and indirect investments announced so far is JPY 6.8 billion, and the share buyback is JPY 8.0 billion, including the JPY 6.0 billion resolved in April this year and the JPY 2.0 billion increased this time for investment purposes, and we will allocate JPY 5.7 billion for future indirect investment opportunities. The green portion represents shareholder return, which is approximately one-third of the total amount of JPY 10.0 billion, consisting of JPY 6.0 billion in total profit from the disposition, plus a JPY 4.0 billion limit on share buyback for the purpose of return. The potential cash position could expand to about JPY 60 billion, taking into account the fixed amount of JPY 30.5 billion, JPY 11.9 billion in standby funds from cash flow during the period, and potential future dispositions of properties. Therefore, it can be said that we have secured a source of funds that does not depend on the capital market for some time to come. See page 12. Before explaining yesterday's newly announced share buyback, we are reviewing how effective the share buyback announced in April of this year has been over the past six months. One of the characteristics of LLR's share buyback program was to clearly state in advance that it would purchase shares at or below a certain share price level, with the goal of investing at an attractive share price and absorbing any temporary deterioration in supply and demand. From an attractive investment perspective, the average buyback price of 1,548 shares acquired through the end of September was JPY 142,002, which is 0.86 times the net asset value per unit announced yesterday. In terms of implied cap rate, this is 4.4%, or the equivalent of acquiring LLR's own portfolio at that price, which is about 40 basis points undervalued compared to the implied cap rate at one times NAV. In terms of absorbing the temporary selling pressure, if you look at the graph on the right side, here is a comparison of LLR and other logistics REIT weighted average NAV multiples since April 15th, and you can see that it has outperformed the sub-sector on many days. The number of days that the buyback period remained above 0.9 times, the buyback period's purchase threshold, amounted to approximately 75% of the period and averaged 0.035 times NAV multiple over all logistics REITs, which we interpret as creating a value of just under JPY 5,700 per day in terms of LLR's share price. On the other hand, since the number of units actually purchased was only 1,548 units or 0.08% of the total, the actual effect of improving distribution per unit was limited, and some may argue that the size of the purchase was small and had little impact. When we initially devised this purchase method, we envisioned that the purchase would have the effect of a put option, whereby a decline in the share price would result in an increase in the distribution per unit. The inverse proportion between the share price movement during the period and the size of the purchase was, to a certain extent, as expected. In addition, since we have a policy of continuity in share buyback, we are considering reallocating any unused funds that are not repurchased to the next round of share buyback. We believe that one of the benefits of introducing a conditional share buyback program is the ability to extend the share buyback while awaiting a full recovery in share prices. See page 13. Based on an examination of the effectiveness of the share buyback program to date, LLR now expanded its share buyback program. First, the buyback amount was doubled from JPY 6 billion to JPY 12 billion. The maximum number of shares to be bought back was also doubled to 4.6% of the total number of buyback shares. In addition, the buyback period has been extended for one year to October 14th, just prior to the scheduled announcement of next year's financial results, which is expected to have a long-lasting effect. For the purchase price line, we set one boundary, i.e., the NAV multiple of 0.9 times as the purchase price line in the previous section. This time we set two boundaries, one for each purpose. This way, two price bands are formed, as depicted on this page. Expressed by analogy to the Earth's atmosphere, we define the investment price band as investment price band. Because the stock price is considered as the altitude and the band where the altitude is less than 0.9 times NAV multiple exists as an investment objective at the same attractive stock price level as before. The new band is higher than the investment price band between 0.9 times and 1 times NAV multiple, and is defined as a shareholder return price band, where there is a high probability that a purchase will be made at the current share price level. In other words, a band for the purpose of shareholder return. As explained earlier in the capital allocation policy, based on the policy of a two-to-one ratio of investment to return, the maximum amount in the investment price band has been increased to a maximum of JPY 8 billion, while the maximum amount in the shareholder return price band has been set at JPY 4 billion. This is due in part to the fact that the amount is sloped in order to increase shareholder value by purchasing more shares when the share price is lower, and also to the fact that there are differences in the purchase method. See page 14. At the beginning of this document, I explained that LLR has adopted the concept of total return as a way to enhance its earnings on capital, following the example of corporates. Total return is a concept that takes into account both dividends and share buybacks. In