Good morning, and welcome to the EastGroup Properties first quarter 2019 earnings conference call. At this time, all participants are in a listen-only mode. Later, you will have the opportunity to ask questions during the question and answer session. You may register to ask a question at any time by pressing the star and one on your touch tone phone. Please note this call may be recorded. It is now my pleasure to turn the conference over to Marshall Loeb, President and CEO. Please go ahead.
Thank you. Good morning and thanks for calling in for our first quarter 2019 conference call. As always, we appreciate your interest. Brent Wood, our CFO, is also participating on the call, and since we'll make forward-looking statements, we ask that you listen to the following disclaimer.
The discussion today involves forward-looking statements. Please refer to the safe harbor language included in the company's news release announcing results for this quarter that describes certain risk factors and uncertainties that may impact the company's future results and may cause the actual results to differ materially from those projected. The content of this conference call contains time-sensitive information that's subject to the safe harbor statement included in the news release is accurate only as of the date of this call. The company has disclosed reconciliations of GAAP to non-GAAP measures in its quarterly supplemental information, which can be found on the company's website at www.eastgroup.net.
Thanks, Keena. Our team performed well this quarter, starting the year off with a strong tone. Some of the positive trends we saw were funds from operations coming in above guidance, achieving a 5.3% increase compared to first quarter last year. This marks 24 consecutive quarters of higher FFO per share as compared to the prior year quarter. Based on the quarter and the market strength, we further raised our annual FFO guidance by $0.05 a share. The vitality of the industrial market is further demonstrated through a number of metrics, such as another solid quarter of occupancy, strong same-store NOI results, and positive re-leasing spreads. As the statistics bear out, the current operating environment is allowing us to steadily increase rents and create value through ground-up development and value-add acquisitions. At quarter end, we were 97.7% leased and 96.9% occupied.
This marks 23 consecutive quarters where occupancy has been roughly 95% or better, truly a long-term trend. In short, demand continues growing for our infill location, shallow bay buildings. Several markets exceeded 98% leased. Houston, our largest market, was over 97% leased. While still our largest market, Houston has fallen from roughly 21% of NOI to slightly below 14% for 2019. Supply and specifically shallow bay industrial supply remains in check in our markets. In this cycle, the supply is predominantly institutionally controlled, and as a result, deliveries remain disciplined, and as a byproduct of the institutional control, it is largely focused on big box construction. Our same property NOI growth was 4.5% cash and 3.7% GAAP. We are also pleased with an average quarterly occupancy of 96.9%, up 60 basis points from first quarter 2018. Rent spreads continued their positive trend, rising 5.3% cash and 14.2% GAAP respectively.
Further, the quarterly results were materially impacted by a 125,000 sq ft Houston lease where the rents declined. Pulling that one lease out of our pool, our cash and GAAP numbers rise to 10.6% and 20.2% respectively. Given the intensely competitive and extensive acquisition market, we view our development program as an attractive risk-adjusted path to create value. We effectively manage development risk as the majority of our developments are additional phases within an existing park. The average investment for our shallow bay business distribution buildings is $12 million. While our threshold is 150 basis point projected investment return premium over market cap rates, we have been averaging 200 to 300 basis point premiums. At quarter end, the development pipeline projected return was 7.3%, whereas we estimate an upper fours market cap rate.
During the first quarter, we began construction on five buildings in five different cities totaling 650,000 sq ft. While coming out of the pipeline, we transferred three 100% leased projects totaling 421,000 sq ft into the portfolio with an average yield of 7.4%. At quarter end, our development pipeline consisted of 19 projects in 10 cities containing two and a half million sq ft with a projected cost of $230 million. For 2019, we are raising our projected starts to $160 million. As color commentary, the $148 million in starts we had last year were a record. We are excited to raise this year's forecast. As further color on our 2019 starts, we project starting over 70% of those by mid-year. As the year progresses, we will continue to revisit projected starts. Finally, our activity is spread over nine different cities.
This geographic diversity reduces risk while enhancing our ability to grow the development pipeline. First quarter was relatively quiet for acquisitions, but our pipeline was active. We are committed to acquire three separate off-market properties. We expect to close soon on a two-building, 142,000 sq ft new development at the DFW Airport , which is currently 19% leased for a total investment of $15 million. Next, we have a seven-acre site in the Miramar area of San Diego under contract for $13 million, which will accommodate 125,000 sq ft building. Finally, we are reacquiring two buildings totaling 142,000 sq ft in Phoenix. We sold the buildings to the Arizona Department of Transportation in 2016, but they were not torn down during freeway construction. As a result, we will reacquire the buildings for just over $9 million and invest an additional $2.6 million to redevelopment.
On the disposition side, we sold World Houston Five, a 51,000 sq ft building for $3.8 million in the first quarter. Brent will now review a variety of financial topics included in our 2019 guidance.
Good morning. We continue to experience positive results due to superior execution by our team in the field and the strong overall performance of our portfolio. FFO per share for the first quarter exceeded the upper end of our guidance range at $1.20 per share compared to first quarter 2018 of $1.14, an increase of 5.3%. As noted in the earnings release, we reported FFO of $1.16 per share during the first quarter of 2018. In connection with our adoption of the Nareit Funds From Operations white paper titled 2018 Restatement, we now exclude gains and losses on sales of non-operating real estate from FFO. For comparison purposes, we adjusted the prior year results to exclude the gain on a land sale and the gain on the sale of a partial interest in a private plane.
