The industrial REIT analyst at the Bank of America U.S. Research Team. I'm also joined here by fellow colleague, Sarah Cooper, who is Global Sales, as well as Andrew Byun, Andrew Berger, and Dan Byun. We're excited to kick off the next roundtable session with Prologis. Representing the company is Tim Arndt, CFO. We just ask for just to kick off each session with a quick overview 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, so the first couple of months, we have occupancy relatively flat to the end of the second quarter. We're 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 three- to six-month lag between signing a lease and it commencing in 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 two months of the third quarter, it was 73%. I'm underlining that to emphasize that is all a mix. That is not some view that rents have come in by that delta. It's just we 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.
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's probably getting sick of hearing, I'm sick of saying normalization, but it's really, you know, 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 are not 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.
I would say quarters and quarters are going by of 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: Well, yeah, but are we going to drive past normal? And we haven't seen that. Things have really stuck into that, that historically strong range.
But if we look at one of those charts in that update, you put out a slide on leasing status, which shows activity is tracking above 2019 levels. 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.
Okay.
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. That's a combination of what's occurring in build-to-suits, together with the status of of spec leasing. You should understand, you know, I don't know if that sounds low at all, but 40%-45% is always historically in that level, because the moment something gets leased, it, it's ejected from the pool, obviously. So we've seen that trending in a normal range as well.
Can you comment on the occupancy outlook in this more normalized demand environment?
Yeah, so we have seen... We have guidance for vacancy that would build. Despite what I said earlier about us 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 2024. 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 2022 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 2024 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 2024 and then even into 2025.
So I think on a pretty balanced and normalized, as you said, demand picture, that supply picture is looking pretty good for our fundamentals.
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?
Yeah, I would say that this is where 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, you know, all of that has been interrupted with, you know, what has been this last year of elevated yields and discount rates. But still, market rent grows 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, you know, 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 that market's 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's, it just happens in different phases and to different degree, but they are long-term drivers of demand, in every region that we operate.
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 two months of the quarter that I referenced. The SoCal component of that was roughly 115%, in that neighborhood. So it is a strong market. We have to all remember, for all of the SoCal discussion, it is a strong market, and there is 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, you know, I speak to SoCal in this way.
I think there are three or four 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 three years. Rents 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 five or ten cents of rent, and they act differently than large owners of a portfolio who are incentivized to uphold rents across a 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, you know, 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 gonna see much of the impact of that here in 2023, I would think. But by 2024, some of the more normalized port volume 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 in the Inland Empire, should return. But you know, 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 L.A.?
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 and end, and then the supply picture, similarly.
I'm just checking the floor. It's. We really filled up. We had to bring in extra chairs because the room is high interest, so in case anyone has any questions.
I have a question on development. Considering that the demand continues to be strong-
Mm-hmm.
Rent growth continues to be solid, why is supply slowing? You're not necessarily seeing in other areas, and I know office isn't like retail, but, you know, we're still seeing supply in multifamily and storage. Why is it dropping off in industrial?
I can't really... Oh, do you want me to-- Go ahead.
Yeah. Just for the webcast, the question was, why is supply slowing?
Yeah, and it, it's hard for me to probably contrast it against the other sectors, 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 six months of 2022, and I remember being at this conference, and 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 were going to be impacted. In that period, in that following six months, we're leading into, in our case, you know, our budgets for 2023, what is it that we want to start?
You know, we started new developments about $5 billion in 2022, and our guidance has us in a range of $2.5 billion-$3 billion this year. So, you know, 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 our arms around the cost of capital and really understanding before committing to new development, what 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 the mid-7s percent in a few quarters now, so that was good. Then I think we and others were, you know, 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 are markets going to hold up? They've held up very well. We've lost very little occupancy in the markets. Rent growth has continued. I'm putting SoCal to the side, and all those comments is, hopefully, I've made my case that it's fairly bespoke conditions. And now I think that is manifested.
I think people see, like, yeah, operating conditions are strong, but now we come into the summer here, where the Fed continues to ratchet rates. The ten-year has been not just high, but I would say volatile. You know, I don't like either of those things, but I could at least deal with a ten-year treasury that stays put for more than two or three days. And that has people kind of sitting 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 is that much better. I'm not positive on that. But we are not incentivized.
We'll also get asked, well, in 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, you know, 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. That'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 $500 million or $1 billion and 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 a new spec. I'll say one more thing, which is, I think we've taken a view, you've heard this from us, that, you know, righting a supply issue to the extent we could on our own, which we couldn't, we're not, we're not that big.