the share buyback I explained earlier, the size of the buyback may vary depending on the share price. This is due to the characteristics of share buyback by REITs. In other words, the amount of buyback share may fluctuate and the total return may not remain constant. In order to reduce this instability, LLR recently amended its management guidelines to specify shareholder return as the purpose of implementing temporary excess earnings distributions. Accordingly, the distribution policy has now been changed. In a nutshell, the plan is to buy back shares for the purpose of shareholder return. If not all JPY 4 billion of shareholder return price band are not used, it will be distributed to investors as a temporary excess earnings distribution. Specifically, using the figures for the fiscal year ending August 31, 2025, if the maximum purchase of JPY 2.0 billion is made in a half year out of the maximum JPY 4.0 billion return band, the maximum amount of JPY 450 million will be added to the temporary excess earnings distribution for the current period to maintain the total return to the maximum extent possible. For example, even if the amount of buyback shares for the current period is only JPY 1.55 billion, JPY 450 million will be added to the temporary excess earnings distribution, so the total return will be maintained at JPY 2 billion. In addition, LLR pays out approximately JPY 450 million in recurring excess earnings distributions each fiscal period. So the maximum total return will be JPY 2.45 billion. The forecasted net income for August 2025 is JPY 6.42 billion plus JPY 2.45 billion in total payout ratio, or JPY 8.87 billion, which is 112% of the forecasted FFO of JPY 7.93 billion. Then multiplying the projected ROE of 7.3% for the current year by the total payout ratio of 112% yields an estimated total payout on equity of 8.2%. By continuing to provide total return to shareholders, in addition to internal growth of owned properties and disposition of properties, LLR will continue to operate with the goal of 8% total payout on equity as its capital earnings target, as long as the cost of capital remains high and the NAV multiple remains below one times as it is now. See page 15. So far, we have been talking about returns, but let me shift the topic to the investment side. The left-hand side shows the current property sizes of sidecar funds, stabilized asset SPVs or development SPVs, and the sponsor development pipeline, all of which have indirect investments under the concept of off-balance-sheet AUM growth strategy. The total amount of indirect investments, including equity participation in the three upper rows, is equivalent to approximately JPY 124.0 billion. Although the sponsor development pipeline currently has a size of approximately JPY 200 billion, in light of LLR's current strategy, the main scenario for acquisition in the immediate future is indirect investment through SPVs, including equity participation. Indirect investment, to repeat from the previous period, is a structure that is expected to generate higher earnings than direct acquisition of properties, and in an environment where the cost of capital remains at a high level, it is expected to improve portfolio earnings. At the same time, from a risk management perspective, there is no change from the previous period in our current investment limit of approximately 5% of total asset size. The current target is to achieve an assumed investment return of approximately 8% above the current level. One point that should be added is regarding the unrealized profit margin of the properties held by stabilized asset SPV. LLR has been pursuing property exchange transactions rather than simple property dispositions. One advantage of exchange transactions is that they are relative transactions. We basically select properties that offer downside protection and cash flow and value or potential upside in the future in order to suit the structure of indirect investment. In measuring this, we will tell you that there is a buffer of about 10% when converted to an appraisal-like fair market value for the acquisition price. This is of the same nature as one of the excess earnings of the excess return strategy that we have been advocating since 2018. Page 16 reiterates the overview of LRF3, an important fund for maintaining flexibility in the investment corporation's external growth strategy. There is no change from the previous period, and we would like to reiterate that we continue to have a buying capacity of approximately JPY 100 billion and a total investment period of five years. Page 17 is also a reiteration of the last announcement, but there is a total pipeline of approximately JPY 220 billion outside of the sidecar fund. In the previous fiscal year, construction was completed on LOGIPORT Tama Mizuho, LOGIPORT Fukuoka Kasuya, and the Matsudo Matsuhidai Logistics Center, which is operated by a development SPV with an external business partner. In addition, construction of the Sendai project is progressing smoothly, and the amount of the second investment payment, which was press-released on September 27th, is less than originally planned. The impact of the steep rise in construction costs is minimal, and in fact, progress is below budget. Please see page 18. Portfolio occupancy rates and contract renewal status are described, along with the assumptions used in the earnings forecast. First, as for the occupancy rate of the portfolio, the warehouse section continues to be almost fully occupied. The assumptions used in the earnings forecast are also normal conservative