As tradition for EastGroup, we will continue our standard of reporting FFO as defined by Nareit. Our protracted strong performance, both operationally and in share price, has continued to allow us to strengthen our balance sheet. While this is demonstrated in metrics in the earnings release and supplemental information, what is less obvious and perhaps sometimes overlooked is the diversity in our revenue stream. Our 39.6 million sq ft operating portfolio consists of an average tenant size of 28,000 sq ft, and our average building size is 100,000 sq ft. Accordingly, 58% of our rental revenue is sourced from tenants smaller than 50,000 sq ft, and 84% of our rents are from tenants smaller than 100,000 sq ft. We're benefiting from both our tenant and geographic diversity, where we have a presence in 13 of the 15 fastest-growing metropolitan areas in the U.S., mitigating concentration risk for our shareholders.
Looking forward, FFO guidance for the second quarter of 2019 is estimated to be in the range of $1.17 to $1.21 per share and $4.84 to $4.94 for the year. Those midpoints represent an increase of 2.6% and 4.9% compared to the prior year restated respectively, and an increase of $0.05 per share in the midpoint of our guidance for the year. You may recall that in the second quarter of 2018, we had a $1.2 million involuntary conversion gain that is included in FFO. Excluding that gain, the midpoint of second quarter FFO guidance represents a 5.3% increase over the prior year. Our first quarter results, combined with the leasing assumptions that comprise updated guidance, produce an increase in both average occupancy for the year from 96.2% to 96.4%, and an increase in cash same-store NOI of 30 basis points to 3.8%-4.8%.
Other notable assumption guidance revisions include increasing development starts by $19 million, increasing value-add property acquisitions by $55 million, increasing termination fee income by $315,000 due to known upcoming fees, and increasing our estimated common stock issuance by $85 million as the direct result of finding more opportunities to invest capital. In summary, our financial metrics and operating results continue to be some of the best we have experienced, and we anticipate that momentum continuing throughout 2019. Marshall will make some final comments.
Thanks, Brent. Industrial property fundamentals are solid and continue improving in the vast majority of our markets. Based on the strength we're seeing, we continue investing in upgrading and geographically diversifying our portfolio. As we pursue opportunities, we're also committed to maintaining a strong, healthy balance sheet with improving metrics as demonstrated by the equity we've raised the past few years. We view this combination of pursuing opportunities while continually improving our balance sheet as an effective strategy to manage risk while capitalizing on the strong current operating environment. The mix of our team, our operating strategy, and our markets has us optimistic about our future. We'll now take your questions.
At this time, if you would like to ask a question, please press star and one on your touch-tone phone. You may withdraw yourself from the question queue at any time by pressing the pound key. Once again, to ask a question, please press star one now. We would also like to ask that you keep your questions to two questions per queue. We will pause a moment to allow questions to queue. Our first question comes from Jamie Feldman from BAML. Please go ahead.
Great. Thank you. Good morning.
Morning.
I was hoping you could talk a little bit more about the supply picture. We have seen stats showing it is creeping in in some markets. Can you just give more color around your building size and where you may be seeing some supply, and maybe what gives you some comfort that this can continue for some time where your product type's a little bit more protected than some of the others?
Yeah. Jamie, good morning. It's Marshall. Thanks. Good question. You'll see some large supply numbers, especially in the major markets. At least in our markets, we'll see it in Dallas, Atlanta, certainly Inland Empire. Then really what we do or have our teams do a good job of really digging into it. I would say long-term, if you said, what keeps you guys up at night, we would say finding good infill sites that we can get zoned industrial that we can develop into parks. We know how hard it is to find land for that next park. I'll give our team credit that they seem to keep coming up with the next site, but we struggle, and the brokers we work with struggle. A couple of stats to throw at you that'll kind of demonstrate it.
In Dallas, for example, these are CBRE stats that I'm quoting. There's 22.7 million square feet under construction, 10 buildings count for over 45% of that 22 million. Our average building size is 100,000 square feet. What we develop may get up to 120,000, 130,000 square feet. If you think of the depth of those buildings and our average tenant size being around 28,000, 30,000 feet, they just aren't configured that you could not divide even a 400,000 or 500,000 square foot building to accommodate that. I was surprised that only 10 buildings account for moving towards half of that supply in Dallas. In Atlanta, for example, the market's 6% vacant, but shallow bay and C I don't know CBRE's definition. It's probably a little bit larger than our average building.
It's only 3.7%. The vacancy rate drops pretty dramatically. In Atlanta, there's 19.3 million square feet under construction. Last year, they absorbed a little over 18 million. It's pretty much in parity, even in the big box. There's eight buildings that are over 900,000 square feet under construction. Both in Dallas and Atlanta, maybe those are extreme in terms of larger markets. Most of what's being delivered is big box. We seem to see that pattern, whether we're in Denver, Dallas, Atlanta, Houston, where our peers are. It's nice where our smaller size helps us. We're so much larger. For them, a Clarion, a Heitman, AEW, whoever to put the capital out there, they need to go to the edge of town and build a 600,000-foot building. By design, our tenants can't make those spaces work.
They can't get the loading doors. The buildings are too deep. Hopefully, that answers your question.
Yeah, that's great. That's helpful. I guess for Brent, just moving to the guidance. You lowered your bad debt expense outlook by $100,000, and you increased your termination fees. Can you just talk about the moving pieces and then maybe also just address your credit watch list and anything we might need to think about here?
Sure, Jamie. On term fees, we did up guidance $315,000. That's primarily being driven by one known large second quarter termination fee of $525,000. It's a 50,000 sq ft space in Tampa. The company was closing their North American location. We were able to negotiate what we felt was an attractive termination fee. It represented just in excess of 16 months of rent, and we feel confident in backfilling the space timely. We felt like net-net would come out ahead. That was the primary single driver. There wasn't any kind of rash of people wanting out of their spaces per se. It was just really driven by that one particular transaction. Bad debt, we continue to be very pleased. First quarter, just $129,000, which was about $100,000 less than we had budgeted.