But that incentive is not really there in terms of, you know, the market being undersupplied is favorable to the other 1.2 billion sq ft that we own and our ability to push, 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.
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%-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 gonna be on December thirty-first of this year?" Which is, in effect, what we're doing when we talk about 2023 rent growth may move into a mode of looking more at, like, the next 12 months. What do we foresee?
Don't have that right now, but on the year, I think we'll, we'll hit our number.
But 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?
Yeah, yeah, for sure. And it's, 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 2024, when you see, you know, 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.
Maybe just touch on your expectations on peak re-leasing spreads within the portfolio?
Yeah. So this year, we, I think we said in 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 2023. That's a strange, 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 2025 are only, I think, a few percentage points above 2024. So, there's some good comps out there to deal with in the next few years.
The real answer to your question is when are peak spreads requires, you know, a view on market rent growth. That's from here. What, what is it from here? So you, you would have to take that into, into account to, to make that official call. But, I think we said in our prior call, we, we expected that 2024 could have stronger, rent change than, than 2023.
Is there enough pricing stability to contribute to the contributions into the bond spread?
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, you know that over the last few quarters and since that date, we had said we are gonna honor those redemptions. We now have. I'll speak to that in a moment. But we are gonna wait for values to settle because we knew on, September thirtieth, the appraised values that were coming in were not gonna be right. There's going to be a lag. We have seen this kind of, you know, sharp market adjustment before.
And, I just like, I, 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 and the first quarter. At the end of the first quarter, we said, "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, in April, I think it was. And, sure enough, European values were relatively flat over the second quarter. Seems they're gonna 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 one more quarter." Values hadn't adjusted very significantly by, by March of 2023.
We said, "Let's give that one more quarter." We had U.S. values move, I think it was 5% in the second quarter. 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, you know, we have demonstrated confidence in values from here, that our willingness to sell is there. It takes the willing buyer on each of the funds. There's not a must 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, and capital for continued investment from here.
That's for all the reasons I said about ten 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. I would highlight that Prologis is executing on contribution activity regardless. We had, and I don't know the number right now, but it's hundreds of millions 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.
Can we touch on, like, while staying on the transaction market and valuations, recently, you completed that deal with Blackstone, and you mentioned you can deliver an 8% unlevered IRR returns at a property level?
Mm-hmm.
What are some other returns that Prologis can generate from here?
Yeah, so yeah, 8% unlevered IRR, I would highlight, we tend to underwrite more conservatively than most. So just as a side comment, say, you know, 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. You know, it's a 14 million sq ft 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, something you're 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 sq ft to build out, build out solar. That is not in the 8% IRR. So, we looked at the deal very, very fondly. 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 today are understated in a few ways and don't account for everything that we're going to be able to do. The other thing I would add, it doesn't account for would be we, we've talked about Duke and leasing performance on Duke. So we bought Duke last year now, and we measure, well, what is our leasing spread performance to how we underwrote that portfolio?
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 five 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, 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.
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. 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 of capital is far, 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 underleveraged 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 4.5x debt to EBITDA. I think we're about 20 times 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.
We get that question from equity investors all the time. "Why don't you lever up a bit?" So that, you know, that was a logical mode for us to use in capitalizing this deal. But I'll highlight something else that just talks about, you know, 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. You know, I expect EBITDA growth ought to be something like 8%-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, you know, 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, you know, we've got a very good relationship with, 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. 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, yeah, 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's starting of this business 40 years ago, that logistics was not only kind of the cheapest house on the block, but you know, 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.
It's turned out that a lot of that property has not converted to anything other than logistics, but it's our strongest rent growth property. It's probably some of our gnarliest 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 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. First one on the Fed: Do you believe the Fed is done hiking, yes or no?
No, sadly.
Do you expect the Fed to cut in 2024, yes or no?
Yes.
And then second, do you believe real estate transactions will meaningfully pick up by, A, the fourth quarter of 2023, B, first half of 2024, or C, second half of 2024?
Hmm. I'll say first half of 2024.
Third, are you using AI today to help you run your business, yes or no?
Yeah, I think so. I don't think we called it AI three or four 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 stand apart on that basis.
Okay, so I can mark you down as a yes.
Yes. Did I qualify it too much? Yeah.
Thank you.
Yeah. Okay. Thank you.
Thank you, everyone.