assumptions based on informally agreed rents, and there is no specific tenant departure or vacancy risk that would affect earnings. The rent increase/decrease rate for the entire portfolio, including the Higashi Ogishima leasehold parcel, is expected to be +4.4% in the 17th fiscal period, in line with the previous period's forecast, and +7.2% and +9.2% in the current and next fiscal periods, respectively, for the parcels that have been informally decided upon. The rate of pre-lease rate is also progressing well ahead of the historical average, with 95% of offers already made for the current term and 72% for the next term. The following is a breakdown of the 19 fixed lease properties and three Higashi Ogishima properties in the forecasted second fiscal period. +6.8% rent change for fixed lease properties in the current period and +9.7% for Higashi Ogishima, all in fixed lease sections. In the next fiscal year, we were able to substantially increase rents by 6.8% for fixed lease properties and 24.9% for Higashi Ogishima. The figures for Higashi Ogishima are attributable to the fact that rents on approximately 1,700 tsubo of Japanese traditional lease parcels, where rents had remained almost unchanged since listing, were raised to market rents at a stroke. As for the LOGIPORT Higashi Ogishima A, B, C building, it accounts for about 20% of the total leased floor space in the portfolio, of which fixed lease and Japanese traditional lease account for about half, but it has the potential to contribute to future internal growth, although it varies from fiscal period to fiscal period, which is one of the characteristics of LLR's portfolio. See page 19. We have been analyzing ALM, or the overall management of assets and liabilities, since the last quarter. For 6 months, we have rolled over both ladders and updated our estimates on the impact of growth rates from the top line to the bottom line. On the asset side, based on the lease maturity ladder, approximately 40% of the portfolio will continue to be due for contract renewal, or in the case of Japanese traditional leases, for renewal within the next 2 years, although the number is exceptionally low for the August 2025 period. On the debt side, based on the debt maturity ladder, the number of maturities coming due within 2 years has increased from the previous period, and the equivalent of about 24% will be covered in the future. A simplified analysis of the earning structure over the next 2 years estimates an annual earnings growth of approximately 1%-2% in the range of 5%-10% rent growth. In contrast, we estimate that a 30-60 basis points increase in debt costs at refinancing would result in a range of 0.7%-3.0% annual growth on a net income basis. At the lower end of the range, there is a possibility of a slight slowdown in the growth rate of net income relative to the 1% growth rate of rental revenues. We believe it is important to control debt costs closely as a financial strategy on the debt side of ALM, such as refinancing with some short-term maturities while maintaining diversification in the maturity ladder. We believe it is important to control the cost of debt finally, for example, by refinancing a portion of the debt with a shorter term while maintaining diversification of the maturity ladder. See page 20, Financial Strategy Policy. What the ALM analysis just described suggests is that it is appropriate for us to think of our financial strategy in a rising interest rate environment as one that supports internal growth, not one that is tied to external growth, such as borrowing capacity. As for LTV, as the name implies, we are considering monitoring mainly an index that reflects the market value of the real estate based on the appraisal value. The LTV ratio is currently at a healthy level of approximately 35%, and we intend to maintain this level for the time being. In the event that the loan-to-value ratio is expected to increase significantly in the future due to property dispositions or share buyback, we will consider capital allocation with the aim of reducing the LTV. As we said in the ALM analysis for debt maturity, we will consider partially shortening the debt maturity based on interest rate hedge costs so as not to impede internal growth. Given the recent rise in short-term interest rates, we intend to maintain approximately 90% of our fixed-rate debt as long-term debt. Although there is a balance with interest rate hedge costs, if we were to procure floating-rate debt, we would procure it as a bridge loan and make it permanent when long-term interest rates stabilize. Finally, ESG topics are listed on page 21. This is the fifth consecutive year that we have received a five-star rating from the GRESB, which is released every October, and the eighth consecutive year that we have received a Green Star rating. In addition, LLR was recently selected for inclusion in the FTSE4Good index, which is linked to several financial instruments focused on sustainable investment in recognition of its ESG-related efforts. I understand that there are still only a few J-REITs that are included in this index. With regard to ESG initiatives, LLR will continue to work with the sponsor's global sustainability team to prioritize initiatives that contribute to improving investment performance and will give priority to improving the energy efficiency of the portfolio and on-site renewable energy generation in line with the energy hierarchy. Power generation will continue to be a priority. That concludes the explanation of the financial results. Thank you very much for your attention.