Just looking at our AR, the good news is just a potpourri of just miscellaneous here and there, pretty standard items. Last time we reported, Mattress Firm had affirmed the bulk of all their leases with us. They remain current. We've had no issue there. Bad debt, AR, term fees, all of that, it feels good. This early into the year, it feels good.
Okay.
I'll add to that. Jamie, I'll give you and Josh credit. You had pulled a report together showing tenant concentration, and happy to see our top 10 tenants have drifted down. We were 8.3% at the end of the year. We're 8.1% this quarter. Our largest customers, some of them are in multiple locations, multiple buildings, is, I believe, per your report, it's the lowest concentration within the industrial sector. Even when I look through our top 10 tenants, there's a couple of things going on where I think that percentage is One, if the company grows, and then specifically within those tenants, where that number should keep drifting down the next two to three quarters.
All right. Thanks. Keep promoting our research. We appreciate it.
Yeah. You're welcome.
Our next question comes from Alexander Goldfarb with Sandler O'Neill. Please go ahead.
Good morning. Just a few questions for you guys. On the guidance, Marshall, you guys on the fourth quarter call granted the year ended definitely at a low point as far as the capital markets were concerned. You guys still spoke about your portfolio being strong and tenant demand healthy. Yet, pretty strong improvement in the guidance from the initial, just a few months ago to now. Is this just that you guys were just too overly cautious, when you laid out your initial numbers, or has something really fundamentally changed in the portfolio operations that's led to this improvement? It doesn't sound like it's anything really one time, apart from that penny of lease term. It sounds like it's just core operations driving it, which $0.05 jump this early in the year.
Look, it bodes well for shareholders, but it seems pretty dramatic, in just a few months' time.
A fair question, and my answer is, which was it, is almost a yes, in that it was a little bit of both, in that we were pleasantly surprised. This was a record quarter for us to average 96.9% occupied. Last year, we averaged company-wide 96.1%, and typically we would say a building's full at 95%. Our occupancy surprised us to the upside. I don't think we were overly. We did see a little bit of a pause in the world within our tenants. Not all of them, but a fair number, especially the larger the tenant, probably the more they hit the pause button.
A little bit, it's hard to tell over the holidays, but a little bit, the world was pretty nervous in December and probably the first half of January, and that feels now like it was two years ago, that the tenant demand has picked back up and people seem to have kind of moving beyond that time with the government shutdown and trade wars and things like that. I think, it's our job to. We kid about being paranoidly optimistic. We were worried about where things were going to head back in January and a little bit cautious, although things were still moving, and then they have improved since then. I don't like to think we weren't overly cautious based on what we heard.
Really in the economy, things feel better than they did a couple of years ago based on everything we read, and certainly even more so what we see on the ground.
Alex, this is Brent. I would just add to that, you mentioned moving that much early in the year. I would contend that moving early in the year by a fair amount is a little easier to do. I mean, we beat by $0.02, then we raised by an additional $0.03, which at this time of the year, basically essentially comes out to about $0.01 a quarter. As you get later in the year, obviously, it's harder to move that delta as much. As Marshall said, the good news, and to your point, it's no one-time items.
It's being driven by property net operating income, and especially, I just want to point out from our development pipeline, not included in same-store, all the developments that have rolled in since January 1 of 2018, those properties are contributing more and faster, than we're guiding to quarterly. They continue to outperform, which we'll take that as long as it can happen.
Okay. Brent, that leads me to the second. Part of that $0.05 total increase, you guys also increased your ATM activity for increased investments. Maybe you could just provide a little bit more color on the acquisition yields. Then two, given how quickly you were able to match, whether it's chicken and the egg, whether it's better ATM, so hey guys, go out and get more acquisitions, or hey, we have acquisitions if we have better ATM, whichever. It sounds like between the acquisition front and the fact that Marshall, I think you said 70% of the starts are going to be by mid-year. It sounds like investment activity in the back half of the year could ramp up even more, which I'm guessing would benefit on the earnings front, given that you wouldn't do one without the other.
maybe you can just talk a little bit about the interplay between the cost of the ATM versus the cost and the accretion of the acquisitions.
Yeah, then let Marshall talk more specific about the assets. I would be clear to say that acquisitions are driving our capital at being at 21%. We ended the quarter at debt-to-total market cap. We obviously have a very strong balance sheet, so we're not issuing an effort to continue to lower that. As we said at last call, we'll be a little more conscious of trying to line up ATM issuance with opportunity. Opportunity will drive what we do or don't do on the ATM, and that's assuming that the price is there and we like it. Right now, we view it as readily available.
Let Marshall touch on it, as long as each, whether it's development, value add or an acquisition, as long as they stand on their own merit and make good, what we feel like are good long-term sense, we certainly are apt to do it.
Thanks, Brent. Really in terms of color, probably two buckets. We feel some visibility on the $50 million in acquisitions this year, although that's the hardest bucket to fill given the competition, and everybody's got a checkbook, so we really aren't different from the other bidders. Feel more comfortable today on that front than we would have, say, 60, 90 days ago at our last call. Then the value add, we like long term. There are better benefits for 2020 than 2019. Kind of just walking through them, the two Interstate Commons buildings that we're buying back in Phoenix, we had a four-building complex. We knew that Arizona DOT was going to acquire them, so we kind of stopped spending money for obviously a couple of years before they acquired them. It's been a couple of years since they've had them.
Those will take a little bit to redevelop and re-lease. We like it long term, and we think we'll be just north of a 7 in terms of once it's redeveloped. A development type yield on a value add. There in DFW, they're brand-new buildings, 18%, 19% leased with good activity. By the time we get the leases signed, the TI is done, and the tenant's in. That's in the high 6s type yield. The San Diego land that we disclosed, what I like about it's right just east, if you know San Diego, of the 805 freeway, in Miramar. We're just north of Miramar Naval Air Station. It's a former car lot, it's really a better lot than we typically see for industrial land. It's really a last-mile location. Right on the other side of the 805 is La Jolla.
If you want to get products delivered quickly into La Jolla, we think it's a great site. The only downside, the biggest problem is I wish it was a bigger site. We have a ground lease on it, we'll get a return until they decide when their lease expires, really, and then we'll develop it. We like all three acquisitions. It'll just take a minute before we can really get them stabilized and in the portfolio. It's probably more 2020, Brent will raise the capital for us to close this year.
Okay. Thank you.
Sure. You're welcome.
Our next question comes from John Guinee with Stifel. Please go ahead.
Great. Thanks. Hey, just sort of curiosity questions. I'll off, then you could address them. I noticed somewhere that you bought a property with a 40-year ground lease, which seems a little bit unusual. Can you talk about maybe some options you have on that ground lease at the end of the 40th year? Second, in your infill development strategy, how often are you actually buying greenfield dirt versus second-generation development where an existing asset's being demolished? And then third, when you're leasing up your development, how much of the lease-up is basically moving existing tenants of yours into a new building, and how much is filling up those buildings with new non-EastGroup tenants?
Thanks. I'll try to answer those, Brent chime in.
Is that all, John? Is that all you have?
Tell me when I'm
That was just one question.
On the ground lease, fair observation, good observation. If you've studied DFW, I think the number's 18,000 acres that that airport has. Their typical lease is a 40-year ground lease. There's all types of industrial. It's really a who's who in terms of national developers that are there on those ground leases, as well as hotel, retail, office. The first, we have, call it, 39 years left on our 40-year ground lease. Some of the older ones, there'll be precedent set well before we roll and go back into DFW to renew. We looked at it in terms of pricing, kind of maybe walking you through the weeds. If it were fee simple and it is right at the exit, just off one of the tarmacs at DFW, it's probably a four and three-quarters yield and in the market.
In talking to some of the brokers, probably 50 basis point premium to go from fee simple to a ground lease. That's probably around a five and a quarter. As we underwrote market rents and carry and things like that, we're six and a half to seven type yield. We feel like we're getting paid for the premium of the ground lease there. It really ties into your second question. Most of what we're looking at is, as I mentioned earlier, we struggle to find good sites. We'd rather it be fee simple, there's simply nothing left at the airport. In talking to our guys, the good problem they had, they have one vacancy in our Dallas portfolio and tenants that wanted to expand.
Buying these buildings at DFW, we'd prefer them to be fee simple, but we like this location, especially given the prominence of DFW Airport over the next 40 years and how that continues to grow. Most of what we build is still greenfield, but all of it seems to have a story where we're relocating someone or like Churchill Downs, it was semi green. We tore the stables down in Miami, and we do things. We're looking at a site in Texas that a church would relocate off of, or here, a ground lease. We kind of apologized to our investment committee. We promised we're not trying to make things complicated, but infill sites get harder and harder to find, and we'll certainly do more and more redevelopment.
What's nice about having the parks, where I'd probably call it moving towards 50% of our development leasing, is we have someone in, I'll pick Charlotte, in Steel Creek 3, and they need more space. They'll either do an early renewal and expansion in Steel Creek 9, or we'll relocate them if they really want to be in one location into the new building. That's part of our pitch in the market to tenants. If you're in World Houston or Steel Creek or Kyrene, we can accommodate your growth. Every tenant usually probably overestimates. Most people are optimists how much they're gonna grow. We like that ability when it's midterm of someone's lease, because then they can't move down the street, that we can accommodate your growth and fill up our parks.
It's probably approaching half of our development leasing as the economy's good and tenants are expanding. The good news about a good economy, the spaces we're getting back are typically below market. They'll be vacant a little bit, but typically, the leases are a couple of three years old, and so those are below market. We get an early at-bat to go backfill those spaces as well.
Great. Thank you.
Sure. You're welcome.
Our next question comes from Ki Bin Kim with SunTrust. Please go ahead.
Thanks. Your tenant retention ratio dropped a little bit this quarter. It's just one quarter in a long history of really high retention, but anything noteworthy there?
This is Brent. Yeah, Ki Bin, we had a tenant in California, one of our larger tenants, that sublet 135,000 square feet to three tenants. Their lease still runs for a number of years. Basically, those subtenants, we sign leases with them to then lease behind that tenant out into the future. Just trying to stick to the way we've, quote, "always done things," we thought the fairest way to treat that, we basically treated that square footage during the quarter as a, quote, "non-renewal," which technically, it won't be at that point. It will not be renewable. We've leased the space behind that. I would definitely call the quarter a little bit That skewed the retention percentage. Again, just in being comparison-friendly to how we've handled that type situation in the past, we treated it the same.
I think you'll definitely see that click back upward, in absence of not having another anomaly like that.
Is there any, maybe besides this quarter, any kind of discernible trends on why tenants choose not to renew?
Usually, if we can't renew them, I think the biggest problem that we run into in some cases is we don't have the space for them, and they're growing. I would think that. Typically, we average over time around 70% or a little over 70%, it's kind of our historical average. In Tampa where we had the termination, it was a European company, and their business model just did not work in the U.S. They closed. A bankruptcy, or probably what we see more and more is they're growing, and we try to have that next development ready, but if we don't have the space, that's probably our biggest reason right now, is not able to accommodate growth. That said, I still think by the end of the year, we'll average 70% or low 70s tenant retention.
Some high-class problems.
Knock on wood, I hope so yes.
All right. Thank you.
Thank you.
Our next question comes from Manny Korchman with Citi. Please go ahead.
Hey, guys, it's Jill Schleicher here with Manny. Marshall, given your earlier comments on the oversupply in the Atlanta market and also with the same-store results in the quarter, have your perceptions of that market or desire to grow in that market changed?
In Atlanta, Jill? I'm sorry. Is that your thing?
Yes, Atlanta.
Okay, yeah. We like Atlanta, and we'd like to grow there. In the last week, have hired someone at the vice president level. It's a backfill of a spot, but they'll be based in Atlanta. John Coleman, our regional, moved to Atlanta. We like the market a lot with our product type being under 4% vacant. As I mentioned, there's over, I guess if it helps, 19 million square feet under construction, but absorption last year was over 18 million square feet. The market is Dallas and Atlanta are a little bit, and you'll read the supply, and it kind of takes your breath away, but then you look at the absorption over the last few years, and what's being delivered keeps getting absorbed.
Thankfully, where the numbers get a little bit shocking, it is because of those 600,000 sq ft buildings and up that most of our peers gravitate to. We're pursuing growth, but trying to be disciplined in Atlanta, and we just came in second, unfortunately, on a building in the last week, trying to acquire it. We'll kind of keep picking our battles and trying to stay disciplined, but we like the market long-term, and it's right in our backyard and kind of identified that, call it 10:00 to 2:00 on the map right now. We're kind of 12:00 to 2:00. What they call the Golden Triangle of Atlanta seems to be a good fit for our type building and where the path of growth is also in Atlanta up north in terms of higher-end residential. Hopefully that's helpful.
Okay, great. Any interest in looking at bigger acquisitions or maybe bigger portfolios, just given the way your stock price is trading?
We look at those. Yes, interest. Usually we'll kid, the bigger the portfolio and the better the sales package, the more intense the competition is. It just gets priced to perfection, really, where our acquisitions, we'll look maybe 2 to 4 years in the future and not a 10-year ARGUS run like a lot of our peers. That typically no one underwrites a downturn in years 5 through 7 type thing. We try to not go too far out there and assume too much in terms of rent growth. Maybe as a result of that, it makes it awfully hard. We like them. We certainly have picked up the value-add acquisitions this quarter. We like those as almost a shadow development pipeline in terms of getting a good, attractive return and managing the risk for our shareholders.
We feel more comfortable in our acquisition assumptions, we'll stay at it. It's hard. In Atlanta, there was a package we looked at in the last year, and we were one of 24, 25 bids in the initial round, If you're the winner of it's hard to believe you're the winner of it almost. Time will tell. It'll take a few years on just how competitive the wall of global capital for industrial, as the brokers talk about, is real, and we lose a lot of bids each month on those. We'll keep trying, and I hope we can surprise you with one at some point.
Great. Thanks, Marshall.
Okay. You're welcome.
Our next question comes from Craig Mailman with KeyBanc Capital. Please go ahead.
Hey. Good morning, guys. Marshall, just maybe follow up on your competition talk. You guys, it sounds like the yields on some of these value-add plays is pretty close to development without the construction risk. Can you just talk about what the competition was for these and how you sourced them?
Good question. Each of these was off-market, in no particular order. In Dallas, our guys there called on the developer. It's a local regional developer and kind of developed a relationship, and I think it was going on a year before he agreed to sell that. Again, I think we like the yield there. We need to get it leased, but we have good activity. Interstate Commons in Phoenix was an anomaly a little bit, in that we had sold the buildings to ADOT and had a right to repurchase if they didn't tear them down. The freeway work is done, so our visibility and access is even better, and thankfully, they didn't tear our buildings down in the process. There we had a right to repurchase at appraised value. Again, off-market there.
The Miramar land, it's a little bit the same. It's a 20-year relationship that we've had with a group out of Southern California, based in L.A., and they had tied up this land thinking it was a friends and family deal, and we cajoled them a little bit into letting us participate in it and doing a 95/5 JV. We're excited about the site, and it's turning over a lot of stones to maybe find a small deal here or there, but hopefully they add up over the course of the year for us. When it goes to market, we'll bid on it, but it's awfully hard to be the winning bidder in that case.
It's really driving around in a car with a broker, and they'll say, "If you lob in an offer on this seller may be willing to sell." All of them are long shots, but that's almost a better path to buy things for us or find value adds than to wait and get the email blast that everybody gets.
That's helpful. Unlike the DFW deal, it sounds like the developer's got sort of a construction fee. Is there anything on the back end that they try to negotiate with you?
Thankfully, not on that. On those, a lot of times, and I don't know on this case, I know who the developer is, but I don't know how his financing's arranged. Usually, they've got a financial partner, and we'll get you into your IRR promote, and you can go down the road and build your next building, which is really what they typically want to do. They'll make some money and take some chips off the table, and he'll probably move on to his next development. No promote down the road for him. He was doing the leasing in-house, which is good for him, but we like having a third-party broker that's really fully focused on leasing. We think hopefully we can pick up some leasing velocity by stepping in.
He did a nice job finding the site and designing the buildings, and hopefully, we'll take the back half of it from here.
That's helpful. Just separately, you guys have a little bit of a different product mix than some of your peers have. I'm just curious. We all know demand is good, you guys have had sort of a presence in some of your legacy EastGroup markets for a long time. How have your guys on the ground seen the demand composition change? Has there been a change, or is it sort of evolving as e-commerce and those type of tenants evolve?
We would say, Brent, chime in. Our traditional tenants are still there, and typically almost all of them, it's about 1,500, 1,600 tenants doing well, and kind of, if you almost call it old economy. The floor supply guy, the granite tile, the HVAC contractor, different industries like that, all want to be closer to their customer, and they typically are doing well. As that evolves, also in our legacy markets, the traffic gets worse in Tampa and in Dallas and in Houston. We'll see then, like in Dallas, that's what we liked about Fort Worth, is you may need Goodman HVAC, who is a tenant in Dallas, also needed a facility in Fort Worth because you could spend all day in traffic, and when your air conditioner's out in Dallas in July, you want someone there immediately. We see a little bit of that evolution.
Each quarter, there's more and more e-commerce tenants. People change their model, like Lowe's is a tenant we've worked with recently, the retailer where no one drives home with a washer, dryer, or refrigerator, but they've leased a couple of spaces from us as they roll out their strategy. You buy it in the store or buy it online, and it gets delivered from an EastGroup facility, and that's been a new change. Some e-commerce, some just people closing physical brick and mortar, and we're lower rents, but if it's lower rents and close to the consumer, we can be that last touch and get it to your house fairly quickly.
The only thing I would add to that, Craig, is a lot of it is dictated on tenant psychology. I think across the board in all our markets, the tenant psychology, how they feel about their business and overall economy is good. Anytime you have that kind of underlying the current is a positive. Also, I think we have enough depth and activity in most of our markets where there's competition for spaces. I always equate this a lot to residential because people relate to that better. If you're looking at a home and there's very little activity, you don't feel that pressure to get that offer out very quickly. If you're looking at a residential market where it goes on market, if you don't put the offer in in 24 hours, it's going to be gone.
There is that sense of urgency, which are all signs of a landlord market, but there is that bit more sense of urgency in our markets too, which all that adds up. Like Marshall said, with the varying type tenants that are out there, it's all stacking up to just be solid, deep activity.
Helpful. Thanks, guys.
Sure.
Our next question comes from Jason Green with Evercore. Please go ahead.
Good morning. Given a good portion of the guidance increase is due to better than expected impact from development, is there any additional upside to that development impact for fiscal year 2019? Is everything, more or less baked into guidance at this point?
I hope. I guess I'll preface it by saying I'm an optimist, but we did move it this quarter by, call it the $19 million, and 70%, a little north of that are starts in the first half of the year. We have our development starts and really our leasing. What I love about our model is rather than at corporate, we decide, hey, we're going to go build an 800,000-foot building south of Atlanta or on the southwest side of Phoenix. It's really almost like a retail store where they're out of inventory, and we deliver the next building to put on the shelf. We keep a shadow development pipeline, and that's still a pretty good material size out there.
I'm hopeful there could be upside to our $160 million, although I'm also, talking to the guys in the field, appreciative that $160 million would be a record this year in terms of starts for us. We used to say $100 million in starts and have worked our way up to $140 million and $160 million. We'll push it as much as the market allows us to, and Brent and the team have done a nice job of de-leveraging the balance sheet, which I like having a more, as we stretch on some operational risk in a good market, let's also keep our balance sheet almost as a hedge, safer and safer. With luck, I'd love to bump the $160 million up another one of these quarters and have that news for you, and it'll really depend on what our tenants want to do.
I would just add to that, Jason, we are a little more back-end weighted in the year with our FFO growth, especially third and fourth quarters. That is being driven pretty heavily by what we're factoring in for developments and value add. When I say developments and value add, I'm talking about properties that have been added into the portfolio since 1/1/18 and onwards. They're not same-store properties, outside of same-store increase. We have a fair factor in first quarter. I think we have about $3.3 million of property net operating income from that development pot, and we're looking by fourth quarter of that growing to $5.7 million. It is playing a large and significant role, and we're counting on it continuing to push through the rest of the year.
All right, thank you. Maybe we could just touch on development costs and how those are impacting your yields, and how development costs have been trending over the last 12 months.
Good question, we think rents will keep following. I guess as an aside, it's easy to say, if we pull the one lease out in Houston, we would've had record GAAP re-leasing spreads at over 20%. You're seeing a tight market and construction costs, rising construction costs push rents, we feel like. Concrete prices, steel prices have gone up, and then underlying all that, it's a good economy, all of the GCs and all of the subs are busy, and we've even heard stories of competition at one of our sites trying to hire the workers away during construction. Just the labor shortage is also pushing rents up. It's probably moved. Our yields are 7.3%, 7.4%. I think what we're doing, from memory, what we rolled into the portfolio was a 7.4%. What's in the portfolio is a 7.3%.
Miami's a little bit lower yield, but lower cap rate, so it should come down, but those probably would've been about a 7.5% two years ago. It's just construction prices continue to creep up in a good economy. That's certainly something we watch and talk about a fair amount.
Okay. Thank you.
Sure.
Our next question comes from Bill Crow with Raymond James. Please go ahead.
Thanks. Good morning, Marshall. I'm just curious, with your infill portfolio, are you seeing increased demand from grocers? That's one of the retail areas that seems to be growing, and what is your thought about getting into at least partially, if not fully, refrigerated space on new developments?
Good question. We've read about that. That certainly seems to be the trend where things are going. I know there's even a cold storage REIT that's come public, what, in the last year and change. Brent chime in because he's had direct experience with it. We like keeping our buildings fairly generic, that when you get into that freezer cooler space, sometimes you can have issues. One, the equipment gets dated fairly quickly. Then sometimes too, it can damage the slab and some issues like that. Some of the tenants are also startups. We steered away from a startup in the Bay Area just because the TIs were heavy. It was an online grocery delivery, and just thought in a tight market we had better options, and thinking about if something happened and the next tenant down the road.
We may be missing it, and it seems to be a growing area, but we really haven't pursued it or focused on it because I like having about $0.40 per square foot per year of TI when our tenants move out, is what our average is. Brent, you've lived with it too. You've had a bad experience or two on that.
Yeah. I think, Bill, and good morning. The challenge with freezer cooler space, as Marshall said, ideally, you know on the front end going into it, that's what you're building for because there's design specific things you would do to
Protect your slab, protect your subslab, meaning the dirt underneath the concrete to keep it from not freezing and then unfreezing and then structural issues. There would be some commitment of TI or building specific improvements that you would ideally want to do on the front end, and then your very small percentage chance for us that we would lease to an actual grocer, then you've sunk that money into the building, and it doesn't actually get utilized. In a build-to-suit situation, we would definitely be a little deeper, and you'd want plenty of term, you could design it more specifically. On a day in, day out basis, it's just not something prevalent enough that we've seen to warrant changing and taking on that additional capital risk on the front end.
Within your markets, you're not seeing Publix or Kroger clamoring to get direct-to-consumer space or anything like that?
Delivery from the store where you click it online, pull up, and they bring it out and pick it up. Certainly that, but we've not seen a lot of grocers yet out in the market. It's something that's been tried for a long time. We signed a lease with a group called groceryworks.com back in 2000, about 18 years ago.
Yep.
That didn't work at that time. Here we are 18 years later, and still people are trying to figure out how to make groceries online work. It'll get there in some of the heavy metropolitan areas, really densely populated, but I don't see that in the near term being a big catalyst to industrial lease up, not traditional space.
I guess I've seen Walmart out looking, and again, if we could do dry goods, we certainly would. A good question. I've read more about it than we've seen it in terms of people clamoring, whether, as you say, Publix, Kroger, H-E-B in Texas, people like that, we just haven't seen it.
One last one for me, and this may be premature, but certainly, there's talk in California about the Proposition 13 changes. Have you done a preliminary assessment of what that might mean to you?
Thankfully, we've owned some buildings for a fair amount of time in California, so we would have some tax jumps. Everything, almost all of our leases, knock on wood, not 100%, but the high 90% are going to be triple net.
Yeah
pass it through, and all of our peers would have it, I guess, depending on how recently they acquired their building. It could hinder rental rate growth in California. In short term, it would have minimal effect, because we pass it through to our tenants, and it would be an impact on them. It would be when those leases roll, our ability to push those rents to market, that everything's, knock on wood, generally well below market in California, if it's just a few years old, and some of that may end up being CAM rather than rent, was what would happen under Prop 13.
We're watching it and have read about it, and just know there'll be I can't imagine, Irvine Company, Watson Land, Carson Land, there'll be some huge players that get involved in the lobbying for this that would be pretty heavily impacted, I would imagine, in how this plays out.
Yep. Okay. Thanks. That's it for me. Appreciate it.
Bill.
Our next question comes from Eric Frankel with Green Street Advisors. Please go ahead.
Thank you. Can we just talk about Houston and that big lease roll-down? Obviously, fundamentals in the market are better there, but there seems to be a fair amount of supply in the market. I'm just wondering if that lease roll was an anomaly.
Fair question, Goodman. An anomaly in the sense that it was a single tenant. I guess what rolled in Houston, kind of the details of it was a single tenant, pre-leased or build-to-suit, 125,000 foot lease up at World Houston. That tenant, it was about a quarter office within the 125,000 feet, and a fair amount of that was 50/50 mezzanine office. Second story office. That tenant also had, as a 3PL, they were able to use an outside yard storage. They consolidated, moved out during the downturn. We sat on the space for a couple of years with it vacant, then decided, this is a little bit of a unique animal. We had a similar situation in Phoenix a couple of years ago, where you end up with a building, I'll tie it to freezer cooler.
When a building becomes pretty specific for a tenant's use, it makes it harder to re-lease it. After a 10-year lease with annual bumps, it sat there vacant, we decided to stretch and just make the deal we could. Without that, again, our GAAP numbers would've been, as a company, just over 20%. Even in Houston, our GAAP re-leasing spreads would've been 19%. We can't pick and choose our metrics, obviously, and we're not doing that. If it helps you, out of 84 of the 85 leases we signed this quarter, all looked, you kind of nod your head and nod along. Here, we had a pretty tenant-specific building that rolled, sat vacant for a while, we finally just said, "All right." My fingerprints are on the gun, whether we should have done it or not.
Let's just take the tenant in hand. I'm partially guilty, too. Brent's giving me a look. My fingerprints are on it of, "Let's do this deal and move on." Brent's only defense has been, "Hey, I wasn't there to do the renewal as well. I would've gotten a better rate." It was his original deal. Calder, Brent, did I cover it?
Yeah, I think that covers it. I think the bigger point is that the 19% gap is what it would've been absent that one lease. Talking to the guys in the field, we do think that's a one-off situation, not a, we've got four more of these coming over the next couple of quarters. Fully expect that to bump back up. We'll just point out, too, that pulled Texas down, and just again, without that one lease
Would go from 3% to 16% as a GAAP increase, which is really where we've been as a run rate as a company for the past, well, we were there 2017, 2018. Really minus that lease, we're slightly better than that first quarter 2019.
I'll throw back a couple other just kind of Houston stats I was glancing at, that the overall market's 5.4% vacant. The north market, where our World Houston Park is 6.2 at the end of first quarter, which is the lowest it's been since 2012. We were encouraged by that. Then Houston's a little bit of an anomaly market for us as well. The rents in the north market are pretty much back to peak. Usually, when we say that, people would refer to the downturn. In North Houston, they're back to where they were in 2015. As Brent said, we think this was an anomaly. It's glad to see the market recover back to where we were in 2015. That was a much more recent downturn than the balance of our markets.
Okay. I appreciate the additional color. Just a follow-up question on external growth and acquisitions and asset pricing. I think you've alluded to a pretty competitive environment, but maybe you could quantify where you think stabilized cap rates have trended for some of the markets you're targeting. Are cap rates down 10, 20, 30 basis points since, say, six months ago?
Yeah. I would say broad brush, kind of the major markets is kind of what we hear and see, L.A., Dallas, Atlanta, maybe Miami. They're high threes maybe to four. You can get prices per square foot that are pushing $150, $200 per square foot. Land at approaching $60 a square foot in L.A., and in San Diego in the $40s, or we've seen a $70 per square foot land comp in San Diego. These are all industrial sites. What we've heard, again, I'll quote CBRE. They said they've been predicting cap rates would compress into secondary markets, meaning a Charlotte, Denver, Phoenix, Tampa, those type markets. Last year, they did compress there. That now you're in the five to five and a half in most of those markets.
It is a long laundry list of international capital that we've seen coming into U.S. industrial. We've been the favorite asset class. Brent and I met with HFF recently, their comment was there's a bid-ask spread in about every product type right now. That there's more dry powder on the sidelines than they've ever, kind of as they measure, kept track of. There's a bid-ask spread in all product types but for industrial. That there's such demand, it's the most efficient product when they bring properties to market.
That's interesting. Thanks. Just, sorry, one quick follow-up question. It's related to, I guess, the grocery question that was mentioned earlier. Are tenants investing at all more in sort of equipment handling budgets just to move product more quickly through your facility? More robotics? Is there more just general automation that's occurring in some of the new leases that have been signed?
I would say generally, yes. Usually, the larger the tenant and probably the better capitalized the company. Certainly, like we have FedEx in a number of locations. They're cutting edge on that. Tenants do that. Certainly, all of them are doing it a little more. It's just a matter of what their product is and how fast and what their balance sheet looks like. We think with the labor shortage, I think it will keep trending that way, and they'll get more efficient in how they're moving product through the warehouse. Again, we think we're early on smaller spaces closer to the consumer so they can get that quick delivery.
Okay. Thank you.
Sure.
Our next question comes from Rich Anderson with SMBC Nikko. Please go ahead.
Thanks. Good morning. Hey, Brent, did you mention the rise in the G&A guidance from a couple of months ago in your prepared remarks? I don't think I heard it, but if you didn't, I'd love to know what the nature of it is.
Yeah. Rich, good to speak with you. Good to hear you. Yeah. G&A was up a bit, and a little bit of it's comp and restricted stock oriented, but there is some component of it that relates to a South Florida lawsuit that we've been involved with. That was discussed in the notes to the 10-K. It will be discussed very summarily in the 10-Q that'll be out in the next day or two. We incurred, I think, $320,000 of that cost related to defending ourselves in that suit, which we feel is without merit, but yet you have to defend yourself. We have some costs dialed in into the year to deal with that. There are a few moving pieces up and down, but I would say that was the new piece that primarily drove the increase that you see there in the guidance.
Okay. Good enough. For Marshall or anyone, I'd like to sort of ask a question about risk management. There's nothing wrong with your balance sheet, of course, but you're increasing your development spend. You're going after value-add acquisitions and given the demand that's out there for your product. What are you looking for to not go forward, but just take a step backwards? You're getting 2 to 300 basis point premium spreads versus acquisitions and development. If that number starts trending down, is that a sort of a foreshadow to maybe we got to take our foot off the accelerator, or is it maybe the spread between leased and occupancy, which is only 80 basis points now? What are some of the things that you're looking for to manage, not this year, but two or three years from now?
Good. Fair question, you're right. Usually, we'll target Our internal rule of thumb is 150 basis point premium-
Right
when we do a development over market cap rates. Again, thankfully, we've been north of that. Typically, when we do our underwriting, we'll use the yields we project on current market rents. We won't put an inflation factor on rents, albeit we've benefited from those over the past few years. If that number gets closer to 150, we certainly would take our foot off the accelerator. Or I like as our model worked where I compared us to retail earlier, if we're delivering buildings and they're not leasing up, and during the downturn in Houston, we were able to stop development. I'll give our model credit for working.
Same time in Phoenix, a couple of years ago, we had vacancy within our portfolio and in some new developments, we really stopped development and really stopped looking at acquisitions, until we caught up and digested what was on our plate. We've done a little bit, we're about there in Atlanta, even more recently, we had added some value add product in Atlanta, had vacancy, there we've said, "All right, let's finish and catch up to what our own internal supply is in that market before we really pursue new acquisitions or new land sites." We try to almost market by market, if what's on the shelves isn't moving, we won't add to the shelves there, unless it's in a compelling reason.
If we've developed vacancy, I don't want to go to our investment committee and say, "The third or fourth vacant building's the charm. Let us build another one." We'll really get our first buildings leased up then go back to committee. When things are good, I view it, if we can build to those yields, we'll try to make hay while the sun shines, where it's been the last couple of years, keep a safe balance sheet, because when things do slow down, they may slow down quickly. I like that we're trying to be more geographically diversified in case it slows down in one market and not another. Just watch each development.
Knock on wood, our last, what, 16 developments that we've started, we'll miss one or two here probably coming up, have all rolled into the portfolio. We'll roll them in the earlier of when they get 90% leased or one year past completion. Our last 16 have all rolled in at 100%, which that's an anomaly, that to me feels like, okay, the market's telling you to keep doing that, keep creating that value for our shareholder until you see it start to slip, then we'll play defense again.
All right. Fair enough. Just one comment. If you're making churches move to accommodate your industrial buildings, I'd perhaps not walking outside during a lightning storm. That's all I have. Thank you.
Very much. Bless you. Thank you.
It does appear that there are no further questions over the phone at this time.
Thank you. Thanks everyone for your time. Appreciate your interest in EastGroup, and we're certainly available for any follow-up questions you may have. Take care.
This does conclude today's program. Thank you for your participation. You may disconnect at any time.